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SMITH A O CORP

2019-02-15

2018-12-31

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas and electric water heaters, boilers, tanks and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our Rest of World segment also manufactures and markets in-home air purification products in China. In our North America segment, we project our sales in the U.S. will grow in 2019 compared to 2018 due to higher residential water heater and boiler volumes resulting from expected industry-wide new construction growth and expansion of replacement demand. We expect the North America commercial water heater industry to be flat in 2019, after declining over five percent in 2018 following growth of 11 percent in 2017, partially due to an anticipated regulatory change. Our sales of boilers grew nine percent in 2018, and we expect ten percent sales growth in 2019, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. We continued to expand our North America water treatment platform in 2018 by being named exclusive supplier of water treatment products to Lowe’s, with sales commencing in August 2018. We expect sales of North America water treatment products to increase by 35 to 40 percent in 2019, compared to 2018, primarily due to volume growth and a full year of sales to Lowe’s. In our Rest of World segment, we expect China sales to decline in 2019 at a rate of between seven and 10 percent in U.S. dollars and three to six percent in local currency, as we believe the Chinese economy will continue to be weak and the Chinese currency will depreciate compared to the U.S. dollar by approximately four percent in 2019 compared with 2018. In addition, we expect our sales in India to grow over 30 percent in 2019 from approximately $34 million in 2018. Combining all of these factors, we expect our consolidated sales to grow one to 2.5 percent and between 2.5 to four percent in local currency terms in 2019. Our stated acquisition strategy includes a number of our water-related strategic initiatives. We will seek to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our introduction of water treatment products in India and Vietnam and air purification products in China in 2015. RESULTS OF OPERATIONS Our sales in 2018 were a Company record $3,188 million surpassing 2017 sales of $2,997 million by 6.4 percent. The increase in sales in 2018 was primarily due to pricing actions related to higher steel costs and higher sales of boilers and residential water heaters in the U.S. as well as higher sales of water treatment products in China. Our global water treatment sales grew to approximately $400 million in 2018. Sales in China grew four percent in 2018. Excluding the impact of the appreciation of the U.S. dollar against the Chinese currency, our sales in China increased almost two percent in 2018. Our sales in 2017 were higher than 2016 sales of $2,686 million by 11.6 percent, primarily due to higher sales in China as well as higher sales of water heaters and boilers in North America. Our sales in China grew 15.9 percent in 2017 to over $1 billion, and excluding the impact of the appreciation of the U.S dollar against the Chinese currency, sales in China grew 17.9 percent in 2017 compared to 2016. Our gross profit margin in 2018 of 41.0 percent was essentially flat compared to our gross profit margin of 41.1 percent in 2017. Our gross profit margin in 2017 decreased from 41.5 percent in 2016. The slightly lower margin in 2017 compared to 2016 was due to significantly higher steel costs that more than offset pricing actions taken in 2017 in North America and China. Selling, general and administrative (SG&A) expenses were $31.0 million higher in 2018 than in 2017. The increase in SG&A expenses in 2018 to $753.8 million was primarily due to higher advertising expenses related to brand building and higher product development engineering expenses in China. SG&A expenses were $60.3 million higher in 2017 than in 2016 primarily due to higher selling and advertising expenses to support increased volumes and brand building in our newer product categories. On March 21, 2018, we announced a plan to close our Renton, Washington plant and transfer water heater, boiler and storage tank production to our other U.S. plants. The majority of the consolidation of operations occurred in the second quarter of 2018 and the Renton plant was fully closed in the third quarter of 2018. As a result of the relocation of production, we incurred pre-tax restructuring and impairment expenses of $6.7 million in the first quarter of 2018, primarily related to employee severance and compensation-related costs, building lease exit costs and the impairment of assets. These activities are reflected in “restructuring and impairment expenses” in the accompanying financial statements. We are providing non-GAAP measures (adjusted earnings, adjusted earnings per share (EPS), and adjusted segment earnings) that exclude Renton related restructuring and impairment expenses and one-time expenses associated with the U.S. Tax Cuts & Jobs Act (U.S. Tax Reform). Reconciliations to measures on a GAAP basis are provided later in this section. Interest expense was $8.4 million in 2018 compared to $10.1 million in 2017 and $7.3 million in 2016. Higher interest rates in 2018 were offset by lower debt levels, primarily due to the repatriation of approximately $312 million of cash from outside of the U.S., which was primarily used to pay down floating rate debt, as well as, to fund our share repurchase activity and dividend payments. The higher interest expense in 2017 compared to 2016 was primarily related to higher interest rates as well as higher overall debt levels primarily due to increased share repurchases and acquisitions completed in 2016 and 2017. Other income was $21.2 million in 2018 compared to $21.3 million in 2017 and $18.1 million in 2016. The increase in other income in 2017 compared to 2016 was primarily due to higher non-service cost related pension income and higher interest income. Pension income in 2018 was $8.7 million compared to $9.1 million in 2017 and $6.9 million in 2016. The service cost component of our pension income is reflected in cost of products sold and SG&A expenses. All other components of our pension income are reflected in other income. Our effective income tax rate was 20.4 percent in 2018, compared with 43.1 percent in 2017 and 29.4 percent in 2016. The significant increase in our effective income tax rate in 2017 compared to prior years was due to one-time charges associated with U.S. Tax Reform of $81.8 million, primarily related to the mandatory repatriation tax on undistributed foreign earnings that we are required to pay over eight years. Excluding the impact of the U.S. Tax Reform one-time charges, our adjusted effective income tax rate was 27.4 percent in 2017. Our effective income tax rate in 2018 was lower than our adjusted effective income tax rate in 2017 due to lower federal income taxes related to U.S. Tax Reform. Our adjusted effective income tax rate in 2017 was lower than our effective income tax rate in 2016 primarily due to lower U.S. state income taxes and higher deductions for share-based compensation. We estimate our annual effective income tax rate for the full year 2019 will be approximately 21.5 percent. North America Sales in our North America segment were $2,045 million in 2018 or $140 million higher than sales of $1,905 million in 2017. The increase in sales in 2018 compared to 2017 was primarily due to pricing actions related to higher steel costs and higher volumes of boilers and residential water heaters in the U.S. North America water treatment sales, including a full year of sales from Hague and the launch of products at Lowe’s commencing in August 2018, incrementally added approximately $29 million of sales in 2018. Sales in 2017 were $162 million higher than sales of $1,743 million in 2016. The increase in sales in 2017 compared to 2016 was primarily due to higher volumes of water heaters and boilers, price increases in the U.S. for water heaters largely related to steel cost increases as well as our customers’ pre-buy of commercial water heaters in advance of an anticipated 2018 regulatory change. North America water treatment sales, comprised of Hague, acquired in September 2017 and Aquasana, acquired in August 2016, incrementally added approximately $40 million of sales in 2017. North America segment earnings were $464.1 million in 2018 compared to segment earnings of $428.6 million and $385.9 million in 2017 and 2016, respectively. Segment margins were 22.7 percent, 22.5 percent and 22.1 percent in 2018, 2017 and 2016, respectively. Adjusted segment earnings and segment margin in 2018, which exclude restructuring and impairment expenses, were $470.8 million and 23.0 percent, respectively. The higher adjusted segment earnings and adjusted segment margin in 2018 compared to 2017 were primarily due to the favorable impact from higher sales of residential water heaters and boilers and pricing actions in the U.S. that were partially offset by higher steel costs and one-time expenses associated with the launch of water treatment products at Lowe’s. The higher segment earnings and segment margin in 2017 compared to 2016 were primarily due to higher water heater and boiler volumes and pricing actions which were partially offset by higher steel costs. We estimate our 2019 North America segment margin will be between 23 and 23.5 percent. Rest of World Sales in our Rest of World segment in 2018 were $1,174 million or $58 million higher than sales of $1,116 million in 2017. Sales in China grew four percent in 2018 primarily due to higher sales of water treatment products, including consumables, which were partially offset by lower sales of electric water heaters and air purifiers. The appreciation of the U.S. dollar against the Chinese currency contributed approximately $23 million to segment sales in 2018. Excluding the benefit of the U.S. dollar appreciation, sales in China increased 1.9 percent in 2018. Water heater and water treatment sales in India increased $8 million, over 30 percent, in 2018 compared to 2017. Sales in our Rest of World segment in 2017 were $150 million higher than sales of $966 million in 2016. Sales in China grew 15.9 percent to over $1 billion in 2017 due to higher demand for our consumer products, led by water treatment and air purification products and pricing actions primarily due to higher steel and installation costs. Excluding the impact from the appreciation of the U.S. dollar in 2017, sales in China increased 17.9 percent. Water heater and water treatment sales in India increased $8 million, over 40 percent, in 2017 compared to 2016. Rest of World segment earnings were $149.3 million in 2018 compared to segment earnings of $149.3 million and $129.1 million in 2017 and 2016, respectively. Segment margins were 12.7 percent in 2018 compared to 13.4 percent and 13.4 percent in 2017 and 2016, respectively. Segment earnings in 2018 were flat compared to 2017 primarily due to higher water treatment product sales and improved performance in India that were offset by lower sales of electric water heaters and air purifiers as well as higher SG&A expenses. Higher SG&A expenses in China were primarily due to higher advertising expenses related to brand building and higher product development engineering expenses. Segment margin declined in 2018 compared to 2017 as a result of the factors above. Higher segment earnings in 2017 compared to 2016 were primarily due to higher sales in China, which included a price increase, partially offset by higher steel costs, higher fees paid to installers and increased SG&A expenses. Higher SG&A expenses in China were primarily due to the expansion of water treatment and air purification product retail outlets in tier 2 and tier 3 cities, higher advertising expenses related to brand building in our newer product categories and higher water treatment product development engineering costs. We expect our 2019 Rest of World segment margin will be approximately 12 to 12.5 percent due to lower sales and profitability in China. LIQUIDITY AND CAPITAL RESOURCES Our working capital was $853.2 million at December 31, 2018 compared with $973.1 million and $791.2 million at December 31, 2017 and December 31, 2016, respectively. Approximately $312 million in foreign cash was repatriated in 2018 and utilized to repay floating rate debt, pay dividends and repurchase shares. The decline in cash, cash equivalents and marketable securities balances more than offset sales-related increases in accounts receivable, and explains the majority of the decline in working capital in 2018. Cash generation in China and sales-related increases in accounts receivable, and inventory levels led to the majority of the increase in working capital in 2017. As of December 31, 2018, essentially all of our $645.0 million of cash, cash equivalents and marketable securities was held by our foreign subsidiaries. We expect to repatriate approximately $150 million in the first half of 2019 and use the proceeds to repay floating rate debt. Cash provided by operating activities during 2018 was $448.9 million compared with $326.4 million during 2017 and $446.6 million during 2016. The increase in cash flows in 2018 compared to 2017 was primarily due to higher earnings and lower outlays for working capital in 2018. The decline in cash flows in 2017 compared to 2016 was primarily due to higher outlays for working capital than the below normal levels experienced in 2016, which more than offset the impact of higher earnings in 2017. Our capital expenditures were $85.2 million in 2018, $94.2 million in 2017 and $80.7 million in 2016. We broke ground in 2016 on the construction of a new water treatment and air purification products manufacturing facility in Nanjing, China, to support the expected growth of these products in China. The facility became operational in May 2018. Included in 2018 capital expenditures were approximately $13 million related to capacity expansion in China. Included in 2017 capital expenditures were approximately $24 million related to capacity expansion in China. Included in 2016 capital expenditures were approximately $13 million related to capacity expansion in China as well as approximately $11 million related to the continuation of our enterprise resource planning (ERP) system implementation. For 2019, we project approximately $85 million of capital expenditures and approximately $75 million of depreciation and amortization expense. In November 2016, we issued $45 million of fixed rate term notes in two tranches to two insurance companies. Principal payments commence in 2023 and 2028 and the notes mature in 2029 and 2034, respectively. The notes carry interest rates of 2.87 and 3.10, respectively. We used proceeds of the notes to pay down borrowings under our revolving credit facility. In December 2016, we completed a $500 million multi-currency five year revolving credit facility with a group of nine banks. The facility has an accordion provision which allows it to be increased up to $700 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2018. The facility backs up commercial paper and credit line borrowings, and it expires on December 15, 2021. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings as well as drawings under the facility are classified as long-term debt. At December 31, 2018, we had available borrowing capacity of $398.6 million under this facility. We believe that our combination of cash, available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future. Our total debt declined to $221.4 million at December 31, 2018 compared with $410.4 million at December 31, 2017. We repatriated approximately $312 million cash and paid down debt, which was partially offset by share repurchase activity exceeding cash generation in the U.S. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 11.4 percent at the end of 2018 compared with 19.9 percent at the end of 2017. Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2018. We forecast that we will not be required to make a contribution to the plan in 2019, and we do not plan to make any voluntary contributions in 2019. For further information on our pension plans, see Note 12 of the Notes to Consolidated Financial Statements. In 2018, we repurchased 3,797,800 shares at an average price of $53.34 per share and a total cost of $202.6 million. Our Board of Directors increased the number of shares we are authorized to repurchase by 2,500,000 shares and 5,000,000 shares at its July 2018 and December 2018 meetings, respectively. A total of 6,075,253 shares remained on the existing repurchase authorization at December 31, 2018. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, such as acquisitions, we expect to spend approximately $200 million on share repurchase activity in 2019 using a combination of a 10b5-1 repurchase plan and opportunistic purchases. We have paid dividends for 79 consecutive years with annual amounts increasing each of the last 27 years. We paid dividends of $0.76 per share in 2018 compared with $0.56 per share in 2017. We increased our dividend rate twice in 2018, and the five year compound annual growth rate of our dividend is approximately 30 percent. Aggregate Contractual Obligations A summary of our contractual obligations as of December 31, 2018, is as follows: As of December 31, 2018, our liability for uncertain income tax positions was $8.3 million. Due to the high degree of uncertainty regarding timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We utilize blanket purchase orders to communicate expected annual requirements to many of our suppliers. Requirements under blanket purchase orders generally do not become committed until several weeks prior to our scheduled unit production. The purchase obligation amount presented above represents the value of commitments that we consider firm. Recent Accounting Pronouncements Refer to Recent Accounting Pronouncements in Note 1 of Notes to Consolidated Financial Statements. Critical Accounting Policies Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above. Goodwill and Indefinite-lived Intangible Assets In conformity with U.S. Generally Accepted Accounting Principles (GAAP), goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arm’s-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct thorough and competent annual valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2018. Product warranty Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2018 and 2017, our reserve for product warranties was $139.3 million and $141.2 million, respectively. Product liability Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2018, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million. We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also utilize an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2018 and 2017, our reserve for product liability was $39.3 million and $40.1 million, respectively. Pensions We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 7.15 percent in 2018 and 7.50 percent in 2017. The discount rate used to determine net periodic pension costs decreased to 3.65 percent in 2018 from 4.15 percent in 2017. For 2019, our expected return on plan assets is 7.15 percent and our discount rate is 4.32 percent. In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to equity managers is approximately 30 to 60 percent, with the remainder allocated primarily to bond managers, private equity managers and real estate managers. Our actual asset allocation as of December 31, 2018, was 40 percent to equity managers, 48 percent to bond managers, 10 percent to real estate managers, and two percent to private equity managers. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 8.9 percent and 8.5 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 7.15 percent expected return on plan assets for 2019 is reasonable. The discount rate assumptions used to determine future pension obligations at December 31, 2018 and 2017 were based on the Aon AA Only Above Median yield curve, which was designed by Aon to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard & Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary. We recognized pension income of $8.7 million, $9.1 million, and $6.9 million in 2018, 2017, and 2016, respectively. Costs associated with our replacement retirement plan in 2018 were approximately $6 million, consistent with 2017. We made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014. Lowering the expected return on plan assets by 25 basis points would decrease our net pension income for 2018 by approximately $2.0 million. Lowering the discount rate by 25 basis points would increase our 2018 net pension income by approximately $0.1 million. Non-GAAP Measures We provide non-GAAP measures (adjusted earnings, adjusted earnings per share (EPS) and adjusted segment earnings) that exclude restructuring and impairment expenses in 2018 and the impact of a one-time charge associated with U.S. Tax Reform in 2017. We believe that the measures of adjusted earnings, adjusted EPS and adjusted segment earnings provide useful information to investors about our performance and allow management and our investors to better compare our performance year over year. A. O. SMITH CORPORATION Adjusted Earnings and Adjusted EPS (dollars in millions, except per share data) (unaudited) The following is a reconciliation of net earnings and diluted earnings per share (EPS) to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP): The following is a reconciliation of reported segment earnings to adjusted segment earnings (non-GAAP): (1) We recognized $6.7 million of restructuring and impairment expenses in connection with the move of manufacturing operations from our Renton, Washington facility to other U.S. facilities. For additional information, see Note 4 of Notes to Consolidated Financial Statements. (2) Excluding the impact of one-time U.S. Tax Reform charges, our 2017 adjusted effective income tax rate was 27.4 percent as compared to our effective income tax rate of 43.1 percent in 2017. For additional information, see Note 14 of Notes to Consolidated Financial Statements. Outlook We expect continued strong boiler and residential water heater sales in North America in 2019. We project that sales in China will decline by seven to ten percent in U.S. dollar terms and three to six percent in local currency in 2019. The decrease is due to our expectation of relatively flat consumer demand in China and without the increase of the channel inventory build in China that we experienced primarily in the first quarter of 2018 which we estimate was at least five percent of 2018 China sales. As a result, we expect our consolidated sales to grow one to 2.5 percent and between 2.5 to four percent in local currency terms in 2019. We expect to achieve full-year earnings of between $2.67 and $2.77 per share, which excludes the potential impact from future acquisitions. OTHER MATTERS Environmental Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2018 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves together with available insurance coverage are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage. Market Risk We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures for periods of less than one year. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements. We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2018, we had net foreign currency contracts outstanding with notional values of $210.9 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $21.1 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged. Our earnings exposure related to movements in interest rates is primarily derived from outstanding floating-rate debt instruments that are determined by short-term money market rates. At December 31, 2018, we had $101.4 million in outstanding floating-rate debt with a weighted-average interest rate of 2.9 percent at year end. A hypothetical ten percent annual increase or decrease in the year-end average cost of our outstanding floating-rate debt would result in a change in annual pre-tax interest expense of approximately $0.3 million. Forward-Looking Statements This filing contains statements that we believe are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “guidance” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: a further weakening of the Chinese economy and/or a further decline in the growth rate of consumer spending or housing sales in China; negative impact to our businesses from international tariffs and trade disputes; potential weakening in the high efficiency boiler segment in the U.S.; significant volatility in raw material prices; our inability to implement or maintain pricing actions; potential weakening in U.S. residential or commercial construction or instability in our replacement markets; foreign currency fluctuations; our inability to successfully integrate or achieve our strategic objectives resulting from acquisitions; competitive pressures on our businesses; the impacts of potential information technology or data security breaches; changes in government regulations or regulatory requirements; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and we are under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the Company, or persons acting on our behalf, are qualified entirely by these cautionary statements.

<s>[INST] Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas and electric water heaters, boilers, tanks and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our Rest of World segment also manufactures and markets inhome air purification products in China. In our North America segment, we project our sales in the U.S. will grow in 2019 compared to 2018 due to higher residential water heater and boiler volumes resulting from expected industrywide new construction growth and expansion of replacement demand. We expect the North America commercial water heater industry to be flat in 2019, after declining over five percent in 2018 following growth of 11 percent in 2017, partially due to an anticipated regulatory change. Our sales of boilers grew nine percent in 2018, and we expect ten percent sales growth in 2019, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. We continued to expand our North America water treatment platform in 2018 by being named exclusive supplier of water treatment products to Lowe’s, with sales commencing in August 2018. We expect sales of North America water treatment products to increase by 35 to 40 percent in 2019, compared to 2018, primarily due to volume growth and a full year of sales to Lowe’s. In our Rest of World segment, we expect China sales to decline in 2019 at a rate of between seven and 10 percent in U.S. dollars and three to six percent in local currency, as we believe the Chinese economy will continue to be weak and the Chinese currency will depreciate compared to the U.S. dollar by approximately four percent in 2019 compared with 2018. In addition, we expect our sales in India to grow over 30 percent in 2019 from approximately $34 million in 2018. Combining all of these factors, we expect our consolidated sales to grow one to 2.5 percent and between 2.5 to four percent in local currency terms in 2019. Our stated acquisition strategy includes a number of our waterrelated strategic initiatives. We will seek to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our introduction of water treatment products in India and Vietnam and air purification products in China in 2015. RESULTS OF OPERATIONS Our sales in 2018 were a Company record $3,188 million surpassing 2017 sales of $2,997 million by 6.4 percent. The increase in sales in 2018 was primarily due to pricing actions related to higher steel costs and higher sales of boilers and residential water heaters in the U.S. as well as higher sales of water treatment products in China. Our global water treatment sales grew to approximately $400 million in 2018. Sales in China grew four percent in 2018. Excluding the impact of the appreciation of the U.S. dollar against the Chinese currency, our sales in China increased almost two percent in 2018. Our sales in 2017 were higher than 2016 sales of $2,686 million by 11.6 percent, primarily due to higher sales in China as well as higher sales of water heaters and boilers in North America. Our sales in China grew 15.9 percent in 2017 to over $1 billion, and excluding the impact of the appreciation of the U.S dollar against the Chinese currency, sales in China grew 17.9 percent in 2017 compared to 2016. Our gross profit margin in 2018 of 41.0 percent was essentially flat compared to our gross profit margin of 41.1 percent in 2017. Our gross profit margin in 2017 decreased from 41.5 percent in 2016. The slightly lower margin in 2017 compared to 2016 [/INST] Positive. </s>

SMITH A O CORP

2020-02-24

2019-12-31

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas and electric water heaters, boilers, tanks and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our Rest of World segment also manufactures and markets in-home air purification products in China. In our North America segment, we project our sales in the U.S. will grow approximately six percent in 2020 compared to 2019 due to higher water heater and boiler volumes resulting from expected industry-wide new construction growth and expansion of replacement demand. We continued to expand our North America water treatment platform in 2019 by acquiring Water-Right, Inc. and its affiliated entities (Water-Right) in April 2019. We expect sales of North America water treatment products to increase by 20 to 25 percent in 2020, compared to 2019, primarily due to volume growth and a full year of Water-Right sales. In our Rest of World segment, we expect 2020 China sales to grow by approximately one percent in U.S. dollar terms and approximately 2.5 percent in local currency compared with 2019, as we believe the Chinese economy will continue to be weak. In addition, we expect our sales in India to grow between 15 and 20 percent in 2020 from approximately $39 million in 2019. Combining all of these factors, we expect our consolidated sales to grow 4.5 to 5.5 percent in 2020. Our 2020 guidance introduced on January 28, 2020, excludes the potential impact to our businesses from the coronavirus originating in China. As of the date of this filing, while not yet quantifiable, we now expect the coronavirus will have a material adverse impact on our operating results in the first quarter of 2020 and we continue to assess the financial impact for the remainder of 2020. Our stated acquisition strategy includes a number of our water-related strategic initiatives. We will seek to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our introduction of water treatment products in India and Vietnam and air purification products as well as range hoods and cooktops in China. RESULTS OF OPERATIONS Our sales in 2019 were $2,993 million, a decline of 6.1 percent compared to our 2018 sales of $3,188 million. The decrease in 2019 sales was primarily due to a 23 percent decline in China sales in U.S. dollar terms, which was largely a result of weaker end-market demand in the region, year over year channel inventory shifts, and a higher mix of sales of mid-price products versus premium price products than in the prior year. Excluding the unfavorable impact from currency translation, China sales declined 19 percent in 2019. The sales reduction in China more than offset the benefits of higher sales in North America, which were primarily a result of higher sales of water treatment products, including incremental sales from our acquisition, Water-Right, and water heater pricing actions related to steel and freight cost increases. The increase in North America sales was partially offset by lower residential water heater volumes. Our sales in 2018 were a company record $3,188 million surpassing 2017 sales of $2,997 million by 6.4 percent. The increase in sales in 2018 was primarily due to pricing actions related to higher steel costs and higher sales of boilers and residential water heaters in the U.S. as well as higher sales of water treatment products in China. Our global water treatment sales grew to approximately $400 million in 2018. Total sales in China grew four percent in 2018. Excluding the impact of the appreciation of the Chinese currency against the U.S. dollar, our sales in China increased almost two percent in 2018. Our gross profit margin in 2019 of 39.5 percent declined compared to our gross profit margin of 41.0 percent in 2018 primarily due to the lower sales volumes in China and a higher mix of mid-price products, which have lower margins, in that region. Our gross profit margin in 2018 of 41.0 percent was essentially flat compared to our gross profit margin of 41.1 percent in 2017. Selling, general and administrative (SG&A) expenses were $715.6 million in 2019 or $38.2 million lower than in 2018. The decrease in SG&A expenses in 2019 was primarily due to lower advertising and selling expenses in China. SG&A expenses were $31.0 million higher in 2018 than in 2017. The increase in SG&A expenses in 2018 to $753.8 million was primarily due to higher advertising expenses related to brand building and higher product development engineering expenses in China. On March 21, 2018, we announced a plan to transfer water heater, boiler and storage tank production from our Renton, Washington plant to our other U.S. plants. The majority of the consolidation of operations occurred in the second quarter of 2018. As a result of the relocation of production, we incurred pre-tax restructuring and impairment expenses of $6.7 million in the first quarter of 2018, primarily related to employee severance and compensation-related costs, building lease exit costs and the impairment of assets. These activities are reflected in “restructuring and impairment expenses” in the accompanying financial statements. We are providing non-U.S. Generally Accepted Accounting Principles (GAAP) measures (adjusted earnings, adjusted earnings per share, and adjusted segment earnings) that exclude restructuring and impairment expenses. Reconciliations to measures on a GAAP basis are provided later in this section. We believe that the measures of adjusted earnings, adjusted EPS, and adjusted segment earnings provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items we do not consider to be a component of our core operating performance. Interest expense was $11.0 million in 2019 compared to $8.4 million in 2018 and $10.1 million in 2017. The increase in interest expense in 2019 was primarily due to higher debt levels to fund the acquisition of Water-Right and share repurchase activity. The decline in interest expense in 2018 compared to 2017 was a result of lower debt levels, primarily due to the repatriation of approximately $312 million of cash from outside of the U.S, which was primarily used to pay down floating rate debt, as well as to fund our share repurchase activity and dividend payments. This decline was partially offset by higher interest rates in 2018. Other income was $18.0 million in 2019 compared to $21.2 million in 2018 and $21.3 million in 2017. The decrease in other income in 2019 compared to 2018 was primarily due to lower non-service cost related pension income and lower interest income. Pension income in 2019 was $6.2 million compared to $8.7 million in 2018 and $9.1 million in 2017. The service cost component of our pension income is reflected in cost of products sold and SG&A expenses. All other components of our pension income are reflected in other income. Our effective income tax rate was 21.6 percent in 2019, compared with 20.4 percent in 2018 and 43.1 percent in 2017. Our effective income tax rates in 2019 and 2018 were lower than our adjusted effective income tax rate in 2017 due to lower federal income taxes related to the U.S. Tax Cuts and Jobs Act of 2017 (U.S. Tax Reform). Our effective income tax rate in 2019 was higher than 2018 primarily due to a change in geographic earnings mix. The effective income tax rate in 2017 was significantly higher due to one-time charges associated with U.S. Tax Reform of $81.8 million, primarily related to the mandatory repatriation tax on undistributed foreign earnings that we are required to pay over eight years. Excluding the impact of the U.S. Tax Reform one-time charges, our adjusted effective income tax rate was 27.4 percent in 2017. We estimate our annual effective income tax rate for the full year 2020 will be approximately 21.5 to 22.0 percent. North America Sales in our North America segment were $2,084 million in 2019 or $39 million higher than sales of $2,045 million in 2018. The increase in segment sales was primarily due to the incremental Water-Right sales of $44 million, water heater pricing actions related to steel and freight cost increases, and higher sales of water treatment products, which were partially offset by lower residential water heater volumes. Sales in our North America segment were $2,045 million in 2018 or $140 million higher than sales of $1,905 million in 2017. The increase in sales in 2018 compared to 2017 was primarily due to pricing actions related to higher steel costs and higher volumes of boilers and residential water heaters in the U.S. North America water treatment sales, including a full year of sales from Hague, which we purchased in 2017, and the launch of products at Lowe’s commencing in August 2018, incrementally added approximately $29 million of sales in 2018. North America segment earnings were $488.9 million in 2019 compared to segment earnings of $464.1 million and $428.6 million in 2018 and 2017, respectively. Segment margins were 23.5 percent, 22.7 percent and 22.5 percent in 2019, 2018 and 2017, respectively. Adjusted segment earnings and segment margin in 2018, which exclude restructuring and impairment expenses, were $470.8 million and 23.0 percent, respectively. The higher segment earnings and segment margin in 2019 compared to 2018 adjusted segment earnings and adjusted segment margin were primarily a result of pricing actions, lower steel costs, and higher sales of water treatment products, that included incremental volumes from our acquisition, Water-Right. These increases were partially offset by the unfavorable impact from lower residential water heater volumes. The higher adjusted segment earnings and adjusted segment margin in 2018 compared to 2017 were primarily due to the favorable impact from higher sales of residential water heaters and boilers and pricing actions in the U.S. that were partially offset by higher steel costs and one-time expenses associated with the launch of water treatment products at Lowe’s. We estimate our 2020 North America segment margin will be between 23.25 and 24.25 percent. Rest of World Sales in our Rest of World segment in 2019 were $936 million or $238 million lower than sales of $1,174 million in 2018. Lower sales in 2019 compared to 2018 was largely a result of decreased China sales which declined 23 percent in U.S. dollar terms and 19 percent in local currency terms. The decline in China sales was primarily due to weaker end-market demand, elevated channel inventory levels for the first three quarters of 2019 that returned to a more normal range of two to three months by the end of 2019, and a higher mix of mid-price products versus premium priced products. In addition, the weaker Chinese currency unfavorably impacted translated sales by approximately $39 million. Sales in India grew approximately 13 percent in 2019 compared to 2018. Sales in China grew four percent in 2018 compared to 2017 primarily due to higher sales of water treatment products, including consumables, which were partially offset by lower sales of electric water heaters and air purifiers. The appreciation of the Chinese currency against the U.S. dollar contributed approximately $23 million to segment sales in 2018. Excluding the benefit of the Chinese currency appreciation, sales in China increased 1.9 percent in 2018. Water heater and water treatment sales in India increased $8 million, over 30 percent, in 2018 compared to 2017. Rest of World segment earnings were $40.2 million in 2019 compared to segment earnings of $149.3 million in both 2018 and 2017. Segment margins were 4.3 percent in 2019 compared to 12.7 percent and 13.4 percent in 2018 and 2017, respectively. The decline in 2019 segment earnings and margin compared to 2018 was primarily due to lower sales in China and a higher mix of mid-price products, which have lower margins, that when combined, more than offset benefits to profits from lower SG&A expenses and material costs in that region. Currency translation reduced segment earnings by approximately $3.0 million in 2019 compared to 2018. Segment earnings in 2018 were flat compared to 2017 primarily due to higher water treatment product sales and improved performance in India that were offset by lower sales of electric water heaters and air purifiers in China as well as higher SG&A expenses. Higher SG&A expenses in China were primarily due to higher advertising expenses related to brand building and higher product development engineering expenses. Segment margin declined in 2018 compared to 2017 as a result of the factors above. We expect our 2020 Rest of World segment margin will be approximately five percent. LIQUIDITY AND CAPITAL RESOURCES Our working capital was $733.9 million at December 31, 2019 compared with $853.2 million and $973.1 million at December 31, 2018 and December 31, 2017, respectively. Approximately $165 million in foreign cash, cash equivalents and marketable securities was repatriated in 2019 and utilized to repay floating rate debt, pay dividends and repurchase shares. The decline in cash, cash equivalents and marketable securities and sales-related decreases in accounts receivable partially offset by lower accounts payable balances explains the majority of the decline in working capital in 2019. Approximately $312 million in foreign cash was repatriated in 2018 and utilized to repay floating rate debt, pay dividends and repurchase shares. The decline in cash, cash equivalents and marketable securities balances more than offset sales-related increases in accounts receivable and explains the majority of the decline in working capital in 2018. As of December 31, 2019, essentially all of our $551.4 million of cash, cash equivalents and marketable securities was held by our foreign subsidiaries. We expect to repatriate approximately $150 million in the first half of 2020 and use the proceeds to repay floating rate debt. Cash provided by operating activities during 2019 was $456.2 million compared with $448.9 million during 2018 and $326.4 million during 2017. The increase in cash flows in 2019 compared with 2018 was primarily due to lower outlays for working capital which offset lower earnings in 2019. The increase in cash flows in 2018 compared to 2017 was primarily due to higher earnings and lower outlays for working capital in 2018. Our capital expenditures were $64.4 million in 2019, $85.2 million in 2018 and $94.2 million in 2017. We broke ground in 2016 on the construction of a new water treatment and air purification products manufacturing facility in Nanjing, China, to support the expected growth of these products in China. The facility became operational in May 2018. Included in 2018 capital expenditures were approximately $13 million related to capacity expansion in China. Included in 2017 capital expenditures were approximately $24 million related to capacity expansion in China. For 2020, we project approximately $80 million of capital expenditures and approximately $85 million of depreciation and amortization expense. In December 2016, we completed a $500 million multi-currency five-year revolving credit facility with a group of nine banks. The facility has an accordion provision which allows it to be increased up to $700 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2019. The facility backs up commercial paper and credit line borrowings, and it expires on December 15, 2021. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings as well as drawings under the facility are classified as long-term debt. At December 31, 2019, we had available borrowing capacity of $336.0 million under this facility. We believe that our combination of cash, available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future. Our total debt increased to $284.0 million at December 31, 2019 compared with $221.4 million at December 31, 2018. We repatriated approximately $150 million cash and paid down debt, which was more than offset by the purchase of Water-Right and share repurchase activity exceeding cash generation in the U.S. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 14.6 percent at the end of 2019 compared with 11.4 percent at the end of 2018. Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2019. We forecast that we will not be required to make a contribution to the plan in 2020, and we do not plan to make any voluntary contributions in 2020. For further information on our pension plans, see Note 13 of Notes to Consolidated Financial Statements. In 2019, we repurchased 6,113,038 shares at an average price of $47.06 per share and a total cost of $287.7 million. Our Board of Directors increased the number of shares we are authorized to repurchase by 3,000,000 shares at its June 2019 meeting. A total of 2,962,215 shares remained on the existing repurchase authorization at December 31, 2019. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, such as acquisitions, we expect to spend approximately $200 million on share repurchase activity in 2020 using a combination of a 10b5-1 repurchase plan and opportunistic purchases. We have paid dividends for 80 consecutive years with annual amounts increasing each of the last 28 years. We paid dividends of $0.90 per share in 2019 compared with $0.76 per share in 2018. We increased our dividend by nine percent in the fourth quarter of 2019, and the five-year compound annual growth rate of our dividend is approximately 25 percent. Aggregate Contractual Obligations A summary of our contractual obligations as of December 31, 2019, is as follows: As of December 31, 2019, our liability for uncertain income tax positions was $9.7 million. Due to the high degree of uncertainty regarding timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We utilize blanket purchase orders to communicate expected annual requirements to many of our suppliers. Requirements under blanket purchase orders generally do not become committed until several weeks prior to our scheduled unit production. The purchase obligation amount presented above represents the value of commitments that we consider firm. Recent Accounting Pronouncements Refer to Recent Accounting Pronouncements in Note 1 of Notes to Consolidated Financial Statements. Critical Accounting Policies Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above. Goodwill and Indefinite-lived Intangible Assets In conformity with U.S. Generally Accepted Accounting Principles (GAAP), goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct thorough and competent annual valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2019. Product warranty Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2019 and 2018, our reserve for product warranties was $134.3 million and $139.4 million, respectively. Product liability Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2019, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million. We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also utilize an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2019 and 2018, our reserve for product liability was $33.1 million and $39.3 million, respectively. Pensions We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 7.15 percent in 2019 and 2018. The discount rate used to determine net periodic pension costs increased to 4.32 percent in 2019 from 3.65 percent in 2018. For 2020, our expected return on plan assets is 6.75 percent and our discount rate is 3.18 percent. In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to equity managers is approximately 30 to 60 percent, with the remainder allocated primarily to bond managers, private equity managers and real estate managers. Our actual asset allocation as of December 31, 2019, was 42 percent to equity managers, 47 percent to bond managers, 10 percent to real estate managers, and one percent to private equity managers. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 9.2 percent and 9.3 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 6.75 percent expected return on plan assets for 2020 is reasonable. The discount rate assumptions used to determine future pension obligations at December 31, 2019 and 2018 were based on the Aon AA Only Above Median yield curve, which was designed by Aon to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard & Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary. We recognized pension income of $6.2 million, $8.7 million, and $9.1 million in 2019, 2018, and 2017, respectively. Costs associated with our replacement retirement plan in 2019 were approximately $6 million, consistent with 2018. We made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014. Lowering the expected return on plan assets by 25 basis points would decrease our net pension income for 2019 by approximately $1.9 million. Lowering the discount rate by 25 basis points would increase our 2019 net pension income by approximately $0.4 million. In 2019, as part of our strategy to de-risk our defined benefit pension plan, the qualified defined benefit pension plan purchased a group annuity contract whereby an unrelated insurance company assumed a $31 million obligation to pay and administer future annuity payments for certain retirees and beneficiaries. Non-GAAP Measures We provide non-GAAP measures (adjusted earnings, adjusted earnings per share (EPS) and adjusted segment earnings) that exclude restructuring and impairment expenses in 2018 and the impact of a one-time charge associated with U.S. Tax Reform in 2017. We believe that the measures of adjusted earnings, adjusted EPS, and adjusted segment earnings provide useful information to investors about our performance and allow management and our investors to better understand our performance between periods without regard to items we do not consider to be a component of our core operating performance. A. O. SMITH CORPORATION Adjusted Earnings and Adjusted EPS (dollars in millions, except per share data) (unaudited) The following is a reconciliation of net earnings and diluted earnings per share (EPS) to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP): The following is a reconciliation of reported segment earnings to adjusted segment earnings (non-GAAP): (1) We recognized $6.7 million of restructuring and impairment expenses in connection with the move of manufacturing operations from our Renton, Washington facility to other U.S. facilities. For additional information, see Note 5 of Notes to Consolidated Financial Statements. (2) Excluding the impact of one-time U.S. Tax Reform charges, our 2017 adjusted effective income tax rate was 27.4 percent as compared to our effective income tax rate of 43.1 percent in 2017. For additional information, see Note 15 of Notes to Consolidated Financial Statements. Outlook We expect higher boiler, water heater, and water treatment sales in North America in 2020 and project segment sales to grow by approximately six percent compared to 2019. Although China channel inventory levels have normalized to the range of two to three months, we believe the Chinese economy will remain weak in 2020 and expect that 2020 sales in China will increase by one percent in U.S. dollar terms and 2.5 percent in local currency terms. As a result, we expect our consolidated sales to grow between 4.5 to 5.5 percent in 2020. We plan to achieve full-year earnings of between $2.40 and $2.50 per share, which excludes the potential impacts from future acquisitions. Our 2020 guidance above which was introduced on January 28, 2020, excludes the potential impact on our businesses from the coronavirus originating in China. As of the date of this filing, while not yet quantifiable, we now expect the effects of the coronavirus to have a material adverse impact on our operating results in the first quarter of 2020 and we continue to assess the financial impact for the remainder of the year. OTHER MATTERS Environmental Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2019 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves together with available insurance coverage are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage. Market Risk We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures for periods of less than one year. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements. We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2019, we had net foreign currency contracts outstanding with notional values of $205.6 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $20.6 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged. Our earnings exposure related to movements in interest rates is primarily derived from outstanding floating-rate debt instruments that are determined by short-term money market rates. At December 31, 2019, we had $164.0 million in outstanding floating-rate debt with a weighted-average interest rate of 2.5 percent at year end. A hypothetical ten percent annual increase or decrease in the year-end average cost of our outstanding floating-rate debt would result in a change in annual pre-tax interest expense of approximately $0.4 million. Forward-Looking Statements This filing contains statements that the Company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “continue,” “guidance” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: a further weakening of the Chinese economy and/or a further decline in the growth rate of consumer spending or housing sales in China; negative impact to the company’s businesses as a result of the coronavirus, originating in China; negative impact to the company’s businesses from international tariffs and trade disputes; potential weakening in the high-efficiency boiler segment in the U.S.; significant volatility in raw material prices; inability of the company to implement or maintain pricing actions; potential weakening in U.S. residential or commercial construction or instability in the company’s replacement markets; foreign currency fluctuations; the company’s inability to successfully integrate or achieve its strategic objectives resulting from acquisitions; competitive pressures on the company’s businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this filing, and the company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

<s>[INST] Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas and electric water heaters, boilers, tanks and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our Rest of World segment also manufactures and markets inhome air purification products in China. In our North America segment, we project our sales in the U.S. will grow approximately six percent in 2020 compared to 2019 due to higher water heater and boiler volumes resulting from expected industrywide new construction growth and expansion of replacement demand. We continued to expand our North America water treatment platform in 2019 by acquiring WaterRight, Inc. and its affiliated entities (WaterRight) in April 2019. We expect sales of North America water treatment products to increase by 20 to 25 percent in 2020, compared to 2019, primarily due to volume growth and a full year of WaterRight sales. In our Rest of World segment, we expect 2020 China sales to grow by approximately one percent in U.S. dollar terms and approximately 2.5 percent in local currency compared with 2019, as we believe the Chinese economy will continue to be weak. In addition, we expect our sales in India to grow between 15 and 20 percent in 2020 from approximately $39 million in 2019. Combining all of these factors, we expect our consolidated sales to grow 4.5 to 5.5 percent in 2020. Our 2020 guidance introduced on January 28, 2020, excludes the potential impact to our businesses from the coronavirus originating in China. As of the date of this filing, while not yet quantifiable, we now expect the coronavirus will have a material adverse impact on our operating results in the first quarter of 2020 and we continue to assess the financial impact for the remainder of 2020. Our stated acquisition strategy includes a number of our waterrelated strategic initiatives. We will seek to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our introduction of water treatment products in India and Vietnam and air purification products as well as range hoods and cooktops in China. RESULTS OF OPERATIONS Our sales in 2019 were $2,993 million, a decline of 6.1 percent compared to our 2018 sales of $3,188 million. The decrease in 2019 sales was primarily due to a 23 percent decline in China sales in U.S. dollar terms, which was largely a result of weaker endmarket demand in the region, year over year channel inventory shifts, and a higher mix of sales of midprice products versus premium price products than in the prior year. Excluding the unfavorable impact from currency translation, China sales declined 19 percent in 2019. The sales reduction in China more than offset the benefits of higher sales in North America, which were primarily a result of higher sales of water treatment products, including incremental sales from our acquisition, WaterRight, and water heater pricing actions related to steel and freight cost increases. The increase in North America sales was partially offset by lower residential water heater volumes. Our sales in 2018 were a company record $3,188 million surpassing 2017 sales of $2,997 million by 6.4 percent. The increase in sales in 2018 was primarily due to pricing actions related to higher steel costs and higher sales of boilers and residential water heaters in the U.S. as well as higher sales of water treatment products in China. Our global water treatment sales grew to approximately $400 million in 2018. Total sales in China grew four percent in 2018. Excluding the impact of the appreciation of the Chinese currency against the U.S. dollar, our sales in China increased almost two percent in 2018. Our gross profit margin in 2019 of 39.5 percent declined compared to our gross [/INST] Negative. </s>

DIEBOLD INC

2015-02-17

2014-12-31

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10-K. Introduction Diebold, Incorporated and its subsidiaries (collectively, the Company) is a global leader in providing financial self-service (FSS) delivery, integrated services and software, and security systems to primarily the financial, commercial, retail and other markets. Founded in 1859, the Company currently has approximately 16,000 employees with business in more than 90 countries worldwide. The Company unveiled its multi-year turnaround strategy, Diebold 2.0, at the Investment Community Conference in November 2013. The objective of Diebold 2.0 is to transform the Company into a world-class, services-led and software enabled company, supported by innovative hardware, that automates the way people connect with their money. The turnaround strategy will follow a “Crawl, Walk, Run” approach, which includes stabilizing the core business operations in the “Crawl” phase and building the foundation for future growth in the “Walk” and “Run” phases. The company is nearing the completion of the “Crawl” phase and expects to transition to “Walk” in the second half of 2015. Four core pillars provide the Company a clear path toward reaching this multi-year objective: • Reduce its cost structure and improve its near-term delivery and execution. • Generate increased free cash flow in order to fund the investments necessary to drive profitable growth, while preserving the ability to return value to shareholders in the form of reliable dividends and, as appropriate, share repurchases. • Attract and retain the talent necessary to drive innovation and the focused execution of the transformation strategy. • Return the Company to a sustainable, profitable growth trajectory. The Company sees opportunities to leverage its capabilities in services, software and innovation to meet the needs of its rapidly evolving markets. The Company has sharpened its focus on executing its core strategies in FSS and electronic security. This includes making the appropriate investments to deliver growth within these areas, especially in research, development and engineering. In addition, the Company remains committed to a disciplined risk assessment process, focused on proactively identifying and mitigating potential risks to the Company's continued success. Net income (loss) attributable to Diebold, Incorporated for the year ended December 31, 2014 was $114,417, or $1.76 per share, an increase of $296,022, or $4.61 per share from the year ended December 31, 2013. Total revenue for the year ended December 31, 2014 was $3,051,053, an increase of $193,562 from the year ended December 31, 2013. The year ended December 31, 2014 included a $13,709 pre-tax gain from the sale of the Company's Diebold Eras, Incorporated (Eras) subsidiary. Cryptera A/S (Cryptera) was acquired for a purchase price of approximately $13,000 and is included in the Europe, Middle East and Africa (EMEA) segment within the Company' s consolidated financial statements from July 1, 2014, the date of acquisition. Pre-tax restructuring charges of $11,872 related to the Company's multi-year realignment plan were also included in the year ended December 31, 2014. The year ended December 31, 2013 included a $67,593 pre-tax non-cash pension charge related to the voluntary early retirement program, a $70,000 pre-tax goodwill impairment charge, $57,015 of pre-tax restructuring charges related to the Company's multi-year realignment plan, including $31,282 related to the voluntary early retirement program, $28,000 of additional pre-tax losses related to the settlement of the global Foreign Corrupt Practices Act (FCPA) investigation, a $17,245 pre-tax net charge related to settlement of the securities class action, and $9,300 of pre-tax executive severance. Internationally, improvement was driven by higher FSS sales in AP and EMEA combined with security sales growth in Brazil, mainly due to the GAS Tecnologia (GAS) acquisition in Brazil. These increases were partially offset by a reduction in election systems and lottery sales in Brazil as well as a decline in FSS volume for LA. Additionally, the 2013 results were significantly impacted by a higher tax rate, which is a result of tax expense related to the repatriation of previously undistributed earnings and the establishment of a valuation allowance on certain Brazil deferred tax assets. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Diebold 2.0 - Turnaround Strategy Diebold 2.0 is built on four core pillars: cost, cash, talent and growth. Underpinned by the four core pillars, the turnaround strategy encompasses eight specific actions to achieve top-tier performance and generate sustainable, profitable growth. Eight-Point Program: 1. Establish a Competitive Cost Structure Reducing the Company’s fixed cost envelope and driving operational rigor is fundamental. The multi-year transformation plan launched in 2013 will drive efficiency while reducing general and administrative costs and the cost of goods sold. As a result of the Company's transformation efforts, gross margin improved over 300 basis points compared to the prior year. In December 2014, the Company announced the extension of its cost savings plan into 2016 and 2017. 2. Drive Sustainable Improvement in Cash Flow The Company is committed to improving cash generation in order to increase shareholder value and fuel the investments necessary to grow the business. An emphasis on working capital improvements and cash generation extends beyond the finance organization into our operations across all regions. For 2014, we were able to exceed our expectations for the year, generating approximately $125,000 in free cash flow, which is up approximately 40 percent year-over-year. 3. Improve Sales Effectiveness The Company’s sales teams must enhance skills, tools and coverage to reach more prospects more effectively. For example, the global deployment of Salesforce.com will enhance the ability to plan, forecast and allocate resources more productively. In 2014, we were able to implement Salesforce.com across our regions and ended the year with total product backlog up approximately 3 percent on a constant currency basis. 4. Increase Speed and Agility Streamlining the management structure will drive greater accountability, accelerate decision-making and facilitate the transition to a global business. Change is being viewed as an enabler of progress throughout the organization. Product development has been accelerated, as evidenced by the number of innovative solutions we were able to bring to market in 2014, such as our responsive banking concept and ActivEdge™ secure card reader. 5. Instill a Winning Culture Grounded in Execution The message being driven to every member of the organization: The Company is not merely to participate in a market, but to succeed, and win through a culture built upon accountability and execution. As an example, the Company has taken steps to better align targets and employee compensation with Company performance. Under this structure, Diebold has recruited top leadership talent to the organization, which will help drive the transformation going forward. 6. Collaborate With Customers and Partners to Drive Innovative Solutions The Company must accelerate new ideas through teamwork with capable partners and collaboration with customers. For example, the Company rolled out a number of innovative solutions over the past 12 months, which include the ActivEdge™ secure card reader, the responsive banking concept and the world’s greenest automated teller machine (ATM), as well as launched its new ATM product platform. 7. Further Leverage Services and Software The Company expects the size and importance of its software stack to increase, and our expertise in services and system integration to be a key differentiator in the market. The objective is to further expand the percentage of sales derived from services and software, which is expected to exceed 60 percent during the transformation. For 2014, services and software comprised approximately 55 percent of the Company’s total revenue and we were able to expand our value-added services footprint with notable wins across the globe. 8. Generate Long-Term, Profitable Growth The seven actions defined above are designed to put the Company on a sustainable, profitable growth trajectory. A commitment to operational rigor, improved analytics and data-driven decision-making is expected to position the Company to benefit from secular trends in outsourcing and mobility, expand its electronic security business and drive both organic and inorganic growth. As part of the transformation, the Company engaged Accenture LLP (Accenture) to provide finance and accounting, human resources and procurement business process outsourcing services. The Company's multi-year outsourcing agreement with Accenture focuses on creating one global delivery model that enhances the quality, controls and efficiency of the Company’s integrated global business processes. The Company plans to utilize Accenture’s industry leading practices, technologies and global MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) delivery network to establish more synchronized operational controls, improve operational transparency, lower spending and reduce costs. Solutions The Company leverages its strong base of maintenance and advanced services to deliver comprehensive managed services. Banks are continuously being challenged to reduce costs while increasing operational efficiencies. Through outsourced services, banks entrust the management of their ATM and security operations to the Company, allowing their staffs to focus on core competencies. Furthermore, the Company's managed services offering provides banks and credit unions with the leading-edge technology they need to stay competitive in the marketplace. As a leader in outsourcing services, the Company is poised to capitalize on the secular outsourcing trends in the marketplace. Another demand driver in the global ATM marketplace is branch automation. The concept is to help financial institutions reduce their costs by migrating routine transactions, typically done inside the branch, to lower-cost automated channels, including the ATM, as well as adding convenience and additional security for the banks' customers. One area of branch automation that continues to gain traction is deposit automation. Among the largest U.S. national banks, there has been extensive deployment of deposit automation-enabled terminals. Today, approximately 30 percent of ATMs globally are configured for automated deposits. Another solution the Company offers as part of its branch automation efforts is Concierge Video Services™, most recently launched in North America. The solution provides consumers with on-demand access to bank call center representatives right at the ATM for sales or bank account maintenance support. In addition to delivering a personal touch outside of regular business hours, Concierge Video Services™ ultimately assists financial institutions by maximizing operational efficiencies, improving the consumer experience and enhancing the overall consumer relationship. Mobile integration is another emerging trend in the FSS space, as consumers look for multiple ways to interact with their financial institutions. In July 2013, Diebold introduced its cardless Mobile Cash Access solution, which allows consumers to stage a transaction with their mobile device and complete it at the ATM without the need for a card. This capability provides consumers with a more convenient and secure option, while giving financial institutions the opportunity to offer their own branded mobile wallet solution. A new technology that enhances security for customers is Diebold’s ActivEdge™ secure card reader. This is the ATM industry's first complete anti-skimming card reader that prevents all known forms of skimming, the most prevalent type of ATM crime, as well as other forms of ATM fraud. ActivEdge™ can help financial institutions avoid skimming-related fraud losses which, according to the ATM Industry Association, total more than $2 billion annually worldwide. ActivEdge™ requires users to insert cards into the reader via the long edge, instead of the traditional short edge. We believe by shifting a card's angle 90 degrees, ActivEdge™ prevents modern skimming devices from reading the card's full magnetic strip, eliminating the devices' ability to steal card data. Another opportunity for a successful managed services approach relates to security challenges and the systems to address them, which have grown increasingly complex. This has created a strong business case among financial institutions and commercial customers for managed services, particularly in the areas of monitoring, services and software management. Today, the Company is focusing its expertise on the financial and commercial sectors, with a dedicated effort to secure large, complex and technologically demanding projects. The Company has customer-focused teams that possess high levels of logical and enterprise security expertise that are required in this business. The Company is also leveraging best practices and some of the best talent to continue building upon its security managed service business. As it relates to security, the Company introduced a new online security management tool in North America, called SecureStat®, that streamlines how customers manage their security operations. At the core of the solution is a personalized dashboard that utilizes customizable, distinct widgets to provide a snapshot of a user's entire security platform, including locations, security systems and devices. In addition, SecureStat® can unify security services and disparate systems, while providing a single interface for real-time administration of security operations across an enterprise. SecureStat® is a great example of the software-driven platforms the Company is investing in to strengthen its services offering and differentiate itself in the marketplace. Moving forward, the Company intends to create shareholder value by leveraging the opportunities it sees within the area of branch automation, growing its services, outsourcing and software capabilities, further building out its electronic security business and MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) taking advantage of key commercial trends around the world. Many opportunities lie ahead, and the Company will continue to invest in developing new services, software and security solutions that align with the needs of its core markets. Multi-Year Transformation Plan The Company is committed to its multi-year transformation plan aimed at establishing a competitive cost structure throughout the organization. The Company has identified targeted savings of $200,000 that are expected to be fully realized by the end of 2017 and plans to reinvest a portion of the savings, approximately 50 percent, to drive long-term growth. Areas of reinvestment include: research and development of innovative new customer solutions; improving and updating the Company's information technology systems and infrastructure; transforming the general and administrative back-office functions; and strengthening sales coverage and marketing, processes and tools. In addition, some of the savings should offset price erosion, wage inflation in emerging markets and volatile commodity prices in the Company’s core business. Given these factors, the Company anticipates that approximately 50 percent of the savings will positively impact operating profit. In addition to the cost savings impact, the Company expects that the plan will enhance its competitive position by focusing on globalizing the Company's service organization, creating a unified center-led global organization for research and development as well as transforming the Company's general and administrative cost structure. Restructuring charges associated with the multi-year realignment plan were $11,872 and $57,015 for 2014 and 2013, respectively, primarily related to severance costs of employees due to the Company's business process outsourcing initiative with Accenture. Business Drivers The business drivers of the Company's future performance include, but are not limited to: • timing of self-service equipment upgrades and/or replacement cycles, including deposit automation in mature markets such as the United States; • demand for products and solutions related to bank branch transformation opportunities; • demand for services, including outsourcing and managed services; • demand for security products and services for the financial and commercial sectors; and • high levels of deployment growth for new self-service products in emerging markets, such as AP. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) The table below presents the changes in comparative financial data for the years ended December 31, 2014, 2013 and 2012. Comments on significant year-to-year fluctuations follow the table. The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes that appear elsewhere in this annual report on Form 10-K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) RESULTS OF OPERATIONS 2014 comparison with 2013 Net Sales The following table represents information regarding our net sales for the years ended December 31: The increase in FSS sales included a net unfavorable currency impact of $53,181 or 2.6 percent, of which 43 percent related to the Brazilian real. The following segment results include the impact of foreign currency. NA FSS sales decreased $17,247 or 2.0 percent primarily from lower volume within the U.S. national bank business partially offset by improvement between years in the U.S. regional bank space and Canada. AP FSS sales increased $19,671 or 4.3 percent primarily due to growth in India, China and the Philippines partially offset by a decline in Indonesia due to a large order in the prior year. EMEA FSS sales increased $59,571 or 16.5 percent with the main drivers being growth in Western Europe, higher volume in Africa and the acquisition of Cryptera. LA FSS sales were flat compared to the prior year as a decline in Colombia coupled with a decrease in Venezuela resulting from the currency control policy of the Venezuelan government were offset by higher volume in Mexico and a net gain in the rest of the region. Brazil FSS sales decreased $29,491 or 10.9 percent due to lower product sales volume. Security sales increased due to growth in the electronic security business, which was partially offset by a decline in the physical security business. From a regional perspective, the increase in total security sales resulted primarily from growth in NA. Brazil other increased due to lottery sales volume combined with the favorable impact of deliveries of information technology (IT) equipment to the education ministry primarily in the first quarter of 2014, which are not expected to recur in 2015, offset in part by a decrease in election systems sales. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: The increase in service gross margin was primarily driven by NA, which benefited from lower employee-related expense associated with restructuring initiatives implemented as part of the Company’s service transformation efforts, including the ongoing benefit from its pension freeze and voluntary early retirement program. Total service gross margin in 2014 compared to the prior year was also favorably impacted by margin improvement in Brazil. Total service gross profit in 2014 and 2013 included restructuring charges of $1,398 and $27,107, respectively. The increase in product gross margin resulted from margin improvements in each international region. LA was a strong contributor as the Company benefited from certain contractual provisions in Venezuela that settled in the year ended December 31, 2014. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) EMEA was also a contributor largely due to higher volume. Total product gross profit in 2014 included a non-routine benefit of $5,821 and 2013 included non-routine expense of $819, both of which were related to Brazil indirect tax. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: The decrease in selling and administrative expense resulted primarily from lower non-routine expense and restructuring charges, savings realized from the Company's continued focus on cost structure and favorable currency impact, partially offset by the reinvestment of the Company’s savings into transformation initiatives. Non-routine expenses of $9,166 and $128,739 were included in 2014 and 2013, respectively. The primary components of the 2013 non-routine expense were a $67,593 non-cash pension charge, additional losses of $28,000 related to the settlement of the FCPA investigation, $17,245 related to the settlement of the securities class action lawsuit and executive severance costs of $9,300. Selling and administrative expense also included $9,859 and $22,561 of restructuring charges in 2014 and 2013, respectively. Restructuring charges in 2014 and 2013 related to the Company's multi-year realignment plan. Excluding non-routine expenses and restructuring charges, selling and administrative expense increased $51,132, which is nearly flat as a percentage of net sales in 2014 compared to the prior year. The increase in selling and administrative expense primarily relates to approximately $21,000 of incremental commission expense and $30,000 of investments related to our back office transformation. Research, development and engineering expense as a percent of net sales in 2014 and 2013 were relatively flat. The Company increased investment in 2014 related to development efforts to support the Company's innovation in future products, which was offset by restructuring charges of $6,091 incurred in 2013. The Company performed an other-than-annual assessment for its Brazil reporting unit in the third quarter of 2013 based on a two-step impairment test and concluded that the goodwill within the Brazil reporting unit was partially impaired. The Company recorded a $70,000 pre-tax, non-cash goodwill impairment charge in the third quarter of 2013 due to deteriorating macro-economic outlook, structural changes to an auction-based purchasing environment and new competitors entering the market. During the second quarter of 2014, the Company divested Eras within the NA segment, resulting in a gain on sale of assets of $13,709. During the first quarter of 2013, the Company recognized a gain on assets of $2,191 resulting from the sale of certain U.S. manufacturing operations to a long-time supplier. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The increase in operating profit (loss) resulted from a reduction in operating expense mainly due to lower non-routine and restructuring charges. Operating profit also improved in total margin and higher product sales, offset in part by higher spend partially attributable to reinvestment of the Company’s savings into transformation strategies. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Other (Expense) Income The following table represents information regarding our other (expense) income for the years ended December 31: The increase in investment income compared to the prior year was driven by Brazil due to leasing portfolio growth. The foreign exchange loss for 2014 and the foreign exchange gain in 2013 included losses of $12,101 and $1,584, respectively, related to the devaluation of the Venezuelan currency. Net Income (Loss) The following table represents information regarding our net income (loss) for the years ended December 31: The increase in net income was driven by higher operating profit related mainly to significantly lower non-routine and restructuring expense, an improvement in service margin and higher product sales. These benefits were offset in part by higher spend partially attributable to reinvestment of the Company’s savings into transformation initiatives and unfavorable other (expense) income in 2014 resulting from foreign exchange loss due to the devaluation of the Venezuelan currency. The negative tax rate for 2013 is a result of tax expense of approximately $55,000 related to the repatriation of previously undistributed earnings and the establishment of a valuation allowance of approximately $39,200 on deferred tax assets in the Company's Brazilian manufacturing facility. The 2013 tax rate was also negatively impacted by the partially non-deductible Brazil goodwill impairment and the FCPA penalty charge. Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: NA revenue decreased due to lower FSS sales resulting from decreased volume in the U.S. national bank sector partially due to the impact of a large non-recurring project in the prior year, offset in part by improvement between years in the U.S. regional bank business and Canada. NA revenue also declined due to lower physical security sales between years offset by higher electronic security revenue. Operating profit increased despite the net sales decline due to an improvement in service margin primarily driven by lower employee-related expense resulting from restructuring initiatives in addition to the ongoing benefit from the Company's pension freeze and voluntary early retirement program. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) AP revenue in 2014 included net unfavorable currency impact of $14,129. Including the impact of foreign currency, revenue in 2014 compared to 2013 increased mainly from growth in India, China and the Philippines partially offset by a decrease in Indonesia because of a large order in 2013. Operating profit increased due to higher volume and improved margin performance in the region partially offset by higher operating expense. EMEA revenue increased primarily from higher sales volume in Western Europe and Africa. The acquisition of Cryptera in the third quarter of 2014 resulted in incremental revenue and operating profit of $14,925 and $1,232, respectively. The overall volume increase led to product gross margin expansion driving the improvement in operating profit compared to the prior year. LA revenue decreased due to a decline in sales concentrated mainly in Colombia and Venezuela, partially offset by FSS growth in Mexico and a net overall improvement in the rest of the region. The Venezuela decrease resulted principally from the adverse impact of currency control policy measures instituted by the Venezuelan government, offset by certain contractual provisions in Venezuelan contracts. Operating profit in 2014 compared to 2013 increased mainly due to the benefit from certain contractual provisions in Venezuela that settled in the year ended December 31, 2014. Service margin was flat year over year despite a lower of cost or market adjustment of $4,073 in 2014 as a result of the Venezuelan currency devaluation. Brazil revenue increased in 2014 compared to 2013, including a net unfavorable currency impact of $29,093. The constant currency revenue improvement related to lottery sales volume and deliveries of IT equipment to the education ministry in the first quarter of 2014 partially offset by a decrease in FSS volume and elections systems sales. Operating profit increased as a result of the higher product sales volume and a gain in service margin offset by an increase in operating expenses. Refer to note 20 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) 2013 comparison with 2012 Net Sales The following table represents information regarding our net sales for the years ended December 31: The decrease in FSS sales included a net unfavorable currency impact of $36,869 or 1.6 percent, of which approximately 73 percent related to the Brazilian real. The following segment highlights include the impact of foreign currency. NA FSS sales decreased $167,104 or 15.9 percent due primarily to lower volume within the U.S. regional bank business partially offset by growth in the national bank sector. A significant portion of the decline was associated with the expiration of the ADA compliance deadline in 2012. The product volume decrease in regional bank business caused a corresponding reduction in the service business specific to installation and professional services sales. AP increased $56,544 or 14.1 percent due to higher volume in India and China. EMEA increased $36,125 or 11.1 percent mainly from higher volume in Western Europe and the Middle East primarily in the emerging market of Turkey due in part to the Altus acquisition partially offset by a net decrease in the remainder of the region. Brazil decreased $20,754 or 7.1 percent, including $26,969 in unfavorable currency impact. LA declined $7,440 or 3.7 percent mainly due to volume deterioration in Mexico, partially offset by an increase in Colombia. Security sales decreased from declines in the LA, NA and AP regions. LA decreased $8,869 or 15.2 percent largely due declines in Chile. NA experienced a reduction of $8,378 or 1.6 percent. AP decreased $4,960 or 19.7 percent as the company executed on its decision in 2013 to exit the security business in Australia. These reductions were partially offset by Brazil increasing from the prior year due to the GAS acquisition. The decrease in Brazil other sales resulted from lower volume in lottery and election systems driven by cyclical purchasing decisions within the country offset by growth in the IT equipment business. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Total service gross margin remained at 25.3 percent in 2013. NA service gross margin increased due to improvements resulting from lower employee related expense associated with restructuring initiatives and a decrease in insurance and vehicle related expense in the U.S. maintenance business. In addition, NA benefited from stronger performance in the enterprise security business. These benefits were partially offset by lower FSS product volume within the U.S. regional business related to the expiration of the ADA compliance deadline in 2012, which negatively impacted services utilization specific to professional service and installation. Total service gross margin also benefited from higher volume and improved margins in EMEA and AP, partially offset by a margin decrease in Brazil. Total service gross profit in 2013 and 2012 included restructuring charges of $27,107 and $6,226, respectively. The decrease in total product gross margin was driven by NA, which had significantly lower volume, particularly in the U.S. regional bank business, due to the expiration of the ADA compliance deadline in 2012. In addition, the decline in U.S regional MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) bank business coupled with an increase in U.S. national bank sales created a customer mix shift that contributed to the product margin deterioration. Total product gross margin was also negatively influenced by unfavorable customer mix and continued pricing pressure in AP while there was a partially offsetting improvement in EMEA mainly due to favorable manufacturing performance resulting primarily from beneficial currency impact on material purchase prices. Total product gross profit included restructuring charges of $1,256 in 2013 compared to a net restructuring accrual benefit of $1,849 in 2012. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: The increase in selling and administrative expense resulted from higher non-routine expense and restructuring charges, partially offset by lower compensation and commission related expense, savings realized from the Company's continued focus on cost structure and favorable currency impact of $6,240. Non-routine expenses of $128,739 and $41,542 were included in 2013 and 2012, respectively. The primary components of the 2013 non-routine expense were a $67,593 non-cash pension charge, additional losses of $28,000 related to the settlement of the FCPA investigation, $17,245 related to the settlement of the securities class action and executive severance costs of $9,300. The majority of the 2012 non-routine expense pertained to $21,907 in early pension buy-out payments made to certain deferred terminated vested participants and estimated losses of $16,750 related to the FCPA investigation. Selling and administrative expense also included $22,561 and $9,037 of restructuring charges in 2013 and 2012, respectively. Restructuring charges in 2013 related to the Company's multi-year realignment plan, including $31,282 related to the voluntary early retirement program. The 2012 restructuring charges related to the Company's global realignment and global shared services plans. Research, development and engineering expense as a percent of net sales in 2013 and 2012 were 3.2 percent and 2.9 percent, respectively. The spend increase between years resulted from higher restructuring charges and higher expense related to software development in 2013. Research, development and engineering expense included restructuring charges of $6,091 and $1,827 in 2013 and 2012, respectively. During the third quarter of 2013, the Company performed an other-than-annual assessment for its Brazil reporting unit based on a two-step impairment test as a result of a reduced earnings outlook for the Brazil business unit due to deteriorating macro-economic outlook, structural changes to an auction-based purchasing environment and new competitors entering the market. The Company concluded that the goodwill within the Brazil reporting unit was partially impaired and recorded a $70,000 pre-tax, non-cash goodwill impairment charge. During the second quarter of 2012, the Company impaired previously capitalized software and software-related costs of $6,701 due to changes in the global enterprise resource planning (ERP) system implementation plan related to configuration and design. In the third quarter of 2012, the Company recorded an impairment of $7,930 related to its 50 percent ownership in Shanghai Diebold King Safe Company, Ltd. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Operating (Loss) Profit The following table represents information regarding our operating profit (loss) for the years ended December 31: The decline in operating (loss) profit was influenced primarily by lower volume and a shift in customer mix within NA and significant increases in impairment, non-routine expenses and restructuring charges, partially offset by lower operational spend in NA and an overall improvement in service margin. Other (Expense) Income The following table represents information regarding our other (expense) income for the years ended December 31: The decline in investment income was primarily driven by Brazil due to a decrease in total investments, lower interest rates and unfavorable currency impact. Foreign exchange gain, net, in 2013 included a $1,584 devaluation of the Venezuelan balance sheet. (Loss) Income from Continuing Operations The following table represents information regarding our income from continuing operations, net of tax for the years ended December 31: The decrease in (loss) income from continuing operations, net of tax was driven by reduced operating profit mostly related to the decrease in sales volume and the significant increases in impairment, non-routine expenses and restructuring charges, unfavorable movement in other (expense) income and higher taxes. These decreases were partially offset by lower operational spend and an improvement in service margin. The negative tax rate for 2013 is a result of tax expense of approximately $55,000 related to the repatriation of previously undistributed earnings and the establishment of a valuation allowance of approximately $39,200 on deferred tax assets in the Company's Brazilian manufacturing facility. The 2013 tax rate was also negatively impacted by the partially non-deductible Brazil goodwill impairment and the FCPA penalty charge. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: The decrease in revenue and operating profit was driven by lower FSS product volume in the U.S. regional bank business associated with the expiration of the ADA compliance deadline in 2012. The product volume decrease in regional bank business caused a corresponding reduction in the service business specific to installation and professional services. These detriments were partially offset by lower compensation and commission related expense, savings realized from the Company's continued focus on cost structure, and margin improvement in the U.S. maintenance business resulting from restructuring initiatives and growth in the national bank business. Revenue growth resulted from higher product and service sales primarily within India and China. Operating profit remained neutral to prior year as higher service gross profit resulting from the increased sales and improved service margin performance was offset by a reduction in product gross profit and higher operating expense. Total product gross profit was negatively impacted by unfavorable customer mix and continued pricing pressure in the region. Revenue increased from growth in Western Europe and the Middle East due in part to the Altus acquisition in Turkey, partially offset by a net decline in the rest of EMEA. The increase in operating profit resulted from higher product and service sales complemented by improved margins especially on the product side mainly due to favorable manufacturing performance resulting primarily from beneficial currency impact on material purchase prices. These favorable influences on operating profit were partially offset by higher selling and administrative expense. Revenue declined as lower product sales, primarily due to decreased volume in Mexico and Venezuela, was partially offset by higher sales in the service business. Operating profit was negatively impacted by the net revenue decrease coupled with an overall gross margin decline and higher operating expense. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) The decrease in revenue included a net unfavorable currency impact of $36,722. Excluding the negative currency impact, revenue increased from security revenue due to the GAS acquisition and higher IT equipment and FSS sales, partially offset by lower lottery and election systems sales. Operating profit increased as the benefit of lower operating expense outweighed the unfavorable impact of the total revenue decline between years. Refer to note 20 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. LIQUIDITY AND CAPITAL RESOURCES Capital resources are obtained from income retained in the business, borrowings under the Company’s senior notes, committed and uncommitted credit facilities, long-term industrial revenue bonds and operating and capital leasing arrangements. Management expects that the Company’s capital resources will be sufficient to finance planned working capital needs, research and development activities, investments in facilities or equipment, pension contributions, the payment of dividends on the Company’s common shares and any repurchases of the Company’s common shares for at least the next 12 months. At December 31, 2014, $438,136 or 95.5 percent of the Company’s cash and cash equivalents and short-term investments reside in international tax jurisdictions. Repatriation of these funds could be negatively impacted by potential payments for foreign and domestic taxes, excluding $88,388 that is available for repatriation with no additional tax expense because the Company has already provided for such taxes. Part of the Company’s growth strategy is to pursue strategic acquisitions. The Company has made acquisitions in the past and intends to make acquisitions in the future. The Company intends to finance any future acquisitions with either cash and short-term investments, cash provided from operations, borrowings under available credit facilities, proceeds from debt or equity offerings and/or the issuance of common shares. The Company's global liquidity as of December 31, 2014 and 2013 was as follows: The following table summarizes the results of our consolidated statement of cash flows for the years ended December 31: Net cash provided by operating activities was $186,906 for the year ended December 31, 2014 compared to $124,224 for the year ended December 31, 2013, an increase of $62,682. Cash flows from operating activities are generated primarily from net income and managing the components of working capital. Cash flows from operating activities during the year ended December 31, 2014 compared to the year ended December 31, 2013 were positively impacted by a $293,541 increase in net income, primarily related MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) to the FCPA, securities litigation action, and voluntary employee retirement program, which were recorded in 2013. Cash flows from operating activities are also impacted by changes in the components of our working capital, which vary based on normal activities with our customers and vendors. As compared to the year ended December 31, 2013, cash flow during the corresponding period in 2014 was adversely impacted by an increase in our change in trade receivables of $30,698, which results in part to growth in our revenue. Trade receivables as of December 31, 2013, were down $41,134 compared to December 31, 2012, as a result of strong cash collections in the fourth quarter of 2013. The cash flow effect of the change in inventories corresponds with the change in accounts payable. This change is a result of our investment in inventory to support planned customer demand. The cash flow impact associated with deferred revenue largely represents prepayments received on service contracts and product sales. Finance lease receivables increased in the year ended December 31, 2014 primarily due to increases in customer financing arrangements mostly in Brazil. Net cash provided by investing activities was $13,799 for the year ended December 31, 2014 compared to net cash used in investing activities of $52,719 for the year ended 2013. The $66,518 change mostly related to a $105,719 increase in net investment activity primarily in Brazil to fund our finance leasing arrangement with the Brazilian education ministry, an increase of $10,905 in proceeds from the sale of assets primarily related to the sale of Eras in the second quarter of 2014 which was partially offset by a decrease of $11,749 relating to cash payments for the Cryptera acquisition. Capital expenditures increased $26,006 to $61,453 for the year ended December 31, 2014 from $35,447 for the year ended December 31, 2013 as a result of additional capital reinvestment related to the Company's transformation strategy. Net cash used in financing activities was $81,154 for the year ended December 31, 2014 compared to the net cash used in financing activities of $204,449 for the year ended 2013, an increase of $123,295. The increase was primarily due to a $109,477 change in debt repayments and borrowing year over year and $14,755 reduction in distributions to noncontrolling interest holders. Effect of exchange rate changes on cash and cash equivalents was negatively impacted by $6,051 in the first quarter of 2014 related to the currency devaluation in Venezuela for the year ended December 31, 2014. Benefit Plans The Company expects to contribute $18,648 to its pension plans during the year ending December 31, 2015. Beyond 2015, minimum statutory funding requirements for the Company's U.S. pension plans may become more significant. The actual amounts required to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory actions related to pension funding obligations. The Company has adopted a pension investment policy designed to achieve an adequate funded status based on expected benefit payouts and to establish an asset allocation that will meet or exceed the return assumption while maintaining a prudent level of risk. The plan's target asset allocation adjusts based on the plan's funded status. As the funded status improves or declines, the debt security target allocation will increase and decrease, respectively. Management monitors assumptions used for our actuarial projections as well as any funding requirements for the plans. Payments due under the Company's other post-retirement benefit plans are not required to be funded in advance. Payments are made as medical costs are incurred by covered retirees, and are principally dependent upon the future cost of retiree medical benefits under these plans. The Company expects the other post-retirement benefit plan payments to be approximately $1,533 in 2015 (refer to note 13 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further discussion of the Company's pension and other post-retirement benefit plans). Dividends The Company paid dividends of $74,946, $73,997 and $72,830 in the years ended December 31, 2014, 2013 and 2012, respectively. Annualized dividends per share were $1.15, $1.15 and $1.14 for the years ended December 31, 2014, 2013 and 2012, respectively. The first quarterly dividend of 2015 represents an annualized dividend of $1.15 per share. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Contractual Obligations The following table summarizes the Company’s approximate obligations and commitments to make future payments under contractual obligations as of December 31, 2014: (1) Amounts represent estimated contractual interest payments on outstanding long-term debt and notes payable. Rates in effect as of December 31, 2014 are used for variable rate debt. At December 31, 2014, the Company also maintained uncertain tax positions of $14,967, for which there is a high degree of uncertainty as to the expected timing of payments (refer to note 5 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). As of December 31, 2014, the Company had various short-term uncommitted lines of credit with borrowing limits of $139,942. The weighted-average interest rate on outstanding borrowings on the short-term uncommitted lines of credit as of December 31, 2014 and 2013 was 2.96 percent and 3.24 percent, respectively. The decrease in the weighted-average interest rate is attributable to the change in mix of borrowings in foreign entities. Short-term uncommitted lines mature in less than one year. The amount available under the short-term uncommitted lines at December 31, 2014 was $115,192. In August 2014, the Company amended and extended its credit facility. As of December 31, 2014, the Company has increased its borrowing limits under its amended credit facility from $500,000 to $520,000. The amended facility expires in August 2019 and did not change any of the covenants related to the previous agreement. Under the terms of the amended credit facility agreement, the Company has the ability, subject to various approvals, to increase the borrowing limits by $250,000. Up to $50,000 of the revolving credit facility is available under a swing line subfacility. The weighted-average interest rate on outstanding credit facility borrowings as of December 31, 2014 and 2013 was 1.69 percent and 1.36 percent, respectively, which is variable based on the London Interbank Offered Rate (LIBOR). The amount available under the credit facility as of December 31, 2014 was $280,000. The Company incurred $1,368 of fees related to its amended credit facility in 2014, which are amortized as a component of interest expense over the term of the facility. In March 2006, the Company issued senior notes in an aggregate principal amount of $300,000 with a weighted-average fixed interest rate of 5.50 percent. The Company entered into a derivative transaction to hedge interest rate risk on $200,000 of the senior notes, which was treated as a cash flow hedge. This reduced the effective interest rate from 5.50 percent to 5.36 percent. The Company funded the repayment of $75,000 of the senior notes at maturity in March 2013 using borrowings under its revolving credit facility. The maturity dates of the remaining senior notes are staggered, with $175,000 and $50,000 due in 2016 and 2018, respectively. The Company’s financing agreements contain various restrictive financial covenants, including net debt to capitalization and net interest coverage ratios. As of December 31, 2014, the Company was in compliance with the financial covenants in its debt agreements. Off-Balance Sheet Arrangements The Company enters into various arrangements not recognized in the consolidated balance sheets that have or could have an effect on its financial condition, results of operations, liquidity, capital expenditures or capital resources. The principal off-balance sheet arrangements that the Company enters into are guarantees, operating leases (refer to note 14 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K) and sales of finance receivables. The Company provides its global operations guarantees and standby letters of credit through various financial institutions to suppliers, customers, regulatory agencies and insurance providers. If the Company is not able to comply with its contractual obligations, the suppliers, regulatory agencies and insurance providers may draw on the pertinent bank (refer to note 15 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company has sold finance receivables to financial institutions while continuing to service the receivables. The Company records these sales by MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) removing finance receivables from the consolidated balance sheets and recording gains and losses in the consolidated statement of operations (refer to note 7 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements. The consolidated financial statements of the Company are prepared in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP). The preparation of the accompanying consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities and reported amounts of revenues and expenses. Such estimates include revenue recognition, the valuation of trade and financing receivables, inventories, goodwill, intangible assets, other long-lived assets, legal contingencies, guarantee obligations, and assumptions used in the calculation of income taxes, pension and post-retirement benefits and customer incentives, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors. Management monitors the economic conditions and other factors and will adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. The Company’s significant accounting policies are described in note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K. Management believes that, of its significant accounting policies, its policies concerning revenue recognition, allowances for credit losses, inventory reserves, goodwill, long-lived assets, taxes on income, contingencies and pensions and post-retirement benefits are the most critical because they are affected significantly by judgments, assumptions and estimates. Additional information regarding these policies is included below. Revenue Recognition The Company records revenue when it is realized, or realizable and earned. The application of U.S. GAAP revenue recognition principles to the Company's customer contracts requires judgment, including the determination of whether an arrangement includes multiple deliverables such as hardware, software, maintenance and /or other services. For contracts that contain multiple deliverables, total arrangement consideration is allocated at the inception of the arrangement to each deliverable based on the relative selling price method. The relative selling price method is based on a hierarchy consisting of vendor specific objective evidence (VSOE) (price sold on a stand-alone basis), if available, or third-party evidence (TPE), if VSOE is not available, or estimated selling price (ESP) if neither VSOE nor TPE is available. The Company's ESP is consistent with the objective of determining VSOE, which is the price at which we would expect to transact on a stand-alone sale of the deliverable. The determination of ESP is based on applying significant judgment to weigh a variety of company-specific factors including our pricing practices, customer volume, geography, internal costs and gross margin objectives. This information is gathered from experience in customer negotiations, recent technological trends and the competitive landscape. In contracts that involve multiple deliverables, maintenance services are typically accounted for under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605-20, Separately Priced Extended Warranty and Product Maintenance Contracts. There have been no material changes to these estimates for the periods presented and the Company believes that these estimates generally should not be subject to significant changes in the future. However, changes to deliverables in future arrangements could materially impact the amount of earned or deferred revenue. For sales of software, excluding software required for the equipment to operate as intended, the Company applies the software revenue recognition principles within FASB ASC 985-605, Software - Revenue Recognition. For software and software-related deliverables (software elements), the Company allocates revenue based upon the relative fair value of these deliverables as determined by VSOE. If the Company cannot obtain VSOE for any undelivered software element, revenue is deferred until all deliverables have been delivered or until VSOE can be determined for any remaining undelivered software elements. When the fair value of a delivered element cannot be established, but fair value evidence exists for the undelivered software elements, the Company uses the residual method to recognize revenue. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement consideration is allocated to the delivered elements and recognized as revenue. Determination of amounts deferred for software support requires judgment about whether the deliverables can be divided into more than one unit of accounting and whether the separate deliverables have value to the customer on a stand-alone basis. There have been no material changes to these deliverables for the periods presented. However, changes to deliverables in future arrangements and the ability to establish VSOE could affect the amount and timing of revenue recognition. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Allowances for Credit Losses The Company maintains allowances for potential credit losses and such losses have been minimal and within management’s expectations. Since the Company’s receivable balance is concentrated primarily in the financial and government sectors, an economic downturn in these sectors could result in higher than expected credit losses. The concentration of credit risk in the Company’s trade receivables with respect to financial and government customers is largely mitigated by the Company’s credit evaluation process and the geographical dispersion of sales transactions from a large number of individual customers. Inventory Reserves At each reporting period, the Company identifies and writes down its excess and obsolete inventories to net realizable value based on usage forecasts, order volume and inventory aging. With the development of new products, the Company also rationalizes its product offerings and will write-down discontinued product to the lower of cost or net realizable value. Goodwill Goodwill is the cost in excess of the net assets of acquired businesses (refer to note 11 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company tests all existing goodwill at least annually as of November 30 for impairment on a reporting unit basis. The Company tests for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the carrying value of a reporting unit below its reported amount. The Company’s five reporting units are defined as Domestic and Canada, Brazil, LA, AP and EMEA. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount, the Company considers the following events and circumstances, among others, if applicable: (a) macroeconomic conditions such as general economic conditions, limitations on accessing capital or other developments in equity and credit markets; (b) industry and market considerations such as competition, multiples or metrics and changes in the market for the Company's products and services or regulatory and political environments; (c) cost factors such as raw materials, labor or other costs; (d) overall financial performance such as cash flows, actual and planned revenue and earnings compared with actual and projected results of relevant prior periods; (e) other relevant events such as changes in key personnel, strategy or customers; (f) changes in the composition of a reporting unit's assets or expected sales of all or a portion of a reporting unit; and (g) any sustained decrease in share price. If the Company's qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying value, or if management elects to perform a quantitative assessment of goodwill, a two-step impairment test is used to identify potential goodwill impairment and measure the amount of any impairment loss to be recognized. In the first step, the Company compares the fair value of each reporting unit with its carrying value. The fair value is determined based upon discounted estimated future cash flows as well as the market approach or guideline public company method. The Company’s Step 1 impairment test of goodwill of a reporting unit is based upon the fair value of the reporting unit, defined as the price that would be received to sell the net assets or transfer the net liabilities in an orderly transaction between market participants at the assessment date. In the event that the net carrying amount exceeds the fair value, a Step 2 test must be performed whereby the fair value of the reporting unit’s goodwill must be estimated to determine if it is less than its net carrying amount. In its two-step test, the Company uses the discounted cash flow method and the guideline company method for determining the fair value of its reporting units. Under these methods, the determination of implied fair value of the goodwill for a particular reporting unit is the excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities in the same manner as the allocation in a business combination. The techniques used in the Company's qualitative assessment and, if necessary, two-step impairment test have incorporated a number of assumptions that the Company believes to be reasonable and to reflect market conditions forecast at the assessment date. Assumptions in estimating future cash flows are subject to a high degree of judgment. The Company makes all efforts to forecast future cash flows as accurately as possible with the information available at the time the forecast is made. To this end, the Company evaluates the appropriateness of its assumptions as well as its overall forecasts by comparing projected results of upcoming years with actual results of preceding years and validating that differences therein are reasonable. Key assumptions, all of which are Level 3 inputs (refer to note 19 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K), relate to price trends, material costs, discount rate, customer demand, and the long-term growth and foreign exchange rates. A number of benchmarks from independent industry and other economic publications were also used. Changes in assumptions and estimates after the assessment date may lead to an outcome where impairment charges would be required in future periods. Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Management determined that the Brazil and AP reporting units had excess fair value of approximately $61,000 or 17 percent and approximately $114,200 or 39 percent, respectively, when compared to their carrying amounts. The Domestic and Canada and LA reporting units had excess fair value greater than 100 percent when compared to their carrying amounts. During the third quarter of 2013, the Company performed an other-than-annual assessment for its Brazil reporting unit based on a two-step impairment test as a result of a reduced earnings outlook for the Brazil business unit. This was due to a deteriorating macro-economic outlook, structural changes to an auction-based purchasing environment and new competitors entering the market. The Company concluded that the goodwill within the Brazil reporting unit was partially impaired and recorded a $70,000 pre-tax, non-cash goodwill impairment charge. In the fourth quarter of 2013, the Brazil reporting unit was reviewed for impairment based on a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In addition, the remaining reporting units were reviewed based on a two-step test. These tests resulted in no additional impairment in any of the Company's reporting units. Long-Lived Assets Impairment of long-lived assets is recognized when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized at that time to reduce the asset to the lower of its fair value or its net book value. Taxes on Income Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized for deductible temporary differences, operating loss carry-forwards and tax credits. Deferred tax liabilities are recognized for taxable temporary differences and undistributed earnings in certain jurisdictions. Deferred tax assets are reduced by a valuation allowance when, based upon the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Determination of a valuation allowance involves estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income and the impact of tax planning strategies. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company operates in numerous taxing jurisdictions and is subject to examination by various federal, state and foreign jurisdictions for various tax periods. Additionally, the Company has retained tax liabilities and the rights to tax refunds in connection with various acquisitions and divestitures of businesses. The Company’s income tax positions are based on research and interpretations of the income tax laws and rulings in each of the jurisdictions in which the Company does business. Due to the subjectivity of interpretations of laws and rulings in each jurisdiction, the differences and interplay in tax laws between those jurisdictions, as well as the inherent uncertainty in estimating the final resolution of complex tax audit matters, the Company’s estimates of income tax liabilities may differ from actual payments or assessments. The Company assesses its position with regard to tax exposures and records liabilities for these uncertain tax positions and any related interest and penalties, when the tax benefit is not more likely than not realizable. The Company has recorded an accrual that reflects the recognition and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. Additional future income tax expense or benefit may be recognized once the positions are effectively settled. At the end of each interim reporting period, the Company estimates the effective tax rate expected to apply to the full fiscal year. The estimated effective tax rate contemplates the expected jurisdiction where income is earned, as well as tax planning alternatives. Current and projected growth in income in higher tax jurisdictions may result in an increasing effective tax rate over time. If the actual results differ from estimates, the Company may adjust the effective tax rate in the interim period if such determination is made. Contingencies Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. There is no liability recorded for matters in which the liability is not probable and reasonably estimable. Attorneys in the Company's legal department monitor and manage all claims filed against the Company and review all pending investigations. Generally, the estimate of probable loss related to these matters is developed in consultation with internal and outside legal counsel representing the Company. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The Company attempts to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments, or fines, MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) after appeals, differ from the estimates, the future results may be materially impacted. Adjustments to the initial estimates are recorded when a change in the estimate is identified. Pensions and Other Post-retirement Benefits Annual net periodic expense and benefit liabilities under the Company’s defined benefit plans are determined on an actuarial basis. Assumptions used in the actuarial calculations have a significant impact on plan obligations and expense. Members of the management investment committee periodically review the actual experience compared with the more significant assumptions used and make adjustments to the assumptions, if warranted. The discount rate is determined by analyzing the average return of high-quality (i.e., AA-rated) fixed-income investments and the year-over-year comparison of certain widely used benchmark indices as of the measurement date. The expected long-term rate of return on plan assets is determined using the plans’ current asset allocation and their expected rates of return based on a geometric averaging over 20 years. The rate of compensation increase assumptions reflects the Company’s long-term actual experience and future and near-term outlook. Pension benefits are funded through deposits with trustees. Other post-retirement benefits are not funded and the Company’s policy is to pay these benefits as they become due. The following table represents assumed healthcare cost trend rates at December 31: The healthcare trend rates are reviewed based upon the results of actual claims experience. The Company used healthcare cost trends of 7.5 percent in both 2015 and 2014 decreasing to an ultimate trend of 5.0 percent in 2020 for both medical and prescription drug benefits using the Society of Actuaries Long Term Trend Model with assumptions based on the 2008 Medicare Trustees’ projections. Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. A one-percentage-point change in assumed healthcare cost trend rates would have the following effects: During 2014, the Society of Actuaries released a series of updated mortality tables resulting from recent studies conducted by them measuring mortality rates for various groups of individuals. As of December 31, 2014, the Company updated theses mortality tables which reflect improved trends in longevity and therefore have the effect of increasing the estimate of benefits to be received by plan participants. Management will continue to monitor assumptions used for our actuarial projections along with any funding requirements for the plans. RECENTLY ISSUED ACCOUNTING GUIDANCE Refer to note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for information on recently issued accounting guidance. FORWARD-LOOKING STATEMENT DISCLOSURE In this annual report on Form 10-K, statements that are not reported financial results or other historical information are “forward-looking statements.” Forward-looking statements give current expectations or forecasts of future events and are not guarantees of future performance. These forward-looking statements relate to, among other things, the Company’s future operating performance, the Company’s share of new and existing markets, the Company’s short- and long-term revenue and earnings growth rates, the Company’s implementation of cost-reduction initiatives and measures to improve pricing, including the optimization of the Company’s manufacturing capacity. The use of the words "will," "believes," "anticipates," "plans," "projects," "expects," "intends" and similar expressions is intended to identify forward-looking statements that have been made and may in the future be made by or on behalf of the Company. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2014 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in thousands, except per share amounts) Although the Company believes that these forward-looking statements are based upon reasonable assumptions regarding, among other things, the economy, its knowledge of its business, and on key performance indicators that impact the Company, these forward-looking statements involve risks, uncertainties and other factors that may cause actual results to differ materially from those expressed in or implied by the forward-looking statements. The Company is not obligated to update forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Some of the risks, uncertainties and other factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements include, but are not limited to: • competitive pressures, including pricing pressures and technological developments; • changes in the Company's relationships with customers, suppliers, distributors and/or partners in its business ventures; • changes in political, economic or other factors such as currency exchange rates, inflation rates, recessionary or expansive trends, taxes and regulations and laws affecting the worldwide business in each of the Company's operations; • global economic conditions, including any additional deterioration and disruptions in the financial markets, including bankruptcies, restructurings or consolidations of financial institutions, which could reduce our customer base and/or adversely affect our customers’ ability to make capital expenditures, as well as adversely impact the availability and cost of credit; • acceptance of the Company's product and technology introductions in the marketplace; • the Company’s ability to maintain effective internal controls; • changes in the Company’s intention to further repatriate cash and cash equivalents and short-term investments residing in international tax jurisdictions could negatively impact foreign and domestic taxes; • unanticipated litigation, claims or assessments, as well as the outcome/impact of any current/pending litigation, claims or assessments, including with respect to the Company's Brazilian tax dispute; • variations in consumer demand for FSS technologies, products and services; • potential security violations to the Company's information technology systems; • the investment performance of the Company’s pension plan assets, which could require the Company to increase its pension contributions, and significant changes in healthcare costs, including those that may result from government action; • the amount and timing of repurchases of the Company’s common shares, if any; • the Company's ability to achieve benefits from its cost-reduction initiatives and other strategic changes, including its multi-year realignment plan and other restructuring actions, as well as its business process outsourcing initiative; and • the risk factors described above under "Part I - Item 1A - Risk Factors” of this Form 10-K.

<s>[INST] Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10K. Introduction Diebold, Incorporated and its subsidiaries (collectively, the Company) is a global leader in providing financial selfservice (FSS) delivery, integrated services and software, and security systems to primarily the financial, commercial, retail and other markets. Founded in 1859, the Company currently has approximately 16,000 employees with business in more than 90 countries worldwide. The Company unveiled its multiyear turnaround strategy, Diebold 2.0, at the Investment Community Conference in November 2013. The objective of Diebold 2.0 is to transform the Company into a worldclass, servicesled and software enabled company, supported by innovative hardware, that automates the way people connect with their money. The turnaround strategy will follow a “Crawl, Walk, Run” approach, which includes stabilizing the core business operations in the “Crawl” phase and building the foundation for future growth in the “Walk” and “Run” phases. The company is nearing the completion of the “Crawl” phase and expects to transition to “Walk” in the second half of 2015. Four core pillars provide the Company a clear path toward reaching this multiyear objective: Reduce its cost structure and improve its nearterm delivery and execution. Generate increased free cash flow in order to fund the investments necessary to drive profitable growth, while preserving the ability to return value to shareholders in the form of reliable dividends and, as appropriate, share repurchases. Attract and retain the talent necessary to drive innovation and the focused execution of the transformation strategy. Return the Company to a sustainable, profitable growth trajectory. The Company sees opportunities to leverage its capabilities in services, software and innovation to meet the needs of its rapidly evolving markets. The Company has sharpened its focus on executing its core strategies in FSS and electronic security. This includes making the appropriate investments to deliver growth within these areas, especially in research, development and engineering. In addition, the Company remains committed to a disciplined risk assessment process, focused on proactively identifying and mitigating potential risks to the Company's continued success. Net income (loss) attributable to Diebold, Incorporated for the year ended December 31, 2014 was $114,417, or $1.76 per share, an increase of $296,022, or $4.61 per share from the year ended December 31, 2013. Total revenue for the year ended December 31, 2014 was $3,051,053, an increase of $193,562 from the year ended December 31, 2013. The year ended December 31, 2014 included a $13,709 pretax gain from the sale of the Company's Diebold Eras, Incorporated (Eras) subsidiary. Cryptera A/S (Cryptera) was acquired for a purchase price of approximately $13,000 and is included in the Europe, Middle East and Africa (EMEA) segment within the Company' s consolidated financial statements from July 1, 2014, the date of acquisition. Pretax restructuring charges of $11,872 related to the Company's multiyear realignment plan were also included in the year ended December 31, 2014. The year ended December 31, 2013 included a $67,593 pretax noncash pension charge related to the voluntary early retirement program, a $70,000 pretax goodwill impairment charge, $57,015 of pretax restructuring charges related to the Company's multiyear realignment plan, including $31,282 related to the voluntary early retirement program, $28,000 of additional pretax losses related to the settlement of the global Foreign Corrupt Practices Act (FCPA) investigation, a $17,245 pretax net charge related to settlement of the securities class action, and $9,300 of pretax executive severance. Internationally, [/INST] Positive. </s>

DIEBOLD INC

2016-02-29

2015-12-31

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10-K. Introduction Diebold provides the services, software and technology that connect people around the world with their money - bridging the physical and digital worlds of cash conveniently, securely and efficiently. Since its founding in 1859, the Company believes it has evolved to become a leading provider of exceptional self-service innovation, security and services to financial, retail, commercial and other markets. At December 31, 2015, the Company employed approximately 16,000 associates globally, of which approximately 1,000 relate to the Company's recently divested electronic security business. The Company’s service staff is one of the financial industry’s largest, with professionals in more than 600 locations and businesses in more than 90 countries worldwide. The Company continues to execute its multi-year transformation, Diebold 2.0, with the primary objective of transforming the Company into a world-class, services-led and software-enabled company, supported by innovative hardware, which automates the way people connect with their money. Diebold 2.0 consists of four pillars: • Cost - Streamline the cost structure and improve near-term delivery and execution. • Cash - Generate increased free cash flow in order to fund the investments necessary to drive profitable growth, while preserving the ability to return value to shareholders in the form of reliable dividends and, as appropriate, share repurchases. • Talent - Attract and retain the talent necessary to drive innovation and the focused execution of the transformation strategy. • Growth - Return Diebold to a sustainable, profitable growth trajectory. The Company's multi-year transformation plan is expected to occur in three phases: 1) Crawl, 2) Walk, and 3) Run. As part of the transformation, the Company has identified targeted savings of $200.0 that are expected to be fully realized by the end of 2017 and plans to reinvest approximately 50 percent of the cost savings to drive long-term growth. During the “Crawl” phase, the Company was primarily focused on taking cost out of the business and reallocating a portion of these savings as reinvestments in systems and processes. The Company engaged Accenture LLP (Accenture) in a multi-year outsourcing agreement to provide finance and accounting and procurement business process services. With respect to talent, the Company attracted new leaders from top technology and services companies. During the second half of 2015, the Company transitioned into the “Walk” phase of Diebold 2.0 whereby the Company will continue to build on each pillar of cost, cash, talent and growth. The main difference in the “Walk” phase will be a greater emphasis on increasing the mix of revenue from services and software, as well as shaping the Company’s portfolio of businesses. As it relates to increasing the mix of services and software, the Company has recently sharpened its focus on pursuing and winning multi-vendor services contracts in North America to further diversify its portfolio of services offerings. The total number of non-Diebold automated teller machines (ATMs) signed under contract as of December 31, 2015 was more than 12,000, which gives the Company a solid platform for future growth. For the software business, the recent acquisition of Phoenix Interactive Design, Inc., (Phoenix) has significantly enhanced the Company’s ability to capture more of the dynamic self-service market. The integration of Phoenix is tracking to plan and all of the Company’s global software activities are being coordinated through the new development center in London, Ontario. As it relates to shaping the portfolio of businesses, the Company’s announcements subsequent to the third quarter of 2015 are consistent with its strategy of transforming into a world-class services-led, software-enabled company, supported by innovative hardware. On October 25, 2015, the Company entered into a definitive asset purchase agreement to divest its North America-based electronic security business. For ES to continue its growth, it would require resources and investment that Diebold is not committed to make given its focus on the self-service market. On February 1, 2016, the Company divested its North America electronic security business to Securitas AB for an aggregate purchase price of $350.0 in cash, 10.0% of which is contingent on the successful transition of certain customer relationships, which management expects to receive full payment of $35.0 in the first quarter of 2016 now that all contingencies for this payment have been achieved. The Company is estimating a pre-tax gain of approximately $245.0 on the ES divestiture which will be recognized in the first quarter of 2016 and is subject to change upon the finalization of the working capital adjustments and the income tax effect of gain on sale. The Company has also agreed to provide certain transition services for a $6.0 credit. Additionally, the Company is narrowing its scope in the Brazil other business to primarily focus on lottery and elections to help rationalize its solution set in that market. These decisions enable the Company to refocus its resources and better position itself to pursue growth opportunities in the dynamic self-service industry. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) In December 2015, the Company announced it is forming a new joint venture with a subsidiary of the Inspur Group, a Chinese cloud computing and data center company, to develop, manufacture and distribute financial self-service (FSS) solutions in China. Inspur will hold a majority stake of 51 percent in the new joint venture, which will be named Inspur Financial Information Systems, Ltd. The joint venture will offer a complete range of self-service terminals within the Chinese market, including ATMs. Also, Diebold will serve as the exclusive distributor outside of China for all products developed by the new joint venture, which will be sold under the Diebold brand. In addition, to support Diebold's services-led approach to the market, Inspur will acquire a minority share of Diebold's current China joint venture. Moving forward, this business will be focused on providing a whole suite of services including installation, maintenance, professional and managed services related to ATMs and other automated transaction solutions. Solutions The Company believes it is a leader in managed and maintenance services with a dedicated service network serving our customers across the globe. The combination of the Company’s differentiated security, remote management and highly-trained field technicians has made the Company the preferred choice for current and emerging self-service solutions. Through managed services, banks entrust the management of their ATM and security operations to the Company, allowing their associates to focus on core competencies. Furthermore, the Company’s managed services provides banks and credit unions with a leading-edge technology that they need to stay competitive in the marketplace. A significant demand driver in the global ATM marketplace is branch automation. The concept is to help financial institutions reduce their costs by migrating routine transactions, typically done inside the branch, to lower-cost automated channels, while also growing revenue, and adding convenience and security for the banks’ customers. The Company serves as a strategic partner to its customers by offering a complete branch automation solution-services, software and technology-that addresses the complete value chain of consult, design, build and operate. The Company’s Advisory Services team collaborates with our clients to help define the ideal customer experience, modify processes, refine existing staffing models and deploy technology to meet branch automation objectives. The Diebold 9900 in-lobby teller terminal (ILT) provides branch automation technology by combining the speed and accuracy of a self-service terminal with intelligence from the bank’s core systems, as well as the ability to complete higher value transactions away from the teller line. The Company also offers hardware-agnostic, omni-channel software solutions for ATMs and a host of other self-service applications. These offerings include highly configurable, enterprise-wide software that automates and migrates financial services across channels, changing the way financial products are delivered to consumers. Mobile integration is an emerging trend in branch automation, as consumers look for more convenient ways to interact with their financial institutions. To address this need, the Company offers its innovative Mobile Cash Access software solution, which enables consumers to initiate ATM transactions with a mobile device. By eliminating the need for an ATM card, Mobile Cash Access dramatically speeds up transaction time and reduces the risk of card skimming, fraud and theft since sensitive customer information is never stored on the mobile device and is passed to the ATM via a secure virtual private network connection. The Company has demonstrated success with this solution in North America (NA), and Europe, Middle East and Africa (EMEA). As part of its branch automation solution, the Company offers two-way video capabilities. The solution provides consumers with on-demand access to bank call center representatives at the ATM for sales or bank account maintenance support. In addition to delivering a personal touch outside of regular business hours, it ultimately assists financial institutions by maximizing operational efficiencies, improving the consumer experience and enhancing the overall consumer relationship. An innovation that enhances security for customers is Diebold’s ActivEdge™ secure card reader. This is the ATM industry’s first complete anti-skimming, EMV compliant card reader that prevents all known forms of skimming, the most prevalent type of ATM crime. ActivEdge™ can assist financial institutions avoid skimming-related fraud losses which, according to the ATM Industry Association, totals more than $2 billion annually worldwide. ActivEdge™ requires users to insert cards into the reader via the long edge, instead of the traditional short edge. the Company believes by shifting a card’s angle 90 degrees, ActivEdge™ prevents modern skimming devices from reading the card’s full magnetic strip, eliminating the devices’ ability to steal card data. The Company will continue to invest in developing new services, software and security solutions that align with the needs of its customers. During the third quarter, the Company added its high-performance cash-dispensing and full-function ATM models to its self-service platform. Over the past year, the Company has unveiled three new lines of ATMs-standard market, extended branch and the high-performance line, which are designed to meet specific market and branch needs for customers. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Business Drivers The business drivers of the Company's future performance include, but are not limited to: • demand for services and software, including managed services and professional services; • timing of self-service equipment upgrades and/or replacement cycles; • demand for products and solutions related to bank branch automation opportunities; • demand for security products and services for the financial and commercial sectors; and • high levels of deployment growth for new self-service products in emerging markets. Pending Business Combination with Wincor Nixdorf In the fourth quarter of 2015, the Company announced its intention to acquire Wincor Nixdorf ordinary shares through a tender offer for €38.98 in cash and 0.434 common shares of the Company per outstanding ordinary share of Wincor Nixdorf. The Company considered a number of factors in connection with its evaluation of the proposed transaction, including significant strategic opportunities and potential synergies, as generally supporting its decision to enter into the business combination agreement. The final purchase price is dependent on the stock price of the Company at the time of close. Based on the closing stock price of the Company on January 26, 2016 and the U.S. dollar to euro foreign currency exchange rate of $1.0845 per euro, the total estimated purchase price will be $1,609.7 as incorporated in the Company's Form S-4/A filed with the U.S. Securities and Exchange Commission on February 5, 2016. The Company intends to finance the cash portion of the purchase price as well as any Wincor Nixdorf debt outstanding under our revolving and term loan credit agreement entered into on December 23, 2015 and bridge agreement entered into on November 23, 2015. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) The table below presents the changes in comparative financial data for the years ended December 31, 2015, 2014 and 2013. Comments on significant year-to-year fluctuations follow the table. The operating results for the NA electronic security business have been reclassified to discontinued operations for all of the periods presented. The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes that appear elsewhere in this annual report on Form 10-K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) RESULTS OF OPERATIONS 2015 comparison with 2014 Net Sales The following table represents information regarding our net sales for the years ended December 31: FSS sales decreased $88.5 or 4.0 percent inclusive of a net unfavorable currency impact of $161.2. The unfavorable currency impact was related primarily to the Brazil real and the euro. The following segment results include the impact of foreign currency. • NA FSS sales increased $6.4 or 0.7 percent due primarily to increased volume in Canada from a large deposit automation upgrade project combined with the incremental sales from the acquisition of Phoenix in the first quarter of 2015. The United States (U.S.) experienced growth in multi-vendor services within the national bank space as significant contracts were won in the first, third and fourth quarters of 2015. This favorability was partially offset by a product volume decline related to two large enterprise accounts in the U.S. and the winding down of the Agilis 3 and Windows 7 upgrade project in the U.S. regional bank space. • Asia Pacific (AP) FSS sales decreased $55.9 or 11.7 percent impacted by $17.8 in unfavorable currency. The decline was primarily attributable to a decrease in product revenue in China where the government is encouraging banks to increase their use of domestic ATM suppliers. This decline was partially offset by an increase in service revenue as India, Philippines and China have experienced growth in their service installation base as well as higher professional services volume across a majority of the region. • EMEA FSS sales decreased $28.3 or 6.7 percent inclusive of a $66.6 unfavorable currency impact mainly related to the weakening of the euro. Excluding the unfavorable currency impact, EMEA FSS sales increased $38.3 due to higher product volume in Turkey and with European distributors, as well as a full year benefit of Cryptera, which was acquired in the third quarter of 2014. In addition to the unfavorable currency, offsetting declines occurred in Italy due to lower product volume while Belgium, Austria and the UK had large projects in 2014. • Latin America (LA) FSS sales decreased $10.7 or 2.5 percent inclusive of $69.5 unfavorable currency impact mainly related to the weakening of the Brazil real. Excluding the unfavorable currency impact, LA FSS sales increased $58.8 due to growth across a majority of the region, including Mexico which experienced double digit growth related to several customers renewing their existing ATM fleets. This was offset by the unfavorable currency impact and the sale of the Company’s equity interest in the Venezuelan joint venture. Security sales decreased $19.6 or 6.3 percent impacted by $6.1 in unfavorable currency. Approximately two-thirds of the decrease was related to continuing electronic security business, driven by volume declines in LA due to government mandated security updates in 2014. There were volume declines in AP as a result of exiting the business in Australia. Physical security was down due to volume declines in AP, LA and both the regional and national bank space in the U.S. Brazil other sales included an unfavorable currency impact of $62.8 and a decrease related to deliveries of information technology (IT) equipment to the Brazil education ministry in the prior year. Additionally, market-specific economic and political factors continue to weigh on the purchasing environment driving lower volume in country. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Service gross margin increased during the time period with slight improvements throughout the international regions. AP service gross margin increased largely due to operational efficiencies gained through organizational restructuring while EMEA was driven primarily by higher service parts volume with EMEA distributors. LA’s margin improvement was driven by Venezuela, which had a lower cost of market adjustment in 2014 that favorably affected margins between the time periods. NA experienced a declines in gross margin and gross profit as a result of volume and service mix. Service gross profit in 2015 and 2014 included restructuring charges of $3.1 and $1.3, respectively. Product gross margin decreased during the time period due to a decline in volume and a shift in product solution mix. In addition, product gross margin was adversely impacted by $4.7 of inventory reserves related to the cancellation of certain projects in connection with the current Brazil economic and political environment. Product gross profit included total restructuring charges and non-routine expenses of $1.6 in 2015 and net benefit of $5.2 in 2014, which was related to Brazil indirect tax reversals. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: The increase in selling and administrative expense resulted primarily from higher non-routine and restructuring charges and an increase in the bad debt reserve of $4.6 in the third quarter of 2015 related to the cancellation of a previously awarded government contract in connection with the current Brazil economic and political environment, net of lower operational spend and favorable currency impact. Non-routine expenses of $36.3 and $9.2 were included in 2015 and 2014, respectively. The non-routine expenses pertained to legal, indemnification and professional fees related to corporate monitor efforts, which was $14.7 and $9.2 in 2015 and 2014, respectively. Additionally, 2015 included divestiture and potential acquisition costs of $21.1 in non-routine expense, with no comparable expense in 2014. Selling and administrative expense also included $16.7 and $9.7 of restructuring charges in 2015 and 2014, respectively. Restructuring charges in 2015 and 2014 consisted of the Company's transformation and business process outsourcing initiative. There were additional costs in 2015 associated with executive delayering. Research, development and engineering expense as a percent of net sales in 2015 and 2014 were relatively flat. The Company increased investment in 2015 related to the acquisition and integration of Phoenix as well as incremental expense associated with the acquisition of Cryptera, which was completed in the second half of 2014. This increase was offset by favorable currency impact and a decrease between the time periods mainly due to higher material and labor costs in 2014 related to the launch of new ATM models and enhanced modules. As of March 31, 2015, the Company agreed to sell its equity interest in its Venezuela joint venture to its joint venture partner and recorded a $10.3 impairment of assets in the first quarter of 2015. On April 29, 2015, the Company closed the sale for the estimated fair market value and recorded a $1.0 reversal of impairment of assets based on final adjustments in the second quarter of 2015, MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) resulting in a $9.3 impairment of assets. Final fair value adjustments resulted in an overall impairment of $9.7. The Company no longer has a consolidating entity in Venezuela but will continue to operate in Venezuela on an indirect basis. Additionally, the Company recorded an impairment related to other intangibles in LA in the second quarter of 2015 and an impairment of $9.1 related to redundant legacy Diebold internally-developed software as a result of the acquisition of Phoenix in the first quarter of 2015 in which the carrying amounts of the assets were not recoverable. During the second quarter of 2014, the Company divested its Eras subsidiary, resulting in a gain on sale of assets of $13.7. Operating Profit The following table represents information regarding our operating profit (loss) for the years ended December 31: The decrease in operating profit resulted from lower product revenue primarily in Brazil and China combined with higher net non-routine and restructuring charges. Impairment of assets and gain on sales of assets unfavorably impacted operating profit as a result of impairments in the first half of 2015 and the gain on the sale of Eras in 2014. Improvement in service margin helped to partially offset these declines. Other (Expense) Income The following table represents information regarding our other (expense) income for the years ended December 31: The decrease in investment income was driven primarily by unfavorable currency impact in Brazil. The foreign exchange loss net for 2015 and 2014 included $7.5 and $12.1, respectively, related to the devaluation of the Venezuela currency. The change in miscellaneous, net was primarily related to income derived from the fair value re-measurement of foreign currency option contracts. Net Income from Continuing Operations, net of tax The following table represents information regarding our net income from continuing operations, net of tax for the years ended December 31: The decrease in net income was driven by lower operating profit resulting from lower product revenue in conjunction with higher net non-routine and restructuring charges as well as a net detriment between years associated with impairment of assets and gain on sales of assets. The tax rate benefit for the year ended December 31, 2015 resulted from the repatriation of foreign earnings, the associated recognition of foreign tax credits and related benefits due to the passage of the Protecting Americans from Tax Hikes (PATH) Act of 2015. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Income from Discontinued Operations, Net of Tax On February 1, 2016, the Company executed a definitive asset purchase agreement (Purchase Agreement) with a wholly owned subsidiary of Securitas AB (Securitas Electronic Security) to divest its electronic security business located in the U.S. and Canada for an aggregate purchase price of approximately $350.0 in cash, 10.0 percent of which is contingent based on the successful transition of certain customer relationships, which management expects to receive full payment of $35.0 in the first quarter of 2016 now that all contingencies for this payment have been achieved. The Company has also agreed to provide certain transition services to Securitas Electronic Security after the closing, including providing the Securitas Electronic Security a $6.0 credit for such services. Income from discontinued operations, net of tax was $15.9 and $9.7 for the years ended December 31, 2015 and 2014, respectively. The operating results for the electronic security business were previously included in the Company's NA segment and have been reclassified to discontinued operations for all of the periods presented. Additionally, the assets and liabilities of this business are classified as held for sale in the Company's consolidated balance sheets for all of the periods presented. Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: NA revenue increased due to higher FSS sales. The key drivers of this growth were higher volume in Canada from a large deposit automation upgrade project, increased multi-vendor services revenue in the U.S. and the acquisition of Phoenix. This was offset in part by decreased product volume in the U.S. in both the national and regional bank space. Physical security sales were lower between the time periods with volume declines in product revenue more than offsetting an increase in service. Operating profit decreased principally due to the mix between regional and national customers, product mix and increased operating expenses resulting from the Phoenix acquisition. AP revenue in 2015 decreased from the prior year mainly as a result of a 39.4 percent decline in product revenue in China where the government is encouraging banks to increase their use of domestic ATM suppliers. AP Revenue in 2015 was also adversely impacted by unfavorable currency of $19.3. These declines were partially offset by service revenue growth in a majority of the countries related to higher professional services and billed work volume. Operating profit decreased as a result of lower product volume combined with higher operating expense, which was offset by increased service margin largely due to operational efficiencies gained through organizational restructuring. EMEA revenue decreased primarily due to an unfavorable currency impact of $66.6 as well as product volume declines in Italy, Belgium, Austria and the UK. This was offset by higher product volume in the Middle East and increased service parts sales to distributors, as well as the benefit of the Cryptera acquisition of $8.6. Operating profit declined primarily due to the aforementioned currency impact as well as lower product volume and revenue mix combined with higher operating expenses due to incremental spend resulting from the Cryptera acquisition. This was offset by additional service revenue associated with parts sales to a distributor in the Middle East. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) LA revenue decreased in 2015 compared to 2014, including a net unfavorable currency impact of $136.9. In Brazil, market-specific economic and political factors affecting the purchasing environment have driven lower Brazil other volume as well as a delivery of IT equipment to a Brazil education ministry in 2014 that was non-recurring. This was partially offset by FSS revenue growth related to product volume, particularly in Mexico where several customers are renewing their install bases. Operating profit decreased due to product volume decline in the Brazil other business and $9.3 of bad debt and inventory reserve increases primarily related to the cancellation of previously awarded government contracts in connection with the current Brazil economic and political environment. Operating profit benefited from decreased operating expenses during the time period mainly related to favorable currency impact. Refer to note 20 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. 2014 comparison with 2013 Net Sales The following table represents information regarding our net sales for the years ended December 31: The increase in FSS sales included a net unfavorable currency impact of $53.2 or 2.5 percent, of which 43 percent related to the Brazil real. The following segment results include the impact of foreign currency. NA FSS sales decreased $17.6 or 2.0 percent primarily from lower volume within the U.S. national bank business partially offset by improvement between years in the U.S. regional bank space and Canada. AP FSS sales increased $19.6 or 4.3 percent primarily due to growth in India, China and the Philippines partially offset by a decline in Indonesia due to a large order in the prior year. EMEA FSS sales increased $59.6 or 16.5 percent with the main drivers being growth in Western Europe, higher volume in Africa and the acquisition of Cryptera. LA FSS sales decreased $30.8 or 6.6 percent due to lower product sales volume primarily in Brazil, a decline in Colombia and a decrease in Venezuela resulting from the currency control policy of the Venezuelan government offset by higher volume in Mexico and a net gain in the rest of the region. Security sales decreased due to a decline in the physical security business, which was partially offset by an increase in the electronic security business. From a regional perspective, the decrease in total physical security sales resulted primarily from a decline in NA. The increase in electronic security related to LA, where in Chile a large government project was completed in the fourth quarter of 2014. Brazil other increased due to lottery sales volume combined with the favorable impact of deliveries of IT equipment to the education ministry primarily in the first quarter of 2014, which are not expected to recur in 2015, offset in part by a decrease in election systems sales. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Gross Profit The following table represents information regarding our gross profit for the years ended December 31: The increase in service gross margin was primarily driven by NA, which benefited from lower employee-related expense associated with restructuring initiatives implemented as part of the Company’s service transformation efforts, including the ongoing benefit from its pension freeze and voluntary early retirement program. Total service gross margin in 2014 compared to the prior year was also favorably impacted by margin improvement in LA. Total service gross profit in 2014 and 2013 included restructuring charges of $0.5 and $25.6, respectively. The increase in product gross margin resulted from margin improvements in each international region. LA was a strong contributor as the Company benefited from certain contractual provisions in Venezuela that settled in the year ended December 31, 2014. EMEA was also a contributor largely due to higher volume. Total product gross profit in 2014 included a non-routine benefit of $5.8 and 2013 included non-routine expense of $0.8, both of which were related to Brazil indirect taxes. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: The decrease in selling and administrative expense resulted primarily from lower non-routine expense and restructuring charges, savings realized from the Company's continued focus on cost structure and favorable currency impact, partially offset by the reinvestment of the Company’s savings into transformation initiatives. Non-routine expenses of $9.2 and $128.7 were included in 2014 and 2013, respectively. The primary components of the 2013 non-routine expense were a $67.6 non-cash pension charge, additional losses of $28.0 related to the settlement of the Foreign Corrupt Practices Act (FCPA) investigation, $17.2 related to the settlement of the securities class action lawsuit and executive severance costs of $9.3. Selling and administrative expense also included $9.7 and $20.3 of restructuring charges in 2014 and 2013, respectively. Restructuring charges in 2014 and 2013 related to the Company's multi-year realignment plan. Excluding non-routine expenses and restructuring charges, selling and administrative expense increased $43.9, which is nearly flat as a percentage of net sales in 2014 compared to the prior year. The increase in selling and administrative expense primarily relates to incremental commission expense and investments related to our back office transformation. Research, development and engineering expense as a percent of net sales in 2014 and 2013 were relatively flat. The Company increased investment in 2014 related to development efforts to support the Company's innovation in future products, which was offset by restructuring charges of $6.0 incurred in 2013. The Company performed an other-than-annual assessment for its Brazil reporting unit in the third quarter of 2013 based on a two-step impairment test and concluded that the goodwill within the Brazil reporting unit was partially impaired. The Company recorded a $70.0 pre-tax, non-cash goodwill impairment charge in the third quarter of 2013 due to deteriorating macro-economic outlook, structural changes to an auction-based purchasing environment and new competitors entering the market. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) During the second quarter of 2014, the Company divested Eras within the NA segment, resulting in a gain on sale of assets of $13.7. During the first quarter of 2013, the Company recognized a gain on assets of $2.2 resulting from the sale of certain U.S. manufacturing operations to a long-time supplier. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The increase in operating profit (loss) resulted from a reduction in operating expense mainly due to lower non-routine and restructuring charges. Operating profit also improved in total margin and higher product sales, offset in part by higher spend partially attributable to reinvestment of the Company’s savings into transformation strategies. Other (Expense) Income The following table represents information regarding our other (expense) income for the years ended December 31: The increase in investment income compared to the prior year was driven by LA due to leasing portfolio growth in Brazil. The foreign exchange loss for 2014 and the foreign exchange gain in 2013 included losses of $12.1 and $1.6, respectively, related to the devaluation of the Venezuelan currency. Income from Discontinued Operations, Net of Tax Income from discontinued operations, net of tax was $9.7 and $13.7 for the years ended December 31, 2014 and 2013, respectively. The operating results for the electronic security business were previously included in the Company's NA segment and have been reclassified to discontinued operations for all of the periods presented. Additionally, the assets and liabilities of this business are classified as held for sale in the Company's consolidated balance sheet for all of the periods presented. Income (Loss) from Continuing Operations, Net of Tax The following table represents information regarding our income (loss) from continuing operations, net of tax, for the years ended December 31: The increase in net income was driven by higher operating profit related mainly to significantly lower non-routine and restructuring expense, an improvement in service margin and higher product sales. These benefits were offset in part by higher spend partially attributable to reinvestment of the Company’s savings into transformation initiatives and unfavorable other (expense) income in 2014 resulting from foreign exchange loss due to the devaluation of the Venezuelan currency. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) The negative tax rate for 2013 is a result of tax expense of approximately $55.0 related to the repatriation of previously undistributed earnings and the establishment of a valuation allowance of approximately $39.2 on deferred tax assets in the Company's Brazil manufacturing facility. The 2013 tax rate was also negatively impacted by the partially non-deductible goodwill impairment related to the Brazil reporting unit and the FCPA penalty charge. Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: NA revenue decreased due to lower FSS sales resulting from decreased volume in the U.S. national bank sector partially due to the impact of a large non-recurring project in the prior year, offset in part by improvement between years in the U.S. regional bank business and Canada. NA revenue also declined due to lower physical security sales between years. Operating profit increased despite the net sales decline due to an improvement in service margin primarily driven by lower employee-related expense resulting from restructuring initiatives in addition to the ongoing benefit from the Company's pension freeze and voluntary early retirement program. AP revenue in 2014 included net unfavorable currency impact of $14.1. Including the impact of foreign currency, revenue in 2014 compared to 2013 increased mainly from growth in India, China and the Philippines partially offset by a decrease in Indonesia because of a large order in 2013. Operating profit increased due to higher volume and improved margin performance in the region partially offset by higher operating expense. EMEA revenue increased primarily from higher sales volume in Western Europe and Africa. The acquisition of Cryptera in the third quarter of 2014 resulted in incremental revenue and operating profit of $14.9 and $1.2, respectively. The overall volume increase led to product gross margin expansion driving the improvement in operating profit compared to the prior year. LA revenue increased in 2014 compared to 2013, including a net unfavorable currency impact of $29.1. The constant currency revenue improvement related to lottery sales volume and deliveries of IT equipment to the education ministry in the first quarter of 2014 partially offset by a decrease in FSS volume and elections systems sales. Operating profit increased as a result of the higher product sales volume, the benefit from certain contractual provisions in Venezuela that settled in the year ended December 31, 2014 and a gain in service margin primarily in Brazil. This was partially offset by an increase in operating expenses and a lower of cost or market adjustment of $4.1 in 2014 as a result of the Venezuelan currency devaluation. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Refer to note 20 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. LIQUIDITY AND CAPITAL RESOURCES Capital resources are obtained from income retained in the business, borrowings under the Company’s senior notes, committed and uncommitted credit facilities and operating and capital leasing arrangements. Management expects that the Company’s capital resources will be sufficient to finance planned working capital needs, research and development activities, investments in facilities or equipment, pension contributions, the payment of dividends on the Company’s common shares and any repurchases of the Company’s common shares for at least the next 12 months. At December 31, 2015, $326.5 or 92.4 percent of the Company’s cash and cash equivalents and short-term investments reside in international tax jurisdictions. Repatriation of these funds could be negatively impacted by potential payments for foreign and domestic taxes, excluding $107.1 that is available for repatriation with no additional tax expense because the Company has already provided for such taxes. Part of the Company’s growth strategy is to pursue strategic acquisitions. The Company has made acquisitions in the past and intends to make acquisitions in the future, including the potential acquisition of Wincor Nixdorf. The Company intends to finance any future acquisitions with either cash and short-term investments, cash provided from operations, borrowings under available credit facilities, proceeds from debt or equity offerings and/or the issuance of common shares. The Company intends to finance the cash portion of the purchase price as well as any Wincor Nixdorf debt outstanding under our revolving and term loan credit agreement entered into on December 23, 2015 and bridge agreement entered into on November 23, 2015. The Company's global liquidity as of December 31, 2015 and 2014 was as follows: The following table summarizes the results of our consolidated statement of cash flows for the years ended December 31: Operating Activities. Cash flows from operating activities can fluctuate significantly from period to period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Net cash provided by operating activities was $31.6 for the year ended December 31, 2015, a decrease of $157.5 from $189.1 for the year ended December 31, 2014. The overall decline was primarily due to lower income from continuing operations, higher working capital and reductions in deferred revenue. Additional detail is included below: • Cash flows from continuing operating activities during the year ended December 31, 2015 compared to the year ended December 31, 2014 were negatively impacted by a $47.8 decrease in income from continuing operations, net of tax, primarily related to the aforementioned market-specific economic and political factors affecting the purchasing environment in Brazil, bad debt and inventory reserve increases related to the cancellation of certain projects in connection with the current Brazil economic and political environment, $18.9 impairment of assets, the adverse impact of foreign currency compared to the same period of 2014, and the gain on sale of assets of $13.7 in the second quarter of 2014 which resulted from the Company's divestiture of its Eras subsidiary. The decrease in share-based compensation expense to $12.4 in 2015 from $21.5 in 2014 was primarily due to changes in the assumptions related to performance shares. The impairment of assets, primarily in the first quarter of 2015, related to the sale of the Company's equity interest in Venezuela as well as impairment of redundant legacy Diebold internally-developed software as a result of the acquisition of Phoenix. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) • Accounts receivable and inventory used an aggregate of $107.6 during the year ended December 31, 2015 compared to the $81.0 during the year ended December 31, 2014. The $26.6 increase related to an increase in accounts receivable related to unbilled work which impacted the timing of cash collections and a build up in inventory related to securing multi-vendor services contracts in North America. • Deferred revenue used $14.7 of operating cash during the year ended December 31, 2015, compared to $50.7 provided in the year ended December 31, 2014. The decrease in cash flow associated with deferred revenue is due to a reduction of prepayments, primarily in China, received from customers on service contracts and product sales compared to the same period of 2014 and higher installations in 2015. • The aggregate of refundable and deferred income taxes used $46.4 of operating cash during the year ended December 31, 2015, compared to $1.7 used in 2014. This increase in cash used in operating activities is a result of the timing of cash payments for income taxes related to 2014 and the increase in deferred tax assets related to foreign tax credits and credits related to research and development activities primarily in the U.S. Investing Activities. Net cash used in investing activities was $62.4 for the year ended December 31, 2015 compared to net cash provided by investing activities of $15.1 for the year ended December 31, 2014. The $77.5 change was primarily related to a $37.7 decrease in net investment activity primarily in Brazil, which is primarily used to fund the repayment of our offshore debt, a decrease of $13.4 in proceeds from the sale of assets related to the sale of Eras in the second quarter of 2014, and a $47.7 increase in cash payments related to the acquisitions. These were partially offset by a decrease of $7.8 in capital expenditures related to capital reinvestment in Diebold’s transformation strategy to $52.3 for the year ended December 31, 2015 from $60.1 for the year ended December 31, 2014. The Company anticipates capital expenditures of approximately $40.0 related primarily to the completion of the reinvestment of capital in connection with the Diebold transformation strategy, which is expected to culminate in 2016. These capital expenditures will be expended primarily in North America. Currently, we finance these investments primarily with funds provided by income retained in the business, borrowings under Diebold’s committed and uncommitted credit facilities, and operating and capital leasing arrangements. Financing Activities. Net cash provided by financing activities was $42.2 for the year ended December 31, 2015 compared to net cash used in financing activities of $81.2 for the year ended 2014, an increase of $123.4. The increase was primarily due to a $134.2 change in debt borrowing net of repayments, including associated debt issuance costs, year-over-year as a result of funding the $75.6 in dividend payments and the Phoenix acquisition with borrowings from the credit facility, partially offset by a decrease of $11.1 related to the issuance of common shares. Effect of exchange rate changes on cash and cash equivalents was negatively impacted by $9.5 and $6.1 related to the currency devaluation in Venezuela for the years ended December 31, 2015 and 2014. Benefit Plans. The Company is not currently planning to contribute to its pension plans during the year ending December 31, 2016. Beyond 2016, minimum statutory funding requirements for the Company's U.S. pension plans may become more significant. The actual amounts required to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory actions related to pension funding obligations. The Company has adopted a pension investment policy designed to achieve an adequate funded status based on expected benefit payouts and to establish an asset allocation that will meet or exceed the return assumption while maintaining a prudent level of risk. The plan's target asset allocation adjusts based on the plan's funded status. As the funded status improves or declines, the debt security target allocation will increase and decrease, respectively. Management monitors assumptions used for our actuarial projections as well as any funding requirements for the plans. Payments due under the Company's other post-retirement benefit plans are not required to be funded in advance. Payments are made as medical costs are incurred by covered retirees, and are principally dependent upon the future cost of retiree medical benefits under these plans. The Company expects the other post-retirement benefit plan payments to be approximately $1.4 in 2016 (refer to note 13 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further discussion of the Company's pension and other post-retirement benefit plans). The Company records a curtailment when an event occurs that significantly reduces the expected years of future service or eliminates the accrual of defined benefits for the future services of a significant number of employees. A curtailment gain is recorded when the employees who are entitled to the benefits terminate their employment; a curtailment loss is recorded when it becomes probable a loss will occur. Expense from curtailments is recorded in selling and administrative expense. Dividends. The Company paid dividends of $75.6, $74.9 and $74.0 in the years ended December 31, 2015, 2014 and 2013, respectively. Annualized dividends per share were $1.15 for each of the years ended December 31, 2015, 2014 and 2013. The MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) first quarterly dividend of 2016 is 28.75 cents per share. The Company announced during the fourth quarter of 2015, its intention to pay a dividend at a rate less than the Company's current annual dividend rate, following the close of the potential business combination with Wincor Nixdorf. Contractual Obligations. The following table summarizes the Company’s approximate obligations and commitments to make future payments under contractual obligations as of December 31, 2015: (1) Amounts represent estimated contractual interest payments on outstanding long-term debt and notes payable. Rates in effect as of December 31, 2015 are used for variable rate debt. At December 31, 2015, the Company also maintained uncertain tax positions of $13.1, for which there is a high degree of uncertainty as to the expected timing of payments (refer to note 5 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company had various short-term uncommitted lines of credit with borrowing limits of $89.0 and $139.9, of which $20.0 and $24.7 were outstanding as of December 31, 2015 and 2014, respectively. The weighted-average interest rate on outstanding borrowings on the short-term uncommitted lines of credit as of December 31, 2015 and 2014 was 5.66 percent and 2.96 percent, respectively. The increase in the weighted-average interest rate is attributable to the change in mix of borrowings in foreign entities. Short-term uncommitted lines mature in less than one year. The amount available under the short-term uncommitted lines at December 31, 2015 was $69.0. The Company entered into a revolving and term loan credit agreement (Credit Agreement), dated as of November 23, 2015, among the Company and certain of the Company's subsidiaries, as borrowers, JPMorgan Chase Bank, N.A., as Administrative Agent, and the lenders named therein. The Credit Agreement included, among other things, mechanics for the Company’s existing revolving and term loan A facilities to be refinanced under the Credit Agreement. On December 23, 2015, the Company entered into a Replacement Facilities Effective Date Amendment among the Company, certain of the Company’s subsidiaries, the lenders identified therein and JPMorgan Chase Bank, N.A., as Administrative Agent, pursuant to which the Company refinanced its existing $520.0 revolving and $230.0 term loan A senior unsecured credit facilities (which have been terminated and repaid in full) with, respectively, a new secured revolving facility (the Revolving Facility) in an amount of up to $520.0 and a new (non-delayed draw) secured term loan A facility (the Term A Facility) on substantially the same terms as the Delayed Draw Term Facility (as defined in the Credit Agreement) in the amount of up to $230.0. The Revolving Facility and Term A Facility will be subject to the same maximum consolidated net leverage ratio and minimum consolidated interest coverage ratio as the Delayed Draw Term Facility. On December 23, 2020, the Term A Facility will mature and the Revolving Facility automatically terminates. The weighted-average interest rate on the term loan as of December 31, 2015 was 2.33 percent, which is variable based on the London Interbank Offered Rate (LIBOR). The amount available under the Revolving Facility as of December 31, 2015 was $352.0. The Company incurred $6.0 and $1.4 of fees related to amending its credit facility in 2015 and 2014, respectively, which are amortized as a component of interest expense over the term of the facility. In March 2006, the Company issued senior notes in an aggregate principal amount of $300.0 with a weighted-average fixed interest rate of 5.50 percent. The Company entered into a derivative transaction to hedge interest rate risk on $200.0 of the senior notes, which was treated as a cash flow hedge. This reduced the effective interest rate from 5.50 percent to 5.36 percent. The Company funded the repayment of $75.0 of the senior notes at maturity in March 2013 using borrowings under its revolving credit facility. The maturity dates of the remaining senior notes are staggered, with $175.0 and $50.0 due in March 2016 and 2018, respectively. For the $175.0 of the Company's senior notes maturing in March 2016, management intends to fund the repayment through the revolving credit facility and/or proceeds from the sale of the Company's electronic security business. The Company has received the majority and expects to receive the full $350.0 in cash proceeds, subject to customary working capital adjustments, from the divestiture of its electronic security business during the first quarter of 2016. The proceeds from the MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) divestiture, net of deal costs and other related divestiture costs, will be placed in escrow to provide for the repayment of the senior notes due March 2016 and a portion of the financing for the Business Combination. The use of these funds will be restricted to the earlier of November 21, 2016, the cancellation of the tender offer or the payments for certain acquisition related items. On November 23, 2015, the Company entered into foreign exchange option contracts to purchase €1,416.0 for $1,547.1 to hedge against the effect of exchange rate fluctuations on the euro denominated cash consideration related to the Business Combination and estimated euro denominated deal related costs and any outstanding Wincor Nixdorf borrowings. The weighted average strike price is $1.09 per euro. These foreign exchange option contracts are non-designated and included in other current assets or other current liabilities based on the net asset or net liability position, respectively. As of December 31, 2015, these hedges represented a net asset fair value of $7.0. The arrangement will net settle with an additional maximum payout of approximately $60.0, which relates to a delayed premium due at maturity of the contracts in November 2016. In 2015, the $7.0 gain on these non-designated derivative instruments is reflected in other income (expense) miscellaneous, net. Off-Balance Sheet Arrangements. The Company enters into various arrangements not recognized in the consolidated balance sheets that have or could have an effect on its financial condition, results of operations, liquidity, capital expenditures or capital resources. The principal off-balance sheet arrangements that the Company enters into are guarantees, operating leases (refer to note 14 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K) and sales of finance receivables. The Company provides its global operations guarantees and standby letters of credit through various financial institutions to suppliers, customers, regulatory agencies and insurance providers. If the Company is not able to comply with its contractual obligations, the suppliers, regulatory agencies and insurance providers may draw on the pertinent bank (refer to note 15 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company has sold finance receivables to financial institutions while continuing to service the receivables. The Company records these sales by removing finance receivables from the consolidated balance sheets and recording gains and losses in the consolidated statement of operations (refer to note 7 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements. The consolidated financial statements of the Company are prepared in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP). The preparation of the accompanying consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities and reported amounts of revenues and expenses. Such estimates include revenue recognition, the valuation of trade and financing receivables, inventories, goodwill, intangible assets, other long-lived assets, legal contingencies, guarantee obligations, and assumptions used in the calculation of income taxes, pension and post-retirement benefits and customer incentives, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors. Management monitors the economic conditions and other factors and will adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. The Company’s significant accounting policies are described in note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K. Management believes that, of its significant accounting policies, its policies concerning revenue recognition, allowances for credit losses, inventory reserves, goodwill, long-lived assets, taxes on income, contingencies and pensions and post-retirement benefits are the most critical because they are affected significantly by judgments, assumptions and estimates. Additional information regarding these policies is included below. Revenue Recognition. The Company’s revenue recognition policy is consistent with the requirements of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605, Revenue Recognition (ASC 605). The Company records revenue when it is realized, or realizable and earned. The application of U.S. GAAP revenue recognition principles to the Company's customer contracts requires judgment, including the determination of whether an arrangement includes multiple deliverables such as hardware, software, maintenance and /or other services. For contracts that contain multiple deliverables, total arrangement consideration is allocated at the inception of the arrangement to each deliverable based on the relative selling price method. The relative selling price method is based on a hierarchy consisting of vendor specific objective evidence (VSOE) (price sold on a stand-alone basis), if available, or third-party evidence (TPE), if VSOE is not available, or estimated selling price (ESP) if neither VSOE nor TPE is available. The Company's ESP is consistent with the objective of determining VSOE, which is the price at which we would expect to transact on a stand-alone sale of the deliverable. The determination of ESP is based on applying significant judgment to weigh a variety of company-specific factors including our pricing practices, customer volume, geography, internal costs and gross margin objectives. This information is gathered from experience in customer negotiations, recent technological trends and the competitive landscape. In contracts that involve multiple deliverables, maintenance services are typically accounted for under FASB ASC 605-20, Separately Priced Extended Warranty and Product Maintenance Contracts. There have been no material changes MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) to these estimates for the periods presented and the Company believes that these estimates generally should not be subject to significant changes in the future, until the adoption of the new revenue standard. However, changes to deliverables in future arrangements could materially impact the amount of earned or deferred revenue. For sales of software, excluding software required for the equipment to operate as intended, the Company applies the software revenue recognition principles within FASB ASC 985-605, Software - Revenue Recognition. For software and software-related deliverables (software elements), the Company allocates revenue based upon the relative fair value of these deliverables as determined by VSOE. If the Company cannot obtain VSOE for any undelivered software element, revenue is deferred until all deliverables have been delivered or until VSOE can be determined for any remaining undelivered software elements. When the fair value of a delivered element cannot be established, but fair value evidence exists for the undelivered software elements, the Company uses the residual method to recognize revenue. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement consideration is allocated to the delivered elements and recognized as revenue. Determination of amounts deferred for software support requires judgment about whether the deliverables can be divided into more than one unit of accounting and whether the separate deliverables have value to the customer on a stand-alone basis. There have been no material changes to these deliverables for the periods presented. However, changes to deliverables in future arrangements and the ability to establish VSOE could affect the amount and timing of revenue recognition. Allowances for Credit Losses. The Company maintains allowances for potential credit losses and such losses have been minimal and within management’s expectations. Since the Company’s receivable balance is concentrated primarily in the financial and government sectors, an economic downturn in these sectors could result in higher than expected credit losses. The concentration of credit risk in the Company’s trade receivables with respect to financial and government customers is largely mitigated by the Company’s credit evaluation process and the geographical dispersion of sales transactions from a large number of individual customers. Inventory Reserves. At each reporting period, the Company identifies and writes down its excess and obsolete inventories to net realizable value based on usage forecasts, order volume and inventory aging. With the development of new products, the Company also rationalizes its product offerings and will write-down discontinued product to the lower of cost or net realizable value. Acquisitions and Divestitures. Acquisitions are accounted for using the purchase method of accounting. This method requires the Company to record assets and liabilities of the business acquired at their estimated fair market values as of the acquisition date. Any excess cost of the acquisition over the fair value of the net assets acquired is recorded as goodwill. The Company generally uses valuation specialists to perform appraisals and assist in the determination of the fair values of the assets acquired and liabilities assumed. These valuations require management to make estimates and assumptions that are critical in determining the fair values of the assets and liabilities. For divestitures, the Company considers assets to be held for sale when management approves and commits to a formal plan to actively market the assets for sale at a price reasonable in relation to their estimated fair value, the assets are available for immediate sale in their present condition, an active program to locate a buyer and other actions required to complete the sale have been initiated, the sale of the assets is probable and expected to be completed within one year (or, if it is expected that others will impose conditions on the sale of the assets that will extend the period required to complete the sale, that a firm purchase commitment is probable within one year) and it is unlikely that significant changes will be made to the plan. Upon designation as held for sale, the Company records the assets at the lower of their carrying value or their estimated fair value, reduced for the cost to dispose of the assets, and ceases to record depreciation expense on the assets. The Company reports financial results for discontinued operations separately from continuing operations to distinguish the financial impact of the divestiture from ongoing operations. Discontinued operations reporting occurs only when the disposal of a component or a group of components of the Company represents a strategic shift that will have a major effect on the Company's operations and financial results. During the year ended December 31, 2015, management of the Company, through receipt in October 2015 of the required authorization from its Board of Directors after a potential buyer had been identified, committed to a plan to divest the electronic security business. As such, all of the criteria required for held for sale and discontinued operations classification were met during the fourth quarter of 2015. The pending divestiture of its electronic security business closed on February 1, 2016. Accordingly, the assets and liabilities, operating results and operating and investing cash flows for are presented as discontinued operations separate from the Company’s continuing operations for all periods presented. Prior period information has been reclassified to present this business as discontinued operations for all periods presented, and has therefore been excluded from both continuing operations and segment results for all periods presented in these consolidated financial statements and the notes to the consolidated financial statements. All assets and liabilities classified as held for sale are included in total current assets based on the cash conversion of these assets and liabilities within one year. These items had no impact on the amounts of previously reported net income attributable to Diebold, Incorporated or total Diebold, Incorporated shareholders' equity (refer to note 21 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Assets and liabilities of a discontinued operation are reclassified as held for sale for all comparative periods presented in the consolidated balance sheet. The results of operations of a discontinued operation are reclassified to income from discontinued operations, net of tax, for all periods presented. For assets that meet the held for sale criteria but do not meet the definition of a discontinued operation, the Company reclassifies the assets and liabilities in the period in which the held for sale criteria are met, but does not reclassify prior period amounts. Goodwill. Goodwill is the cost in excess of the net assets of acquired businesses (refer to note 11 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company tests all existing goodwill at least annually for impairment on a reporting unit basis. In 2015, the annual goodwill impairment test was performed as of October 31 compared to November 30 in prior years for administrative improvements. The Company tests all existing goodwill at least annually as of October 31 for impairment on a reporting unit basis. The Company tests for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the carrying value of a reporting unit below its reported amount. The Company’s four reporting units are defined as Domestic and Canada, LA, AP and EMEA. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount, the Company considers the following events and circumstances, among others, if applicable: (a) macroeconomic conditions such as general economic conditions, limitations on accessing capital or other developments in equity and credit markets; (b) industry and market considerations such as competition, multiples or metrics and changes in the market for the Company's products and services or regulatory and political environments; (c) cost factors such as raw materials, labor or other costs; (d) overall financial performance such as cash flows, actual and planned revenue and earnings compared with actual and projected results of relevant prior periods; (e) other relevant events such as changes in key personnel, strategy or customers; (f) changes in the composition of a reporting unit's assets or expected sales of all or a portion of a reporting unit; and (g) any sustained decrease in share price. If the Company's qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying value, or if management elects to perform a quantitative assessment of goodwill, a two-step impairment test is used to identify potential goodwill impairment and measure the amount of any impairment loss to be recognized. In the first step, the Company compares the fair value of each reporting unit with its carrying value. The fair value of the reporting units is determined based upon a combination of the income valuation and market approach in valuation methodology. The income approach uses discounted estimated future cash flows, whereas the market approach or guideline public company method utilizes market data of similar publicly traded companies. The Company’s step 1 impairment test of goodwill of a reporting unit is based upon the fair value of the reporting unit, defined as the price that would be received to sell the net assets or transfer the net liabilities in an orderly transaction between market participants at the assessment date. In the event that the net carrying amount exceeds the fair value, a step 2 test must be performed whereby the fair value of the reporting unit’s goodwill must be estimated to determine if it is less than its net carrying amount. In its two-step test, the Company uses the discounted cash flow method and the guideline company method for determining the fair value of its reporting units. Under these methods, the determination of implied fair value of the goodwill for a particular reporting unit is the excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities in the same manner as the allocation in a business combination. The techniques used in the Company's qualitative assessment and, if necessary, two-step impairment test incorporate a number of assumptions that the Company believes to be reasonable and to reflect market conditions forecast at the assessment date. Assumptions in estimating future cash flows are subject to a high degree of judgment. The Company makes all efforts to forecast future cash flows as accurately as possible with the information available at the time the forecast is made. To this end, the Company evaluates the appropriateness of its assumptions as well as its overall forecasts by comparing projected results of upcoming years with actual results of preceding years and validating that differences therein are reasonable. Key assumptions, all of which are Level 3 inputs (refer to note 19 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K), relate to price trends, material costs, discount rate, customer demand, and the long-term growth and foreign exchange rates. A number of benchmarks from independent industry and other economic publications were also used. Changes in assumptions and estimates after the assessment date may lead to an outcome where impairment charges would be required in future periods. Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions. During 2015, management determined that the LA and AP reporting units had excess fair value of approximately $7.2 or 1.3 percent and approximately $149.4 or 56.5 percent, respectively, when compared to their carrying amounts. The Domestic and Canada reporting unit, included in the NA reportable segment, had excess fair value greater than 100 percent when compared to its carrying amount. As of December 31, 2015, the LA and AP reporting units had goodwill of approximately $24.4 and $37.6, respectively. A further change in macroeconomic conditions, as well as future changes in the judgments, assumptions and estimates that are used in the Company's goodwill impairment testing for the LA and AP reporting units, including the discount rate and future cash flow projections, could result in a significantly different estimate of the fair value. EMEA had no net goodwill as of December 31, 2015. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) During the third quarter of 2013, the Company performed an other-than-annual assessment for its LA reporting unit based on a two-step impairment test as a result of a reduced earnings outlook for the LA business unit. This was due to a deteriorating macro-economic outlook, structural changes to an auction-based purchasing environment and new competitors entering the market. The Company concluded that the goodwill within the LA reporting unit was partially impaired and recorded a $70.0 pre-tax, non-cash goodwill impairment charge. In the fourth quarter of 2013, the LA reporting unit was reviewed for impairment based on a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In addition, the remaining reporting units were reviewed based on a two-step test. These tests resulted in no additional impairment in any of the Company's reporting units in 2013. Long-Lived Assets. Impairment of long-lived assets is recognized when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized at that time to reduce the asset to the lower of its fair value or its net book value. The Company tests all existing indefinite-lived intangibles at least annually for impairment as of October 31. As of December 31, 2015, the Company had approximately $4.5 of indefinite-lived tangibles included in other intangibles. Taxes on Income. Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized for deductible temporary differences, operating loss carry-forwards and tax credits. Deferred tax liabilities are recognized for taxable temporary differences and undistributed earnings in certain jurisdictions. Deferred tax assets are reduced by a valuation allowance when, based upon the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Determination of a valuation allowance involves estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income and the impact of tax planning strategies. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company operates in numerous taxing jurisdictions and is subject to examination by various federal, state and foreign jurisdictions for various tax periods. Additionally, the Company has retained tax liabilities and the rights to tax refunds in connection with various acquisitions and divestitures of businesses. The Company’s income tax positions are based on research and interpretations of the income tax laws and rulings in each of the jurisdictions in which the Company does business. Due to the subjectivity of interpretations of laws and rulings in each jurisdiction, the differences and interplay in tax laws between those jurisdictions, as well as the inherent uncertainty in estimating the final resolution of complex tax audit matters, the Company’s estimates of income tax liabilities may differ from actual payments or assessments. The Company assesses its position with regard to tax exposures and records liabilities for these uncertain tax positions and any related interest and penalties, when the tax benefit is not more likely than not realizable. The Company has recorded an accrual that reflects the recognition and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. Additional future income tax expense or benefit may be recognized once the positions are effectively settled. At the end of each interim reporting period, the Company estimates the effective tax rate expected to apply to the full fiscal year. The estimated effective tax rate contemplates the expected jurisdiction where income is earned, as well as tax planning alternatives. Current and projected growth in income in higher tax jurisdictions may result in an increasing effective tax rate over time. If the actual results differ from estimates, the Company may adjust the effective tax rate in the interim period if such determination is made. Contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. There is no liability recorded for matters in which the liability is not probable and reasonably estimable. Attorneys in the Company's legal department monitor and manage all claims filed against the Company and review all pending investigations. Generally, the estimate of probable loss related to these matters is developed in consultation with internal and outside legal counsel representing the Company. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The Company attempts to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments, or fines, after appeals, differ from the estimates, the future results may be materially impacted. Adjustments to the initial estimates are recorded when a change in the estimate is identified. Pensions and Other Post-retirement Benefits. Annual net periodic expense and benefit liabilities under the Company’s defined benefit plans are determined on an actuarial basis. Assumptions used in the actuarial calculations have a significant impact on plan obligations and expense. Members of the management investment committee periodically review the actual experience compared with the more significant assumptions used and make adjustments to the assumptions, if warranted. The discount rate is determined by analyzing the average return of high-quality (i.e., AA-rated) fixed-income investments and the year-over-year comparison of certain widely used benchmark indices as of the measurement date. The expected long-term rate of return on plan assets is MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) determined using the plans’ current asset allocation and their expected rates of return based on a geometric averaging over 20 years. The rate of compensation increase assumptions reflects the Company’s long-term actual experience and future and near-term outlook. Pension benefits are funded through deposits with trustees. Other post-retirement benefits are not funded and the Company’s policy is to pay these benefits as they become due. The following table represents assumed healthcare cost trend rates at December 31: The healthcare trend rates are reviewed based upon the results of actual claims experience. The Company used healthcare cost trends of 7.0 percent and 7.5 percent in 2016 and 2015, respectively, decreasing to an ultimate trend of 5.0 percent in 2020 for both medical and prescription drug benefits using the Society of Actuaries Long Term Trend Model with assumptions based on the 2008 Medicare Trustees’ projections. Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. A one-percentage-point change in assumed healthcare cost trend rates would have the following effects: During 2014, the Society of Actuaries released a series of updated mortality tables resulting from recent studies conducted by them measuring mortality rates for various groups of individuals. As of December 31, 2014, the Company updated theses mortality tables which reflect improved trends in longevity and therefore have the effect of increasing the estimate of benefits to be received by plan participants. Management will continue to monitor assumptions used for our actuarial projections along with any funding requirements for the plans. RECENTLY ISSUED ACCOUNTING GUIDANCE Refer to note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for information on recently issued accounting guidance. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2015 DIEBOLD, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) FORWARD-LOOKING STATEMENT DISCLOSURE In this annual report on Form 10-K, statements that are not reported financial results or other historical information are “forward-looking statements.” Forward-looking statements give current expectations or forecasts of future events and are not guarantees of future performance. These forward-looking statements include, but are not limited to, statements regarding the Business Combination, its financing of the Business Combination, its expected future performance (including expected results of operations and financial guidance), and the Company’s future financial condition, operating results, strategy and plans. Forward-looking statements may be identified by the use of the words “anticipates,” “expects,” “intends,” “plans,” “will,” “believes,” “estimates,” “potential,” “target,” “predict,” “project,” “seek,” and variations or similar expressions. These statements are used to identify forward-looking statements. These forward-looking statements reflect the current views of the Company with respect to future events and involve significant risks and uncertainties that could cause actual results to differ materially. Although the Company believes that these forward-looking statements are based upon reasonable assumptions regarding, among other things, the economy, its knowledge of its business, and on key performance indicators that impact the Company, these forward-looking statements involve risks, uncertainties and other factors that may cause actual results to differ materially from those expressed in or implied by the forward-looking statements. The Company is not obligated to update forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Some of the risks, uncertainties and other factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements include, but are not limited to: • the Company’s ability to successfully consummate the Business Combination, including obtaining and consummating the necessary financing, hedging transactions and satisfying closing conditions; • the ultimate outcome and results of integrating the operations of the Company and Wincor Nixdorf, the ultimate outcome of the Company’s pricing and operating strategy applied to Wincor Nixdorf and the ultimate ability to realize synergies; • the effects of the Business Combination, including the Company’s future financial condition, operating results, strategy and plans; • the effects of governmental regulation on the Company’s businesses or potential business combination transactions; • the ability to obtain regulatory approvals and meet other conditions to the Business Combination on a timely basis; • the success of the Company’s strategic business alliance with Securitas AB; • the Company's ability to extract costs related to its electronic security business from its ongoing operations; • competitive pressures, including pricing pressures and technological developments; • changes in the Company’s relationships with customers, suppliers, distributors and/or partners in its business ventures; • changes in political, economic or other factors such as currency exchange rates, inflation rates, recessionary or expansive trends, taxes and regulations and laws affecting the worldwide business in the Company’s operations; • global economic conditions, including any additional deterioration and disruptions in the financial markets, including bankruptcies, restructurings or consolidations of financial institutions, which could reduce the Company’s customer base and/or adversely affect its customers’ ability to make capital expenditures, as well as adversely impact the availability and cost of credit; • acceptance of the Company’s product and technology introductions in the marketplace; • the Company’s ability to maintain effective internal controls; • changes in the Company’s intention to further repatriate cash and cash equivalents and short-term investments residing in international tax jurisdictions could negatively impact foreign and domestic taxes; • unanticipated litigation, claims or assessments, as well as the outcome/impact of any current/pending litigation, claims or assessments, including, but not limited to, the Company’s Brazil tax dispute; • variations in consumer demand for FSS technologies, products and services; • potential security violations to the Company’s information technology systems; • the investment performance of the Company’s pension plan assets, which could require the Company and to increase its pension contributions, and significant changes in healthcare costs, including those that may result from government action; • the amount and timing of repurchases of common shares, if any; • the Company's ability to achieve benefits from its cost-reduction initiatives and other strategic changes, including its multi-year realignment plan and other restructuring actions, as well as its business process outsourcing initiative; and • the risk factors described above under "Part I - Item 1A - Risk Factors” of this Form 10-K. Except to the extent required by applicable law or regulation, the Company undertakes no obligation to update these forward-looking statements to reflect future events or circumstances or to reflect the occurrence of unanticipated events.

<s>[INST] Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10K. Introduction Diebold provides the services, software and technology that connect people around the world with their money bridging the physical and digital worlds of cash conveniently, securely and efficiently. Since its founding in 1859, the Company believes it has evolved to become a leading provider of exceptional selfservice innovation, security and services to financial, retail, commercial and other markets. At December 31, 2015, the Company employed approximately 16,000 associates globally, of which approximately 1,000 relate to the Company's recently divested electronic security business. The Company’s service staff is one of the financial industry’s largest, with professionals in more than 600 locations and businesses in more than 90 countries worldwide. The Company continues to execute its multiyear transformation, Diebold 2.0, with the primary objective of transforming the Company into a worldclass, servicesled and softwareenabled company, supported by innovative hardware, which automates the way people connect with their money. Diebold 2.0 consists of four pillars: Cost Streamline the cost structure and improve nearterm delivery and execution. Cash Generate increased free cash flow in order to fund the investments necessary to drive profitable growth, while preserving the ability to return value to shareholders in the form of reliable dividends and, as appropriate, share repurchases. Talent Attract and retain the talent necessary to drive innovation and the focused execution of the transformation strategy. Growth Return Diebold to a sustainable, profitable growth trajectory. The Company's multiyear transformation plan is expected to occur in three phases: 1) Crawl, 2) Walk, and 3) Run. As part of the transformation, the Company has identified targeted savings of $200.0 that are expected to be fully realized by the end of 2017 and plans to reinvest approximately 50 percent of the cost savings to drive longterm growth. During the “Crawl” phase, the Company was primarily focused on taking cost out of the business and reallocating a portion of these savings as reinvestments in systems and processes. The Company engaged Accenture LLP (Accenture) in a multiyear outsourcing agreement to provide finance and accounting and procurement business process services. With respect to talent, the Company attracted new leaders from top technology and services companies. During the second half of 2015, the Company transitioned into the “Walk” phase of Diebold 2.0 whereby the Company will continue to build on each pillar of cost, cash, talent and growth. The main difference in the “Walk” phase will be a greater emphasis on increasing the mix of revenue from services and software, as well as shaping the Company’s portfolio of businesses. As it relates to increasing the mix of services and software, the Company has recently sharpened its focus on pursuing and winning multivendor services contracts in North America to further diversify its portfolio of services offerings. The total number of nonDiebold automated teller machines (ATMs) signed under contract as of December 31, 2015 was more than 12,000, which gives the Company a solid platform for future growth. For the software business, the recent acquisition of Phoenix Interactive Design, Inc., (Phoenix) has significantly enhanced the Company’s ability to capture more of the dynamic selfservice market. The integration of Phoenix is tracking to plan and all of the Company’s global software activities are being coordinated through the new development center in London, Ontario. As it relates to shaping the portfolio of businesses, the Company’s announcements subsequent to the third quarter of 2015 are consistent with its strategy of transforming into a worldclass servicesled, softwareenabled company, supported by innovative hardware. On October 25, 2015, the Company entered into a definitive asset purchase agreement to divest its North Americabased electronic security business. For ES to continue its growth, it would require resources and investment that Diebold is not committed to make given its focus on the selfservice market. On February 1, 2016, the Company divested its North America electronic security business to Securitas AB [/INST] Positive. </s>

DIEBOLD NIXDORF, Inc

2017-02-24

2016-12-31

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10-K. Introduction Diebold Nixdorf, Incorporated (collectively with its subsidiaries, the Company) provides connected commerce services, software and technology to enable millions of transactions each day. The Company’s approximately 25,000 employees design and deliver convenient, “always on” and highly secure solutions that bridge the physical and the digital worlds of transactions. Customers of the Company include nearly all of the world’s top 100 financial institutions and a majority of the top 25 global retailers. Strategy The Company’s Connected Commerce strategy seeks to continually enhance the customer experience at banking or retail locations by integrating services, software and systems. This requires ongoing investment and development of our industry-leading field services organization as well as the development and integration of innovative technology including cloud computing technology, sensors and connectivity to the Internet of Things, as well as open and agile software. The Company will continuously refine its R&D spend in support of a better transaction experience for consumers Multi-Year Integration Program The Company is executing a multi-year integration program designed to optimize the assets, business processes, and IT systems of Diebold Nixdorf. This program, in aggregate, has identified an opportunity to realize approximately $160 of cost synergies over three years. These cost synergies include: • Realizing volume discounts on direct materials • Harmonizing the solutions set • Increasing utilization rates of the service technicians • Rationalizing facilities in the regions • Streamlining corporate and general and administrative functions • Harmonizing back office solutions. The Company has and will continue to invest significant dollars to restructure the workforce, optimize legacy systems, streamline legal entities and consolidate real estate holdings. By executing these integration activities, the Company expects to deliver greater innovation for customers, career enrichment opportunities for employees, and enhanced value for shareholders. Financial Self-Service Solutions The Company is a leader in providing connected commerce solutions to financial institutions. These solutions are supported by a dedicated field service organization. The combination of high reliability, industry-leading security, remote management capabilities and highly-trained field technicians has made the Company a preferred choice for FSS solutions. Through managed services, banks entrust the management of their ATM and security operations to the Company, allowing their associates to focus on core competencies. Furthermore, the Company’s managed services deliver greater operational efficiencies and provide financial institutions with a leading-edge solutions that they need to stay competitive in the marketplace. A significant demand driver in the global ATM marketplace is branch automation, which helps financial institutions grow revenue, reduce costs, and increase convenience and security for the banks’ customers by migrating routine transactions, typically done inside the branch, to lower-cost automated channels. The Company serves as a strategic partner to its customers by offering a complete branch automation solution - services, software and technology - that addresses the complete value chain of consult, design, build and operate. The Company’s advisory services team collaborates with its clients to help define the ideal customer experience, modify processes, refine existing staffing models and deploy technology to meet branch automation objectives. The in-lobby teller terminal provides branch automation technology by combining the speed and accuracy of a self-service terminal with intelligence from the bank’s core systems, as well as the ability to complete higher value transactions away from the teller line. The Company also offers hardware-agnostic, omni-channel software solutions for ATMs and a host of other self-service applications. These offerings include highly configurable, enterprise-wide software that automates and migrates financial services across channels, changing the way financial products are delivered to consumers. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) The Company continues to invest in supporting current and developing new services, software and security solutions that align with the needs of its customers. At recent trade shows, the Company showcased several new FSS concepts. The Company is piloting advanced analytics capabilities with Banco Popular that enable financial institutions to have a complete view of the self-service channel and improve ATM availability by anticipating maintenance needs. Additionally, the Company introduced the new Extreme ATM™ concept - the smallest ATM ever developed - which utilizes a cardless Bluetooth-enabled mobile interface. The Company offers an integrated line of self-service solutions and technology, including comprehensive ATM outsourcing, ATM security, deposit automation, recycling, payment terminals and software. The Company also offers advanced functionality terminals capable of supporting mobile cardless transactions and two-way video technology to enhance bank branch automation. The Company is a global supplier of ATMs and related services and holds a leading market position in many countries around the world. Retail Solutions The Company’s retail solutions primarily consist of omni-channel retailing, store transformation and global delivery excellence. Omni-channel retailing ensures a seamless consumer experience across all consumer touchpoints. Store transformation is focused on providing leading technologies that improve consumer experience and productivity. Global delivery excellence drives operational improvements that increase efficiency while reducing costs. The Company differentiates itself by developing, delivering and operating globally integrated IT solutions for customers and adjusting them with the help of local experts to meet customer requirements globally. For the twelve months ended September 30, 2016, retail solution revenues were €1,035.3 as reported using IFRS issued by the EU. Software is a key differentiator for the retail business and in this sector the Company provides a comprehensive, modular solutions platform. Click & collect, reserve & collect, in-store ordering and return to store are typical shopping processes that consumers expect retailers to be able to deliver across their footprint and digital sales channels. With TP.net, the Company offers a comprehensive software solution to improve end-to-end store processes in support of omni-channel retailing. TP.net and the other components of the TP Application Suite are designed on a modular principle and can be integrated fully or partially into existing infrastructures. Data from typical information sources such as inventories, omni-channel transactions and customer information are available at the customer touchpoints in stores, including traditional Point of Sale (POS) terminals and self-service checkout systems, kiosk terminals and mobile devices like tablets, as well as at enterprise functions at the retailers’ headquarter. Retail service experts are trained to install, monitor and operate store IT solutions on a global scale and provide retail companies with full service support throughout the store’s life cycle. The service experts can install and operate multi-vendor solutions. Retailers that aim to optimize their total cost of ownership utilize the Company’s services to increase system availability. The services ensure the rapid recovery of system failures and are provided on-site by field service engineers or by means of remote maintenance. The Company also provides cash cycle management services, which ensures the availability of cash recycling systems in both the front and back-offices. The Company also provides innovative and reliable POS technology that is being optimized continually to meet increasing automation requirements and to support omni-channel retailing. The checkout portfolio includes modular, integrated and mobile POS systems. Supplementing the POS systems is a broad range of peripherals, including printers, scales and mobile scanners, as well as the cash management portfolio which offers a wide range of banknote and coin processing systems. Also in the portfolio, the Company provides self-checkout terminals that ensure a consistent purchasing experience with their focus on speed, convenience and flexibility. The latest hybrid product generation can be switched from attended operation to self-checkout by the cashier with the press of a button and is thus a highly attractive solution for retailers with fluctuating store traffic throughout the day. Business Drivers The business drivers of the Company's future performance include, but are not limited to: • demand for services and software, including managed services and professional services; • timing of equipment upgrades and/or replacement cycles; • demand for products and solutions related to branch and store transformation; • demand for security products and services for the financial, retail and commercial sectors; and • high levels of deployment growth for new self-service products in emerging markets. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Acquisition of Diebold Nixdorf AG Diebold Nixdorf AG is one of the world's leading providers of IT solutions and services to retail banks and the retail industry. The Acquisition is consistent with the Company's transformation into a world-class, services-led and software-enabled company, supported by innovative hardware. Diebold Nixdorf AG complements and extends our existing capabilities. The Company considered a number of factors in connection with its evaluation of the transaction, including significant strategic opportunities and potential synergies, as generally supporting its decision to enter into the business combination agreement with Diebold Nixdorf AG. The Acquisition expands the Company's presence substantially, especially in EMEA. The Diebold Nixdorf AG business enhances the Company's existing portfolio. Diebold Nixdorf AG has a fiscal year end of September 30. For the twelve months ended September 30, 2016, Diebold Nixdorf AG recorded net sales of €2,578.6 as reported using IFRS as issued by the EU. In the fourth quarter of 2015, the Company announced its intention to acquire all 29.8 Diebold Nixdorf AG ordinary shares outstanding (33.1 total Diebold Nixdorf AG ordinary shares issued inclusive of 3.3 treasury shares) through a voluntary tender offer for €38.98 in cash and 0.434 common shares of the Company per Diebold Nixdorf AG ordinary share outstanding. On August 15, 2016, the Company consummated the Acquisition by acquiring, through Diebold KGaA, a German partnership limited by shares and a wholly-owned subsidiary of the Company, 22.9 Diebold Nixdorf AG ordinary shares representing 69.2 percent of total number of Diebold Nixdorf AG ordinary shares inclusive of treasury shares (76.7 percent of all Diebold Nixdorf AG ordinary shares outstanding) in exchange for an aggregate preliminary purchase price consideration of $1,265.7, which included the issuance of 9.9 common shares of the Company. The Company financed the cash portion of the Acquisition as well as the repayment of Diebold Nixdorf AG debt outstanding with funds available under the Company’s Credit Agreement (as defined in note 14 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K) and proceeds from the issuance and sale of $400.0 aggregate principal amount of 8.5 percent senior notes due 2024 (the 2024 Senior Notes). Subsequent to the closing of the Acquisition, the board of directors of the Company, the supervisory and management boards of Diebold Nixdorf AG as well as the extraordinary shareholder meetings of Diebold KGaA and Diebold Nixdorf AG on September 26, 2016 each approved the proposed DPLTA. The DPLTA became effective by entry in the commercial register at the local court of Paderborn (Germany) on February 14, 2017. Pursuant to the DPLTA, subject to certain limitations pursuant to applicable law, (i) Diebold KGaA has the ability to issue binding instructions to the management board of Diebold Nixdorf AG, (ii) Diebold Nixdorf AG will transfer all of its annual profits to Diebold KGaA, and (iii) Diebold KGaA will generally absorb all annual losses incurred by Diebold Nixdorf AG. In addition, the DPLTA offers the Diebold Nixdorf AG minority shareholders, at their election, (i) the ability to put their Diebold Nixdorf AG ordinary shares to Diebold KGaA in exchange for cash compensation of €55.02 per Diebold Nixdorf AG ordinary share, or (ii) to remain Diebold Nixdorf AG minority shareholders and receive a recurring compensation in cash of €3.13 (€2.82 net under the current taxation regime) per Diebold Nixdorf AG ordinary share for each full fiscal year of Diebold Nixdorf AG. The ultimate timing and amount of any future cash payments related to the DPLTA are uncertain. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) The table below presents the changes in comparative financial data for the years ended December 31, 2016, 2015 and 2014. Comments on significant year-to-year fluctuations follow the table. The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes that appear elsewhere in this annual report on Form 10-K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) RESULTS OF OPERATIONS 2016 comparison with 2015 Net Sales The following table represents information regarding our net sales for the years ended December 31: FSS sales increased $417.8 or 19.8 percent inclusive of a net unfavorable currency impact of $49.0. The Acquisition accounted for $616.7 in FSS sales. FSS revenue was negatively impacted $9.8 related to purchase accounting adjustments. The following results include the impact of foreign currency and purchase accounting adjustments: • NA FSS sales increased $9.7 or 1.1 percent including unfavorable currency impact of $4.1 related to the Canada dollar. Excluding the impact of the Acquisition of $36.6 and currency, FSS sales decreased as a result of a decline in product revenue in the U.S. regional bank space related to the completion of the Agilis 3/Windows 7 upgrade activity and lower volume in Canada as a result of a large deposit automation upgrade project that ended in the third quarter of 2015. This decline was partially offset by an increase in product revenue in the U.S. national bank space as well as higher maintenance service revenue related to an increase in multi-vendor service contracts. • AP FSS sales decreased $8.7 or 2.1 percent impacted by $18.6 in unfavorable currency mainly related to the China renminbi and India rupee of $9.0 and $6.7, respectively. Excluding the impact of the Acquisition of $108.3 and currency, the decrease was largely attributable to a decline in product revenue stemming from lower volume primarily in China, where the government continues to encourage banks to increase their use of domestic ATM suppliers. India also significantly contributed to the decline as the government’s demonetization program in the current year hindered customer growth which negatively impacted both product and service revenue. • EMEA FSS sales increased $415.0 or 105.7 percent and included an unfavorable currency impact of $15.6 mainly related to the South Africa rand, Turkey lira and Great Britain pound sterling of $6.4, $4.0 and $2.8, respectively. Excluding the impact of the Acquisition of $447.1 and currency, FSS revenue decreased due to lower product volume within our distributor channels and Poland as well as an unfavorable mix of product sales in Italy. Additionally, lower product revenue from large projects in the prior year which did not recur, primarily in Belgium and Russia also contributed to the decline. In Belgium, the Company had project revenue in 2015 related to a Window 7 upgrade activity that did not recur in 2016. A significant increase in product volume in Switzerland, Spain and South Africa helped to partially offset the overall decline in product revenue. FSS service revenue increased slightly as lower billed work revenue was more than offset by higher contract service and installation revenue. • LA FSS sales increased $1.8 or 0.4 percent inclusive of a $10.8 unfavorable currency impact related primarily to the Brazil real. Excluding the impact of the Acquisition of $24.7 and currency, the decrease in the period was primarily the result of product volume declines in Central America, Colombia, Peru and Chile as several large customers were renewing and increasing their ATM installation base in the prior year. Lower product volume within LA distributor channels also contributed to the decline. Product volume increases in Mexico and Brazil partially offset these declines as well as higher service contract revenue across a majority of the region, based on the renewals noted in the prior year. Retail sales were $438.1 as a result of the Acquisition and were negatively impacted by $6.4 related to purchase accounting adjustments. Security sales decreased $19.4 or 6.6 percent impacted by $1.2 in unfavorable currency. Excluding the impact of currency, the NA physical security business decreased due to a decline in service contract base and product volume declines more heavily weighted in the national bank space when compared to the prior year. The decrease in the electronic security business was attributable to LA as a result of lower sales in Chile, Colombia, Ecuador and Brazil, which was partially offset by the transition services revenue in NA as a sub-contractor to Securitas AB. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Brazil other sales increased $60.5 inclusive of an unfavorable currency impact of $2.4. The increase was due to higher election and lottery equipment sales that was partially offset by a reduction in information technology sales, consistent with the Company's narrowing of scope in the Brazil other business to primarily focus on lottery and elections to rationalize the solution set in the market. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Service gross margin was lower due to the impact of the Acquisition as well as declines in AP related to customer mix in addition to service level agreement penalties in the region. Diebold Nixdorf AG utilizes an outsourcing model to support its service revenue stream, which generally results in lower margins. Additionally, NA was unfavorably impacted due to retro-active contract adjustments and customer service level agreement penalties. Service gross profit included non-routine charges of $8.1 related to purchase accounting adjustments associated with the Acquisition in 2016. Service gross profit also included restructuring charges of $18.4 and $3.1 in 2016 and 2015, respectively. Product gross margin decreased as a result of purchase accounting valuation adjustments associated with the Acquisition, primarily related to inventory revaluation. Purchase accounting adjustments included an $8.1 reduction in product revenue and an increase in product cost of sales of $82.6. Product gross profit included total restructuring charges of $7.1 and $1.4 in 2016 and 2015, respectively. Excluding the impact of non-routine and restructuring, product gross margin increased slightly related to the impact of the Acquisition. NA product gross margin declined due to unfavorable customer and product solution mix in the current year. Additionally, product gross margins in EMEA, LA and AP were relatively flat due to the favorable impact of the Acquisition, which was partially offset by an unfavorable blend of country revenue and the deteriorating market conditions in China. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: Excluding the impact of incremental expense associated with the Acquisition of $220.6, the increase in selling and administrative expense primarily resulted from higher total non-routine charges. To a lesser extent, an increase in bad debt expense in NA and higher corporate legal and professional fees also negatively impacted selling and administrative expense in the current year. These increases were partially offset by favorable selling expense primarily related to the recovery of bad debt expense in Brazil, a decrease in sales commission expense, lower IT and marketing expenses related to transformation initiatives and a favorable currency impact. Non-routine expenses in selling and administrative expense of $150.8 and $36.3 were included in 2016 and 2015, respectively. The primary components of the non-routine expenses pertained to acquisition and divestiture costs totaling $118.9 and purchase accounting adjustments of $29.7 related to intangible asset amortization. Selling and administrative expense included restructuring charges of $28.8 and $16.1 in 2016 and 2015, respectively. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Research, development and engineering expense as a percent of net sales in 2016 and 2015 was 3.3 percent and 3.6 percent, respectively. Excluding the impact of the Acquisition, research and development expense decreased primarily as a result of lower reinvestment associated with the maturity of the Company's transformation initiatives compared to the prior year. Research, development and engineering expense included restructuring charges of $5.1 and $0.6 in 2016 and 2015, respectively. During the fourth quarter of 2016, the Company recorded a $9.8 impairment charge related to redundant legacy Diebold internally-developed software and an indefinite-lived trade name in NA as a result of the Acquisition. The decrease in the gross carrying value of internally-developed software is primarily due to a $9.1 impairment during the first quarter of 2015 of certain internally-developed software related to redundant legacy Diebold software as a result of the acquisition of Phoenix. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The decrease in operating profit was due to a decline in product gross profit primarily associated with the inventory valuation adjustment from the Acquisition and higher operating expenses. These operating expenses included amortization of acquired intangible assets, restructuring and non-routine costs of acquisitions and divestitures. Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: The decrease in interest income was driven primarily by a decrease in customer financing in Brazil and was negatively impacted by currency of $1.2. Interest expense was higher than the prior year associated with the financing required for the Acquisition. The foreign exchange loss, net in 2015 included $7.5 related to the devaluation of Venezuela currency. Miscellaneous, net in 2016 included a mark-to-market gain of $35.6 associated with the Company's foreign currency option contracts entered into on November 23, 2015, a mark-to-market loss of $26.4 associated with the Company’s foreign currency forward contract entered into on April 29, 2016 and $6.3 in financing fees related to the Company’s bridge financing required for the Acquisition. Net Income from Continuing Operations, net of tax The following table represents information regarding our net income from continuing operations, net of tax for the years ended December 31: Income (loss) from continuing operations, net of tax was $(170.7). This was primarily due to higher non-routine expenses, increased interest expense and the change in income tax benefit. The effective tax rate for 2016 was 28.4 percent on the overall loss from continued operations. The benefit on the overall loss was negatively impacted by the Acquisition including a valuation allowance for certain post-acquisition losses and non-deductible acquisition related expenses. The overall effective tax rate was decreased further by the jurisdictional income (loss) mix and varying statutory rates within the acquired entities. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) In 2015, the overall negative effective tax rate of (29.9) percent on income from continued operations resulted from the repatriation of foreign earnings, the associated recognition of foreign tax credits and related benefits due to the passage of the Protecting Americans from Tax Hikes (PATH) Act of 2015. In addition, the overall negative effective tax rate was due to the combined income mix and varying statutory rates in the Company's foreign operations. Income (Loss) from Discontinued Operations, Net of Tax Income from discontinued operations, net of tax was $143.7 and $15.9 for the years ended December 31, 2016 and 2015, respectively. The closing of the NA electronic security divestiture occurred on February 1, 2016 and the Company recorded a gain on sale, net of tax, of $145.0 for the year ended December 31, 2016. Additionally, the income from discontinued operations, net of tax includes a net loss of $1.3 as a result of the operations included through February 1, 2016 and net income of $15.9 for the year ended December 31, 2015. The closing purchase price was subject to a customary working capital adjustment, which was finalized in the third quarter of 2016. Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: NA revenue increased $23.7 and included an unfavorable currency impact of $4.1. Excluding the impact of the Acquisition of $59.8 and currency, NA revenue decreased compared to the prior year period primarily due to lower product revenue in the U.S. regional and Canada FSS businesses as well as lower revenue from physical security. These decreases were partially offset by higher service revenue in the U.S. as a result of increased multi-vendor service contracts and higher product sales within our national customer portfolio. Segment operating profit decreased due to lower product volume and unfavorable customer and product solution mix, which adversely impacted gross profit. An increase in service gross profit attributable to the incremental impact of the Acquisition partially offset the decline in product gross profit. Segment operating profit was also impacted by higher operating expense as a result of incremental expense associated with acquisitions and higher bad debt expense. AP revenue increased $30.4 inclusive of an unfavorable currency impact of $19.2. Excluding the impact of the Acquisition of $145.5 and currency, AP revenue decreased from the prior year mainly as a result of a decline in product revenue stemming from lower volume, particularly in China, where the government continues to encourage banks to increase their use of domestic ATM suppliers. India also contributed to the decline due in part to the government’s demonetization program which led to lower product sales volume and corresponding installation service revenue as well as a decrease in managed services revenue. Segment operating profit benefited from incremental gross profit associated with the Acquisition but was more than offset by higher operating expense, also associated with the Acquisition. Excluding the impact of the Acquisition, operating profit decreased from a combination of lower product gross profit primarily driven by volume declines and deteriorating market conditions in China and lower service gross profit related to customer service level agreement contract requirements in India. These declines were partially offset by lower operating expense primarily in China. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) EMEA revenue increased $788.1 and was adversely impacted by unfavorable currency of $15.6. Excluding the impact of the Acquisition of $820.0 and currency, revenue decreased as a result of lower product volume within distributor channels and Poland as well as an unfavorable mix of product sales in Italy. Additionally, lower product revenue due to large projects in the prior year that did not recur, primarily in Belgium and Russia also contributed to the decline. A significant increase in product volume in Switzerland, Spain and South Africa helped to partially offset the overall decline in product revenue. Service revenue increased nominally as lower billed work revenue was more than offset by higher contract service and installation revenue. Segment operating profit increased due to the additional gross profit contributed as a result of the Acquisition. Excluding the impact of the Acquisition and related purchase accounting adjustments, operating profit decreased mainly attributable to volume declines and an unfavorable product and customer mix. Operating expenses increased as a result of incremental expense associated with the Acquisition. LA revenue increased $54.8 inclusive of an unfavorable currency impact of $13.6. Excluding the impact of the Acquisition of $29.6 and currency, LA revenue increased mainly by higher election equipment sales in Brazil and partially offset by a decrease in FSS product and information technology sales. Additionally, service revenue was higher, primarily in Mexico and Colombia, and was partially offset by a decrease in Venezuela as the Company divested its equity interest in the joint venture in April 2015. Segment operating profit increased primarily as a result of higher product gross profit in Brazil as well as incremental product and service gross profit associated with the Acquisition. Lower operating expenses benefited from bad debt recovery and cost control measures while being partially offset by incremental expense associated with the Acquisition. Refer to note 22 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. 2015 comparison with 2014 Net Sales The following table represents information regarding our net sales for the years ended December 31: FSS sales decreased $88.5 or 4.0 percent inclusive of a net unfavorable currency impact of $161.2. The unfavorable currency impact was related primarily to the Brazil real and the euro. The following segment results include the impact of foreign currency. • NA FSS sales increased $6.4 or 0.7 percent due primarily to increased volume in Canada from a large deposit automation upgrade project combined with the incremental sales from the acquisition of Phoenix in the first quarter of 2015. The U.S. experienced growth in multi-vendor services within the national bank space as significant contracts were won in the first, third and fourth quarters of 2015. This favorability was partially offset by a product volume decline related to two large enterprise accounts in the U.S. and the winding down of the Agilis 3 and Windows 7 upgrade project in the U.S. regional bank space. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) • Asia Pacific FSS sales decreased $55.9 or 11.7 percent impacted by $17.8 in unfavorable currency. The decline was primarily attributable to a decrease in product revenue in China where the government is encouraging banks to increase their use of domestic ATM suppliers. This decline was partially offset by an increase in service revenue as India, Philippines and China have experienced growth in their service installation base as well as higher professional services volume across a majority of the region. • EMEA FSS sales decreased $28.3 or 6.7 percent inclusive of a $66.6 unfavorable currency impact mainly related to the weakening of the euro. Excluding the unfavorable currency impact, EMEA FSS sales increased $38.3 due to higher product volume in Turkey and with European distributors, as well as a full year benefit of Cryptera, which was acquired in the third quarter of 2014. In addition to the unfavorable currency, offsetting declines occurred in Italy due to lower product volume while Belgium, Austria and the U.K. had large projects in 2014. • Latin America FSS sales decreased $10.7 or 2.5 percent inclusive of $69.5 unfavorable currency impact mainly related to the weakening of the Brazil real. Excluding the unfavorable currency impact, LA FSS sales increased $58.8 due to growth across a majority of the region, including Mexico which experienced double digit growth related to several customers renewing their existing ATM fleets. This was offset by the unfavorable currency impact and the sale of the Company’s equity interest in the Venezuelan joint venture. Security sales decreased $19.6 or 6.3 percent impacted by $6.1 in unfavorable currency. Approximately two-thirds of the decrease was related to continuing electronic security business, driven by volume declines in LA due to government mandated security updates in 2014. There were volume declines in AP as a result of exiting the business in Australia. Physical security was down due to volume declines in AP, LA and both the regional and national bank space in the U.S. Brazil other sales included an unfavorable currency impact of $62.8 and a decrease related to deliveries of IT equipment to the Brazil education ministry in the prior year. Additionally, market-specific economic and political factors continue to weigh on the purchasing environment driving lower volume in country. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Service gross margin increased during the time period with slight improvements throughout the international regions. AP service gross margin increased largely due to operational efficiencies gained through organizational restructuring while EMEA was driven primarily by higher service parts volume with EMEA distributors. LA’s margin improvement was driven by Venezuela, which had a lower cost of market adjustment in 2014 that favorably affected margins between the time periods. NA experienced a declines in gross margin and gross profit as a result of volume and service mix. Service gross profit in 2015 and 2014 included restructuring charges of $3.1 and $1.3, respectively. Product gross margin decreased during the time period due to a decline in volume and a shift in product solution mix. In addition, product gross margin was adversely impacted by $4.7 of inventory reserves related to the cancellation of certain projects in connection with the current Brazil economic and political environment. Product gross profit included total restructuring charges and non-routine expenses of $1.6 in 2015 and net benefit of $5.2 in 2014, which was related to Brazil indirect tax reversals. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: The increase in selling and administrative expense resulted primarily from higher non-routine and restructuring charges and an increase in the bad debt reserve of $4.6 in the third quarter of 2015 related to the cancellation of a previously awarded government contract in connection with the current Brazil economic and political environment, net of lower operational spend and favorable currency impact. Non-routine expenses of $36.3 and $9.2 were included in 2015 and 2014, respectively. The non-routine expenses pertained to legal, indemnification and professional fees related to corporate monitor efforts, which was $14.7 and $9.2 in 2015 and 2014, respectively. Additionally, 2015 included divestiture and potential acquisition costs of $21.1 in non-routine expense, with no comparable expense in 2014. Selling and administrative expense also included $16.7 and $9.7 of restructuring charges in 2015 and 2014, respectively. Restructuring charges in 2015 and 2014 consisted of the Company's transformation and business process outsourcing initiative. There were additional costs in 2015 associated with executive delayering. Research, development and engineering expense as a percent of net sales in 2015 and 2014 were relatively flat. The Company increased investment in 2015 related to the acquisition and integration of Phoenix as well as incremental expense associated with the acquisition of Cryptera, which was completed in the second half of 2014. This increase was offset by favorable currency impact and a decrease between the time periods mainly due to higher material and labor costs in 2014 related to the launch of new ATM models and enhanced modules. As of March 31, 2015, the Company agreed to sell its equity interest in its Venezuela joint venture to its joint venture partner and recorded a $10.3 impairment of assets in the first quarter of 2015. On April 29, 2015, the Company closed the sale for the estimated fair market value and recorded a $1.0 reversal of impairment of assets based on final adjustments in the second quarter of 2015, resulting in a $9.3 impairment of assets. Final fair value adjustments resulted in an overall impairment of $9.7. Additionally, the Company recorded an impairment related to other intangibles in LA in the second quarter of 2015 and an impairment of $9.1 related to redundant legacy Diebold internally-developed software as a result of the acquisition of Phoenix in the first quarter of 2015 in which the carrying amounts of the assets were not recoverable. During the second quarter of 2014, the Company divested its Eras subsidiary, resulting in a gain on sale of assets of $13.7. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The decrease in operating profit resulted from lower product revenue primarily in Brazil and China combined with higher net non-routine and restructuring charges. Impairment of assets and gain on sales of assets unfavorably impacted operating profit as a result of impairments in the first half of 2015 and the gain on the sale of Eras in 2014. Improvement in service margin helped to partially offset these declines. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: The decrease in interest income was driven primarily by unfavorable currency impact in Brazil. The foreign exchange loss net for 2015 and 2014 included $7.5 and $12.1, respectively, related to the devaluation of the Venezuela currency. The change in miscellaneous, net was primarily related to income derived from the fair value re-measurement of foreign currency option contracts. Income (Loss) from Continuing Operations, Net of Tax The following table represents information regarding our income (loss) from continuing operations, net of tax, for the years ended December 31: The decrease in net income was driven by lower operating profit resulting from lower product revenue in conjunction with higher net non-routine and restructuring charges as well as a net detriment between years associated with impairment of assets and gain on sales of assets. The tax rate benefit for the year ended December 31, 2015 resulted from the repatriation of foreign earnings, the associated recognition of foreign tax credits and related benefits due to the passage of the PATH Act of 2015. Income (Loss) from Discontinued Operations, Net of Tax On February 1, 2016, the Company executed a definitive asset purchase agreement with a wholly-owned subsidiary of Securitas AB (Securitas Electronic Security) to divest its electronic security business located in the U.S. and Canada for an aggregate purchase price of approximately $350.0 in cash, 10.0 percent of which was contingent based on the successful transition of certain customer relationships and was paid in full in the first quarter of 2016. The Company agreed to provide certain transition services to Securitas Electronic Security after the closing, including providing Securitas Electronic Security a $6.0 credit for such services. Income from discontinued operations, net of tax was $15.9 and $9.7 for the years ended December 31, 2015 and 2014, respectively. The operating results for the electronic security business were previously included in the Company's NA segment. Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: NA revenue increased due to higher FSS sales. The key drivers of this growth were higher volume in Canada from a large deposit automation upgrade project, increased multi-vendor services revenue in the U.S. and the acquisition of Phoenix. This was offset in part by decreased product volume in the U.S. in both the national and regional bank space. Physical security sales were lower between the time periods with volume declines in product revenue more than offsetting an increase in service. Operating profit MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) decreased principally due to the mix between regional and national customers, product mix and increased operating expenses resulting from the Phoenix acquisition. AP revenue in 2015 decreased from the prior year mainly as a result of a 39.4 percent decline in product revenue in China where the government is encouraging banks to increase their use of domestic ATM suppliers. AP revenue in 2015 was also adversely impacted by unfavorable currency of $19.3. These declines were partially offset by service revenue growth in a majority of the countries related to higher professional services and billed work volume. Operating profit decreased as a result of lower product volume combined with higher operating expense, which was offset by increased service margin largely due to operational efficiencies gained through organizational restructuring. EMEA revenue decreased primarily due to an unfavorable currency impact of $66.6 as well as product volume declines in Italy, Belgium, Austria and the U.K. This was offset by higher product volume in the Middle East and increased service parts sales to distributors, as well as the benefit of the Cryptera acquisition of $8.6. Operating profit declined primarily due to the aforementioned currency impact as well as lower product volume and revenue mix combined with higher operating expenses due to incremental spend resulting from the Cryptera acquisition. This was offset by additional service revenue associated with parts sales to a distributor in the Middle East. LA revenue decreased in 2015 compared to 2014, including a net unfavorable currency impact of $136.9. In Brazil, market-specific economic and political factors affecting the purchasing environment have driven lower Brazil other volume as well as a delivery of IT equipment to a Brazil education ministry in 2014 that was non-recurring. This was partially offset by FSS revenue growth related to product volume, particularly in Mexico where several customers are renewing their install bases. Operating profit decreased due to product volume decline in the Brazil other business and $9.3 of bad debt and inventory reserve increases primarily related to the cancellation of previously awarded government contracts in connection with the Brazil economic and political environment. Operating profit benefited from decreased operating expenses during the time period mainly related to favorable currency impact. Refer to note 22 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. LIQUIDITY AND CAPITAL RESOURCES Capital resources are obtained from income retained in the business, borrowings under the Company’s senior notes, committed and uncommitted credit facilities and operating and capital leasing arrangements. Management expects that the Company’s capital resources will be sufficient to finance planned working capital needs, research and development activities, investments in facilities or equipment, pension contributions, the payment of dividends on the Company’s common shares, the payment of dividends on the Diebold Nixdorf AG ordinary shares not controlled by the Company and any repurchases of the Company’s common shares for at least the next 12 months. At December 31, 2016, $576.1 or 80.4 percent of the Company’s cash and cash equivalents and short-term investments reside in international tax jurisdictions. Repatriation of these funds could be negatively impacted by potential payments for foreign and domestic taxes, excluding $142.4 that is available for repatriation with no additional tax expense because the Company has already provided for such taxes. Part of the Company’s growth strategy is to pursue strategic acquisitions. The Company has made acquisitions in the past and intends to make acquisitions in the future. The Company intends to finance any MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) future acquisitions with either cash and short-term investments, cash provided from operations, borrowings under available credit facilities, proceeds from debt or equity offerings and/or the issuance of common shares. The Company's total cash and cash availability as of December 31, 2016 and 2015 was as follows: As of December 31, 2016 the Company also has additional cash availability from the Delayed Draw Term Loan A of $250.0, which may be drawn up to one year after the closing date of the Acquisition with certain restrictions. On February 14, 2017, the Company entered into the Fourth Amendment to the Credit Agreement which released certain restrictions on the Delayed Draw Term Loan A effective immediately. The following table summarizes the results of our consolidated statement of cash flows for the years ended December 31: Operating Activities. Cash flows from operating activities can fluctuate significantly from period to period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Net cash provided by operating activities was $39.0 for the year ended December 31, 2016, an increase of $7.4 from $31.6 for the year ended December 31, 2015. The overall increase was primarily due to improved working capital and deferred revenue offset by lower income from continuing operations. Additional detail is included below: • Cash flows from continuing operating activities during the year ended December 31, 2016 compared to the year ended December 31, 2015 were negatively impacted by a $230.2 decrease in income from continuing operations, net of tax, primarily related to higher non-routine expenses, increased interest expense and impairment of assets, the adverse impact of foreign currency compared to the same period of 2015. The increase in share-based compensation expense to $22.2 in 2016 from $12.4 in 2015 was primarily due to changes in the assumptions related to performance shares. The impairment of assets, in the fourth quarter of 2016, related to redundant legacy Diebold internally-developed software as a result of the Acquisition and an indefinite-lived trade name in NA. • Accounts receivable and inventory provided an aggregate of $225.2 during the year ended December 31, 2016 compared to a use of $107.6 during the year ended December 31, 2015. The $332.8 increase is a result of a decrease in accounts receivable related to improved timing of cash collections. Additionally, Diebold Nixdorf AG provided $163.8 based on reductions in accounts receivable and inventory balances since the acquisition date, which included a favorable comparison to the August acquisition date and a purchase accounting inventory revaluation adjustment of $62.7. • Deferred revenue provided $61.6 of operating cash during the year ended December 31, 2016, compared to a use of $14.7 provided in the year ended December 31, 2015. The increase in cash flow associated with deferred revenue is due to timing of customer prepayments, primarily on service contracts, as a result of improved billing processes compared to the prior year. • The aggregate of refundable and deferred income taxes used $161.9 of operating cash during the year ended December 31, 2016, compared to $46.4 used in 2015. This increase in cash used in operating activities is primarily a result of non-cash purchase accounting adjustments. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Investing Activities. Net cash used in investing activities was $923.3 for the year ended December 31, 2016 compared to net cash used in investing activities of $62.4 for the year ended December 31, 2015. The $860.9 change was primarily related to the 2016 payments for acquisition, net of cash acquired of $884.6 offset by the proceeds from divestitures and the sale of assets of $26.3 and the $16.2 net proceeds from sale of the foreign currency option and forward contracts. The proceeds from divestitures and the sale of assets primarily related the $27.7 of cash received for the sale of stock in Aevi International GmbH and Diebold Nixdorf AG China subsidiaries. The prior year acquisition of Phoenix and capital expenditures were the primary uses of cash in investing. The Company anticipates capital expenditures of approximately $100 in 2017 to be utilized in information technology, infrastructure and integration related investments. Currently, we finance these investments primarily with funds provided by income retained in the business, borrowings under the Company's committed and uncommitted credit facilities, and operating and capital leasing arrangements. Financing Activities. Net cash provided by financing activities was $881.6 for the year ended December 31, 2016 compared to net cash provided in financing activities of $42.2 for the year ended 2015, an increase of $839.4. The increase was primarily due to a $841.1 change in debt borrowing net of repayments, including associated debt issuance costs, related to the Acquisition offset by funding the $64.6 in dividend payments, compared to $75.6 in the prior year. Benefit Plans. The Company plans to make contributions to its retirement plans of approximately $26.7 for the year ended December 31, 2017. Beyond 2017, minimum statutory funding requirements for the Company's U.S. pension plans may become more significant. The actual amounts required to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory actions related to pension funding obligations. The Company has adopted a pension investment policy designed to achieve an adequate funded status based on expected benefit payouts and to establish an asset allocation that will meet or exceed the return assumption while maintaining a prudent level of risk. The plan's target asset allocation adjusts based on the plan's funded status. As the funded status improves or declines, the debt security target allocation will increase and decrease, respectively. Management monitors assumptions used for our actuarial projections as well as any funding requirements for the plans. In connection with the Acquisition, the Company acquired $625.1 of additional obligations and $524.2 of assets related to postemployment benefit plans for certain groups of employees at the Company’s new operations outside of the U.S. Plans vary depending on the legal, economic, and tax environments of the respective country. For financially significant defined benefit plans, accruals for pensions and similar commitments have been included in the results for this year. The new significant defined benefit plans are mainly arranged for employees in Germany, the Netherlands and in Switzerland: • In Germany, post-employment benefit plans are set up as employer funded pension plans and deferred compensation plans. The employer funded pension commitments in Germany are based upon direct performance-related commitments in terms of defined contribution plans. Each beneficiary receives, depending on individual pay-scale grouping, contractual classification, or income level, different yearly contributions. The contribution is multiplied by an age factor appropriate to the respective pension plan and credited to the individual retirement account of the employee. The retirement accounts may be used up at retirement by either a one-time lump-sum payout or payments of up to ten years. Insured events include disability, death and reaching of retirement age. • In Switzerland, the post-employment benefit plan is required due to statutory provisions. The employees receive their pension payments as a function of contributions paid, a fixed interest rate and annuity factors. Insured events are disability, death and reaching of retirement age. • In the Netherlands, there is an average career salary plan, which is employer- and employee-financed and handled by an external fund. Insured events are disability, death and reaching of retirement age. In the Netherlands, the plan assets are currently invested in a company pension fund. During the fourth quarter of 2016, the Company recognized a curtailment gain of $4.6 related to its Netherlands' SecurCash B.V. plan due to a restructuring and cessation of accruals in the plan as of December 31, 2016. A transfer to an industry-wide pension fund is planned for the next fiscal year. Other financially significant defined benefit plans exist in the U.K., Belgium and France. Payments due under the Company's other post-retirement benefit plans are not required to be funded in advance. Payments are made as medical costs are incurred by covered retirees, and are principally dependent upon the future cost of retiree medical benefits under these plans. The Company expects the other post-retirement benefit plan payments to be approximately $1.2 in 2017 (refer to note 15 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further discussion of the Company's pension and other post-retirement benefit plans). The Company records a curtailment when an event occurs that significantly reduces the expected years of future service or eliminates the accrual of defined benefits for the future services of a significant number of employees. A curtailment gain is recorded when MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) the employees who are entitled to the benefits terminate their employment; a curtailment loss is recorded when it becomes probable a loss will occur. Upon a settlement, we recognize the proportionate amount of the unamortized gains and losses if the cost of all settlements during the year exceeds the interest component of net periodic cost for the affected plan. Expense from curtailments and settlements is recorded in selling and administrative expense on the consolidated statements of operations. Dividends. The Company paid dividends of $64.6, $75.6 and $74.9 in the years ended December 31, 2016, 2015 and 2014, respectively. Annualized dividends per share were $0.96, $1.15 and $1.15 for the years ended December 31, 2016, 2015 and 2014, respectively. The first quarterly dividend of 2017 is $0.10 per share. Contractual Obligations. The following table summarizes the Company’s approximate obligations and commitments to make future payments under contractual obligations as of December 31, 2016: (1) Amounts represent estimated contractual interest payments on outstanding long-term debt and notes payable. Rates in effect as of December 31, 2016 are used for variable rate debt. At December 31, 2016, the Company also maintained uncertain tax positions of $43.2, for which there is a high degree of uncertainty as to the expected timing of payments (refer to note 7 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company had various short-term uncommitted lines of credit with borrowing limits of $208.0 and $89.0 as of December 31, 2016 and 2015, respectively. The weighted-average interest rate on outstanding borrowings on the short-term uncommitted lines of credit as of December 31, 2016 and 2015 was 9.87 percent and 5.66 percent, respectively. The increase in the weighted-average interest rate is attributable to the change in mix of borrowings in foreign entities. Short-term uncommitted lines mature in less than one year. The amount available under the short-term uncommitted lines at December 31, 2016 was $198.6. The Company entered into a revolving and term loan credit agreement (the Credit Agreement), dated as of November 23, 2015, among the Company and certain of the Company's subsidiaries, as borrowers, JPMorgan Chase Bank, N.A., as Administrative Agent, and the lenders named therein. The Credit Agreement included, among other things, mechanics for the Company’s existing revolving and term loan A facilities to be refinanced under the Credit Agreement. On December 23, 2015, the Company entered into a Replacement Facilities Effective Date Amendment, which amended the Credit Agreement, among the Company, certain of the Company’s subsidiaries, the lenders identified therein and JPMorgan Chase Bank, N.A., as Administrative Agent, pursuant to which the Company refinanced its $520.0 revolving and $230.0 term loan A senior unsecured credit facilities (which have been terminated and repaid in full) with, respectively, a new unsecured revolving facility (the Revolving Facility) in an amount of up to $520.0 and a new (non-delayed draw) unsecured term loan A facility (the Term Loan A Facility) on substantially the same terms as the Delayed Draw Term Facility (as defined in the Credit Agreement) in the amount of up to $230.0. The Delayed Draw Term Facility of $250.0 may be drawn up to one year after the closing date of the Acquisition. The Revolving Facility and Term Loan A Facility are subject to the same maximum consolidated net leverage ratio and minimum consolidated interest coverage ratio as the Delayed Draw Term Facility. On December 23, 2020, the Term Loan A Facility will mature and the Revolving Facility will automatically terminate. The weighted-average interest rate on outstanding revolving credit facility borrowings as of December 31, 2016 and December 31, 2015 was 2.56 percent and 2.33 percent, respectively, which is variable based on the London Interbank Offered Rate (LIBOR). The amount available under the revolving credit facility as of December 31, 2016 was $520.0. On April 19, 2016, the Company issued $400.0 aggregate principal amount of 2024 Senior Notes in an offering, which were registered with the SEC in October 2016 in connection with the Acquisition. The 2024 Senior Notes are and will be guaranteed by certain of the Company’s existing and future domestic subsidiaries. Also in April 2016, allocation and pricing of the term loan B facility (the Term Loan B Facility) provided under the Credit Agreement (which the Term Loan B Facility was used to provide part of the financing for the Acquisition) was completed. The Term Loan B Facility consists of a $1,000.0 U.S. dollar-denominated tranche that bears interest at LIBOR plus an applicable margin of 4.50 percent (or, at the Company’s option, prime plus an applicable margin of 3.50 percent), and a €350.0 euro-denominated tranche that will bear interest at the Euro Interbank Offered Rate (EURIBOR) plus an applicable margin of 4.25 percent. Each tranche was MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) funded during the second quarter of 2016 at 99 percent of par. In November 2016, the Company repaid $200.0 of the outstanding debt from the Term Loan B Facility - USD. On May 6 and August 16, 2016, the Company entered into the Second and Third Amendments to the Credit Agreement, which re-denominated a portion of the Term Loan B Facility into euros and guaranteed the prompt and complete payment and performance of the obligations when due under the Credit Agreement. On February 14, 2017, the Company entered into the Fourth Amendment to the Credit Agreement which released certain restrictions on the Delayed Draw Term Loan A effective immediately. The Credit Agreement financial ratios at December 31, 2016 are as follows: • a maximum total net debt to adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) leverage ratio of 4.50 as of December 31, 2016 (reducing to 4.25 on December 31, 2017, further reduced to 4.00 on December 31, 2018, and further reduced to 3.75 on June 30, 2019); and • a minimum adjusted EBITDA to net interest expense coverage ratio of not less than 3.00 The key affirmative and negative covenants of the Credit Agreement include: Mandatory prepayments are required if the outstanding revolving loans or facility letters of credit exceed the aggregate revolving credit commitments, including due to currency fluctuations if difference is greater than 105 percent, the excess loans must be repaid or facility letters of credit must be cash collateralized. Voluntary prepayments require one business day notice for floating rate loans in $1.0 or multiples thereof and three business days for euro currency rate loans in $5.0 or $1.0 multiples thereof. There is a prepayment premium with respect to the Term B Facility only. Until May 6, 2017, if there is a repricing event, where the Term B Facility is refinanced or amended to reduce the yield, there is a prepayment premium of 1.00 percent refinanced or amended. Other mandatory prepayments include incurrence of new debt outside what is allowed in the Credit Agreement, sale of certain assets beyond a de-minimis exception amount and depending on the net debt leverage, a percentage of "Excess Cash Flows" as defined in the Credit Agreement beginning with 2017 cash flows. The Company incurred $39.2 and $6.0 of fees in the years ended December 31, 2016 and 2015, respectively, related to the Credit Agreement and 2024 Senior Notes, which are amortized as a component of interest expense over the terms. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Below is a summary of financing and replacement facilities information: (i) LIBOR with a floor of 0.75 percent. (ii) EURIBOR with a floor of 0.75 percent. The debt facilities under the Credit Agreement are secured by substantially all assets of the Company and its domestic subsidiaries that are borrowers or guarantors under the Credit Agreement, subject to certain exceptions and permitted liens. In March 2006, the Company issued senior notes (2006 Senior Notes) in an aggregate principal amount of $300.0. The Company funded the repayment of $75.0 aggregate principal amount of the 2006 Senior Notes at maturity in March 2013 using borrowings under its revolving credit facility and the repayment of $175.0 aggregate principal amount of the 2006 Senior Notes that matured in March 2016 through the use of proceeds from the divestiture of the Company's NA electronic security business. Prepayment of the remaining $50.0 aggregate principal amount of the 2006 Senior Notes were paid in full on May 2, 2016. The prepayment included a make-whole premium of $3.9, which was paid in addition to the principal and interest of the 2006 Senior Notes and is included in interest expense for the year ended December 31, 2016. On November 23, 2015, the Company entered into two foreign currency option contracts to purchase €1,416.0 for $1,547.1 to hedge against the effect of exchange rate fluctuations on the euro-denominated cash consideration related to the Acquisition and estimated euro-denominated transaction related costs and any outstanding Diebold Nixdorf AG borrowings. At that time, the euro-denominated cash component of the purchase price consideration approximated €1,162.2. The foreign currency option contracts were sold during the second quarter of 2016 for cash proceeds of $42.6, which are included in investing activities in the consolidated statements of cash flows, resulting in a gain of $35.6 during the year ended December 31, 2016 and $7.0 during the fourth quarter of 2015. The weighted average strike price was $1.09 per euro. These foreign currency option contracts were non-designated and included in other current assets on the consolidated balance sheet as of December 31, 2015 based on the net asset position. On April 29, 2016, the Company entered into one foreign currency forward contract to purchase €713.0 for $820.9 to hedge against the effect of exchange rate fluctuations on the euro-denominated cash consideration related to the Acquisition and estimated euro denominated transaction related costs and any outstanding Diebold Nixdorf AG borrowings. The forward rate was $1.1514. The foreign currency forward contract was settled for $792.6 during the third quarter of 2016, which is included in investing activities in the consolidated statements of cash flows, resulting in a loss of $26.4 during the year ended December 31, 2016. This foreign currency forward contract is non-designated and included in other current assets or other current liabilities based on the net asset or net liability position, respectively, in the consolidated balance sheets. The gains and losses from the revaluation of the foreign currency forward contract are included in other income (expense) miscellaneous, net on the consolidated statements of operations. During November 2016, the Company entered into multiple pay-fixed receive-variable interest rate swaps outstanding with an aggregate notional amount of $400.0. The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in accumulated other comprehensive income (AOCI) and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During the fourth quarter of 2016, such derivatives were used to hedge the variable cash flows associated with existing variable-rate debt. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. Amounts reported in AOCI related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. The Company estimates that an additional $0.8 will be reclassified as an increase to interest expense over the next year. In connection with the Acquisition, the Company acquired an interest swap for a notional amount of €50.0, which was entered into in May 2010 with a ten-year term from October 1, 2010 until September 30, 2020. For this interest swap, the three-month MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) EURIBOR is received and a fixed interest of 2.974 percent is paid. The fair value, which is measured at market prices. On the date of the Acquisition and as of December 31, 2016, the fair value was €(7.9) and €(6.3), respectively. Because this swap was accounted for as a cash flow hedge, the change in fair value of €1.6 was directly recognized in AOCI, having taken into account deferred taxes. For the year ended December 31, 2016, the amount reclassified from equity to profit or loss was not significant. During the year ended December 31, 2016, the Company recorded a $9.3 mark-to-market gain (loss) on foreign currency and forward option contracts reflected in miscellaneous, net. The fair value of the Company's foreign currency forward and option contracts was $7.0 as of December 31, 2015 and was included in other current assets. Off-Balance Sheet Arrangements. The Company enters into various arrangements not recognized in the consolidated balance sheets that have or could have an effect on its financial condition, results of operations, liquidity, capital expenditures or capital resources. The principal off-balance sheet arrangements that the Company enters into are guarantees, operating leases (refer to note 16 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K) and sales of finance receivables. The Company provides its global operations guarantees and standby letters of credit through various financial institutions to suppliers, customers, regulatory agencies and insurance providers. If the Company is not able to comply with its contractual obligations, the suppliers, regulatory agencies and insurance providers may draw on the pertinent bank (refer note 17 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company has sold finance receivables to financial institutions while continuing to service the receivables. The Company records these sales by removing finance receivables from the consolidated balance sheets and recording gains and losses in the consolidated statement of operations (refer to note 9 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements. The consolidated financial statements of the Company are prepared in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP). The preparation of the accompanying consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities and reported amounts of revenues and expenses. Such estimates include revenue recognition, the valuation of trade and financing receivables, inventories, goodwill, intangible assets, other long-lived assets, legal contingencies, guarantee obligations, and assumptions used in the calculation of income taxes, pension and post-retirement benefits and customer incentives, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors. Management monitors the economic conditions and other factors and will adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. The Company’s significant accounting policies are described in note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K. Management believes that, of its significant accounting policies, its policies concerning revenue recognition, allowances for credit losses, inventory reserves, goodwill, long-lived assets, taxes on income, contingencies and pensions and post-retirement benefits are the most critical because they are affected significantly by judgments, assumptions and estimates. Additional information regarding these policies is included below. Revenue Recognition. The Company’s revenue recognition policy is consistent with the requirements of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605, Revenue Recognition (ASC 605). The Company records revenue when it is realized, or realizable and earned. The application of U.S. GAAP revenue recognition principles to the Company's customer contracts requires judgment, including the determination of whether an arrangement includes multiple deliverables such as hardware, software, maintenance and /or other services. For contracts that contain multiple deliverables, total arrangement consideration is allocated at the inception of the arrangement to each deliverable based on the relative selling price method. The relative selling price method is based on a hierarchy consisting of vendor specific objective evidence (VSOE) (price sold on a stand-alone basis), if available, or third-party evidence (TPE), if VSOE is not available, or estimated selling price (ESP) if neither VSOE nor TPE is available. The Company's ESP is consistent with the objective of determining VSOE, which is the price at which we would expect to transact on a stand-alone sale of the deliverable. The determination of ESP is based on applying significant judgment to weigh a variety of company-specific factors including our pricing practices, customer volume, geography, internal costs and gross margin objectives. This information is gathered from experience in customer negotiations, recent technological trends and the competitive landscape. In contracts that involve multiple deliverables, maintenance services are typically accounted for under FASB ASC 605-20, Separately Priced Extended Warranty and Product Maintenance Contracts. There have been no material changes to these estimates for the periods presented and the Company believes that these estimates generally should not be subject to significant changes in the future, until the adoption of the new revenue standard. However, changes to deliverables in future arrangements could materially impact the amount of earned or deferred revenue. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) For sales of software, excluding software required for the equipment to operate as intended, the Company applies the software revenue recognition principles within FASB ASC 985-605, Software - Revenue Recognition. For software and software-related deliverables (software elements), the Company allocates revenue based upon the relative fair value of these deliverables as determined by VSOE. If the Company cannot obtain VSOE for any undelivered software element, revenue is deferred until all deliverables have been delivered or until VSOE can be determined for any remaining undelivered software elements. When the fair value of a delivered element cannot be established, but fair value evidence exists for the undelivered software elements, the Company uses the residual method to recognize revenue. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement consideration is allocated to the delivered elements and recognized as revenue. Determination of amounts deferred for software support requires judgment about whether the deliverables can be divided into more than one unit of accounting and whether the separate deliverables have value to the customer on a stand-alone basis. There have been no material changes to these deliverables for the periods presented. However, changes to deliverables in future arrangements and the ability to establish VSOE could affect the amount and timing of revenue recognition. Allowances for Credit Losses. The Company maintains allowances for potential credit losses and such losses have been minimal and within management’s expectations. Since the Company’s receivable balance is concentrated primarily in the financial and government sectors, an economic downturn in these sectors could result in higher than expected credit losses. The concentration of credit risk in the Company’s trade receivables with respect to financial and government customers is largely mitigated by the Company’s credit evaluation process and the geographical dispersion of sales transactions from a large number of individual customers. Inventory Reserves. At each reporting period, the Company identifies and writes down its excess and obsolete inventories to net realizable value based on usage forecasts, order volume and inventory aging. With the development of new products, the Company also rationalizes its product offerings and will write-down discontinued product to the lower of cost or net realizable value. Acquisitions and Divestitures. Acquisitions are accounted for using the purchase method of accounting. This method requires the Company to record assets and liabilities of the business acquired at their estimated fair market values as of the acquisition date. Any excess cost of the acquisition over the fair value of the net assets acquired is recorded as goodwill. The Company generally uses valuation specialists to perform appraisals and assist in the determination of the fair values of the assets acquired and liabilities assumed. These valuations require management to make estimates and assumptions that are critical in determining the fair values of the assets and liabilities. For divestitures, the Company considers assets to be held for sale when management approves and commits to a formal plan to actively market the assets for sale at a price reasonable in relation to their estimated fair value, the assets are available for immediate sale in their present condition, an active program to locate a buyer and other actions required to complete the sale have been initiated, the sale of the assets is probable and expected to be completed within one year (or, if it is expected that others will impose conditions on the sale of the assets that will extend the period required to complete the sale, that a firm purchase commitment is probable within one year) and it is unlikely that significant changes will be made to the plan. Upon designation as held for sale, the Company records the assets at the lower of their carrying value or their estimated fair value, reduced for the cost to dispose of the assets, and ceases to record depreciation expense on the assets. The Company reports financial results for discontinued operations separately from continuing operations to distinguish the financial impact a divestiture from ongoing operations. Discontinued operations reporting occurs only when the disposal of a component or a group of components of the Company represents a strategic shift that will have a major effect on the Company's operations and financial results. During the year ended December 31, 2015, management of the Company, through receipt in October 2015 of the required authorization from its Board of Directors after a potential buyer had been identified, committed to a plan to divest the NA electronic security business. As such, all of the criteria required for held for sale and discontinued operations classification were met during the fourth quarter of 2015. The divestiture of its NA electronic security business closed on February 1, 2016. Accordingly, the assets and liabilities, operating results and operating and investing cash flows for are presented as discontinued operations separate from the Company’s continuing operations for all periods presented. Prior period information has been reclassified to present this business as discontinued operations for all periods presented, and has therefore been excluded from both continuing operations and segment results for all periods presented in these consolidated financial statements and the notes to the consolidated financial statements. All assets and liabilities classified as held for sale are included in total current assets based on the cash conversion of these assets and liabilities within one year (refer to note 23 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). Assets and liabilities of a discontinued operation are reclassified as held for sale for all comparative periods presented in the consolidated balance sheet. The results of operations of a discontinued operation are reclassified to income from discontinued operations, net of tax, for all periods presented. For assets that meet the held for sale criteria but do not meet the definition of a discontinued operation, the Company reclassifies the assets and liabilities in the period in which the held for sale criteria are met, but does not reclassify prior period amounts. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) Goodwill. Goodwill is the cost in excess of the net assets of acquired businesses (refer to note 13 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company tests all existing goodwill at least annually as of October 31 for impairment on a reporting unit basis. The Company tests for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the carrying value of a reporting unit below its reported amount. The Company’s four reporting units are defined as Domestic and Canada, LA, AP and EMEA. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount, the Company considers the following events and circumstances, among others, if applicable: (a) macroeconomic conditions such as general economic conditions, limitations on accessing capital or other developments in equity and credit markets; (b) industry and market considerations such as competition, multiples or metrics and changes in the market for the Company's products and services or regulatory and political environments; (c) cost factors such as raw materials, labor or other costs; (d) overall financial performance such as cash flows, actual and planned revenue and earnings compared with actual and projected results of relevant prior periods; (e) other relevant events such as changes in key personnel, strategy or customers; (f) changes in the composition of a reporting unit's assets or expected sales of all or a portion of a reporting unit; and (g) any sustained decrease in share price. If the Company's qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying value, or if management elects to perform a quantitative assessment of goodwill, a two-step impairment test is used to identify potential goodwill impairment and measure the amount of any impairment loss to be recognized. In the first step, the Company compares the fair value of each reporting unit with its carrying value. The fair value of the reporting units is determined based upon a combination of the income valuation and market approach in valuation methodology. The income approach uses discounted estimated future cash flows, whereas the market approach or guideline public company method utilizes market data of similar publicly traded companies. The Company’s step 1 impairment test of goodwill of a reporting unit is based upon the fair value of the reporting unit, defined as the price that would be received to sell the net assets or transfer the net liabilities in an orderly transaction between market participants at the assessment date. In the event that the net carrying amount exceeds the fair value, a step 2 test must be performed whereby the fair value of the reporting unit’s goodwill must be estimated to determine if it is less than its net carrying amount. In its two-step test, the Company uses the discounted cash flow method and the guideline company method for determining the fair value of its reporting units. Under these methods, the determination of implied fair value of the goodwill for a particular reporting unit is the excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities in the same manner as the allocation in a business combination. The techniques used in the Company's qualitative assessment and, if necessary, two-step impairment test incorporate a number of assumptions that the Company believes to be reasonable and to reflect market conditions forecast at the assessment date. Assumptions in estimating future cash flows are subject to a high degree of judgment. The Company makes all efforts to forecast future cash flows as accurately as possible with the information available at the time the forecast is made. To this end, the Company evaluates the appropriateness of its assumptions as well as its overall forecasts by comparing projected results of upcoming years with actual results of preceding years and validating that differences therein are reasonable. Key assumptions, all of which are Level 3 inputs (refer to note 20 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K), relate to price trends, material costs, discount rate, customer demand, and the long-term growth and foreign exchange rates. A number of benchmarks from independent industry and other economic publications were also used. Changes in assumptions and estimates after the assessment date may lead to an outcome where impairment charges would be required in future periods. Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions. During 2016, management determined that the LA and AP reporting units had excess fair value of approximately $65.8 or 18.3 percent and approximately $56.1 or 21.5 percent, respectively, when compared to their carrying amounts. The Domestic and Canada reporting unit, included in the NA reportable segment, had excess fair value greater than 100 percent when compared to its carrying amount. As of December 31, 2016, the LA and AP reporting units had goodwill of approximately $28.6 and $37.2, respectively. A further change in macroeconomic conditions, as well as future changes in the judgments, assumptions and estimates that are used in the Company's goodwill impairment testing for the LA and AP reporting units, including the discount rate and future cash flow projections, could result in a significantly different estimate of the fair value. EMEA had no net goodwill as of December 31, 2016. Long-Lived Assets. Impairment of long-lived assets is recognized when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized at that time to reduce the asset to the lower of its fair value or its net book value. The Company tests all existing indefinite-lived intangibles at least annually for impairment as of October 31. Taxes on Income. Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized for deductible temporary differences, operating loss carry-forwards and tax credits. Deferred tax liabilities are recognized for taxable temporary differences and undistributed earnings in certain jurisdictions. Deferred tax assets are reduced by a valuation allowance MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) when, based upon the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Determination of a valuation allowance involves estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income and the impact of tax planning strategies. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company operates in numerous taxing jurisdictions and is subject to examination by various federal, state and foreign jurisdictions for various tax periods. Additionally, the Company has retained tax liabilities and the rights to tax refunds in connection with various acquisitions and divestitures of businesses. The Company’s income tax positions are based on research and interpretations of the income tax laws and rulings in each of the jurisdictions in which the Company does business. Due to the subjectivity of interpretations of laws and rulings in each jurisdiction, the differences and interplay in tax laws between those jurisdictions, as well as the inherent uncertainty in estimating the final resolution of complex tax audit matters, the Company’s estimates of income tax liabilities may differ from actual payments or assessments. The Company assesses its position with regard to tax exposures and records liabilities for these uncertain tax positions and any related interest and penalties, when the tax benefit is not more likely than not realizable. The Company has recorded an accrual that reflects the recognition and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. Additional future income tax expense or benefit may be recognized once the positions are effectively settled. At the end of each interim reporting period, the Company estimates the effective tax rate expected to apply to the full fiscal year. The estimated effective tax rate contemplates the expected jurisdiction where income is earned, as well as tax planning alternatives. Current and projected growth in income in higher tax jurisdictions may result in an increasing effective tax rate over time. If the actual results differ from estimates, the Company may adjust the effective tax rate in the interim period if such determination is made. Contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. There is no liability recorded for matters in which the liability is not probable and reasonably estimable. Attorneys in the Company's legal department monitor and manage all claims filed against the Company and review all pending investigations. Generally, the estimate of probable loss related to these matters is developed in consultation with internal and outside legal counsel representing the Company. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The Company attempts to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments, or fines, after appeals, differ from the estimates, the future results may be materially impacted. Adjustments to the initial estimates are recorded when a change in the estimate is identified. Pensions and Other Post-retirement Benefits. Annual net periodic expense and benefit liabilities under the Company’s defined benefit plans are determined on an actuarial basis. Assumptions used in the actuarial calculations have a significant impact on plan obligations and expense. Members of the management investment committee periodically review the actual experience compared with the more significant assumptions used and make adjustments to the assumptions, if warranted. The discount rate is determined by analyzing the average return of high-quality (i.e., AA-rated) fixed-income investments and the year-over-year comparison of certain widely used benchmark indices as of the measurement date. The expected long-term rate of return on plan assets is determined using the plans’ current asset allocation and their expected rates of return based on a geometric averaging over 20 years. The rate of compensation increase assumptions reflects the Company’s long-term actual experience and future and near-term outlook. Pension benefits are funded through deposits with trustees. Other post-retirement benefits are not funded and the Company’s policy is to pay these benefits as they become due. In connection with the Acquisition, the Company acquired $625.1 of additional obligations and $524.2 of assets related to postemployment benefit plans for certain groups of employees at the Company’s new operations outside of the U.S. Plans vary depending on the legal, economic, and tax environments of the respective country. For financially significant defined benefit plans, accruals for pensions and similar commitments have been included in the results for this year. The new significant defined benefit plans are mainly arranged for employees in Germany, the Netherlands and in Switzerland: • In Germany, post-employment benefit plans are set up as employer funded pension plans and deferred compensation plans. The employer funded pension commitments in Germany are based upon direct performance-related commitments in terms of defined contribution plans. Each beneficiary receives, depending on individual pay-scale grouping, contractual classification, or income level, different yearly contributions. The contribution is multiplied by an age factor appropriate to the respective pension plan and credited to the individual retirement account of the employee. The retirement accounts may be used up at retirement by either a one-time lump-sum payout or payments of up to ten years. Insured events include disability, death and reaching of retirement age. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) • In Switzerland, the post-employment benefit plan is required due to statutory provisions. The employees receive their pension payments as a function of contributions paid, a fixed interest rate and annuity factors. Insured events are disability, death and reaching of retirement age. • In the Netherlands, there is an average career salary plan, which is employer- and employee-financed and handled by an external fund. Insured events are disability, death and reaching of retirement age. In the Netherlands, the plan assets are currently invested in a company pension fund. During the fourth quarter of 2016, the Company recognized a curtailment gain of $4.6 related to its Netherlands' SecurCash B.V. plan due to a restructuring and cessation of accruals in the plan as of December 31, 2016. A transfer to an industry-wide pension fund is planned for the next fiscal year. Other financially significant defined benefit plans exist in the U.K., Belgium and France. The following table represents assumed healthcare cost trend rates at December 31: The healthcare trend rates for the postemployment benefits plans in the U.S. are reviewed based upon the results of actual claims experience. The Company used initial healthcare cost trends of 7.0 percent in both 2016 and 2015 . While the ultimate trend rate was 5.0 percent in both years, the period of time to reach the ultimate was extended from 2015 to 2016.Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. A one-percentage-point change in assumed healthcare cost trend rates would have the following effects: During 2016, the Society of Actuaries released a series of updated mortality tables resulting from recent studies measuring mortality rates for various groups of individuals. As of December 31, 2016, the Company adopted for the pension plan in the U.S. the use of the RP-2014 base mortality table modified to remove the post-2006 projections using the MP-2014 mortality improvement scale and replacing it with projections using the fully generational MP-2016 projection scale. For the plans outside the U.S., the mortality tables used are those either required or customary for local accounting and/or funding purposes. RECENTLY ISSUED ACCOUNTING GUIDANCE Refer to note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for information on recently issued accounting guidance. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) FORWARD-LOOKING STATEMENT DISCLOSURE In this annual report on Form 10-K, statements that are not reported financial results or other historical information are “forward-looking statements.” Forward-looking statements give current expectations or forecasts of future events and are not guarantees of future performance. These forward-looking statements include, but are not limited to, statements regarding the Acquisition, its financing of the Acquisition, its expected future performance (including expected results of operations and financial guidance), and the Company’s future financial condition, operating results, strategy and plans. Forward-looking statements may be identified by the use of the words “anticipates,” “expects,” “intends,” “plans,” “will,” “believes,” “estimates,” “potential,” “target,” “predict,” “project,” “seek,” and variations or similar expressions. These statements are used to identify forward-looking statements. These forward-looking statements reflect the current views of the Company with respect to future events and involve significant risks and uncertainties that could cause actual results to differ materially. Although the Company believes that these forward-looking statements are based upon reasonable assumptions regarding, among other things, the economy, its knowledge of its business, and on key performance indicators that impact the Company, these forward-looking statements involve risks, uncertainties and other factors that may cause actual results to differ materially from those expressed in or implied by the forward-looking statements. The Company is not obligated to update forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Some of the risks, uncertainties and other factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements include, but are not limited to: • the ultimate impact and outcome of the review of the business combination with Diebold Nixdorf AG by the Competition and Markets Authority in the U.K.; • the implementation, ultimate impact and outcome of the DPLTA with Diebold Nixdorf AG including that its effectiveness may be delayed as a result of litigation or otherwise; • the ultimate outcome and results of integrating the operations of the Company and Diebold Nixdorf AG; • the ultimate outcome of the Company’s pricing, operating and tax strategies applied to Diebold Nixdorf AG and the ultimate ability to realize synergies; • the Company's ability to successfully launch and operate its joint ventures in China with the Inspur Group and Aisino Corp.; • changes in political, economic or other factors such as currency exchange rates, inflation rates, recessionary or expansive trends, taxes and regulations and laws affecting the worldwide business in each of the Company's operations; • global economic conditions, including any additional deterioration and disruption in the financial markets, including the bankruptcies, restructurings or consolidations of financial institutions, which could reduce our customer base and/or adversely affect our customers' ability to make capital expenditures, as well as adversely impact the availability and cost of credit; • the finalization of the Company's financial statements for the periods discussed in this release; • the acceptance of the Company's product and technology introductions in the marketplace; • competitive pressures, including pricing pressures and technological developments; • changes in the Company's relationships with customers, suppliers, distributors and/or partners in its business ventures; • the effect of legislative and regulatory actions in the U.S. and internationally and the Company’s ability to comply with government regulations; • the impact of a security breach or operational failure on the Company's business; • the Company's ability to successfully integrate acquisitions into its operations; • the impact of the Company's strategic initiatives; • the Company's ability to maintain effective internal controls; • changes in the Company's intention to further repatriate cash and cash equivalents and short-term investments residing in international tax jurisdictions, which could negatively impact foreign and domestic taxes; • unanticipated litigation, claims or assessments, as well as the outcome/impact of any current/pending litigation, claims or assessments, including but not limited to the Company's Brazil tax dispute; • potential security violations to the Company's information technology systems; • the investment performance of our pension plan assets, which could require us to increase our pension contributions, and significant changes in healthcare costs, including those that may result from government action; • the amount and timing of repurchases of the Company's common shares, if any; and • the Company's ability to achieve benefits from its cost-reduction initiatives and other strategic changes, including its planned restructuring actions, as well as as its business process outsourcing initiative. Except to the extent required by applicable law or regulation, the Company undertakes no obligation to update these forward-looking statements to reflect future events or circumstances or to reflect the occurrence of unanticipated events.

<s>[INST] Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10K. Introduction Diebold Nixdorf, Incorporated (collectively with its subsidiaries, the Company) provides connected commerce services, software and technology to enable millions of transactions each day. The Company’s approximately 25,000 employees design and deliver convenient, “always on” and highly secure solutions that bridge the physical and the digital worlds of transactions. Customers of the Company include nearly all of the world’s top 100 financial institutions and a majority of the top 25 global retailers. Strategy The Company’s Connected Commerce strategy seeks to continually enhance the customer experience at banking or retail locations by integrating services, software and systems. This requires ongoing investment and development of our industryleading field services organization as well as the development and integration of innovative technology including cloud computing technology, sensors and connectivity to the Internet of Things, as well as open and agile software. The Company will continuously refine its R&D spend in support of a better transaction experience for consumers MultiYear Integration Program The Company is executing a multiyear integration program designed to optimize the assets, business processes, and IT systems of Diebold Nixdorf. This program, in aggregate, has identified an opportunity to realize approximately $160 of cost synergies over three years. These cost synergies include: Realizing volume discounts on direct materials Harmonizing the solutions set Increasing utilization rates of the service technicians Rationalizing facilities in the regions Streamlining corporate and general and administrative functions Harmonizing back office solutions. The Company has and will continue to invest significant dollars to restructure the workforce, optimize legacy systems, streamline legal entities and consolidate real estate holdings. By executing these integration activities, the Company expects to deliver greater innovation for customers, career enrichment opportunities for employees, and enhanced value for shareholders. Financial SelfService Solutions The Company is a leader in providing connected commerce solutions to financial institutions. These solutions are supported by a dedicated field service organization. The combination of high reliability, industryleading security, remote management capabilities and highlytrained field technicians has made the Company a preferred choice for FSS solutions. Through managed services, banks entrust the management of their ATM and security operations to the Company, allowing their associates to focus on core competencies. Furthermore, the Company’s managed services deliver greater operational efficiencies and provide financial institutions with a leadingedge solutions that they need to stay competitive in the marketplace. A significant demand driver in the global ATM marketplace is branch automation, which helps financial institutions grow revenue, reduce costs, and increase convenience and security for the banks’ customers by migrating routine transactions, typically done inside the branch, to lowercost automated channels. The Company serves as a strategic partner to its customers by offering a complete branch automation solution services, software and technology that addresses the complete value chain of consult, design, build and operate. The Company’s advisory services team collaborates with its clients to help define the ideal customer experience, modify processes, refine existing staffing models and deploy technology to meet branch automation objectives. The inlobby teller terminal provides branch automation technology by combining the speed and accuracy of a selfservice terminal with intelligence from the bank’s core systems, as well as the ability to complete higher value transactions away from the teller line. The Company also offers hardwareagnostic, omnichannel software solutions for ATMs and a host of other selfservice applications. These offerings include highly configurable, enterprisewide software that automates and migrates financial services across channels, changing the way financial products are delivered to consumers. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2016 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (dollars in millions, except per share amounts) The Company continues to invest in supporting current and developing new services, software and security solutions that align with the needs of its customers. At recent trade shows, the Company showcased several new FSS concepts. The Company is piloting advanced analytics capabilities with Banco Popular that enable financial institutions to have a complete view of the selfservice channel [/INST] Positive. </s>

DIEBOLD NIXDORF, Inc

2018-02-28

2017-12-31

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Significant Highlights During 2017, Diebold Nixdorf: • Launched the DN2020 integration and transformation program and realized more than $100 of cost savings during the year. • Rationalized the manufacturing footprint from a capacity of approximately 180,000 ATMs per year to approximately 100,000 ATMs per year and consolidated approximately 25 percent of service parts depots across the globe. • Shifted production to the manufacturing facility in Suzhou, China operated by its strategic alliance partner, Inspur Group. This strategic alliance is enabling the Company to realize procurement advancements through better access to local suppliers and is enhancing our ability to adapt to market conditions. • Consolidated legal entities in order to simplify sales, service operations and business processes through a single entity in each country. • Was named as the largest manufacturer of ATMs by Retail Banking Research's report "Global ATM Market and Forecasts to 2022." • Introduced new mobility management services offering with as-a-service, security and data analytics offerings. • Won a number of retail contracts to modernize checkout solutions and implement omni-channel retailing, including a $53.0 store lifecycle management deal with a European fashion retailer. • Introduced Vynamic, the first end-to-end Connected Commerce software portfolio in the marketplace. • Announced strategic partnership with Kony, Inc. (Kony) to white label mobile application solutions for financial institutions and retailers. • Received the "Global Self-Checkout Systems Growth Excellence Leadership Award" from Frost & Sullivan in recognition of the Company's product innovation, growth, channel partnership strategies, and ability to serve multiple retailer segments. • Announced product readiness to support the Microsoft® Windows 10 operating system. OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10-K. For additional information regarding general information regarding the Company, its business, strategy, competitors and operations, refer to Item 1. Business. Business Drivers The business drivers of the Company's future performance include, but are not limited to: • Demand for services on distributed IT assets such as ATMs, POS and SCO, including managed services and professional services; • Timing of system upgrades and/or replacement cycles for ATMs, POS and SCO; • Demand for software products and professional services; • Demand for security products and services for the financial, retail and commercial sectors; • Demand for innovative technology in connection with our Connected Commerce strategy; • Integration of legacy salesforce, business processes, procurement, and internal IT systems; and • Realization of cost reductions and synergies, which leverage the Company's global scale, reduce overlap and improve operating efficiencies. During the first quarter of 2017, the Company reorganized the management team reporting to the Chief Operating Decision Maker (CODM) based on the following three LOBs: Services, Systems, and Software. As a result, the Company reclassified comparative periods for consistency, which were previously reported as four geographical segments of: NA, AP, EMEA and LA. The presentation of comparative periods also reflects the reclassification of certain global manufacturing administration expenses from corporate charges not allocated to segments. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) The table below presents the changes in comparative financial data for the years ended December 31, 2017, 2016 and 2015. Comments on significant year-to-year fluctuations follow the table. In August 2016, the Company completed the Acquisition. In February 2016, the Company recognized a gain in discontinued operations related to the divestiture of its NA ES business. These events resulted in a significant impact in the comparative information discussed below. The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes that appear elsewhere in this annual report on Form 10-K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) RESULTS OF OPERATIONS 2017 comparison with 2016 Net Sales The following table represents information regarding our net sales for the years ended December 31: (1) The Company calculates constant currency by translating the prior-year period results at the current year exchange rate. Net sales increased $1,293.0 or 39.0 percent including incremental net sales from the Acquisition of $1,517.7 and a net favorable currency impact of $88.3 primarily related to the euro and the Brazil real. Net sales were adversely impacted by $30.4 related to deferred revenue purchase accounting adjustments. The amounts attributable to the Acquisition are impacted by the alignment and integration of customer portfolios, solution offerings and operations between the legacy companies, which may result in unfavorable comparisons to prior year. The following results include the impact of foreign currency and purchase accounting adjustments: Segments • Services net sales increased $670.6, which included incremental net sales from the Acquisition of $652.5 and a net favorable currency impact of $40.1. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $22.0 attributable to the run-off of multi-vendor service contracts as well as lower installation revenue tied to decreased systems volumes in the Americas. This was partially offset by higher managed services net sales in AP. Services net sales in 2017 also included an unfavorable impact of $15.2 related to purchase accounting adjustments, which was an increase of $7.1 compared to the prior year. • Software net sales increased $220.3, which included incremental net sales from the Acquisition of $202.5 and a net favorable currency impact of $11.1. Excluding the incremental net sales from the Acquisition and currency, net sales increased $6.7 primarily related to higher volume and project activity in EMEA. This increase was partially offset by lower volume in the Americas and AP as noted below. • Systems net sales increased $402.1, including incremental net sales from the Acquisition of $662.7 and a net favorable currency impact of $37.1. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $297.7 as systems net sales were adversely impacted by lower banking solutions activity across the Company and lower retail solutions activity in the Americas. The banking volume declines were primarily due to lower banking project activity in the Americas and EMEA and from structural changes in the AP market. Systems net sales in 2017 also included an unfavorable impact of $15.2 related to purchase accounting adjustments, which was an increase of $7.1 compared to the prior year. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Geographic Regions • Americas net sales decreased $56.5 or 3.4 percent. The incremental net sales from the Acquisition accounted for $105.8. Excluding the incremental net sales from the Acquisition, net sales decreased $162.3 as a result of fewer large systems projects across the Americas, including Brazil voting solutions which was down $54.3 and Mexico banking solutions. In addition, lower services revenue in North America related to a decrease in multi-vendor service contract volume and lower installations resulting from the decrease in large systems projects. • EMEA net sales increased $1,196.9 or 101.2 percent. The incremental net sales from the Acquisition accounted for $1,228.2. Excluding the incremental net sales from the Acquisition, net sales decreased $31.3 primarily attributable to a large prior year systems project in Turkey that was not replicated in 2017 as well as lower systems volume in Germany. Additionally, lower sales in the U.K. also contributed to the decrease related to the Competition and Markets Authority (CMA) review and ultimate divestiture of the Company’s legacy banking business on June 30, 2017. The systems decrease was offset in part by services as a result of higher retail solutions activity and software which benefited from increased volume across the geographic region. • AP net sales increased $152.6 or 32.4 percent. The incremental net sales from the Acquisition accounted for $183.7. Excluding the incremental net sales from the Acquisition, net sales decreased $31.1 primarily due to lower systems volume related to the market structure change in China, partially offset by higher services sales in India. Solutions • Banking net sales increased $629.1 or 22.5 percent . The incremental net sales from the Acquisition accounted for $836.4. Excluding the incremental net sales from the Acquisition, net sales decreased $207.3 primarily due to lower systems volumes and the associated installation activity across the Company, with lower large project activity impacting all regions. Additionally, banking services decreased primarily due to the run-off of multi-vendor service contracts in the Americas and an incremental $8.5 related to purchase accounting adjustments. These decreases were partially offset by higher banking services sales in AP. • Retail net sales increased $663.9 or 128.6 percent. The incremental net sales from the Acquisition accounted for $681.3. Excluding the incremental net sales from the Acquisition, net sales decreased $17.4 due to lower demand for voting solutions in Brazil of $54.3. Lower voting solutions volume was partially offset by increased services and software revenue in EMEA and higher systems volume and the associated services in AP. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Services and software gross margin was lower in 2017 due in part to the impact of the Acquisition, which utilizes a third-party labor model to support its service and software revenue stream, resulting in a dilutive effect on margins. Services and software gross margin was adversely impacted by higher non-routine and restructuring costs compared to the prior year, as 2017 included non-routine charges of $41.5 primarily related to restructuring charges of $27.4 and purchase accounting adjustments associated with the Acquisition. Additionally, gross margin was also impacted by lower contract maintenance revenue in Americas combined with increased labor costs and investments. The labor investments are a result of higher turnover rates of technicians and the associated training to support additional product lines. Systems gross margin in 2017 increased primarily as a result of higher non-routine costs in the prior year of $90.1 compared to $39.8 in 2017. The higher non-routine costs in the prior year primarily relate to purchase accounting adjustments to record inventory MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) acquired in the Acquisition at fair value. Additionally, the incremental gross profit associated with the Acquisition includes higher margin business across both banking and retail solutions. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: The selling and administrative expense in 2017 increased $172.5 inclusive of incremental expenses from the Acquisition of $272.4 and an unfavorable currency impact of $17.9. Excluding the impact of currency and the Acquisition, selling and administrative expense decreased $117.8 from the overall cost reductions tied to DN2020 as well as lower incentive compensation expense related to the Company's annual incentive plans. Additionally, there were decreases noted in restructuring and non-routine costs primarily related to legal, acquisition and divestiture expenses. Selling and administrative non-routine expenses were $175.4 and $150.8 in 2017 and 2016, respectively. The primary components of the non-routine expenses in 2017 pertained to acquisition and divestiture costs, including related integration activities, totaling $85.0, purchase accounting adjustments of $85.0 related to intangible asset amortization and executive severance of $5.4. The year-over-year increase was primarily related to incremental purchase accounting and integration expenses offset by a decrease in legal, acquisition and divestiture costs. Selling and administrative expense included restructuring charges of $21.3 and $28.8 in 2017 and 2016, respectively. Research, development and engineering expense increased by $45.3 to $155.5 in 2017 due primarily to incremental expense associated with the Acquisition of $62.7. Excluding the incremental impact of the Acquisition, expense was favorably impacted by the benefits of streamlining the cost structure as part of the Company's integration activities. Research, development and engineering expense included restructuring reversals of $(1.1) in 2017 compared to $5.1 of restructuring costs in 2016. In 2017, the Company recorded impairments totaling $3.1 related to IT transformation and integration activities. In 2017, the loss on sale of assets was primarily related to the divestiture of the Company's electronic security (ES) business in Chile and from building closures in EMEA due to integration efforts. These losses were partially offset by a gain on sale of assets primarily related to the Company's divestiture of its business in the U.K. and its ES business in Mexico. Operating expense as a percent of net sales in 2017 was 23.7 percent compared with 26.6 percent in 2016 due to increased revenue and overall cost reductions tied to DN2020 which more than offset the incremental operating costs from the Acquisition. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The operating loss decreased in 2017 compared to 2016 primarily due to higher gross margin that more than offset an increase in operating expense, which included amortization of acquired intangible assets, restructuring and non-routine costs related to acquisitions and divestitures. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: The decrease in interest income in 2017 compared with 2016, was a result of lower interest income of the Company's marketable securities, which are primarily held for cash management in Brazil. Interest expense was higher in 2017 associated with the financing required for the Acquisition, offset by improved interest rates from the Company's repricing certain of its debt in May 2017. Foreign exchange gain (loss), net in 2017 was unfavorable as a result of the incremental impact of the Acquisition. Miscellaneous, net in 2017 consisted primarily of income from the Aisino and Inspur strategic alliances in China. Miscellaneous, net in 2016 included a mark-to-market net gain of $9.2 associated with the Company's foreign currency option contracts entered and foreign currency forward contract and $6.3 in financing fees related to the Company’s bridge financing required for the Acquisition. Income (Loss) from Continuing Operations, net of tax The following table represents information regarding our net income from continuing operations, net of tax for the years ended December 31: Income (loss) from continuing operations, net of tax was $(205.5). The increase is primarily due to the reasons described above and the change in income tax (benefit) expense. The effective tax rate for 2017 (17.0) percent on the overall loss from continuing operations. The U.S. enacted the Tax Act that was signed into law by the President on December 22, 2017. The Tax Act changed many aspects of U.S. corporate income taxation and included a reduction of the corporate income tax rate from 35% to 21%, implementation of a territorial tax system and imposition of a tax on deemed repatriated earnings of foreign subsidiaries. The resulting impact to the Company is an estimated $45.1 reduction to deferred income taxes for the income tax rate change and an estimated one-time non-cash charge of $36.6 related to deferred foreign earnings. Due to the complexities involved in accounting for the recently enacted Tax Act, the U.S. SEC’s Staff Accounting Bulletin (SAB) 118 requires that the Company include in its financial statements the reasonable estimate of the impact of the Tax Act on earnings to the extent such reasonable estimate has been determined. The Company recorded a reasonable estimate of such effects, the net one-time charge related to the Tax Act may differ, possibly materially, due to, among other things, further refinement of its calculations, changes in interpretations and assumptions, additional guidance that may be issued by the U.S. Government, and actions and related accounting policy decisions the Company may take as a result of the Tax Act. The Company will complete its analysis over a one-year measurement period ending December 31, 2018 and any adjustments during this measurement period will be included in net earnings from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. The effective tax rate for 2016 of 28.4 percent on the overall loss from continued operations. The benefit on the overall loss was negatively impacted by the Acquisition including a valuation allowance for certain post-acquisition losses and non-deductible acquisition related expenses. The overall effective tax rate was decreased further by the jurisdictional income (loss) and varying respective statutory rates within the acquired entities. Refer to note 7 Income Taxes included in Item 8. Financial Statements and Supplementary Data of this Annual Report for further details regarding the reconciliation of the effective tax rate. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Income from Discontinued Operations, Net of Tax The closing of the NA ES divestiture occurred on February 1, 2016 and the Company recorded a gain (loss) on sale, net of tax, of 145.0 in 2016. Additionally, the income from discontinued operations, net of tax includes a net loss of 1.3 as a result of the operations included through February 1, 2016. Segment Net Sales and Operating Profit Summary The following tables represent information regarding the Company's net sales and operating profit by reporting segment: Services net sales increased $670.6 including incremental net sales from the Acquisition of $652.5 and a net favorable currency impact of $40.1. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $22.0 attributable to the run-off of multi-vendor service contracts as well as lower installation revenue tied to decreased systems volumes in the Americas. This was partially offset by higher managed services net sales in AP. Services net sales in 2017 also included an unfavorable impact of $15.2 related to purchase accounting adjustments, which was an increase of $7.1 compared to the prior year. Segment operating profit increased $46.1 in 2017 compared to 2016. The incremental portion from the Acquisition accounted for $27.2 in operating profit inclusive of restructuring and non-routine items of $39.4 in 2017. Excluding the incremental portion from the Acquisition in addition to restructuring and non-routine items, segment operating profit decreased $20.5 in 2017 driven by lower gross profit partially offset by lower operating expense. Gross profit decreased as a result of contract maintenance revenue declines in the Americas combined with increased labor investments. The labor investments are a result of higher turnover rates of technicians and the associated training to support additional product lines. Additionally, 2017 was adversely impacted by lower installation gross profit as a result of decreased systems volumes. The segment benefited from lower operating expense related to cost reduction activities. Segment operating profit margin decreased primarily due to the impact of the Acquisition, which utilizes a higher third-party labor model to support its service and software revenue stream, resulting in a dilutive effect on margins in 2017. Software net sales increased $220.3 including incremental net sales from the Acquisition of $202.5 and a net favorable currency impact of $11.1. Excluding the incremental net sales from the Acquisition and currency, net sales increased $6.7 primarily related to higher volume and project activity in EMEA. This increase was partially offset by lower volume in the Americas and AP as noted earlier. Segment operating profit increased $24.1 in 2017. The Acquisition contributed an incremental $16.9 segment operating profit in 2017. Excluding the incremental portion from the Acquisition, operating profit increased $7.2 driven by higher gross profit and lower operating expense in EMEA. Segment operating profit margin increased due to the positive incremental impact of the acquired software business as well as lower operating expense resulting from the cost reduction activities in 2017. Systems net sales increased $402.1, including incremental net sales from the Acquisition of $662.7 and a net favorable currency impact of $37.1. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $297.7 as systems net sales were adversely impacted by lower banking solutions activity across the Company, including structural changes in the AP MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) market and lower retail solutions activity in the Americas. Systems net sales in 2017 also included an unfavorable impact of $15.2 related to purchase accounting adjustments, which was an increase of $7.1 compared to the prior year. Segment operating loss in 2017 remained flat compared to the prior year. The incremental portion from the Acquisition was a $16.5 operating profit, inclusive of restructuring and non-routine items of $41.5 in 2017.Excluding the incremental portion from the Acquisition in addition to restructuring and non-routine items, operating profit decreased 57.8 in 2017. The decrease in segment operating profit was derived from lower gross profit due to volume declines in the Americas, higher project activity in EMEA during the prior year and structural market changes in AP. Lower gross profit was partially offset by favorable operating expense in EMEA. Segment operating profit margin was flat to prior year due to the incremental benefit of the Acquisition and lower operating expense resulting from the cost reduction integration activities offset by lower banking solution activity across the Company. Refer to note 22 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. 2016 comparison with 2015 Net Sales The following table represents information regarding our net sales for the years ended December 31: (1) The Company calculates constant currency by translating the prior-year period results at the current year exchange rate. Net sales increased $897.0 or 37.1 percent including incremental net sales from the Acquisition of $1,054.8 and a net unfavorable currency impact of $52.5 primarily related to the Brazil real, China renminbi, India rupee and South Africa rand. In addition, net sales was adversely impacted $16.2 related to deferred revenue purchase accounting adjustments. The following results include the impact of foreign currency and purchase accounting adjustments: Segments • Services net sales increased $431.0 including incremental net sales from the Acquisition of $434.6 and a net unfavorable currency impact of $21.6. Excluding the incremental net sales from the Acquisition and currency, net sales increased $26.7 attributable to higher maintenance service revenue related to an increase in multi-vendor service contracts in the Americas. This was partially offset by lower net sales across service business lines in AP resulting from market structure changes in the region. Services net sales also included an unfavorable impact of $8.1 related to purchase accounting adjustments. • Software net sales increased $117.2 including incremental net sales from the Acquisition of $146.0 and a net unfavorable currency impact of $2.7. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $26.1 primarily related to lower volumes in the Americas and EMEA. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) • Systems net sales increased $348.8, including incremental net sales from the Acquisition of $474.2 and a net unfavorable currency impact of $28.2. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $105.9 as systems net sales were adversely impacted by lower banking solution activity across the Company. In the Americas and EMEA, the volume declines were primarily due to lower banking project activity and in AP mainly due to structural changes in the market. This was partially offset by higher retail solutions activity in the Americas. Systems net sales also included an unfavorable impact of $8.1 related to purchase accounting adjustments. A more detailed discussion of segment net sales is included under "Segment Net Sales and Operating Profit Summary" below. Geographic Regions • Americas net sales increased $88.9 or 5.7 percent. The incremental net sales from the Acquisition accounted for $89.4. Excluding the incremental net sales from the Acquisition, net sales was flat. The Americas benefited from higher systems retail solutions in Brazil and higher services revenue related to an increase in multi-vendor service contract volume. This was offset by fewer large systems banking projects across the region and a decrease in software revenue associated with the conclusion of Agilis 3/Windows 7 upgrade activity. • EMEA net sales increased $776.9 or 191.2 percent. The incremental net sales from the Acquisition accounted for $822.1. Excluding the incremental net sales from the Acquisition, net sales decreased $45.2 primarily attributable to fewer large projects in the Middle East, United Kingdom and Poland in conjunction with lower overall software volume. • AP net sales increased $31.2 or 7.1 percent. The incremental net sales from the Acquisition accounted for $143.3. Excluding the incremental net sales from the Acquisition, net sales decreased $112.1 primarily due to lower systems and services volume related to the market structure changes in China and the local government's demonetization program in India. Solutions • Banking net sales increased $398.4 or 16.6 percent. The incremental net sales from the Acquisition accounted for $616.7. Excluding the incremental net sales from the Acquisition, net sales decreased $218.3 primarily due to lower systems volumes across the Company with lower large project activity impacting all regions. In addition, banking software decreased primarily due to the completion of the Agilis 3/Windows 7 upgrade activity in the Americas. Banking net sales was also unfavorably impacted by $9.8 related to purchase accounting adjustments. • Retail net sales increased $498.6. The incremental net sales from the Acquisition accounted for $438.1. Excluding the incremental net sales from the Acquisition, net sales increased $60.5 due to higher demand in Brazil for voting solutions and was unfavorably impacted by $6.4 related to purchase accounting adjustments. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Services and software gross margin was lower in the year ended December 31, 2016 due in part to the impact of the Acquisition, which utilizes a higher third-party labor model to support its service and software revenue stream, resulting in a dilutive effect on margins. Services and software gross margin was also adversely impacted by higher restructuring and non-routine costs compared to the prior year. In the year ended December 31, 2016, services and software gross profit was adversely impacted by a non-routine revenue reduction of $8.1 related to purchase accounting adjustments associated with the Acquisition. Services and software gross profit also included restructuring charges of $20.8 and $3.1 in 2016 and 2015, respectively. In addition, the Americas was unfavorably impacted due to retro-active contract adjustments and customer service level agreement penalties. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Systems gross margin decreased as a result of purchase accounting valuation adjustments associated with the Acquisition, primarily related to inventory revaluation. Purchase accounting adjustments included an $8.1 reduction in revenue and an increase in cost of sales of $82.6. Gross profit included total restructuring charges of $4.7 and $1.4 in 2016 and 2015, respectively. Excluding the impact of non-routine and restructuring, gross margin was flat between years. Americas systems gross margin declined due to unfavorable customer and product solution mix in 2016. Additionally, systems gross margins in EMEA and AP were relatively flat due to the favorable impact of the Acquisition, which was partially offset by an unfavorable blend of country revenue and the deteriorating market conditions in China. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: Excluding the impact of incremental expense associated with the Acquisition of $220.6, the increase in selling and administrative expense primarily resulted from higher total non-routine charges. To a lesser extent, higher corporate legal and professional fees also negatively impacted selling and administrative expense in 2016. These increases were partially offset by a decrease in sales commission expense, lower IT and marketing expenses related to transformation initiatives, favorable currency impact and a decrease in bad debt expense in the Americas. Non-routine expenses in selling and administrative expense of $150.8 and $36.3 were included in 2016 and 2015, respectively. The primary components of the non-routine expenses pertained to acquisition and divestiture costs totaling $118.9 and purchase accounting adjustments of $29.7 related to intangible asset amortization. Selling and administrative expense included restructuring charges of $28.8 and $16.1 in 2016 and 2015, respectively. Research, development and engineering expense as a percent of net sales in 2016 and 2015 was 3.3 percent and 3.6 percent, respectively. Excluding the impact of the Acquisition, research and development expense decreased primarily as a result of lower reinvestment associated with the Company's transformation initiatives compared to the prior year. Research, development and engineering expense included restructuring charges of $5.1 and $0.6 in 2016 and 2015, respectively. During the fourth quarter of 2016, the Company recorded a $9.8 impairment charge related to redundant legacy Diebold internally-developed software and an indefinite-lived trade name in Americas as a result of the Acquisition. The decrease in the gross carrying value of internally-developed software is primarily due to a $9.1 impairment during the first quarter of 2015 of certain internally-developed software related to redundant legacy Diebold software as a result of the acquisition of Phoenix. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The decrease in operating profit was due to a decline in systems gross profit primarily associated with the inventory valuation adjustment from the Acquisition and higher operating expenses. These operating expenses included amortization of acquired intangible assets, restructuring and non-routine costs of acquisitions and divestitures. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: The decrease in interest income was driven primarily by a decrease in customer financing in Brazil and was negatively impacted by currency of $1.2. Interest expense was higher than the prior year associated with the financing required for the Acquisition. The foreign exchange loss, net in 2015 included $7.5 related to the devaluation of Venezuela currency. Miscellaneous, net in 2016 included a mark-to-market gain of $35.6 associated with the Company's foreign currency option contracts entered into on November 23, 2015, a mark-to-market loss of $26.4 associated with the Company’s foreign currency forward contract entered into on April 29, 2016 and $6.3 in financing fees related to the Company’s bridge financing required for the Acquisition. Income (Loss) from Continuing Operations, Net of Tax The following table represents information regarding our income (loss) from continuing operations, net of tax, for the years ended December 31: Income (loss) from continuing operations, net of tax was $(170.7). This was primarily due to higher non-routine expenses, increased interest expense and the change in income tax benefit. The effective tax rate for 2016 was 28.4 percent on the overall loss from continued operations. The benefit on the overall loss was negatively impacted by the Acquisition including a valuation allowance for certain post-acquisition losses and non-deductible acquisition related expenses. The overall effective tax rate was decreased further by the jurisdictional income (loss) mix and varying statutory rates within the acquired entities. In 2015, the overall negative effective tax rate of (29.9) percent on income from continued operations resulted from the repatriation of foreign earnings, the associated recognition of foreign tax credits and related benefits due to the passage of the Protecting Americans from Tax Hikes (PATH) Act of 2015. In addition, the overall negative effective tax rate was due to the combined income mix and varying statutory rates in the Company's foreign operations. Income from Discontinued Operations, Net of Tax Income from discontinued operations, net of tax was $143.7 and $15.9 for the years ended December 31, 2016 and 2015, respectively. The closing of the NA ES divestiture occurred on February 1, 2016 and the Company recorded a gain on sale, net of tax, of $145.0 for the year ended December 31, 2016. Additionally, the income from discontinued operations, net of tax includes a net loss of $1.3 as a result of the operations included through February 1, 2016 and net income of $15.9 for the year ended December 31, 2015. The closing purchase price was subject to a customary working capital adjustment, which was finalized in the third quarter of 2016. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: Services net sales increased $431.0 including incremental net sales from the Acquisition of $434.6 and a net unfavorable currency impact of $21.6. Excluding the incremental net sales from the Acquisition and currency, net sales increased $26.7 attributable to higher maintenance service revenue related to an increase in multi-vendor service contracts in the Americas. This was partially offset by lower net sales across service business lines in AP. Services net sales also included an unfavorable impact of $8.1 related to purchase accounting adjustments. Segment operating profit increased $35.9 in 2016 compared to 2015. The incremental portion from the Acquisition accounted for $55.5 in segment operating profit in 2016. Excluding the incremental portion from the Acquisition, segment operating profit decreased $19.6 in 2016 driven by lower gross profit in AP mainly due to structural changes in the market and incremental costs related to customer service level agreement contract requirements. Segment operating profit margin decreased in part to the impact of the Acquisition, which utilizes a higher third-party labor model to support its service and software revenue stream, resulting in a dilutive effect on margins in 2016. Software net sales increased $117.2 including incremental net sales from the Acquisition of $146.0 and a net unfavorable currency impact of $2.7. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $26.1 primarily related to lower volumes in the Americas and EMEA. Segment operating profit decreased $2.2 in 2016. The incremental portion from the Acquisition accounted for $22.4 in segment operating profit in 2016. Excluding the incremental portion from the Acquisition, operating profit decreased $24.6 in 2016. The decrease in operating profit was driven by lower gross profit from prior year high margin upgrade projects in North America and lower volume in EMEA. Segment operating profit margin decreased due to lower upgrade project volume in the Americas as well as lower volume in EMEA, partially offset by the positive impact of the Acquisition. Systems net sales increased $348.8, including incremental net sales from the Acquisition of $474.2 and a net unfavorable currency impact of $28.2. Excluding the incremental net sales from the Acquisition and currency, net sales decreased $105.9 as systems net sales were adversely impacted by lower banking solution activity across the Company. In the Americas and EMEA, the volume declines were primarily due to lower banking project activity and in AP mainly due to structural changes in the market. This was partially offset by higher retail solutions activity in the Americas. Systems net sales also included an unfavorable impact of $8.1 related to purchase accounting adjustments. Segment operating loss decreased $24.1 in 2016. The incremental portion from the Acquisition was a $47.4 segment operating profit in 2016. Excluding the incremental portion from the Acquisition, segment operating loss increased $23.4 in 2016. The increase in segment operating loss was attributable to lower gross profit associated with banking volume declines in each region offset by higher retail solutions activity in the Americas. The increase in segment operating loss was offset by lower operating expense, particularly in research and development expense as a result of lower reinvestment associated with the maturity of the Company's transformation initiatives. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Segment operating profit margin increased due to the positive impact of the acquisition in 2016. Refer to note 22 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further details of segment revenue and operating profit. LIQUIDITY AND CAPITAL RESOURCES Capital resources are obtained from income retained in the business, borrowings under the Company’s senior notes, committed and uncommitted credit facilities and operating and capital leasing arrangements. Management expects that the Company’s capital resources will be sufficient to finance planned working capital needs, research and development activities, investments in facilities or equipment, pension contributions, the payment of dividends on the Company’s common shares, the payment of guaranteed dividends, including the purchase of minority shares, related to the Diebold Nixdorf AG ordinary shares not controlled by the Company and any repurchases of the Company’s common shares for at least the next 12 months. At December 31, 2017, $555.6 or 90.1 percent of the Company’s cash and cash equivalents and short-term investments reside in international tax jurisdictions. Repatriation of certain international held funds could be negatively impacted by potential payments for certain foreign taxes. The Company has earnings in certain jurisdictions available for repatriation of $1,399.0 with no additional tax expense primarily as a result of the Tax Act. Part of the Company’s growth strategy is to pursue strategic acquisitions. The Company has made acquisitions in the past and intends to make acquisitions in the future. The Company intends to finance any future acquisitions with either cash and short-term investments, cash provided from operations, borrowings under available credit facilities, proceeds from debt or equity offerings and/or the issuance of common shares. The Company's total cash and cash availability as of December 31, 2017 and 2016 was as follows: The following table summarizes the results of our consolidated statement of cash flows for the years ended December 31: During 2017, cash and cash equivalents decreased $117.5 primarily due to cash utilized for investing and financing activities as well as payments of $72.1, $77.1, $99.9 and $78.2 for integration initiatives, restructuring programs, interest on debt and income taxes, respectively. These uses were offset by the cash provided by continuing operations. Operating Activities. Cash flows from operating activities can fluctuate significantly from period to period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Net cash provided by operating activities was $37.1 for the year ended December 31, 2017, a decrease of $2.2 from $39.3 for the year ended December 31, 2016. The overall decrease was primarily due to lower contributions from working capital and deferred revenue offset by lower income from continuing operations primarily from integration initiatives and restructuring programs. Additional detail is included below: • Cash flows from continuing operating activities during the year ended December 31, 2017 compared to the year ended December 31, 2016 were impacted by a $34.8 increase in loss from continuing operations, net of tax. (refer to Results of Operations for further discussion of the Company's income from continuing operations, net of tax). MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) • The net aggregate of trade accounts receivable, inventories and accounts payable provided $34.6 and $113.1 in operating cash flows during the year ended December 31, 2017 and 2016, respectively. The decrease is a result of the timing of seasonal declines in working capital accounts primarily related to the Acquisition. Additionally in 2016, Diebold Nixdorf AG included a favorable comparison to the acquisition date and a non-cash purchase accounting inventory revaluation adjustment of $62.7. The decrease in cash provided by trade accounts receivables is primarily related to lower cash collected in U.S, and EMEA compared to the prior year. The decrease in cash used by accounts payable is a result of reduced spending in EMEA, AP and the U.S., offset by slightly higher spending in the rest of the Americas compared to the prior year. • Deferred revenue provided $26.0 of operating cash during the year ended December 31, 2017, compared to $61.6 in the year ended December 31, 2016. The decrease in cash flow associated with deferred revenue is due to timing of customer prepayments primarily in EMEA offset by AP and Americas compared to the prior year. • The aggregate of income taxes and deferred income taxes used $20.7 of operating cash during the year ended December 31, 2017, compared to $146.3 used in 2016. The 2017 impact primarily related to the impact of the Tax Act, while the 2016 primarily related to the tax impacts related to the Acquisition. • In the aggregate, the other combined certain assets and liabilities used of $90.0 in 2017 and provided $28.4 in 2016. The increased use of $118.4 was primarily due to payments related to the restructuring accruals associated with DN2020, offset by warranty accrual, collections of finance and lease receivables and the non-cash sources of Diebold Nixdorf AG accrued noncontrolling interest guaranteed dividend. The most significant changes in adjustments to net income include increased depreciation and amortization expense and additional share-based compensation expense. Depreciation and amortization expense increased $117.4 to $252.2 in 2017 compared to$134.8 during 2016 primarily due to incremental depreciation and amortization expense related to the Acquisition.The increase in share-based compensation expense to $33.9 in 2017 from $22.2 in 2016 was primarily due to an incremental increase in awards granted as a result of the Acquisition and an additional synergy grant in 2017 related to DN2020. Other adjustments to net income includes the gains from divestitures of the legacy Diebold business in the U.K. and the ES business located in Mexico offset by the loss from sale of the ES business in Chile during 2017. During 2016, the other adjustments to net income include foreign currency option and forward contracts that hedged against the effect of exchange rate fluctuations on the cash purchase consideration, acquisition related costs and any outstanding Diebold Nixdorf AG borrowings that were euro denominated and expected to be paid on or near the closing of the Acquisition. During 2016, the Company recorded a $9.3 mark-to-market net gain on foreign currency option and forward contracts which is reflected in other income (expense) miscellaneous, net. Investing Activities. Net cash used in investing activities was $128.8 for the year ended December 31, 2017 compared to net cash used in investing activities of $923.3 for the year ended December 31, 2016. The maturities and purchases of investments primarily relate to short-term investment activity in Brazil and for 2017 also include the Company's investment in Kony. The proceeds from the sale of assets primarily include cash from the divestitures of the legacy Diebold business in the U.K. and the ES businesses located in Mexico and Chile. The $794.5 change was primarily due to the funding of the Acquisition offset by $16.2 of proceeds from sale of foreign currency option contracts and payments for acquisitions of Moxx and Visio for $5.6 in the aggregate, net of cash acquired, and other investing activities. This decrease was partially offset by an increase in capital expenditures and certain other assets of $29.9 and $12.9 primarily due to the incremental expenditures related to the Acquisition. The Company's capital expenditures reflect normal investment activities to support operations. As a result of anticipated steps in forming our strategic alliance with Inspur Group, the Company deposited $8.0 into an escrow account, which is included in restricted cash from investing activities of the consolidated statements of cash flows and in other current assets of the consolidated balance sheets. The cash provided by the discontinued operations, net, includes the cash provided by the operations of the NA ES business. In the first quarter of 2016, discontinued operations, net, primarily related to the $365.1 proceeds received for the NA ES business divestiture. The Company anticipates capital expenditures of approximately $85 in 2018 to be utilized in IT, infrastructure and integration related investments. Currently, the Company finances these investments primarily with funds provided by income retained in the business, borrowings under the Company's committed and uncommitted credit facilities, and operating and capital leasing arrangements. Financing Activities. Net cash used in financing activities was $63.7 for the year ended December 31, 2017 compared to net cash provided by financing activities of $881.3 for the year ended 2016, a change of $945.0. The decrease was primarily due to a decrease $968.8 in debt borrowing net of repayments, including associated debt issuance costs, related to the Acquisition. An increase of $7.4 in cash distributions to noncontrolling interests primarily related to Diebold Nixdorf AG partially offset the reduction in dividends paid. Benefit Plans. The Company plans to make contributions to its retirement plans of $49.6 for the year ended December 31, 2018. The Company anticipates reimbursement of approximately $14 in certain benefits paid from its trustee in 2018. Beyond 2018, MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) minimum statutory funding requirements for the Company's U.S. pension plans may become more significant. The actual amounts required to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory actions related to pension funding obligations. The Company has adopted a pension investment policy designed to achieve an adequate funded status based on expected benefit payouts and to establish an asset allocation that will meet or exceed the return assumption while maintaining a prudent level of risk. The plan's target asset allocation adjusts based on the plan's funded status. As the funded status improves or declines, the debt security target allocation will increase and decrease, respectively. Management monitors assumptions used for our actuarial projections as well as any funding requirements for the plans. Payments due under the Company's other post-retirement benefit plans are not required to be funded in advance. Payments are made as medical costs are incurred by covered retirees, and are principally dependent upon the future cost of retiree medical benefits under these plans. The Company expects the other post-retirement benefit plan payments to be $1.1 in 2018 (refer to note 15 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for further discussion of the Company's pension and other post-retirement benefit plans). Dividends. The Company paid dividends of $30.6, $64.6 and $75.6 in the years ended December 31, 2017, 2016 and 2015, respectively. Annualized dividends per share were $0.40, $0.96 and $1.15 for the years ended December 31, 2017, 2016 and 2015, respectively. The first quarterly dividend of 2018 is $0.10 per share payable March 16, 2018 to shareholders of record on February 26, 2018. Contractual Obligations. The following table summarizes the Company’s approximate obligations and commitments to make future payments under contractual obligations as of December 31, 2017: (1) Amounts represent estimated contractual interest payments on outstanding long-term debt and notes payable. Rates in effect as of December 31, 2017 are used for variable rate debt. (2) The amount available under the short-term uncommitted lines at December 31, 2017 was $216.9. Refer to Note 14 Debt in Item 8 Financial Statements and Supplementary Data for additional information. In connection with the Acquisition, the Company entered into the DPLTA, which entitles the Diebold Nixdorf AG minority shareholders to receive recurring cash compensation, or a guaranteed dividend, of €3.13 (€2.82 net under the current taxation regime) per Diebold Nixdorf AG ordinary share for each full fiscal year of Diebold Nixdorf AG. The Company's anticipates paying $24.6 during 2018 for the guaranteed dividend based on the remaining Diebold Nixdorf AG minority shareholders and euro rate as of December 31, 2017. The ultimate amounts of the future cash payments related to recurring guaranteed dividends are uncertain. At December 31, 2017, the Company also maintained uncertain tax positions of $48.4, for which there is a high degree of uncertainty as to the expected timing of payments (refer to note 7 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company entered into a revolving and term loan credit agreement (the Credit Agreement), dated as of November 23, 2015, among the Company and certain of the Company's subsidiaries, as borrowers, JPMorgan Chase Bank, N.A., as Administrative Agent, and the lenders named therein. The Credit Agreement included, among other things, mechanics for the Company’s existing revolving and term loan A facilities to be refinanced under the Credit Agreement. On December 23, 2015, the Company entered into a Replacement Facilities Effective Date Amendment, which amended the Credit Agreement, among the Company, certain of the Company’s subsidiaries, the lenders identified therein and JPMorgan Chase Bank, N.A., as Administrative Agent, pursuant to which the Company refinanced its $520.0 revolving and $230.0 term loan A senior unsecured credit facilities (which have been terminated and repaid in full) with, respectively, a new unsecured revolving facility (the Revolving Facility) in an amount of up to $520.0 and a new (non-delayed draw) unsecured term loan A facility (the Term Loan A Facility) on substantially the same terms as the Delayed Draw Term Facility (as defined in the Credit Agreement) in the amount of up to $230.0. The Revolving Facility and Term Loan A Facility are subject to the same maximum consolidated net leverage ratio and minimum consolidated interest coverage MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) ratio as the Delayed Draw Term Facility. On December 23, 2020, the Term Loan A Facility will mature and the Revolving Facility will automatically terminate. The weighted-average interest rate on outstanding revolving credit facility borrowings as of December 31, 2017 and December 31, 2016 was 3.63 percent and 2.56 percent, respectively, which is variable based on the London Interbank Offered Rate (LIBOR). The amount available under the revolving credit facility as of December 31, 2017 was $445.0. On April 19, 2016, the Company issued $400.0 aggregate principal amount of senior notes due 2024 (the 2024 Senior Notes). The 2024 Senior Notes are and will be guaranteed by certain of the Company’s existing and future domestic subsidiaries. On May 9, 2017, the Company entered into an incremental amendment to its Credit Agreement (the Incremental Agreement) which reduced the initial term loan B facility (the Term Loan B Facility) of a $1,000.0 USD-denominated tranche to $475.0. The reduction was funded using the $250.0 proceeds drawn from the Delayed Draw Term Loan A Facility, a replacement of $70.0 with Term Loan B Facility - Euro and previous principal payments. In connection with the Incremental Agreement, the interest rate with respect to the Term Loan B Facility - USD is based on, at the Company’s option, adjusted LIBOR plus 2.75 percent (with a floor of 0.00 percent) or Alternate Base Rate (ABR) plus 1.75 percent (with an ABR floor of 1.00 percent) and the interest rate with respect to the Term Loan B Facility - Euro is based on adjusted Euro Interbank Offered Rate (EURIBOR) plus 3.00 percent (with a floor of 0.00 percent). Prior to the Incremental Agreement, the interest rate for the Term Loan B Facility - USD was LIBOR plus an applicable margin of 4.50 percent (or, at the Company’s option, prime plus an applicable margin of 3.50 percent), and the interest rate for the Term Loan B Facility - Euro was at the EURIBOR plus an applicable margin of 4.25 percent. The Incremental Amendment also renewed the repricing premium of 1.00 percent in relation to the Term Loan B Facility to the date that is six months after the Incremental Effective Date, removed the requirement to prepay the repriced Dollar Term Loan and the repriced Euro Term Loan upon any asset sale or casualty event if the Company is below a total net leverage ratio of 2.5:1.0 on a pro forma basis for such asset sale or casualty event and provides additional restricted payments and investment carveouts in regards to assets acquired with the Acquisition. All other material provisions under the Credit Agreement were unchanged. On May 6 and August 16, 2016, the Company entered into the Second and Third Amendments to the Credit Agreement, which re-denominated a portion of the Term Loan B Facility into euros and guaranteed the prompt and complete payment and performance of the obligations when due under the Credit Agreement. On February 14, 2017, the Company entered into the Fourth Amendment to the Credit Agreement which released certain restrictions on the Delayed Draw Term Loan A effective immediately. The Credit Agreement financial ratios at December 31, 2017 are as follows: • a maximum total net debt to adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) leverage ratio of 4.25 to 1.00 as of December 31, 2017 (reducing to 4.00 on December 31, 2018, and further reduced to 3.75 on June 30, 2019); and • a minimum adjusted EBITDA to net interest expense coverage ratio of not less than 3.00 to 1.00 The Company incurred $1.1 and $39.2 of fees in the years ended December 31, 2017 and 2016, respectively, related to the Credit Agreement and 2024 Senior Notes, which are amortized as a component of interest expense over the terms. Below is a summary of financing and replacement facilities information: (i) LIBOR with a floor of 0.0 percent. (ii) EURIBOR with a floor of 0.0 percent. The debt facilities under the Credit Agreement are secured by substantially all assets of the Company and its domestic subsidiaries that are borrowers or guarantors under the Credit Agreement, subject to certain exceptions and permitted liens. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) In March 2006, the Company issued senior notes (the 2006 Senior Notes) in an aggregate principal amount of $300.0. The Company funded the repayment of $75.0 aggregate principal amount of the 2006 Senior Notes at maturity in March 2013 using borrowings under its revolving credit facility and the repayment of $175.0 aggregate principal amount of the 2006 Senior Notes that matured in March 2016 through the use of proceeds from the divestiture of the Company's NA ES business. Prepayment of the remaining $50.0 aggregate principal amount of the 2006 Senior Notes were paid in full on May 2, 2016. The prepayment included a make-whole premium of $3.9, which was paid in addition to the principal and interest of the 2006 Senior Notes and is included in interest expense for the year ended December 31, 2016. On November 23, 2015, the Company entered into two foreign currency option contracts to purchase €1,416.0 for $1,547.1 to hedge against the effect of exchange rate fluctuations on the euro-denominated cash consideration related to the Acquisition and estimated euro-denominated transaction related costs and any outstanding Diebold Nixdorf AG borrowings. At that time, the euro-denominated cash component of the purchase price consideration approximated €1,162.2. The foreign currency option contracts were sold during the second quarter of 2016 for cash proceeds of $42.6, which are included in investing activities in the consolidated statements of cash flows, resulting in a gain of $35.6 during the year ended December 31, 2016 and $7.0 during the fourth quarter of 2015. The weighted average strike price was $1.09 per euro. These foreign currency option contracts were non-designated and included in other current assets on the consolidated balance sheet as of December 31, 2016 based on the net asset position. On April 29, 2016, the Company entered into one foreign currency forward contract to purchase €713.0 for $820.9 to hedge against the effect of exchange rate fluctuations on the euro-denominated cash consideration related to the Acquisition and estimated euro denominated transaction related costs and any outstanding Diebold Nixdorf AG borrowings. The forward rate was $1.1514. The foreign currency forward contract was settled for $792.6 during the third quarter of 2016, which is included in investing activities in the consolidated statements of cash flows, resulting in a loss of $26.4 during the year ended December 31, 2016. This foreign currency forward contract is non-designated and included in other current assets or other current liabilities based on the net asset or net liability position, respectively, in the consolidated balance sheets. The gains and losses from the revaluation of the foreign currency forward contract are included in other income (expense) miscellaneous, net on the consolidated statements of operations. During November 2016, the Company entered into multiple pay-fixed receive-variable interest rate swaps outstanding with an aggregate notional amount of $400.0. These instruments were used to hedge the variable cash flows associated with existing variable-rate debt. Additionally, the Company has a non-designated interest swap, which was acquired in connection with the Acquisition, with a notional amount of €50.0 with a fair value of €(5.5) and €(6.9) as of December 31, 2017 and 2016, respectively. During the year ended December 31, 2016, the Company recorded a $9.3 mark-to-market gain (loss) on foreign currency and forward option contracts reflected in miscellaneous, net. Refer to note 19 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K for additional information regarding the Company's hedging and derivative instruments. Off-Balance Sheet Arrangements. The Company enters into various arrangements not recognized in the consolidated balance sheets that have or could have an effect on its financial condition, results of operations, liquidity, capital expenditures or capital resources. The principal off-balance sheet arrangements that the Company enters into are guarantees, operating leases (refer to note 16 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K) and sales of finance receivables. The Company provides its global operations guarantees and standby letters of credit through various financial institutions to suppliers, customers, regulatory agencies and insurance providers. If the Company is not able to comply with its contractual obligations, the suppliers, regulatory agencies and insurance providers may draw on the pertinent bank (refer note 17 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company has sold finance receivables to financial institutions while continuing to service the receivables. The Company records these sales by removing finance receivables from the consolidated balance sheets and recording gains and losses in the consolidated statement of operations (refer to note 9 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements. The consolidated financial statements of the Company are prepared in conformity with U.S. GAAP. The preparation of the accompanying consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities and reported amounts of revenues and expenses. Such estimates include revenue recognition, the valuation of trade and financing receivables, inventories, goodwill, intangible assets, other long-lived assets, legal contingencies, guarantee obligations, and assumptions used in the calculation of income taxes, pension and post-retirement benefits and customer incentives, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors. Management monitors the economic conditions and other factors and will adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. The Company’s significant accounting policies are described in note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K. Management believes that, of its significant accounting policies, its policies concerning revenue recognition, allowances for credit losses, inventory reserves, goodwill, long-lived assets, taxes on income, contingencies and pensions and post-retirement benefits are the most critical because they are affected significantly by judgments, assumptions and estimates. Additional information regarding these policies is included below. Revenue Recognition. The Company’s revenue recognition policy is consistent with the requirements of Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 605, Revenue Recognition (ASC 605). The Company records revenue when it is realized, or realizable and earned. The application of U.S. GAAP revenue recognition principles to the Company's customer contracts requires judgment, including the determination of whether an arrangement includes multiple deliverables such as hardware, software, maintenance and /or other services. For contracts that contain multiple deliverables, total arrangement consideration is allocated at the inception of the arrangement to each deliverable based on the relative selling price method. The relative selling price method is based on a hierarchy consisting of vendor specific objective evidence (VSOE) (price sold on a stand-alone basis), if available, or third-party evidence (TPE), if VSOE is not available, or estimated selling price (ESP) if neither VSOE nor TPE is available. The Company's ESP is consistent with the objective of determining VSOE, which is the price at which we would expect to transact on a stand-alone sale of the deliverable. The determination of ESP is based on applying significant judgment to weigh a variety of company-specific factors including our pricing practices, customer volume, geography, internal costs and gross margin objectives. This information is gathered from experience in customer negotiations, recent technological trends and the competitive landscape. In contracts that involve multiple deliverables, maintenance services are typically accounted for under FASB ASC 605-20, Separately Priced Extended Warranty and Product Maintenance Contracts. There have been no material changes to these estimates for the periods presented and the Company believes that these estimates generally should not be subject to significant changes in the future, until the adoption of the new revenue standard. However, changes to deliverables in future arrangements could materially impact the amount of earned or deferred revenue. For sales of software, excluding software required for the equipment to operate as intended, the Company applies the software revenue recognition principles within FASB ASC 985-605, Software - Revenue Recognition. For software and software-related deliverables (software elements), the Company allocates revenue based upon the relative fair value of these deliverables as determined by VSOE. If the Company cannot obtain VSOE for any undelivered software element, revenue is deferred until all deliverables have been delivered or until VSOE can be determined for any remaining undelivered software elements. When the fair value of a delivered element cannot be established, but fair value evidence exists for the undelivered software elements, the Company uses the residual method to recognize revenue. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement consideration is allocated to the delivered elements and recognized as revenue. Determination of amounts deferred for software support requires judgment about whether the deliverables can be divided into more than one unit of accounting and whether the separate deliverables have value to the customer on a stand-alone basis. There have been no material changes to these deliverables for the periods presented. However, changes to deliverables in future arrangements and the ability to establish VSOE could affect the amount and timing of revenue recognition. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Inventory Reserves. At each reporting period, the Company identifies and writes down its excess and obsolete inventories to net realizable value based on usage forecasts, order volume and inventory aging. With the development of new products, the Company also rationalizes its product offerings and will write-down discontinued product to the lower of cost or net realizable value. Acquisitions and Divestitures. Acquisitions are accounted for using the purchase method of accounting. This method requires the Company to record assets and liabilities of the business acquired at their estimated fair market values as of the acquisition date. Any excess cost of the acquisition over the fair value of the net assets acquired is recorded as goodwill. The Company generally uses valuation specialists to perform appraisals and assist in the determination of the fair values of the assets acquired and liabilities assumed. These valuations require management to make estimates and assumptions that are critical in determining the fair values of the assets and liabilities. For divestitures, the Company considers assets to be held for sale when management approves and commits to a formal plan to actively market the assets for sale at a price reasonable in relation to their estimated fair value, the assets are available for immediate sale in their present condition, an active program to locate a buyer and other actions required to complete the sale have been initiated, the sale of the assets is probable and expected to be completed within one year (or, if it is expected that others will impose conditions on the sale of the assets that will extend the period required to complete the sale, that a firm purchase commitment is probable within one year) and it is unlikely that significant changes will be made to the plan. Upon designation as held for sale, the Company records the assets at the lower of their carrying value or their estimated fair value, reduced for the cost to dispose of the assets, and ceases to record depreciation expense on the assets. The Company reports financial results for discontinued operations separately from continuing operations to distinguish the financial impact of a divestiture from ongoing operations. Discontinued operations reporting occurs only when the disposal of a component or a group of components of the Company represents a strategic shift that will have a major effect on the Company's operations and financial results. During the year ended December 31, 2015, management of the Company, through receipt in October 2015 of the required authorization from its Board of Directors after a potential buyer had been identified, committed to a plan to divest the NA electronic security business. As such, all of the criteria required for held for sale and discontinued operations classification were met during the fourth quarter of 2015. The divestiture of its NA electronic security business closed on February 1, 2016. Accordingly, the assets and liabilities, operating results and operating and investing cash flows for are presented as discontinued operations separate from the Company’s continuing operations for all periods presented. Prior period information has been reclassified to present this business as discontinued operations for all periods presented, and has therefore been excluded from both continuing operations and segment results for all periods presented in these consolidated financial statements and the notes to the consolidated financial statements. All assets and liabilities classified as held for sale are included in total current assets based on the cash conversion of these assets and liabilities within one year (refer to note 23 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). Assets and liabilities of a discontinued operation are reclassified as held for sale for all comparative periods presented in the consolidated balance sheet. The results of operations of a discontinued operation are reclassified to income from discontinued operations, net of tax, for all periods presented. For assets that meet the held for sale criteria but do not meet the definition of a discontinued operation, the Company reclassifies the assets and liabilities in the period in which the held for sale criteria are met, but does not reclassify prior period amounts. Goodwill. Goodwill is the cost in excess of the net assets of acquired businesses (refer to note 13 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K). The Company tests all existing goodwill at least annually as of October 31 for impairment on a reporting unit basis. The Company tests for impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the carrying value of a reporting unit below its reported amount. Beginning with the first quarter of 2017, the Company’s reportable operating segments are based on the conclusion of the assessment on the following lines of business: Software, Systems, and Services and will reclassify comparative periods for consistency. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount, the Company considers the following events and circumstances, among others, if applicable: (a) macroeconomic conditions such as general economic conditions, limitations on accessing capital or other developments in equity and credit markets; (b) industry and market considerations such as competition, multiples or metrics and changes in the market for the Company's products and services or regulatory and political environments; (c) cost factors such as raw materials, labor or other costs; (d) overall financial performance such as cash flows, actual and planned revenue and earnings compared with actual and projected results of relevant prior periods; (e) other relevant events such as changes in key personnel, strategy or customers; (f) changes in the composition of a reporting unit's assets or expected sales of all or a portion of a reporting unit; and (g) any sustained decrease in share price. If the Company's qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying value, or if management elects to perform a quantitative assessment of goodwill, a two-step impairment test is used to identify potential goodwill impairment and measure the amount of any impairment loss to be recognized. In the first step, the MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Company compares the fair value of each reporting unit with its carrying value. The fair value of the reporting units is determined based upon a combination of the income valuation and market approach in valuation methodology. The income approach uses discounted estimated future cash flows, whereas the market approach or guideline public company method utilizes market data of similar publicly traded companies. The Company’s step 1 impairment test of goodwill of a reporting unit is based upon the fair value of the reporting unit, defined as the price that would be received to sell the net assets or transfer the net liabilities in an orderly transaction between market participants at the assessment date. In the event that the net carrying amount exceeds the fair value, a step 2 test must be performed whereby the fair value of the reporting unit’s goodwill must be estimated to determine if it is less than its net carrying amount. In its two-step test, the Company uses the discounted cash flow method and the guideline company method for determining the fair value of its reporting units. Under these methods, the determination of implied fair value of the goodwill for a particular reporting unit is the excess of the fair value of a reporting unit over the amounts assigned to its assets and liabilities in the same manner as the allocation in a business combination. The techniques used in the Company's qualitative assessment and, if necessary, two-step impairment test incorporate a number of assumptions that the Company believes to be reasonable and to reflect market conditions forecast at the assessment date. Assumptions in estimating future cash flows are subject to a high degree of judgment. The Company makes all efforts to forecast future cash flows as accurately as possible with the information available at the time the forecast is made. To this end, the Company evaluates the appropriateness of its assumptions as well as its overall forecasts by comparing projected results of upcoming years with actual results of preceding years and validating that differences therein are reasonable. Key assumptions, all of which are Level 3 inputs (refer to note 20 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K), relate to price trends, material costs, discount rate, customer demand, and the long-term growth and foreign exchange rates. A number of benchmarks from independent industry and other economic publications were also used. Changes in assumptions and estimates after the assessment date may lead to an outcome where impairment charges would be required in future periods. Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions. In August 2016, the Company acquired Diebold Nixdorf AG. During the first quarter of 2017, in connection with the business combination agreement related to the Acquisition, the Company realigned its reportable operating segment to its lines of business to drive greater efficiency and further improve customer service. The acquired Diebold Nixdorf AG goodwill is primarily the result of anticipated synergies achieved through increased scale, a streamlined portfolio of products and solutions, higher utilization of the service organization, workforce rationalization in overlapping regions and shared back office resources. The Company also expects, after completion of the business combination and related integration, to generate improved free cash flow, which would be used to make investments in innovative software and solutions and reduce debt. The Company has allocated goodwill to its Services, Software and Systems reportable operating segments. The goodwill associated with the Acquisition is not deductible for income tax purposes. In the fourth quarter of 2017, goodwill was reviewed for impairment based on a two-step test, which resulted in no impairment in any of the Company's reporting units. The Company estimated the fair value of its nine reporting unit using a combination of the income valuation and market approach in valuation methodology. The determination of the fair value of the reporting unit requires significant estimates and assumptions, including significant unobservable inputs. The key inputs included, but were not limited to, discount rates, terminal growth rates, market multiple data from selected guideline public companies, management’s internal forecasts which include numerous assumptions such as projected net sales, gross profit, sales mix, operating and capital expenditures and earnings before interest and taxes margins, among others. Management determined that the Services-AP and Software-EMEA reporting units had excess fair value of $15.4 or 8.1 percent and $1.3 or 0.6 percent, respectively, when compared to their carrying amounts. The other reporting units had excess fair value of approximately $50 or greater cushion when compared to their carrying amount. Changes in certain assumptions or the Company's failure to execute on the current plan could have a significant impact to the estimated fair value of the reporting units. Long-Lived Assets. Impairment of long-lived assets is recognized when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized at that time to reduce the asset to the lower of its fair value or its net book value. The Company tests all existing indefinite-lived intangibles at least annually for impairment as of October 31. Taxes on Income. Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized for deductible temporary differences, operating loss carry-forwards and tax credits. Deferred tax liabilities are recognized for taxable temporary differences and undistributed earnings in certain jurisdictions. Deferred tax assets are reduced by a valuation allowance when, based upon the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Determination of a valuation allowance involves estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income and the impact of tax planning strategies. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) The Company operates in numerous taxing jurisdictions and is subject to examination by various federal, state and foreign jurisdictions for various tax periods. Additionally, the Company has retained tax liabilities and the rights to tax refunds in connection with various acquisitions and divestitures of businesses. The Company’s income tax positions are based on research and interpretations of the income tax laws and rulings in each of the jurisdictions in which the Company does business. Due to the subjectivity of interpretations of laws and rulings in each jurisdiction, the differences and interplay in tax laws between those jurisdictions, as well as the inherent uncertainty in estimating the final resolution of complex tax audit matters, the Company’s estimates of income tax liabilities may differ from actual payments or assessments. The Company assesses its position with regard to tax exposures and records liabilities for these uncertain tax positions and any related interest and penalties, when the tax benefit is not more likely than not realizable. The Company has recorded an accrual that reflects the recognition and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. Additional future income tax expense or benefit may be recognized once the positions are effectively settled. At the end of each interim reporting period, the Company estimates the effective tax rate expected to apply to the full fiscal year. The estimated effective tax rate contemplates the expected jurisdiction where income is earned, as well as tax planning alternatives. Current and projected growth in income in higher tax jurisdictions may result in an increasing effective tax rate over time. If the actual results differ from estimates, the Company may adjust the effective tax rate in the interim period if such determination is made. Contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. There is no liability recorded for matters in which the liability is not probable and reasonably estimable. Attorneys in the Company's legal department monitor and manage all claims filed against the Company and review all pending investigations. Generally, the estimate of probable loss related to these matters is developed in consultation with internal and outside legal counsel representing the Company. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The Company attempts to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments, or fines, after appeals, differ from the estimates, the future results may be materially impacted. Adjustments to the initial estimates are recorded when a change in the estimate is identified. Pensions and Other Post-retirement Benefits. Annual net periodic expense and benefit liabilities under the Company’s defined benefit plans are determined on an actuarial basis. Assumptions used in the actuarial calculations have a significant impact on plan obligations and expense. Members of the management investment committee periodically review the actual experience compared with the more significant assumptions used and make adjustments to the assumptions, if warranted. The discount rate is determined by analyzing the average return of high-quality (i.e., AA-rated) fixed-income investments and the year-over-year comparison of certain widely used benchmark indices as of the measurement date. The expected long-term rate of return on plan assets is determined using the plans’ current asset allocation and their expected rates of return based on a geometric averaging over 20 years. The rate of compensation increase assumptions reflects the Company’s long-term actual experience and future and near-term outlook. Pension benefits are funded through deposits with trustees. Other post-retirement benefits are not funded and the Company’s policy is to pay these benefits as they become due. The following table represents assumed healthcare cost trend rates at December 31: The healthcare trend rates for the postemployment benefits plans in the U.S. are reviewed based upon the results of actual claims experience. The Company used initial healthcare cost trends of 6.8 percent and 7.0 percent in 2017 and 2016, respectively, with an ultimate trend rate of 5.0 percent reach in 2025. Assumed healthcare cost trend rates have a modest effect on the amounts reported for the healthcare plans. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. A one-percentage-point change in assumed healthcare cost trend rates would have the following effects: During 2017, the Society of Actuaries released a new mortality improvement projection scale (MP-2017) resulting from recent studies measuring mortality rates for various groups of individuals. As of December 31, 2017, the Company adopted for the pension plan in the U.S. the use of the RP-2014 base mortality table modified to remove the post-2006 projections using the MP-2014 mortality improvement scale and replacing it with projections using the fully generational MP-2017 projection scale. For the plans outside the U.S., the mortality tables used are those either required or customary for local accounting and/or funding purposes. RECENTLY ISSUED ACCOUNTING GUIDANCE Refer to note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K, for information on recently issued accounting guidance. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) FORWARD-LOOKING STATEMENT DISCLOSURE In this annual report on Form 10-K, statements that are not reported financial results or other historical information are “forward-looking statements.” Forward-looking statements give current expectations or forecasts of future events and are not guarantees of future performance. These forward-looking statements include, but are not limited to, statements regarding the Acquisition, its financing of the Acquisition, its expected future performance (including expected results of operations and financial guidance), and the Company’s future financial condition, operating results, strategy and plans. Forward-looking statements may be identified by the use of the words “anticipates,” “expects,” “intends,” “plans,” “will,” “believes,” “estimates,” “potential,” “target,” “predict,” “project,” “seek,” and variations or similar expressions. These statements are used to identify forward-looking statements. These forward-looking statements reflect the current views of the Company with respect to future events and involve significant risks and uncertainties that could cause actual results to differ materially. Although the Company believes that these forward-looking statements are based upon reasonable assumptions regarding, among other things, the economy, its knowledge of its business, and on key performance indicators that impact the Company, these forward-looking statements involve risks, uncertainties and other factors that may cause actual results to differ materially from those expressed in or implied by the forward-looking statements. The Company is not obligated to update forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Some of the risks, uncertainties and other factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements include, but are not limited to: • the ultimate impact of the DPLTA with Diebold Nixdorf AG and the outcome of the appraisal proceedings initiated in connection with the implementation of the DPLTA; • the ultimate outcome and results of integrating the operations of the Company and Diebold Nixdorf AG; • the ultimate outcome of the Company’s pricing, operating and tax strategies applied to Diebold Nixdorf AG and the ultimate ability to realize cost reductions and synergies; • the Company's ability to successfully operate its strategic alliances in China with the Inspur Group and Aisino Corp.; • changes in political, economic or other factors such as currency exchange rates, inflation rates, recessionary or expansive trends, taxes and regulations and laws affecting the worldwide business in each of the Company's operations, including the impact of the Tax Act; • the Company’s reliance on suppliers and any potential disruption to the Company’s global supply chain; • the impact of market and economic conditions economic conditions, including any additional deterioration and disruption in the financial and service markets, including the bankruptcies, restructurings or consolidations of financial institutions, which could reduce our customer base and/or adversely affect our customers' ability to make capital expenditures, as well as adversely impact the availability and cost of credit; • the acceptance of the Company's product and technology introductions in the marketplace; • competitive pressures, including pricing pressures and technological developments; • changes in the Company's relationships with customers, suppliers, distributors and/or partners in its business ventures; • the effect of legislative and regulatory actions in the U.S. and internationally and the Company’s ability to comply with government regulations; • the impact of a security breach or operational failure on the Company's business; • the Company's ability to successfully integrate other acquisitions into its operations; • the impact of the Company's strategic initiatives; • the Company's ability to maintain effective internal controls; • changes in the Company's intention to further repatriate cash and cash equivalents and short-term investments residing in international tax jurisdictions, which could negatively impact foreign and domestic taxes; • unanticipated litigation, claims or assessments, as well as the outcome/impact of any current/pending litigation, claims or assessments, including but not limited to the Company's Brazil tax dispute; • potential security violations to the Company's IT systems; • the investment performance of our pension plan assets, which could require us to increase our pension contributions, and significant changes in healthcare costs, including those that may result from government action; • the amount and timing of repurchases of the Company's common shares, if any; and • the Company's ability to achieve benefits from its cost-reduction initiatives and other strategic changes, including its planned restructuring actions, as well as as its business process outsourcing initiative. Except to the extent required by applicable law or regulation, the Company undertakes no obligation to update these forward-looking statements to reflect future events or circumstances or to reflect the occurrence of unanticipated events.

<s>[INST] During 2017, Diebold Nixdorf: Launched the DN2020 integration and transformation program and realized more than $100 of cost savings during the year. Rationalized the manufacturing footprint from a capacity of approximately 180,000 ATMs per year to approximately 100,000 ATMs per year and consolidated approximately 25 percent of service parts depots across the globe. Shifted production to the manufacturing facility in Suzhou, China operated by its strategic alliance partner, Inspur Group. This strategic alliance is enabling the Company to realize procurement advancements through better access to local suppliers and is enhancing our ability to adapt to market conditions. Consolidated legal entities in order to simplify sales, service operations and business processes through a single entity in each country. Was named as the largest manufacturer of ATMs by Retail Banking Research's report "Global ATM Market and Forecasts to 2022." Introduced new mobility management services offering with asaservice, security and data analytics offerings. Won a number of retail contracts to modernize checkout solutions and implement omnichannel retailing, including a $53.0 store lifecycle management deal with a European fashion retailer. Introduced Vynamic, the first endtoend Connected Commerce software portfolio in the marketplace. Announced strategic partnership with Kony, Inc. (Kony) to white label mobile application solutions for financial institutions and retailers. Received the "Global SelfCheckout Systems Growth Excellence Leadership Award" from Frost & Sullivan in recognition of the Company's product innovation, growth, channel partnership strategies, and ability to serve multiple retailer segments. Announced product readiness to support the Microsoft® Windows 10 operating system. OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10K. For additional information regarding general information regarding the Company, its business, strategy, competitors and operations, refer to Item 1. Business. Business Drivers The business drivers of the Company's future performance include, but are not limited to: Demand for services on distributed IT assets such as ATMs, POS and SCO, including managed services and professional services; Timing of system upgrades and/or replacement cycles for ATMs, POS and SCO; Demand for software products and professional services; Demand for security products and services for the financial, retail and commercial sectors; Demand for innovative technology in connection with our Connected Commerce strategy; Integration of legacy salesforce, business processes, procurement, and internal IT systems; and Realization of cost reductions and synergies, which leverage the Company's global scale, reduce overlap and improve operating efficiencies. During the first quarter of 2017, the Company reorganized the management team reporting to the Chief Operating Decision Maker (CODM) based on the following three LOBs: Services, Systems, and Software. As a result, the Company reclassified comparative periods for consistency, which were previously reported as four geographical segments of: NA, AP, EMEA and LA. The presentation of comparative periods also reflects the reclassification of certain global manufacturing administration expenses from corporate charges not allocated to segments. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2017 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) The table below presents the changes in comparative financial data for the years ended December 31, 2017, 2016 and 2015. Comments on significant yeartoyear fluctuations follow the table. In August 2016, the Company completed the Acquisition. In February 2016, the Company recognized a gain in discontinued operations related to the divestiture of its NA ES business. These events resulted in a significant impact in the comparative information discussed below. [/INST] Positive. </s>

DIEBOLD NIXDORF, Inc

2019-03-01

2018-12-31

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Significant Highlights During 2018, Diebold Nixdorf: • Hired Gerrard Schmid to serve as president and chief executive officer. • Named Jeffrey Rutherford as interim senior vice president, chief financial officer, and subsequently appointed him to this role on a full-time basis. • Added Bruce Besanko and Ellen Costello to the Board of Directors • Launched the DN Now transformation program which is comprised of multiple work streams designed to relentlessly focus on our customers and improve operational excellence. This program is targeting gross annualized savings of approximately $400 through 2021. • Raised $650.0 through a new term loan and revised the Company’s credit facility covenants. This enhanced liquidity provides financial flexibility, facilitates acquiring the remaining shares of Diebold Nixdorf AG and supports DN Now initiatives. • Partnered with Mastercard® on key technology and services agreements to strengthen the Company's Connected Commerce offerings and further bridge physical and digital transactions. • Ranked as one of the Top 10 Technology Companies on the 2018 IDC Financial Insights FinTech Rankings. • Won Windows 10 ATM product upgrades with several North America financial institutions, including an agreement with a regional U.S. bank for more than 500 DN Vynamic software licenses and a new managed services agreement. • Enabled the first integrated, digital kiosk in the Middle East in partnership with Emirates NBD. • Entered an agreement with Banco Bolivariano in Ecuador to implement the DN Vynamic Mobile Banking suite. • Was identified as the largest manufacturer of ATMs by Retail Banking Research's report "Global ATM Market and Forecasts to 2023." • Secured a global frame agreement, including North America, to provide kiosks and services for one of the world's largest quick-service restaurants. • Signed a $70.0, multi-year services contract covering about 1,000 Marks & Spencer stores in Western Europe. • Secured a multiyear managed services agreement valued at $68.0 for new POS devices and related software at a leading European home improvement retailer. OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10-K. For additional information regarding general information regarding the Company, its business, strategy, competitors and operations, refer to Item 1 of this annual report on Form 10-K. Business Drivers The business drivers of the Company's future performance include, but are not limited to: • Demand for services on distributed IT assets such as ATMs, POS and SCO, including managed services and professional services; • Timing of system upgrades and/or replacement cycles for ATMs, POS and SCO; • Demand for software products and professional services; • Demand for security products and services for the financial, retail and commercial sectors; • Demand for innovative technology in connection with the Company's Connected Commerce strategy; • Integration of sales force, business processes, procurement, and internal IT systems; and • Realization of cost reductions, which leverage the Company's global scale, reduce overlap and improve operating efficiencies. The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes that appear elsewhere in this annual report on Form 10-K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) RESULTS OF OPERATIONS 2018 comparison with 2017 Net Sales The following table represents information regarding our net sales for the years ended December 31: (1) The Company calculates constant currency by translating the prior-year period results at the current year exchange rate. Net sales decreased $30.7 or 0.7 percent including a net favorable currency impact of $55.4 primarily related to the euro, partially offset by the Brazil real. Additionally, prior year net sales were adversely impacted $30.4 related to deferred revenue purchase accounting adjustments (Deferred Revenue Adjustments). The following results include the impact of foreign currency and purchase accounting adjustments: Segments • Eurasia Banking net sales decreased $103.2, including a net favorable currency impact of $41.3, mainly related to the euro. Prior year net sales were adversely impacted $18.3, including a net unfavorable currency impact of $1.4, related to Deferred Revenue Adjustments. Excluding currency and Deferred Revenue Adjustments, net sales decreased $164.2 due to lower product volume related to fewer product deployments and projects, particularly in Thailand, Turkey, Indonesia, the Middle East and Australia. In addition, services in India decreased as a result of a low-margin maintenance contract roll off. Net sales declined from the Company’s strategic decision to reduce its product and services portfolio in India and China as market conditions became less favorable. These decreases were partially offset by increased unit replacements in Germany related to Windows 10 migrations. • Americas Banking net sales decreased $9.9, including a net unfavorable currency impact of $20.6 related to the Brazil real. Excluding currency, net sales increased $10.7 from higher software license volume in Brazil, professional services volume in North America and higher product volume, particularly in Mexico, Canada and Ecuador. These increases were partially offset by lower product volume in the U.S. as well as low-profit maintenance contract base roll offs of two customers in North America and $4.1 of lower electronic security revenue in Chile due to the business divestiture in September 2017. • Retail net sales increased $82.4, including a net favorable currency impact of $34.7 mainly related to the euro. Prior year net sales were adversely impacted $12.1, including a net unfavorable currency impact of $1.0, related to Deferred Revenue Adjustments. Excluding currency and Deferred Revenue Adjustments, net sales increased $34.6 due to a large North MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) America kiosk project as well as higher POS activity in Central Eastern Europe, the U.K, France and Spain. These increases were partially offset by lower product volume from the Eurasia non-core businesses and large prior year non-recurring POS and kiosk activity in Germany for multiple customers as well as lower lottery equipment volume in Brazil. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Services gross margin decreased 1.8 percent including higher non routine charges of $10.9 primarily related to a spare parts inventory provision of $24.5 and other charges of $1.6 while the prior year was adversely impacted by Deferred Revenue Adjustments of $15.2. Restructuring was $9.5 lower compared to the prior year. Excluding non-routine and restructuring expenses, services gross margin decreased 1.6 percent due in part to higher retail services cost in the Eurasia non-core businesses and higher one-time banking services cost in Brazil in the second quarter of 2018. Additionally, an unfavorable customer mix on professional services volume in Eurasia drove lower margin in the retail segment as well as an unfavorable service customer mix in the Eurasia banking segment and higher services cost in China and Indonesia. These decreases were partially offset by a large, low-margin maintenance contract roll off in India. Product gross margin decreased 2.9 percent, including slightly lower non routine charges of $0.8, primarily from reduced Purchase Accounting Adjustments of $36.4, related to amortization and prior-year Deferred Revenue Adjustments and a benefit from the Brazil indirect tax accrual reversal of $9.0, in addition to lower integration of $0.6 and legal and consulting expense of $0.6, partially offset by higher inventory provision charges of $45.8. Restructuring expense increased $8.9 compared to the prior year. Excluding non-routine and restructuring expenses, product gross margin decreased 2.2 percent, primarily from an unfavorable banking customer mix in the Americas as well as expedited freight cost from supply chain delays in the first half of 2018. Additionally, the retail segment was impacted by an unfavorable customer mix in Brazil, related to license volume, and increased cost and unfavorable customer mix in Eurasia. These decreases were partially offset by increased gross margin in the Eurasia banking segment primarily from a favorable customer mix in various countries, particularly in Germany, Thailand and the Middle East. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: Selling and administrative expense in 2018 decreased $48.1 including lower non-routine charges of $22.0 and higher restructuring of $12.1. Excluding the impact of restructuring and non-routine charges and a net unfavorable currency impact of $9.6, due primarily to the euro, selling and administrative expense was lower by $47.8, mostly from cost reduction initiatives across the Company related to DN Now as well as an increased benefit from the mark-to-market adjustment of the legacy Wincor Nixdorf stock option program of $3.4, partially offset by the retail segment from increased investment in the new North America retail sales organization. Non-routine cost in selling and administrative expenses were $153.4 and $175.4 in 2018 and 2017, respectively. The components of the non-routine expenses in 2018 pertained to purchase accounting adjustments of $89.1 related to intangible asset amortization, integration cost totaling $43.4, legal and consulting cost of $18.3 and executive severance of $2.7. Selling and administrative MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) expense included restructuring charges of $33.4 and $21.3 in 2018 and 2017, respectively, primarily due to the workforce alignment actions under the DN Now plan. Research, development and engineering expense in 2018 increased $1.9 due to higher restructuring cost of $4.1 and an unfavorable currency impact of $4.4, primarily related to the euro, partially offset by lower non-routine expense of $0.3. Excluding restructuring and the impact of currency, expense was down $6.3 mostly from DN Now initiatives and lower associate related expense. As a result of certain impairment triggering events, the Company performed an impairment test of goodwill for its four reporting units during the third quarter of 2018. Based on the results of the impairment testing, the Company recorded a non-cash goodwill impairment loss of $134.4 related to the Eurasia Banking, EMEA Retail and Rest of World Retail reporting units during 2018. During the second quarter of 2018, the Company performed an impairment test of goodwill for all of its LoB reporting units due to the change in its reportable operating segments which resulted in a $83.1 non-cash impairment loss. The year ended December 31, 2018 recorded impairment of $217.5, related to the impairment of goodwill in the second and third quarters, compared to $3.1 in the same prior year period related to information technology transformation and integration activities. The gain on sale of assets in 2018 was primarily related to a gain on sale of buildings in North America of $4.8, the liquidation of the Barbados operating entity of $3.3 and a gain related to a sale of a maintenance contract in Brazil and a certain China investment. This gain on sale of assets was partially offset by the loss pertaining to a settlement of certain matters related to an Americas divestiture in the second quarter of 2018. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The operating loss increased, compared to the prior year, mostly due to higher non-routine expense, including the non-cash goodwill impairment, and incremental restructuring expense. Excluding non-routine and restructuring expense, operating loss increased $57.9 from lower gross profit in the retail and Americas banking segments, partially offset by higher gross profit in the Eurasia banking segment as well as favorable selling and administrative expense attributable to DN Now initiatives. Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: Interest income in 2018 decreased, primarily as a result of overall lower average balances as well as lower U.S. market returns on nonqualified plans and repatriation of cash in Brazil and EMEA. Interest expense was higher compared to the prior year due to higher domestic interest rates and the additional $650.0 of Term Loan A-1 Facility debt with higher incremental interest rates and related fee amortization. Miscellaneous, net in 2018 was unfavorably impacted by higher cost and lower benefits associated with the company owned life insurance. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Income (Loss) from Continuing Operations, net of tax The following table represents information regarding our net income from continuing operations, net of tax for the years ended December 31: The loss before taxes and net loss increased primarily due to the reasons described above. Net loss was also impacted by the change in the income tax expense. The effective tax rate for 2018 was 7.2 percent and is primarily due to a goodwill impairment charge, the U.S. Tax Cuts and Jobs Act (the Tax Act), valuation allowances on certain foreign and state jurisdictions, foreign tax credits and the higher interest expense burden resulting from the debt restructuring. More specifically, the expense on the loss reflects the reduction of the U.S. federal corporate income tax rate from 35 percent to 21 percent, refinement of the transition tax under U.S. SEC's Staff Accounting Bulletin (SAB) 118, a goodwill impairment charge, which for tax purposes is primarily nondeductible and the business interest deduction limitation. As a result of the Company’s debt restructuring activity during the year, a full valuation allowance was required on the current year nondeductible business interest expense. In addition, the overall effective tax rate is impacted by the jurisdictional income (loss) and varying respective statutory rates. The effective tax rate for 2017 was 14.7 percent on the overall loss from continuing operations. The U.S. enacted the Tax Act, which was signed into law on December 22, 2017. The Tax Act changed many aspects of U.S. corporate income taxation and included a reduction of the corporate income tax rate from 35 percent to 21 percent, implementation of a territorial tax system and imposition of a tax on deemed repatriated earnings of foreign subsidiaries. The resulting impact to the Company was an estimated $45.1 reduction to deferred income taxes for the income tax rate change and an estimated one-time non-cash charge of $36.6 related to deferred foreign earnings. Due to the complexities involved in accounting for the recently enacted Tax Act, the SAB 118 requires that the Company include in its financial statements the reasonable estimate of the impact of the Tax Act on earnings to the extent such reasonable estimate has been determined. The Company recorded a reasonable estimate of such effects, the net one-time charge related to the Tax Act may differ, possibly materially, due to, among other things, further refinement of its calculations, changes in interpretations and assumptions, additional guidance that may be issued by the U.S. Government, and actions and related accounting policy decisions the Company may take as a result of the Tax Act. The Company completed its analysis over a one-year measurement period ending December 31, 2018 and any adjustments during this measurement period were included in net loss from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. Segment Net Sales and Operating Profit Summary The following tables represent information regarding the Company's net sales and operating profit by reporting segment: Eurasia Banking net sales decreased $103.2, including a net favorable currency impact of $41.3 mainly related to the euro. Prior year net sales were adversely impacted $18.3, including a net unfavorable currency impact of $1.4, related to Deferred Revenue Adjustments. Excluding currency and Deferred Revenue Adjustments, net sales decreased $164.2 due to lower product volume related to fewer product deployments and projects, particularly in Thailand, Turkey, Indonesia, the Middle East and Australia. In addition, services in India decreased as a result of a low-margin maintenance contract roll off. In addition, net sales declined from the Company’s strategic decision to reduce its product and services portfolio in India and China as market conditions became less favorable. These decreases were partially offset by increased unit replacements in Germany related to Windows 10 migrations. Segment operating profit increased $20.3, compared to the prior year, including a net favorable currency impact of $3.6. Excluding the impact of currency, operating profit increased $16.7 mostly from lower operating expenses tied to the DN Now plan and increased product gross profit related to higher margin pull through on a favorable customer mix, particularly in Germany, Thailand MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) and the Middle East. These increases were partially offset by lower services revenue and associated profit in various Asia Pacific countries as well as higher services cost in China and Indonesia in addition to lower margin pull through on software revenue attributable to an unfavorable customer mix and higher cost in various countries. Segment operating profit margin increased in 2018, primarily as a result of lower operating expense related to the DN Now plan, as well as higher product gross profit, partially offset by lower services and software gross profit. Americas Banking net sales decreased $9.9 including a net unfavorable currency impact of $20.6 related to the Brazil real. Excluding currency, net sales increased $10.7 from higher software license volume in Brazil, professional services volume in North America and higher product volume, particularly in Mexico, Canada and Ecuador. These increases were partially offset by lower product volume in the U.S. as well as low-profit maintenance contract base roll offs of two customers in North America and $4.1 lower electronic security revenue in Chile due to the business divestiture in September 2017. Segment operating profit decreased $40.5, compared to the prior year including a net favorable currency impact of $0.4. Excluding the impact of currency, operating profit decreased $40.9, adversely impacted by one-time services cost in Brazil from the second quarter of 2018. Additionally, product gross profit decreased mostly from higher freight cost, primarily related to supply chain delays in the first half of 2018 in North America and Mexico as well as an unfavorable customer mix in Mexico. Partially offsetting these decreases, selling and administrative expense was lower from cost reduction initiatives related to the DN Now plan and the Company’s annual incentive program as well as higher software gross profit from increased professional services activity in North America. Segment operating profit margin decreased in 2018, primarily as a result of higher freight and one time services cost in the first three quarters of 2018, partially offset by lower selling and administrative expense. Retail net sales increased $82.4, including a net favorable currency impact of $34.7 mainly related to the euro. Prior year net sales were adversely impacted $12.1, including a net unfavorable currency impact of $1.0, related to Deferred Revenue Adjustments. Excluding currency and Deferred Revenue Adjustments, net sales increased $34.6 due to a large North America kiosk project as well as higher POS activity in Central Eastern Europe, the U.K, France and Spain. These increases were partially offset by lower product volume from the Eurasia non-core businesses and large prior year non-recurring POS and kiosk activity in Germany for multiple customers as well as lower lottery equipment volume in Brazil. Segment operating profit decreased $37.6 compared to the prior-year including a $2.6 net favorable currency impact. Excluding currency, Retail operating profit decreased $40.2 primarily due to the under performance from the Eurasia non-core businesses in addition to low-margin service and product revenue unfavorably impacting gross profit in various countries in Eurasia. The current year was also unfavorably impacted by higher selling and administrative expense from developing the North America retail sales organization. Segment operating profit margin decreased in 2018, primarily as a result of the under performance of the non-core businesses and an unfavorable customer mix driving lower gross margin on higher revenue in addition to increased operating expense. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) 2017 comparison with 2016 Net Sales The following table represents information regarding our net sales for the years ended December 31: (1) The Company calculates constant currency by translating the prior-year period results at the current year exchange rate. Net sales increased $1,293.0 or 39.0 percent, including incremental net sales from the Acquisition of $1,517.7 and a net favorable currency impact of $88.3 primarily related to the euro and the Brazil real. 2017 net sales were adversely impacted $30.4 related to Deferred Revenue Adjustments, which was an increase of $14.2 compared to the prior year. The amounts attributable to the Acquisition are impacted by the alignment and integration of customer portfolios, solution offerings and operations between the legacy companies, which may result in unfavorable comparisons to prior year. The following results include the impact of foreign currency and purchase accounting adjustments: Segments • Eurasia Banking net sales increased $670.8, which included incremental net sales from the Acquisition of $756.7, a net favorable currency impact of $40.9 mainly related to the euro and higher Deferred Revenue Adjustments of $8.5. Excluding the impact of the Acquisition, currency and Deferred Revenue Adjustments, net sales decreased $118.3 due mostly to lower banking product project activity in EMEA as well as unfavorable structural changes in the Asia Pacific market, partially offset by higher managed services net sales in Asia Pacific. • Americas Banking net sales decreased $41.7, which included incremental net sales from the Acquisition of $79.7 and a net favorable currency impact of $15.7 mostly related to the Brazil real. Excluding the impact of the Acquisition, currency and Deferred Revenue Adjustments, net sales decreased $137.1 mostly attributable to decreased product volumes, primarily in Mexico, North America and Brazil, as well as the run-off of multi-vendor service contracts in North America. • Retail net sales increased $663.9, which included incremental net sales from the Acquisition of $681.3, a net favorable currency impact of $31.7 mainly related to the Brazil real and higher Deferred Revenue Adjustments of $5.7. Excluding the impact of the Acquisition, currency and Deferred Revenue Adjustments, net sales decreased $43.4, mostly from lower voting machine volume in Brazil, partially offset by increased services and software revenue in EMEA and higher product volume and the associated services in Asia Pacific. A more detailed discussion of segment net sales is included under "Segment Net Sales and Operating Profit Summary" below. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Services gross margin decreased 3.4 percent due in part to the impact of the Acquisition, which utilizes a third-party labor model to support its services revenue stream, resulting in a dilutive effect on margins. Services gross margin was adversely impacted by higher non-routine cost of $10.8 primarily related to purchase accounting adjustments associated with the Acquisition and higher restructuring charges of $8.9. Additionally, gross margin was also impacted by lower contract maintenance revenue in Americas combined with increased labor costs and investments. The labor investments are a result of higher turnover rates of technicians and the associated training to support additional product lines. Product gross margin increased 4.7 percent mostly as a result of lower non-routine cost of $27.8 related to higher purchase accounting adjustments to record inventory acquired in the Acquisition at fair value in the prior year. Additionally, the incremental gross profit associated with the Acquisition includes higher margin business across both banking and retail solutions. This increase was partially offset by higher restructuring of $5.2. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: The selling and administrative expense in 2017 increased $172.5 inclusive of incremental expenses from the Acquisition of $272.4 and a net unfavorable currency impact of $17.9. Excluding the impact of currency and the Acquisition, selling and administrative expense decreased $117.8 from the overall cost reductions tied to DN2020 as well as lower non-routine and restructuring costs and lower incentive compensation expense related to the Company's annual incentive plans. Selling and administrative non-routine expenses were $175.4 and $150.8 in 2017 and 2016, respectively. The primary components of the non-routine expenses in 2017 pertained to acquisition and divestiture costs, including related integration activities, totaling $85.0, purchase accounting adjustments of $85.0 related to intangible asset amortization and executive severance of $5.4. The year-over-year increase was primarily related to incremental purchase accounting and integration expenses offset by a decrease in legal, acquisition and divestiture costs. Selling and administrative expense included restructuring charges of $21.3 and $28.8 in 2017 and 2016, respectively. Research, development and engineering expense increased $45.3 due to incremental expense associated with the Acquisition of $62.7. Excluding the incremental impact of the Acquisition, expense was favorably impacted by the benefits of streamlining the cost structure as part of the Company's integration activities. Research, development and engineering expense included restructuring reversals of $1.1 in 2017 compared to $5.1 of restructuring costs in 2016. In 2017, the Company recorded impairments totaling $3.1 related to IT transformation and integration activities. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) In 2017, the loss on sale of assets was primarily related to the divestiture of the Company's electronic security (ES) business in Chile and from building closures in EMEA due to integration efforts. These losses were partially offset by a gain on sale of assets primarily related to the Company's divestiture of its business in the U.K. and its ES business in Mexico. Operating expense as a percent of net sales in 2017 was 23.7 percent compared with 26.6 percent in 2016 due to increased revenue and overall cost reductions tied to DN2020 which more than offset the incremental operating costs from the Acquisition. Operating Profit (Loss) The following table represents information regarding our operating profit (loss) for the years ended December 31: The operating loss decreased in 2017 compared to 2016 primarily due to higher gross margin that more than offset an increase in operating expense, which included amortization of acquired intangible assets, restructuring and non-routine costs related to acquisitions and divestitures. Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: The decrease in interest income in 2017 compared with 2016 was a result of lower interest income of the Company's marketable securities, which were primarily held for cash management in Brazil. Interest expense was higher in 2017 associated with the financing required for the Acquisition, offset by improved interest rates from the Company's repricing certain of its debt in May 2017. Foreign exchange loss, net in 2017 was unfavorable as a result of the incremental impact of the Acquisition. Miscellaneous, net in 2016 included a mark-to-market net gain of $9.2 associated with the Company's foreign currency option contracts entered and foreign currency forward contract and $6.3 in financing fees related to the Company’s bridge financing required for the Acquisition. Income (Loss) from Continuing Operations, Net of Tax The following table represents information regarding our income (loss) from continuing operations, net of tax, for the years ended December 31: Loss from continuing operations, net of tax was $213.9. This was primarily due to the reasons described above and the change in income tax (benefit) expense. The effective tax rate for 2017 was 14.7 percent on the overall loss from continuing operations. The Tax Act changed many aspects of U.S. corporate income taxation and included a reduction of the corporate income tax rate from 35 percent to 21 percent, implementation of a territorial tax system and imposition of a tax on deemed repatriated earnings of foreign subsidiaries. The resulting impact to the Company is an estimated $45.1 reduction to deferred income taxes for the income tax rate change and an estimated one-time, non-cash charge of $36.6 related to deferred foreign earnings. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) The effective tax rate benefit for 2016 of 27.7 percent on the overall loss from continued operations. The benefit on the overall loss was negatively impacted by the Acquisition including a valuation allowance for certain post-acquisition losses and non-deductible acquisition related expenses. The overall effective tax rate was decreased further by the jurisdictional income (loss) and varying respective statutory rates within the acquired entities. Equity in (loss) earnings of unconsolidated subsidiaries, net consisted primarily of income from the Aisino and Inspur strategic alliances in China. Income from Discontinued Operations, Net of Tax The closing of the NA ES divestiture occurred on February 1, 2016 and the Company recorded a gain (loss) on sale, net of tax, of $145.0 in 2016. Additionally, the income from discontinued operations, net of tax includes a net loss of $1.3 as a result of the operations included through February 1, 2016. Segment Revenue and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: Eurasia Banking net sales increased $670.8, which included incremental net sales from the Acquisition of $756.7, a net favorable currency impact of $40.9 mainly related to the euro and higher Deferred Revenue Adjustments of $8.5. Excluding the impact of the Acquisition, currency and Deferred Revenue Adjustments, net sales decreased $118.3 due mostly to lower banking product project activity in EMEA as well as unfavorable structural changes in the Asia Pacific market, partially offset by higher managed services net sales in Asia Pacific. Segment operating profit increased $38.6 including an incremental impact from the Acquisition of $98.7 in 2017. Excluding the incremental portion from the Acquisition, operating profit decreased $60.1 in 2017 mostly from lower product gross profit driven by declined project activity as well as unfavorable structural changes in the Asia Pacific market and higher operating expense. The unfavorable product gross profit and operating expense was partially offset by higher software and services gross profit. Segment operating profit margin decreased due in part to the impact of the Acquisition, which utilizes a higher third-party labor model to support its service and software revenue stream, resulting in a dilutive effect on margins in 2017. Americas Banking net sales decreased $41.7, which included incremental net sales from the Acquisition of $79.7 and a net favorable currency impact of $15.7 mostly related to the Brazil real. Excluding the impact of the Acquisition, currency and Deferred Revenue Adjustments, net sales decreased $137.1 mostly attributable to decreased product volumes, primarily in Mexico, North America and Brazil, as well as the run-off of multi-vendor service contracts in North America. Segment operating profit decreased $33.7 in 2017. The incremental portion from the Acquisition accounted for $23.6 in segment operating profit in 2017. Excluding the incremental portion from the Acquisition, operating profit decreased $57.3 mostly from lower services gross profit as a result of contract maintenance revenue declines combined with increased labor investments in addition to decreased product installation volume. The labor investments are a result of higher turnover rates of technicians and the associated training to support additional product lines partially offset by lower operating expenses from cost saving initiatives Segment operating profit margin decreased due to higher services cost, partially offset by the positive impact of the Acquisition. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Retail net sales increased $663.9, which included incremental net sales from the Acquisition of $681.3, a net favorable currency impact of $31.7 mainly related to the Brazil real and higher Deferred Revenue Adjustments of $5.7. Excluding the impact of the Acquisition, currency and Deferred Revenue Adjustments, net sales decreased $43.4, mostly from lower voting machine volume in Brazil, partially offset by increased services and software revenue in EMEA and higher product volume and the associated services in Asia Pacific. Segment operating profit increased $53.9 in 2017. The incremental portion from the Acquisition accounted for $55.7 in segment operating profit in 2017. Excluding the incremental portion from the Acquisition, operating profit decreased $1.8 due to slightly higher operating expenses, partially offset by higher services gross profit from the Eurasia non-core business. Segment operating profit margin increased due primarily to the positive impact of the Acquisition in 2016. Refer to note 20 for further details of segment revenue and operating profit. LIQUIDITY AND CAPITAL RESOURCES Capital resources are obtained from income retained in the business, borrowings under the Company’s senior notes, committed and uncommitted credit facilities and operating and capital leasing arrangements. Management expects that the Company’s capital resources will be sufficient to finance planned working capital needs, R&D activities, investments in facilities or equipment, pension contributions, the payment of guaranteed dividends and any repurchases of the Company’s common shares for at least the next 12 months. The Company had $105.3 and $8.0 of restricted cash at December 31, 2018 and 2017, respectively, primarily related to the acquisition of the remaining shares in Diebold Nixdorf AG. At December 31, 2018, $386.6 or 94.8 percent of the Company’s cash and cash equivalents and short-term investments reside in international tax jurisdictions. Repatriation of certain international held funds could be negatively impacted by potential payments for certain foreign taxes. The Company has earnings in certain jurisdictions available for repatriation of $1,364.3 with no additional tax expense primarily as a result of the Tax Act. The Company has made acquisitions in the past and may make acquisitions in the future. Part of the Company's strategy is to optimize the business portfolio through divestitures and complementary acquisitions. The Company intends to finance any future acquisitions with cash and short-term investments, cash provided from operations, borrowings under available credit facilities, proceeds from debt or equity offerings and/or the issuance of common shares. The Company's total cash and cash availability as of December 31, 2018 and 2017 was as follows: The following table summarizes the results of our consolidated statement of cash flows for the years ended December 31: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) During 2018, cash, cash equivalents and restricted cash decreased $77.5 primarily due to operating activities as well as payments of $47.2, $62.1, $129.6 and $64.9 for integration initiatives, restructuring programs, interest on debt and income taxes, respectively. These uses were offset by the cash provided by financing and investing activities related to the proceeds received from the Term A-1 Loan Facility and proceeds from the monetization of the company owned life insurance plans. Operating Activities. Cash flows from operating activities can fluctuate significantly from period to period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Net cash used by operating activities was $104.1 for the year ended December 31, 2018, a decrease of $141.2 from $37.1 cash provided for the year ended December 31, 2017. The overall decrease was primarily due to deferred revenue and finance receivables combined with an increased operating loss primarily from integration initiatives and restructuring programs. These decreases were partially offset by lower working capital balances. Additional detail is included below: • Cash flows from continuing operating activities during the year ended December 31, 2018 compared to the year ended December 31, 2017 were impacted by a $352.1 increase in loss from continuing operations, net of tax. Refer to Results of Operations discussed above for further discussion of the Company's loss from continuing operations, net of tax. • The net aggregate of trade accounts receivable, inventories and accounts payable provided $11.4 and $39.4 in operating cash flows during the year ended December 31, 2018 and 2017, respectively. The decrease is primarily a result of increased cash utilization by accounts payable as a result of critical supplier payments that were made in the current year caused by reduced terms and vendor collection efforts in the second half of the year. Inventory cash use increased compared to the prior year due to increased build up of inventory to satisfy various customer demand. Partially offsetting the changes in inventory and accounts payable, the increase in cash provided by trade receivables was primarily related to higher cash collected in connection with the Company's DN Now working capital management initiative. • Deferred revenue used $42.4 of operating cash during the year ended December 31, 2018, compared to a $26.0 provide in the year ended December 31, 2017. The decrease in cash flow associated with deferred revenue is related to lower customer prepayments primarily in the Americas compared to the prior year as certain customers switched from a yearly prepayment to quarterly or monthly installments. • The aggregate of income taxes and deferred income taxes used $61.3 of operating cash during the year ended December 31, 2018, compared to $22.1 used in 2017. Refer to note 4 for additional discussion on income taxes. • In the aggregate, the other combined certain assets and liabilities used $23.5 and $89.2 in 2018 and 2017, respectively. The decreased use of $65.7 in 2018 primarily due to lower payments related to restructuring and integration and the timing of payments related to VAT and deferred costs. These decreases were partially offset by non-cash changes in accruals for cash compensation plans and insurance. The most significant changes in adjustments to net income include the goodwill impairment and non-routine inventory charge. The goodwill impairment of $217.5 in 2018 compared to $3.1 asset impairment in 2017. The inventory charge of $74.5 in 2018 relates to the Company's focus on streamlining its product portfolio and harvesting inventory resulting in the increased non-cash inventory charge. Other significant items include depreciation and amortization expense and additional share-based compensation expense. Investing Activities. Net cash provided by investing activities was $34.4 for the year ended December 31, 2018 compared to net cash used in investing activities of $120.8 for the year ended December 31, 2017. The $155.2 change was primarily due to the monetization of the Company's investment in the company owned life insurance plans, utilization of short-term investments in Brazil for cash needs across the organization and a decrease in cash spent on capital expenditures. The maturities and purchases of investments primarily related to short-term investment activity in Brazil and for 2017 also include the Company's investment in Kony. The proceeds from the sale of assets primarily include cash from the sale of a building in North America for 2018 and divestitures of the legacy Diebold business in the U.K. and the ES businesses located in Mexico and Chile in 2017. The Company anticipates capital expenditures of approximately $80 in 2019 to be utilized for improvements to the Company's product line. Currently, the Company finances these investments primarily with funds provided by income retained in the business, borrowings under the Company's committed and uncommitted credit facilities, and operating and capital leasing arrangements. Financing Activities. Net cash provided by financing activities was $10.9 for the year ended December 31, 2018 compared to net cash used by financing activities of $63.7 for the year ended 2017, a change of $74.6. The increase was primarily due to an additional $650.0 in proceeds received from the Term Loan A-1 Facility and an increase in net borrowings of the Revolving Facility. The increase in borrowings were partially offset by $337.7 in debt repayments and higher cash distributions primarily related to the redemption of shares and cash compensation to Diebold Nixdorf AG minority shareholders of $377.2 compared to $17.6 in 2017. Refer to note 11 for details of the Company's cash flows related to debt borrowings and repayments. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Benefit Plans. The Company plans to make contributions to its retirement plans as well as benefits payments directly from the Company of approximately $50 for the year ended December 31, 2019. The Company anticipates reimbursement of approximately $13 for certain benefits paid from its trustee in 2019. Beyond 2019, minimum statutory funding requirements for the Company's U.S. pension plans may become more significant. The actual amounts required to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory actions related to pension funding obligations. The Company has adopted a pension investment policy designed to achieve an adequate funded status based on expected benefit payouts and to establish an asset allocation that will meet or exceed the return assumption while maintaining a prudent level of risk. The plan's target asset allocation adjusts based on the plan's funded status. As the funded status improves or declines, the debt security target allocation will increase and decrease, respectively. Management monitors assumptions used for our actuarial projections as well as any funding requirements for the plans. Payments due under the Company's other post-retirement benefit plans are not required to be funded in advance. Payments are made as medical costs are incurred by covered retirees and are principally dependent upon the future cost of retiree medical benefits under these plans. The Company expects the other post-retirement benefit plan payments to be approximately $1 in 2019. Refer to note 15 for further discussion of the Company's pension and other post-retirement benefit plans. Dividends. The Company paid dividends of $7.7, $30.6 and $64.6 in the years ended December 31, 2018, 2017 and 2016, respectively. Annualized dividends per share were $0.10, $0.40 and $0.96 for the years ended December 31, 2018, 2017 and 2016, respectively. In May 2018, the Company announced its decision to reallocate future dividend funds towards debt reduction and other capital resource needs. Contractual Obligations. The following table summarizes the Company’s approximate obligations and commitments to make future payments under contractual obligations as of December 31, 2018: (1) The amount available under the short-term uncommitted lines at December 31, 2018 was $28.0. Refer to note 11 for additional information. (2) Amounts represent estimated contractual interest payments on outstanding long-term debt and notes payable. Rates in effect as of December 31, 2018 are used for variable rate debt. (3) A portion of cash is restricted to fund the purchase of the remaining shares of Diebold Nixdorf AG. At December 31, 2018, the Company also maintained uncertain tax positions of $49.5, for which there is a high degree of uncertainty as to the expected timing of payments (refer to note 4). Refer to note 11 for additional information regarding the Company's debt obligations. Refer to note 17 for additional information regarding the Company's hedging and derivative instruments. Off-Balance Sheet Arrangements. The Company enters into various arrangements not recognized in the consolidated balance sheets that have or could have an effect on its financial condition, results of operations, liquidity, capital expenditures or capital resources. The principal off-balance sheet arrangements that the Company enters into are guarantees, operating leases (refer to note 9) and sales of finance receivables. The Company provides its global operations guarantees and standby letters of credit through various financial institutions to suppliers, customers, regulatory agencies and insurance providers. If the Company is not able to comply with its contractual obligations, the suppliers, regulatory agencies and insurance providers may draw on the pertinent bank (refer to note 17 ). The Company has sold finance receivables to financial institutions while continuing to service the receivables. The Company records these sales by removing finance receivables from the consolidated balance sheets and recording gains and losses in the consolidated statement of operations (refer to note 7). MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements. The consolidated financial statements of the Company are prepared in conformity with generally accepted accounting principles in the United States (U.S. GAAP). The preparation of the accompanying consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities and reported amounts of revenues and expenses. Such estimates include revenue recognition, the valuation of trade and financing receivables, inventories, goodwill, intangible assets, other long-lived assets, legal contingencies, guarantee obligations, and assumptions used in the calculation of income taxes, pension and post-retirement benefits and customer incentives, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors. Management monitors the economic conditions and other factors and will adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. The Company’s significant accounting policies are described in note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K. Management believes that, of its significant accounting policies, its policies concerning revenue recognition, allowances for credit losses, inventory reserves, goodwill, long-lived assets, taxes on income, contingencies and pensions and post-retirement benefits are the most critical because they are affected significantly by judgments, assumptions and estimates. Additional information regarding these policies is included below. Revenue Recognition. Revenue is measured based on consideration specified in a contract with a customer and excludes amounts collected on behalf of third parties. The amount of consideration can vary depending on discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items contained in the contract with the customer of which generally these variable consideration components represents minimal amount of net sales. The Company recognizes revenue when it satisfies a performance obligation by transferring control over a product or service to a customer. The Company's payment terms vary depending on the individual contracts and are generally fixed fee. The Company recognizes advance payments and billings in excess of revenue recognized as deferred revenue. In certain contracts where services are provided prior to billing, the Company recognizes a contract asset within trade receivables and other current assets. Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and that are collected by the Company from a customer are excluded from revenue. The Company recognizes shipping and handling fees billed when products are shipped or delivered to a customer and includes such amounts in net sales. Although infrequent, shipping and handling associated with outbound freight after control over a product has transferred to a customer is not a separate performance obligation, rather is accounted for as a fulfillment cost. Third-party freight payments are recorded in cost of sales. The Company includes a warranty in connection with certain contracts with customers, which are not considered to be separate performance obligations. The Company provides its customers a manufacturer’s warranty and records, at the time of the sale, a corresponding estimated liability for potential warranty costs. For additional information on product warranty refer to note 9. The Company also has extended warranty and service contracts available for its customers, which are recognized as separate performance obligations. Revenue is recognized on these contracts ratably as the Company has a stand-ready obligation to provide services when or as needed by the customer. This input method is the most accurate assessment of progress toward completion the Company can apply. Product revenue is recognized at the point in time that the customer obtains control of the product, which could be upon delivery or upon completion of installation services, depending on contract terms. The Company’s software licenses are functional in nature (the IP has significant stand-alone functionality); as such, the revenue recognition of distinct software license sales is at the point in time that the customer obtains control of the rights granted by the license. Professional services integrate the commercial solution with the customer's existing infrastructure and helps define the optimal user experience, improve business processes, refine existing staffing models and deploy technology to meet branch and store automation objectives. Revenue from professional services are recognized over time, because the customer simultaneously receives and consumes the benefits of the Company’s performance as the services are performed or when the Company’s performance creates an asset with no alternative use and the Company has an enforceable right to payment for performance completed to date. Generally revenue will be recognized using an input measure, typically costs incurred. The typical contract length for service is generally one year and is billed and paid in advance except for installations, among others. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Services may be sold separately or in bundled packages. For bundled packages, the Company accounts for individual services separately if they are distinct. A distinct service is separately identifiable from other items in the bundled package if a customer can benefit from it on its own or with other resources that are readily available to the customer. The consideration (including any discounts) is allocated between separate services or distinct obligations in a bundle based on their stand-alone selling prices. The stand-alone selling prices are determined based on the prices at which the Company separately sells the products or services. For items that are not sold separately, the Company estimates stand-alone selling prices using the cost plus expected margin approach. Revenue on service contracts is recognized ratably over time, generally using an input measure, as the customer simultaneously receives and consumes the benefits of the Company’s performance as the services are performed. In some circumstances, when global service supply chain services are not included in a term contract and rather billed as they occur, revenue on these billed work services are recognized at a point in time as transfer of control occurs. The following is a description of principal solutions offered within the Company's two main industry segments that generate the Company's revenue. Banking Products. Products for banking customers consist of cash recyclers and dispensers, intelligent deposit terminals, teller automation tools and kiosk technologies, as well as physical security solutions. The Company provides its banking customers front-end applications for consumer connection points and back-end platforms that manage channel transactions, operations and integration and facilitate omnichannel transactions, endpoint monitoring, remote asset management, customer marketing, merchandise management and analytics. These offerings include highly configurable, API enabled software that automates legacy banking transactions across channels. Services. The Company provides its banking customers product-related services which include proactive monitoring and rapid resolution of incidents through remote service capabilities or an on-site visit. First and second line maintenance, preventive maintenance and on-demand services keep the distributed assets of the Company's customers up and running through a standardized incident management process. Managed services and outsourcing consists of the end-to-end business processes, solution management, upgrades and transaction processing. The Company also provides a full array of cash management services, which optimizes the availability and cost of physical currency across the enterprise through efficient forecasting, inventory and replenishment processes. Retail Products. The retail product portfolio includes modular, integrated and mobile POS and SCO terminals that meet evolving automation and omnichannel requirements of consumers. Supplementing the POS system is a broad range of peripherals, including printers, scales and mobile scanners, as well as the cash management portfolio which offers a wide range of banknote and coin processing systems. Also in the portfolio, the Company provides SCO terminals and ordering kiosks which facilitate an efficient and user-friendly purchasing experience. The Company’s hybrid product line can alternate from an attended operator to self-checkout with the press of a button as traffic conditions warrant throughout the business day. The Company's platform software is installed within retail data centers to facilitate omnichannel transactions, endpoint monitoring, remote asset management, customer marketing, merchandise management and analytics. Services. The Company provides its retail customers product-related services which include on-demand services and professional services. Diebold Nixdorf AllConnect Services for retailers include maintenance and availability services to continuously improve retail self-service fleet availability and performance. These include: total implementation services to support both current and new store concepts; managed mobility services to centralize asset management and ensure effective, tailored mobile capability; monitoring and advanced analytics providing operational insights to support new growth opportunities; and store life-cycle management to proactively monitors store IT endpoints and enable improved management of internal and external suppliers and delivery organizations. Inventory Reserves. At each reporting period, the Company identifies and writes down its excess and obsolete inventories to net realizable value based on usage forecasts, order volume and inventory aging. With the development of new products, the Company also rationalizes its product offerings and will write-down discontinued product to the lower of cost or net realizable value. The Company’s significant accounting policies and inventories are described in notes 1 and 5. Acquisitions and Divestitures. Acquisitions are accounted for using the purchase method of accounting. This method requires the Company to record assets and liabilities of the business acquired at their estimated fair market values as of the acquisition date. Any excess cost of the acquisition over the fair value of the net assets acquired is recorded as goodwill. The Company generally uses valuation specialists to perform appraisals and assist in the determination of the fair values of the assets acquired and liabilities MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) assumed. These valuations require management to make estimates and assumptions that are critical in determining the fair values of the assets and liabilities. For all divestitures, the Company considers assets to be held for sale when management approves and commits to a formal plan to actively market the assets for sale at a price reasonable in relation to their estimated fair value, the assets are available for immediate sale in their present condition, an active program to locate a buyer and other actions required to complete the sale have been initiated, the sale of the assets is probable and expected to be completed within one year (or, if it is expected that others will impose conditions on the sale of the assets that will extend the period required to complete the sale, that a firm purchase commitment is probable within one year) and it is unlikely that significant changes will be made to the plan. Upon designation as held for sale, the Company records the assets at the lower of their carrying value or their estimated fair value, reduced for the cost to dispose of the assets, and ceases to record depreciation expense on the assets. Assets and liabilities are reclassified as held for sale in the period the held for sale criteria are met. The Company reports financial results for discontinued operations separately from continuing operations to distinguish the financial impact of a divestiture from ongoing operations. Discontinued operations reporting occurs only when the disposal of a component or a group of components of the Company represents a strategic shift that will have a major effect on the Company's operations and financial results. For those divestitures that qualify as discontinued operations, all comparative periods presented are reclassified in the consolidated balance sheet. Additionally, the results of operations of a discontinued operation are reclassified to income from discontinued operations, net of tax, for all periods presented. As of December 31, 2018, the Company had $81.5 and $33.2 of current assets and liabilities held for sale, respectively, primarily related to non-core businesses in Europe and the Americas. As of December 31, 2017, the Company had $2.1 of current assets held for sale primarily related to a building in North America. During the fourth quarter of 2015, the Company classified its NA ES business as held for sale which also met the discontinued operations criteria. The divestiture of its NA ES business closed on February 1, 2016. Accordingly, operating results and operating and investing cash flows for are presented as discontinued operations separate from the Company’s continuing operations for all periods presented. Goodwill. Goodwill is the cost in excess of the net assets of acquired businesses (refer to note 8). The Company tests all existing goodwill at least annually as of October 31 for impairment on a reporting unit basis. The Company tests for interim impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the carrying value of a reporting unit below its reported amount. Beginning with the second quarter of 2018, the Company’s reportable operating segments are based on the conclusion of the assessment on the following solutions: Eurasia Banking, Americas Banking and Retail with comparative periods reclassified for consistency. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount, the Company considers the following events and circumstances, among others, if applicable: (a) macroeconomic conditions such as general economic conditions, limitations on accessing capital or other developments in equity and credit markets; (b) industry and market considerations such as competition, multiples or metrics and changes in the market for the Company's products and services or regulatory and political environments; (c) cost factors such as raw materials, labor or other costs; (d) overall financial performance such as cash flows, actual and planned revenue and earnings compared with actual and projected results of relevant prior periods; (e) other relevant events such as changes in key personnel, strategy or customers; (f) changes in the composition of a reporting unit's assets or expected sales of all or a portion of a reporting unit; and (g) any sustained decrease in share price. If the Company's qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying value, or if management elects to perform a quantitative assessment of goodwill, an impairment test is used to identify potential goodwill impairment and measure the amount of any impairment loss to be recognized. The Company compares the fair value of each reporting unit with its carrying value and recognizes an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The fair value of the reporting units is determined based upon a combination of the income valuation and market approach in valuation methodology. The income approach uses discounted estimated future cash flows, whereas the market approach or guideline public company method utilizes market data of similar publicly traded companies. The fair value of the reporting unit is defined as the price that would be received to sell the net assets or transfer the net liabilities in an orderly transaction between market participants at the assessment date. The techniques used in the Company's qualitative assessment incorporate a number of assumptions that the Company believes to be reasonable and to reflect market conditions forecast at the assessment date. Assumptions in estimating future cash flows are subject to a high degree of judgment. The Company makes all efforts to forecast future cash flows as accurately as possible with the information available at the time the forecast is made. To this end, the Company evaluates the appropriateness of its assumptions as well as its overall forecasts by comparing projected results of upcoming years with actual results of preceding years and validating that differences therein are reasonable. Key assumptions, all of which are Level 3 inputs, relate to price trends, material costs, discount rate, customer demand and the long-term growth and foreign exchange rates. A number of benchmarks from independent industry and other economic publications were also used. Changes in assumptions and estimates after the MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) assessment date may lead to an outcome where impairment charges would be required in future periods. Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions. Long-Lived Assets. Impairment of long-lived assets is recognized when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized at that time to reduce the asset to the lower of its fair value or its net book value. The Company tests all existing indefinite-lived intangibles at least annually for impairment as of October 31. Taxes on Income. Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized for deductible temporary differences, operating loss carry-forwards and tax credits. Deferred tax liabilities are recognized for taxable temporary differences and undistributed earnings in certain jurisdictions. Deferred tax assets are reduced by a valuation allowance when, based upon the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Determination of a valuation allowance involves estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income and the impact of tax planning strategies. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company operates in numerous taxing jurisdictions and is subject to examination by various federal, state and foreign jurisdictions for various tax periods. Additionally, the Company has retained tax liabilities and the rights to tax refunds in connection with various acquisitions and divestitures of businesses. The Company’s income tax positions are based on research and interpretations of the income tax laws and rulings in each of the jurisdictions in which the Company does business. Due to the subjectivity of interpretations of laws and rulings in each jurisdiction, the differences and interplay in tax laws between those jurisdictions, as well as the inherent uncertainty in estimating the final resolution of complex tax audit matters, the Company’s estimates of income tax liabilities may differ from actual payments or assessments. The Company assesses its position with regard to tax exposures and records liabilities for these uncertain tax positions and any related interest and penalties, when the tax benefit is not more likely than not realizable. The Company has recorded an accrual that reflects the recognition and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. Additional future income tax expense or benefit may be recognized once the positions are effectively settled. At the end of each interim reporting period, the Company estimates the effective tax rate expected to apply to the full fiscal year. The estimated effective tax rate contemplates the expected jurisdiction where income is earned, as well as tax planning alternatives. Current and projected growth in income in higher tax jurisdictions may result in an increasing effective tax rate over time. If the actual results differ from estimates, the Company may adjust the effective tax rate in the interim period if such determination is made. Contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. There is no liability recorded for matters in which the liability is not probable and reasonably estimable. Attorneys in the Company's legal department monitor and manage all claims filed against the Company and review all pending investigations. Generally, the estimate of probable loss related to these matters is developed in consultation with internal and outside legal counsel representing the Company. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The Company attempts to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments, or fines, after appeals, differ from the estimates, the future results may be materially impacted. Adjustments to the initial estimates are recorded when a change in the estimate is identified. Pensions and Other Post-retirement Benefits. Annual net periodic expense and benefit liabilities under the Company’s defined benefit plans are determined on an actuarial basis. Assumptions used in the actuarial calculations have a significant impact on plan obligations and expense. Members of the management investment committee periodically review the actual experience compared with the more significant assumptions used and make adjustments to the assumptions, if warranted. The discount rate is determined by analyzing the average return of high-quality (i.e., AA-rated), fixed-income investments and the year-over-year comparison of certain widely used benchmark indices as of the measurement date. The expected long-term rate of return on plan assets is determined using the plans’ current asset allocation and their expected rates of return based on a geometric averaging over 20 years. The rate of compensation increase assumptions reflects the Company’s long-term actual experience and future and near-term outlook. Pension benefits are funded through deposits with trustees. Other post-retirement benefits are not funded and the Company’s policy is to pay these benefits as they become due. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) The following table represents assumed healthcare cost trend rates at December 31: The healthcare trend rates for the postemployment benefits plans in the U.S. are reviewed based upon the results of actual claims experience. The Company used initial healthcare cost trends of 6.5 percent and 6.8 percent in 2018 and 2017, respectively, with an ultimate trend rate of 5.0 percent reach in 2025. Assumed healthcare cost trend rates have a modest effect on the amounts reported for the healthcare plans. Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. A one-percentage-point change in assumed healthcare cost trend rates would have the following effects: During 2017, the Society of Actuaries released a new mortality improvement projection scale (MP-2017) resulting from recent studies measuring mortality rates for various groups of individuals. As of December 31, 2017, the Company adopted for the pension plan in the U.S. the use of the RP-2014 base mortality table modified to remove the post-2006 projections using the MP-2014 mortality improvement scale and replacing it with projections using the fully generational MP-2017 projection scale. For the plans outside the U.S., the mortality tables used are those either required or customary for local accounting and/or funding purposes. RECENTLY ISSUED ACCOUNTING GUIDANCE Refer to note 1 for information on recently issued accounting guidance. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) FORWARD-LOOKING STATEMENT DISCLOSURE In this annual report on Form 10-K, statements that are not reported financial results or other historical information are “forward-looking statements.” Forward-looking statements give current expectations or forecasts of future events and are not guarantees of future performance. These forward-looking statements include, but are not limited to, statements regarding the Company's expected future performance (including expected results of operations and financial guidance) future financial condition, operating results, strategy and plans. Forward-looking statements may be identified by the use of the words “anticipates,” “expects,” “intends,” “plans,” “will,” “believes,” “estimates,” “potential,” “target,” “predict,” “project,” “seek,” and variations thereof or similar expressions. These statements are used to identify forward-looking statements. These forward-looking statements reflect the current views of the Company with respect to future events and involve significant risks and uncertainties that could cause actual results to differ materially. Although the Company believes that these forward-looking statements are based upon reasonable assumptions regarding, among other things, the economy, its knowledge of its business, and key performance indicators that impact the Company, these forward-looking statements involve risks, uncertainties and other factors that may cause actual results to differ materially from those expressed in or implied by the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Some of the risks, uncertainties and other factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements include, but are not limited to: • the ultimate impact of the DPLTA with Diebold Nixdorf AG and the outcome of the appraisal proceedings initiated in connection with the implementation of the DPLTA; • the ultimate outcome and results of integrating the operations of the Company and Diebold Nixdorf AG; • the Company's ability to achieve benefits from its cost-reduction initiatives and other strategic initiatives, such as DN Now, including its planned restructuring actions, as well as its business process outsourcing initiative; • the Company's ability to comply with the covenants contained in the agreements governing its debt; • the ultimate outcome of the Company’s pricing, operating and tax strategies applied to Diebold Nixdorf AG and the ultimate ability to realize cost reductions and synergies; • the Company's ability to successfully operate its strategic alliances in China; • changes in political, economic or other factors such as currency exchange rates, inflation rates, recessionary or expansive trends, taxes and regulations and laws affecting the worldwide business in each of the Company's operations; • the Company’s reliance on suppliers and any potential disruption to the Company’s global supply chain; • the impact of market and economic conditions economic conditions, including any additional deterioration and disruption in the financial and service markets, including the bankruptcies, restructurings or consolidations of financial institutions, which could reduce our customer base and/or adversely affect our customers' ability to make capital expenditures, as well as adversely impact the availability and cost of credit; • interest rate and foreign currency exchange rate fluctuations, including the impact of possible currency devaluations in countries experiencing high inflation rates; • the acceptance of the Company's product and technology introductions in the marketplace; • competitive pressures, including pricing pressures and technological developments; • changes in the Company's relationships with customers, suppliers, distributors and/or partners in its business ventures; • the effect of legislative and regulatory actions in the U.S. and internationally and the Company’s ability to comply with government regulations; • the impact of a security breach or operational failure on the Company's business; • the Company's ability to successfully integrate other acquisitions into its operations; • the Company's success in divesting, reorganizing or exiting non-core and/or non-accretive businesses; • the Company's ability to maintain effective internal controls; • changes in the Company's intention to further repatriate cash and cash equivalents and short-term investments residing in international tax jurisdictions, which could negatively impact foreign and domestic taxes; • unanticipated litigation, claims or assessments, as well as the outcome/impact of any current/pending litigation, claims or assessments; • the investment performance of the Company's pension plan assets, which could require the Company to increase its pension contributions, and significant changes in healthcare costs, including those that may result from government action; and • the amount and timing of repurchases of the Company's common shares, if any. Except to the extent required by applicable law or regulation, the Company undertakes no obligation to update these forward-looking statements to reflect future events or circumstances or to reflect the occurrence of unanticipated events.

<s>[INST] During 2018, Diebold Nixdorf: Hired Gerrard Schmid to serve as president and chief executive officer. Named Jeffrey Rutherford as interim senior vice president, chief financial officer, and subsequently appointed him to this role on a fulltime basis. Added Bruce Besanko and Ellen Costello to the Board of Directors Launched the DN Now transformation program which is comprised of multiple work streams designed to relentlessly focus on our customers and improve operational excellence. This program is targeting gross annualized savings of approximately $400 through 2021. Raised $650.0 through a new term loan and revised the Company’s credit facility covenants. This enhanced liquidity provides financial flexibility, facilitates acquiring the remaining shares of Diebold Nixdorf AG and supports DN Now initiatives. Partnered with Mastercard® on key technology and services agreements to strengthen the Company's Connected Commerce offerings and further bridge physical and digital transactions. Ranked as one of the Top 10 Technology Companies on the 2018 IDC Financial Insights FinTech Rankings. Won Windows 10 ATM product upgrades with several North America financial institutions, including an agreement with a regional U.S. bank for more than 500 DN Vynamic software licenses and a new managed services agreement. Enabled the first integrated, digital kiosk in the Middle East in partnership with Emirates NBD. Entered an agreement with Banco Bolivariano in Ecuador to implement the DN Vynamic Mobile Banking suite. Was identified as the largest manufacturer of ATMs by Retail Banking Research's report "Global ATM Market and Forecasts to 2023." Secured a global frame agreement, including North America, to provide kiosks and services for one of the world's largest quickservice restaurants. Signed a $70.0, multiyear services contract covering about 1,000 Marks & Spencer stores in Western Europe. Secured a multiyear managed services agreement valued at $68.0 for new POS devices and related software at a leading European home improvement retailer. OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10K. For additional information regarding general information regarding the Company, its business, strategy, competitors and operations, refer to Item 1 of this annual report on Form 10K. Business Drivers The business drivers of the Company's future performance include, but are not limited to: Demand for services on distributed IT assets such as ATMs, POS and SCO, including managed services and professional services; Timing of system upgrades and/or replacement cycles for ATMs, POS and SCO; Demand for software products and professional services; Demand for security products and services for the financial, retail and commercial sectors; Demand for innovative technology in connection with the Company's Connected Commerce strategy; Integration of sales force, business processes, procurement, and internal IT systems; and Realization of cost reductions, which leverage the Company's global scale, reduce overlap and improve operating efficiencies. The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes that appear elsewhere in this annual report on Form 10K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2018 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) RESULTS OF OPERATIONS 2018 comparison with 2017 Net Sales The following table represents information regarding our net sales for the years ended December 31: (1) The Company calculates constant currency by translating the prioryear period results at the current year exchange rate. Net sales decreased $30.7 or 0.7 percent including a net favorable currency impact of $55.4 primarily related to the euro, partially offset by the Brazil real. Additionally, prior year net sales [/INST] Negative. </s>

DIEBOLD NIXDORF, Inc

2020-02-26

2019-12-31

ITEM 7: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Significant Highlights During 2019, Diebold Nixdorf: • Successfully amended and extended the vast majority of the Company's $787.0 revolving credit facility and term A loans from December 23, 2020 to April 30, 2022 • Completed the merger squeeze-out of Diebold Nixdorf AG, the Company's German public subsidiary, which has streamlined and simplified the Company's corporate structure • Elected four new independent members to the Company's Board of Directors, continuing to refresh the board to align with the Company's strategy and opportunities • Won a three-year, multi-million dollar agreement with a European DIY retailer to refresh the end-to-end customer checkout experience in more than 600 stores spanning 12 countries • Executed a five-year agreement valued at more than $60.0 with one of the world’s largest fuel and convenience retailers to deploy a new, centralized card acceptance platform. The contract includes software licenses, professional and maintenance services for stores in 10 European markets • Won Windows 10 ATM product upgrades with several financial institutions, including an agreement with 1) KeyBank to digitally transform more than 1,400 self-service devices with DN Vynamic™ Software, and 2) a major Belgian bank to upgrade more than 2,400 devices and cash recyclers to Windows 10, leveraging DN AllConnect ServicesSM and the DN Vynamic software suite • Launched the DN Series™ family of self-service solutions - designed to enable multiple capabilities that support financial institutions' efforts to transform their branch environment, improve performance and differentiate their user experience • Secured a $17.0 win at Banco Itau Unibanco in Brazil to transform its branch network and increase automation via cash recyclers, full-function ATMs and maintenance services • Won a new frame agreement with Commerzbank in Germany for several hundred ATMs with a multi-year software and services maintenance contract • Benefited from solid growth in SCO demand from a number of European customers, including a $7.0 contract with U.K.-based retailer, Co-Op, for more than 400 self-checkout terminals and related services • Renewed a multi-year managed services contract with H&M, a global fashion retailer, providing an integrated solution supporting its global stores with an all-in-one POS system, DN Vynamic Software and DN AllConnect Services • Reached an agreement with Dave & Buster’s, a leading U.S.-based dining and entertainment chain, to provide a self-service solution at locations nationwide built around Diebold Nixdorf's newest K-two interactive kiosk • Signed a multi-million dollar global agreement with Citibank for Vynamic software and DN Series ATMs • Won a multi-year ATM-as-a-Service agreement in Belgium with JoFiCo to update and maintain approximately 1,560 ATMs • Selected by a top U.S. financial institution to provide approximately 20,000 Vynamic software marketing licenses and associated services • Secured a multi-million dollar contract with Swisslos for 5,000 all-in-one POS terminals • Signed a comprehensive solutions contract, valued at nearly $10.0, with one of the largest banks in the Philippines to upgrade its ATM fleet to Windows 10 OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10-K. For additional information regarding general information regarding the Company, its business, strategy, competitors and operations, refer to Item 1 of this annual report on Form 10-K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Business Drivers The business drivers of the Company's future performance include, but are not limited to: • Demand for services on distributed IT assets such as ATMs, POS and SCO, including managed services and professional services • Timing of system upgrades and/or replacement cycles for ATMs, POS and SCO • Demand for software products and professional services • Demand for security products and services for the financial, retail and commercial sectors • Demand for innovative technology in connection with the Company's Connected Commerce strategy • Integration of sales force, business processes, procurement, and internal IT systems • Execution and risk management associated with DN Now transformational activities • Realization of cost reductions, which leverage the Company's global scale, reduce overlap and improve operating efficiencies DN Now Transformation Activities Commensurate with its strategy, the Company is executing its multi-year transformation program called DN Now to relentlessly focus on its customers while improving operational excellence. Key activities include: • Transitioning to a streamlined and customer-centric operating model • Implementing a services modernization plan which focuses on upgrading certain customer touchpoints, automating incident reporting and response, and standardizing service offerings and internal processes • Streamlining the product range of ATMs and manufacturing footprint • Improving working capital management through greater focus and efficiency of payables, receivables and inventory • Reducing administrative expenses, including finance, IT and real estate • Increasing sales productivity through improved coverage and compensation arrangements • Standardizing back-office processes to automate reporting and better manage risks • Optimizing the portfolio of businesses to improve overall profitability These work streams are designed to improve the Company’s profitability and net leverage ratio while establishing a foundation for future growth. The gross annualized savings target for DN Now is approximately $440 through 2021, of which approximately $130 is anticipated to be realized during 2020. In order to achieve these savings, the Company has and will continue to restructure the workforce globally, integrate and optimize systems and processes, transition workloads to lower cost locations, renegotiate and consolidate supplier agreements and streamline real estate holdings. By executing on these and other operational improvement activities, the Company expects to increase customer intimacy and satisfaction, while providing career enrichment opportunities for employees and enhancing value for shareholders. In 2019, the Company achieved approximately $175 in annualized gross run rate savings. The cost to achieve these savings was approximately $115 and was largely due to restructuring and the implementation of DN Now transformational programs. The following discussion should be read in conjunction with the consolidated financial statements and the accompanying notes that appear elsewhere in this annual report on Form 10-K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) RESULTS OF OPERATIONS 2019 comparison with 2018 Net Sales The following table represents information regarding our net sales for the years ended December 31: (1) The Company calculates constant currency by translating the prior-year period results at the current year exchange rate. Net sales decreased $169.9 or 3.7 percent including a net unfavorable currency impact of $151.0 primarily related to the euro and Brazil real. The following results include the impact of foreign currency: Segments • Eurasia Banking net sales decreased $150.4, including a net unfavorable currency impact of $79.3 related primarily to the euro and divestitures of $30.4. Excluding currency and the impact of divestitures, net sales decreased $40.7 primarily due to declining low-margin services solutions, including a low margin maintenance contract roll-off in India, combined with the fewer product roll outs in various countries and under-performance of a non-core business, partially offset by higher product volume in Germany, the Middle East and South Africa related to unit replacements from Windows 10 upgrades. • Americas Banking net sales increased $88.4, including a net unfavorable currency impact of $12.3 primarily related to the Brazil real. Excluding currency and a small divestiture, net sales increased $105.6 driven primarily by product and installation sales in Canada, Brazil, Mexico and the U.S. regional customers related to unit replacements from Windows 10 upgrades, in addition to increased software license volume in the U.S. Partially offsetting these increases, services revenue declined from lower maintenance contract volume and billed work activity in the U.S. • Retail net sales decreased $107.9, including a net unfavorable currency impact of $59.4 mostly related to the euro and divestitures of $18.5. Excluding currency and the impact of divestitures, net sales decreased $30.0 primarily from lower POS installations and reduced low-margin non-core business, partially offset by incremental SCO volume and new service contracts in the U.K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Services gross margin increased 3.6 percent and was favorably impacted by lower restructuring charges of $9.8 and lower non-routine charges of $13.8. Excluding restructuring and non-routine charges, services gross margin increased 2.9 percent as services margin increased in the Eurasia banking segment related to the favorable impact of the services modernization initiatives and favorable mix of higher margin installation activity. The prior year was unfavorably impacted by one-time banking services cost in Brazil. Product gross margin increased 6.2 percent and was favorably impacted by lower restructuring charges of $9.1 and lower non-routine charges of $51.2, primarily related to lower purchase accounting amortization and inventory charges. Excluding the impact of restructuring and non-routine charges, products gross margin increased 2.8 percent. Increased margin was primarily due to improved mix and higher volume from Canada, Brazil and U.S. regional customers as well as higher margin Windows 10 upgrades in certain areas of Europe. These improvements are aligned with the Company's focus on higher margin product mix throughout the geographies as well as improved supply chain management and lower expedited freight costs in the Americas. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: N/M = Not Meaningful Selling and administrative expense increased $15.3. Excluding incremental restructuring of $4.0, increased non-routine charges of $20.6 and a favorable currency impact of $20.3, selling and administrative expense increased $11.0 primarily attributable to an increase in annual incentive plan cost and an unfavorable impact of the mark-to-market adjustment of the legacy Wincor Nixdorf stock option program partially offset by the cost reduction initiatives tied to the DN Now program. Non-routine cost in selling and administrative expenses were $174.1 and $153.5 in 2019 and 2018, respectively. The components of the non-routine expenses consisted of increased DN Now transformation expense, a one-time non-cash item in Brazil and $5.6 from the German real estate tax incurred related to the squeeze out. These increases were partially offset by lower integration expense and purchase accounting adjustments. Selling and administrative expense included restructuring charges of $37.4 and $33.4 in 2019 and 2018, respectively, primarily due to the workforce alignment actions under the DN Now plan. Research, development and engineering expense in 2019 decreased $10.3 including a net favorable currency impact of $5.5. Excluding the impact of currency, research, development and engineering expense decreased $4.8 due primarily to lower headcount tied to the Company’s DN Now restructuring program and prior year investment in the DN Series product line, partially offset by increased software development cost. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) The Company recorded impairment charges of $30.2 in 2019 related primarily related to capitalized software in addition to assets from a non-core business transferred to assets held for sale. A goodwill impairment charge of $180.2 was recorded in the second and third quarters of 2018. The loss on sales of assets, net in 2019 included the divestiture of the Venezuela business and losses from the divestiture and liquidation of non-core businesses in Eurasia offset by a gain on sale of assets related to the Kony transaction. The gain on sale of assets, net in 2018 was primarily related to a gain on sale of buildings in North America, the liquidation of the Barbados operating entity, a gain related to a sale of a maintenance contract in Brazil and a China investment. Operating Loss The following table represents information regarding our operating loss for the years ended December 31: The operating loss decreased compared to the prior year primarily due to product and services gross margin improvements as well as higher impairment charges in 2018, partially offset by higher selling and administrative costs and loss on sale of assets. Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: Interest expense increased $48.0 due to an additional $650.0 Term Loan A-1 Facility debt with higher incremental interest rates and related fee amortization. Foreign exchange loss, net, increased $2.6 and was unfavorably impacted by transactions related to Eurasia in addition to incremental loss associated with the collapse of the Barbados financing structure related to the Acquisition. Net Loss The following table represents information regarding our net loss for the years ended December 31: The loss before taxes and net loss decreased primarily due to the reasons described above. Net loss was also impacted by the change in the income tax expense. The effective tax rate on the loss for 2019 was (51.0) percent and is primarily due to the U.S. taxed foreign income, including global intangible low-taxed income (GILTI), valuation allowances recorded on certain foreign and state jurisdictions and U.S. foreign tax credits that management concluded do not meet the more likely than not criteria for realization and the tax effects related to the Barbados structure collapse. The Company’s collapse of its Barbados structure to meet the covenant requirements under its credit agreement resulted in a net tax expense of $46.2 inclusive of the offsetting valuation allowance release relating to the Company’s nondeductible interest expense that was carried forward from December 31, 2018. No taxes are currently payable related to the Barbados structure collapse. The U.S. Tax Cuts and Jobs Act (Tax Act) was enacted on December 22, 2017. The Tax Act reduced the U.S. federal corporate income tax rate from 35 percent to 21 percent, required companies to pay a one-time transition tax on earnings for certain foreign MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) subsidiaries and created new taxes on certain foreign sourced earnings. Due to the complexities involved in accounting for the enacted Tax Act, the Company applied the guidance in Staff Accounting Bulletin (SAB) 118 and a reasonable estimate of the impacts was included for the year ended December 31, 2017. At December 31, 2017, the Company recorded a non-cash charge to tax expense of $81.7 of which $45.1 represented the reduction to deferred income taxes for the income tax rate change and $36.6 related to the one-time transition tax on deferred foreign earnings. As of December 31, 2018, the Company completed the accounting as required under SAB 118 for items previously considered provisional. While the Company was able to make an estimate of the transition tax for 2017, it continued to gather additional information to more precisely compute the amount reported on its 2017 U.S. Federal tax return which was filed in the fourth quarter of 2018. Additionally, the Company was affected by other analyses related to the Tax Act. Transition tax was $41.1 greater than the Company’s initial estimate and was included in tax expense for 2018. Likewise, while the Company was able to make an estimate of the impact of the reduction to the corporate tax rate, in 2018 the Company recorded additional tax benefits of $2.5 as a result of adjustments made to federal temporary differences including a pension contribution made in 2018 that was deductible for 2017 at the higher 35 percent federal tax rate. In 2018, the Company also recorded a tax benefit of $8.5 related to the one-time transition tax for a fiscal year foreign subsidiary. The Company will continue to analyze the full effects of the Tax Act on its financial statements as additional guidance is issued and interpretations evolve. The effective tax rate on the loss for 2018 was (7.8) percent on the overall loss from operations and was primarily driven by the provisional impacts of the Tax Act. In addition to the impact of the Tax Act, the overall effective tax rate is impacted by the jurisdictional income (loss) and varying respective statutory rates which is reflected in the foreign tax rate differential caption of the rate reconciliation. Segment Net Sales and Operating Profit Summary The following tables represent information regarding the Company's net sales and operating profit by reporting segment: Eurasia Banking net sales decreased $150.4, including a net unfavorable currency impact of $79.3 related primarily to the euro and divestitures of $30.4. Excluding currency and the impact of divestitures, net sales decreased $40.8 primarily due to declining low-margin services solutions, including a low margin maintenance contract roll-off in India, combined with the lower product roll outs in various countries and under-performance of a non-core business, partially offset by higher product volume in Germany, the Middle East and South Africa related to unit replacements from Windows 10 upgrades. Segment operating profit increased $19.2, compared to the prior year, including a net unfavorable currency impact of $10.4 due in part to higher gross margins on services and products. The increase in services margin was primarily attributable to the services modernization program which benefited numerous countries in Europe and Asia in addition to a favorable solutions mix, while products margin also increased from DN Now initiatives as well as favorable country and product mix. Additionally, segment operating profit benefited from lower operating expenses tied to DN Now initiatives, restructuring programs and the phase out of non-profitable service contracts. Segment operating profit margin increased 2.0 percent despite lower net sales, as a result of higher services and products gross margin and lower operating expense primarily attributable to DN Now initiatives. N/M = Not Meaningful Americas Banking net sales increased $88.4 including a net unfavorable currency impact of $12.3 primarily related to the Brazil real. Excluding currency and a small divestiture, net sales increased $105.6 driven primarily by product and installation sales in Canada, Brazil, Mexico and the U.S. regional customers related to unit replacements from Windows 10 upgrades, in addition to increased software license volume in the U.S. Partially offsetting these increases, services revenue declined from lower maintenance contract volume and billed work activity in the U.S. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Segment operating profit increased $102.5 mostly from increased DN Now initiatives favorably impacting both cost of sales and operating expense. Gross profit was favorably impacted by large product refresh projects in Canada and favorable mix in the U.S., Brazil and Latin America. Additionally, the Company made improvements to supply chain management resulting in lower expedited freight costs. Segment operating profit in 2018 was unfavorably impacted by one-time banking services cost in Brazil. Segment operating profit margin increased 6.4 percent primarily as a result of higher product gross margin, in addition to lower cost related to the DN Now initiatives. Retail net sales decreased $107.9, including a net unfavorable currency impact of $59.4 mostly related to the euro and divestitures of $18.5. Excluding currency and the impact of divestitures, net sales decreased $30.0 primarily from lower POS installations, partially offset by incremental SCO volume and new service contracts in the U.K. Segment operating profit increased $11.2 compared to the prior year including a net unfavorable currency impact of $3.0. Excluding the impact of currency, segment operating profit increased $14.2 primarily from lower services cost and operating expenses tied to DN Now initiatives as well as a favorable service mix related to maintenance and support activities in Europe. Segment operating profit margin increased 1.3 percent in 2019 primarily from lower costs and expenses tied to DN Now initiatives as well as a favorable service mix. 2018 comparison with 2017 Net Sales The following table represents information regarding our net sales for the years ended December 31: (1) The Company calculates constant currency by translating the prior-year period results at the current year exchange rate. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Net sales decreased $30.7 or 0.7 percent, including a net favorable currency impact of $55.4 primarily related to the euro, partially offset by the Brazil real. Additionally, prior year net sales were adversely impacted $30.4 related to deferred revenue purchase accounting adjustments (Deferred Revenue Adjustments). The following results include the impact of foreign currency and purchase accounting adjustments: Segments • Eurasia Banking net sales decreased $103.2, including a net favorable currency impact of $41.3 mainly related to the euro. Prior year net sales were adversely impacted $18.3, including a net unfavorable currency impact of $1.4, related to Deferred Revenue Adjustments. Excluding currency and Deferred Revenue Adjustments, net sales decreased $164.2 due to lower product volume related to fewer product deployments and projects, particularly in Thailand, Turkey, Indonesia, the Middle East and Australia. In addition, services in India decreased as a result of a low-margin maintenance contract roll off. Net sales declined from the Company’s strategic decision to reduce its product and services portfolio in India and China as market conditions became less favorable. These decreases were partially offset by increased unit replacements in Germany related to Windows 10 migrations. • Americas Banking net sales decreased $9.9, including a net unfavorable currency impact of $20.6 related to the Brazil real. Excluding currency, net sales increased $10.7 from higher software license volume in Brazil, professional services volume in North America and higher product volume, particularly in Mexico, Canada and Ecuador. These increases were partially offset by lower product volume in the U.S. as well as low-profit maintenance contract base roll offs of two customers in North America and $4.1 of lower electronic security revenue in Chile due to the business divestiture in September 2017. • Retail net sales increased $82.4, including a net favorable currency impact of $34.7 mainly related to the euro. Prior year net sales were adversely impacted $12.1, including a net unfavorable currency impact of $1.0, related to Deferred Revenue Adjustments. Excluding currency and Deferred Revenue Adjustments, net sales increased $34.6 due to a large North America kiosk project as well as higher POS activity in Central Eastern Europe, the U.K, France and Spain. These increases were partially offset by lower product volume from the Eurasia non-core businesses and large prior year non-recurring POS and kiosk activity in Germany for multiple customers as well as lower lottery equipment volume in Brazil. Gross Profit The following table represents information regarding our gross profit for the years ended December 31: Services gross margin decreased 1.5 percent, including higher non routine charges of $10.9 primarily related to a spare parts inventory provision of $24.5 and other charges of $1.6 while the prior year was adversely impacted by Deferred Revenue Adjustments of $15.2. Restructuring was $9.5 lower compared to the prior year. Excluding non-routine and restructuring expenses, services gross margin decreased 1.4 percent due in part to higher retail services cost in the Eurasia non-core businesses and higher one-time banking services cost in Brazil in the second quarter of 2018. Additionally, an unfavorable customer mix on professional services volume in Eurasia drove lower margin in the retail segment as well as an unfavorable service customer mix in the Eurasia banking segment and higher services cost in China and Indonesia. These decreases were partially offset by a large, low-margin maintenance contract roll off in India. Product gross margin decreased 2.9 percent, including slightly lower non routine charges of $0.8, primarily from reduced Purchase Accounting Adjustments of $36.4, related to amortization and prior-year Deferred Revenue Adjustments and a benefit from the Brazil indirect tax accrual reversal of $9.0, in addition to lower integration of $0.6 and legal and consulting expense of $0.6, partially offset by higher inventory provision charges of $45.8. Restructuring expense increased $8.9 compared to the prior year. Excluding non-routine and restructuring expenses, product gross margin decreased 2.2 percent, primarily from an unfavorable banking customer mix in the Americas as well as expedited freight cost from supply chain delays in the first half of 2018. Additionally, the MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) retail segment was impacted by an unfavorable customer mix in Brazil, related to license volume, and increased cost and unfavorable customer mix in Eurasia. These decreases were partially offset by increased gross margin in the Eurasia banking segment primarily from a favorable customer mix in various countries, particularly in Germany, Thailand and the Middle East. Operating Expenses The following table represents information regarding our operating expenses for the years ended December 31: N/M = Not Meaningful Selling and administrative expense in 2018 decreased $40.2 including lower non-routine charges of $22.0 and higher restructuring of $12.1. Excluding the impact of restructuring and non-routine charges and a net unfavorable currency impact of $9.6, due primarily to the euro, selling and administrative expense was lower by $39.8, mostly from cost reduction initiatives across the Company related to DN Now as well as an increased benefit from the mark-to-market adjustment of the legacy Wincor Nixdorf stock option program of $3.4, partially offset by the retail segment from increased investment in the North America retail sales organization. Non-routine cost in selling and administrative expenses were $153.4 and $175.4 in 2018 and 2017, respectively. The components of the non-routine expenses in 2018 pertained to purchase accounting adjustments of $89.1 related to intangible asset amortization, integration cost totaling $43.4, legal and consulting cost of $18.3 and executive severance of $2.7. Selling and administrative expense included restructuring charges of $33.4 and $21.3 in 2018 and 2017, respectively, primarily due to the workforce alignment actions under the DN Now plan. Research, development and engineering expense increased $1.9 due to higher restructuring cost of $4.1 and an unfavorable currency impact of $4.4, primarily related to the euro, partially offset by lower non-routine expense of $0.3. Excluding restructuring and the impact of currency, expense was down $6.3 mostly from DN Now initiatives and lower associate related expense. As a result of certain impairment triggering events, the Company performed an impairment test of goodwill for its four reporting units during the third quarter of 2018. Based on the results of the impairment testing, the Company recorded a non-cash goodwill impairment loss of $109.5 related to the Eurasia Banking, EMEA Retail and Rest of World Retail reporting units during 2018. During the second quarter of 2018, the Company performed an impairment test of goodwill for all of its LoB reporting units due to the change in its reportable operating segments which resulted in a $70.7 non-cash impairment loss. The year ended December 31, 2018 recorded impairment of $180.2, related to the impairment of goodwill in the second and third quarters, compared to $3.1 in the same prior year period related to information technology transformation and integration activities. The gain on sale of assets in 2018 was primarily related to a gain on sale of buildings in North America of $4.8, the liquidation of the Barbados operating entity of $3.3 and a gain related to a sale of a maintenance contract in Brazil and a certain China investment. This gain on sale of assets was partially offset by the loss pertaining to a settlement of certain matters related to an Americas divestiture in the second quarter of 2018. Operating Loss The following table represents information regarding our operating profit (loss) for the years ended December 31: N/M = Not Meaningful The operating loss increased, compared to the prior year, mostly due to higher non-routine expense, including the non-cash goodwill impairment, and incremental restructuring expense. Excluding non-routine and restructuring expense, operating loss increased $57.9 from lower gross profit in all segments, partially offset by lower selling and administrative expense attributable to DN Now initiatives. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Other Income (Expense) The following table represents information regarding our other income (expense) for the years ended December 31: N/M = Not Meaningful Interest income in 2018 decreased, primarily as a result of overall lower average balances as well as lower U.S. market returns on nonqualified plans and repatriation of cash in Brazil and EMEA. Interest expense was higher compared to the prior year due to higher domestic interest rates and the additional $650.0 of Term Loan A-1 Facility debt incurred in 2018 with higher incremental interest rates and related fee amortization. Miscellaneous, net in 2018 was unfavorably impacted by higher cost and lower benefits associated with the company owned life insurance. Income (Loss), Net of Tax The following table represents information regarding our income (loss), net of tax, for the years ended December 31: N/M = Not Meaningful The loss before taxes and net loss increased primarily due to the reasons described above. Net loss was also impacted by the change in the income tax expense. The effective tax rate for 2018 was (7.8) percent and is primarily due to a goodwill impairment charge, the Tax Act, valuation allowances on certain foreign and state jurisdictions, foreign tax credits and the higher interest expense burden resulting from the debt restructuring. More specifically, the expense on the loss reflects the reduction of the U.S. federal corporate income tax rate from 35 percent to 21 percent, refinement of the transition tax under SAB 118, a goodwill impairment charge, which for tax purposes is primarily nondeductible and the business interest deduction limitation. As a result of the Company’s debt restructuring activity during the year, a full valuation allowance was required on the current year nondeductible business interest expense. In addition, the overall effective tax rate is impacted by the jurisdictional income (loss) and varying respective statutory rates. The effective tax rate for 2017 was (14.7) percent on the overall loss from continuing operations. The U.S. enacted the Tax Act, which was signed into law on December 22, 2017. The Tax Act changed many aspects of U.S. corporate income taxation and included a reduction of the corporate income tax rate from 35 percent to 21 percent, implementation of a territorial tax system and imposition of a tax on deemed repatriated earnings of foreign subsidiaries. The resulting impact to the Company was an estimated $45.1 reduction to deferred income taxes for the income tax rate change and an estimated one-time non-cash charge of $36.6 related to deferred foreign earnings. Due to the complexities involved in accounting for the recently enacted Tax Act, the SAB 118 requires that the Company include in its financial statements the reasonable estimate of the impact of the Tax Act on earnings to the extent such reasonable estimate has been determined. The Company recorded a reasonable estimate of such effects, the net one-time charge related to the Tax Act may differ, possibly materially, due to, among other things, further refinement of its calculations, changes in interpretations and assumptions, additional guidance that may be issued by the U.S. Government, and actions and related accounting policy decisions the Company may take as a result of the Tax Act. The Company completed its analysis over a one-year measurement period ending December 31, 2018 and any adjustments during this measurement period were included in net loss from continuing operations as an adjustment to income tax expense in the reporting period when such adjustments are determined. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Segment Net Sales and Operating Profit Summary The following tables represent information regarding our revenue and operating profit by reporting segment for the years ended December 31: Eurasia Banking net sales decreased $103.2,including a net favorable currency impact of $41.3 mainly related to the euro. Prior year net sales were adversely impacted $18.3, including a net unfavorable currency impact of $1.4, related to Deferred Revenue Adjustments. Excluding currency and Deferred Revenue Adjustments, net sales decreased $164.2 due to lower product volume related to fewer product deployments and projects, particularly in Thailand, Turkey, Indonesia, the Middle East and Australia. In addition, services in India decreased as a result of a low-margin maintenance contract roll off. In addition, net sales declined from the Company’s strategic decision to reduce its product and services portfolio in India and China as market conditions became less favorable. These decreases were partially offset by increased unit replacements in Germany related to Windows 10 migrations. Segment operating profit increased $23.3, compared to the prior year, including a net favorable currency impact of $3.6. Excluding the impact of currency, operating profit increased $19.7 mostly from lower operating expenses tied to the DN Now plan and increased product gross profit related to higher margin pull through on a favorable customer mix, particularly in Germany, Thailand and the Middle East. These increases were partially offset by lower services revenue and associated profit in various Asia Pacific countries as well as higher services cost in China and Indonesia in addition to lower margin pull through on software revenue attributable to an unfavorable customer mix and higher cost in various countries. Segment operating profit margin increased in 2018, primarily as a result of lower operating expense related to the DN Now plan, as well as higher product gross profit, partially offset by lower services and software gross profit. Americas Banking net sales decreased $9.9, including a net unfavorable currency impact of $20.6 related to the Brazil real. Excluding currency, net sales increased $10.7 from higher software license volume in Brazil, professional services volume in North America and higher product volume, particularly in Mexico, Canada and Ecuador. These increases were partially offset by lower product volume in the U.S. as well as low-profit maintenance contract base roll offs of two customers in North America and $4.1 lower electronic security revenue in Chile due to the business divestiture in September 2017. Segment operating profit decreased $50.9, compared to the prior year including a net favorable currency impact of $0.5. Excluding the impact of currency, operating profit decreased $51.4, adversely impacted by one-time services cost in Brazil from the second quarter of 2018. Additionally, product gross profit decreased mostly from higher freight cost, primarily related to supply chain delays in the first half of 2018 in North America and Mexico as well as an unfavorable customer mix in Mexico. Partially offsetting these decreases, selling and administrative expense was lower from cost reduction initiatives related to the DN Now plan and the Company’s annual incentive program as well as higher software gross profit from increased professional services activity in North America. Segment operating profit margin decreased in 2018, primarily as a result of higher freight and one time services cost in the first three quarters of 2018, partially offset by lower selling and administrative expense. Retail net sales increased $82.4, including a net favorable currency impact of $34.7 mainly related to the euro. Prior year net sales were adversely impacted $12.1, including a net unfavorable currency impact of $1.0, related to Deferred Revenue Adjustments. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Excluding currency and Deferred Revenue Adjustments, net sales increased $34.6 due to a large North America kiosk project as well as higher POS activity in Central Eastern Europe, the U.K, France and Spain. These increases were partially offset by lower product volume from the Eurasia non-core businesses and large prior year non-recurring POS and kiosk activity in Germany for multiple customers as well as lower lottery equipment volume in Brazil. Segment operating profit decreased $40.8 compared to the prior-year including a $2.6 net favorable currency impact. Excluding currency, Retail operating profit decreased $43.4 primarily due to the under performance from the Eurasia non-core businesses in addition to low-margin service and product revenue unfavorably impacting gross profit in various countries in Eurasia. The current year was also unfavorably impacted by higher selling and administrative expense from developing the North America retail sales organization. Segment operating profit margin decreased in 2018, primarily as a result of the under performance of the non-core businesses and an unfavorable customer mix driving lower gross margin on higher revenue in addition to increased operating expense. Refer to note 20 for further details of segment revenue and operating profit. LIQUIDITY AND CAPITAL RESOURCES Capital resources are obtained from income retained in the business, borrowings under the Company’s senior notes, committed and uncommitted credit facilities and operating and capital leasing arrangements. Management expects that the Company’s capital resources will be sufficient to finance planned working capital needs, R&D activities, investments in facilities or equipment, pension contributions, and any repurchases of the Company’s common shares for at least the next 12 months. The Company had $3.6 and $105.3 of restricted cash at December 31, 2019 and 2018. At December 31, 2019, $286.2 or 98.4 percent of the Company’s cash, cash equivalents and restricted cash and short-term investments reside in international tax jurisdictions. Repatriation of certain international held funds could be negatively impacted by potential payments for certain foreign taxes. The Company has earnings in certain jurisdictions available for repatriation of $1,488.0 with no additional tax expense primarily as a result of the Tax Act. The Company has made acquisitions in the past and may make acquisitions in the future. Part of the Company's strategy is to optimize the business portfolio through divestitures and complementary acquisitions. The Company intends to finance any future acquisitions with cash and short-term investments, cash provided from operations, borrowings under available credit facilities, proceeds from debt or equity offerings and/or the issuance of common shares. Subject to certain limitations in its debt agreements, as market conditions warrant, the Company may from time to time repay, repurchase or otherwise refinance loans that it has borrowed or debt securities that it has issued, including with funds borrowed under existing or new credit facilities or proceeds from the issuance of new securities. The Company's total cash and cash availability as of December 31, 2019 and 2018 was as follows: The following table summarizes the results of our consolidated statement of cash flows for the years ended December 31: During 2019, cash, cash equivalents and restricted cash decreased $87.6 primarily due to payments on long-term debt and the redemption of shares and cash compensation to Diebold Nixdorf AG minority shareholders. This is partially offset by cash provided by operating activities resulting from the impact of DN Now Transformation activities on working capital. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Operating Activities. Cash flows from operating activities can fluctuate significantly from period to period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Net cash provided by operating activities was $135.8 for the year ended December 31, 2019, an increase of $239.9 from $104.1 cash used in operating activities for the year ended December 31, 2018. The overall increase was primarily due to improvements in working capital and a reduction in the net loss. Additional detail is included below: • Cash flows from operating activities during the year ended December 31, 2019 compared to the year ended December 31, 2018 were impacted by a $184.1 decrease in net loss. Refer to Results of Operations discussed above for further discussion of the Company's net loss. • The net aggregate of trade accounts receivable, inventories and accounts payable provided $183.3 and $11.4 in operating cash flows during the year ended December 31, 2019 and 2018, respectively. The $171.9 increase is primarily a result of DN Now transformation activities through greater focus and efficiency of payables, receivables and inventory. • Deferred revenue used $54.9 of operating cash during the year ended December 31, 2019, compared to a $42.4 used in the year ended December 31, 2018. The $12.5 increase in cash use associated with deferred revenue is related to lower customer prepayments primarily due to reducing early payment discounts. • The aggregate of income taxes and deferred income taxes provided $55.1 of operating cash during the year ended December 31, 2019, compared to $61.3 used in 2018. Refer to note 4 for additional discussion on income taxes. • In the aggregate, the other combined certain assets and liabilities used $13.7 and $12.6 in 2019 and 2018, respectively. The increased use of $1.1 in 2019 is primarily due to a $20.0 pre-payment of the minimum statutory funding requirements for the Company's U.S. pension plans offset by changes in certain other assets and liabilities. The most significant changes in adjustments to net income include the non-recurring effects from goodwill impairment and lower non-routine inventory charges partially offset by deferred taxes compared to the prior year. The impairment of assets non-cash adjustment decreased to $30.2 in 2019 compared to $180.2 in 2018, or $150.0, primarily due to the non-recurring effects from goodwill impairment. The non-cash inventory charge of $23.8 in 2019 builds upon the Company's focus on streamlining its product portfolio and harvesting inventory. Other items include depreciation and amortization expense which decreased primarily due to a reduction in amortization of certain acquired intangibles as they become fully amortized and lower share-based compensation expense due to fewer granted awards. Investing Activities. Net cash used by investing activities was $6.8 for the year ended December 31, 2019 compared to net cash provided by investing activities of $34.4 for the year ended December 31, 2018. The $41.2 unfavorable change was primarily due to the monetization of the Company's investment in the company owned life insurance plans in 2018 and a reduction in utilization of short-term investments in Brazil for cash needs across the organization. These were partially offset by increased proceeds from divestitures and the sale of assets primarily related to exiting non-core activities as well as a decrease in cash spent on capital expenditures and certain other assets. The maturities and purchases of investments primarily related to short-term investment activity in Brazil. The Company anticipates capital expenditures of approximately $70 in 2020 to be utilized for improvements to the Company's product line and investments in its infrastructure. Currently, the Company finances these investments primarily with funds provided by income retained in the business, borrowings under the Company's committed and uncommitted credit facilities, and operating and capital leasing arrangements. Financing Activities. Net cash used by financing activities was $215.5 for the year ended December 31, 2019 compared to net cash provided by financing activities of $10.9 for the year ended 2018, a change of $226.4. The change was primarily related to a reduction in borrowings from the revolver and certain facilities under the Credit Agreement partially offset by the redemption of shares and cash compensation paid to Diebold Nixdorf AG minority shareholders of $97.5 for the year ended December 31, 2019 compared to $377.2 in 2018. Refer to note 11 for details of the Company's cash flows related to debt borrowings and repayments. Benefit Plans. The Company plans to make contributions to its retirement plans as well as benefits payments directly from the Company of approximately $23 for the year ended December 31, 2020, which is lower than historical amounts due to a $20.0 pre-payment of the minimum statutory funding requirements for the Company's U.S. pension plans during the fourth quarter of 2019. The Company anticipates reimbursement of approximately $13 for certain benefits paid from its trustee in 2019. Beyond 2020, minimum statutory funding requirements for the Company's U.S. pension plans may become more significant. The actual amounts required to be contributed are dependent upon, among other things, interest rates, underlying asset returns and the impact of legislative or regulatory actions related to pension funding obligations. The Company has adopted a pension investment policy designed to achieve an adequate funded status based on expected benefit payouts and to establish an asset allocation that will MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) meet or exceed the return assumption while maintaining a prudent level of risk. The plan's target asset allocation adjusts based on the plan's funded status. As the funded status improves or declines, the debt security target allocation will increase and decrease, respectively. Management monitors assumptions used for our actuarial projections as well as any funding requirements for the plans. Payments due under the Company's other post-retirement benefit plans are not required to be funded in advance. Payments are made as medical costs are incurred by covered retirees and are principally dependent upon the future cost of retiree medical benefits under these plans. The Company expects the other post-retirement benefit plan payments to be approximately $1 in 2020. Refer to note 15 for further discussion of the Company's pension and other post-retirement benefit plans. Dividends. The Company paid dividends of $7.7 and $30.6 in the years ended December 31, 2018 and 2017, respectively. Annualized dividends per share were $0.10 and $0.40 for the years ended December 31, 2018 and 2017, respectively. In May 2018, the Company announced its decision to reallocate future dividend funds towards debt reduction and other capital resource needs. Contractual Obligations. The following table summarizes the Company’s approximate obligations and commitments to make future payments under contractual obligations as of December 31, 2019: (1) The amount available under the short-term uncommitted lines at December 31, 2019 was $36.7. Refer to note 11 for additional information. (2) Amounts represent estimated contractual interest payments on outstanding long-term debt and notes payable. Rates in effect as of December 31, 2019 are used for variable rate debt. At December 31, 2019, the Company also maintained uncertain tax positions of $50.9, for which there is a high degree of uncertainty as to the expected timing of payments (refer to note 4). Refer to note 11 for additional information regarding the Company's debt obligations. The Company anticipates a repayment of approximately $60 during 2020 as it met certain mandatory repayment provisions pursuant to the Credit Agreement. In February 2020, the Company began soliciting the consents of certain of the lenders under the Credit Agreement necessary to amend the Credit Agreement to permit the Company to incur new secured or unsecured debt. If the required consents are obtained and the Credit Agreement is amended accordingly, subject to market and other conditions, the Company may incur new secured debt to refinance certain of the outstanding term loans under the Credit Agreement. However, there can be no assurance that the Company will be able to amend the Credit Agreement or that it will be able to refinance certain of the term loans on commercially acceptable terms or at all. Refer to note 17 for additional information regarding the Company's hedging and derivative instruments. Off-Balance Sheet Arrangements. The Company enters into various arrangements not recognized in the consolidated balance sheets that have or could have an effect on its financial condition, results of operations, liquidity, capital expenditures or capital resources. The principal off-balance sheet arrangements that the Company enters into are guarantees and sales of finance receivables. The Company provides its global operations guarantees and standby letters of credit through various financial institutions to suppliers, customers, regulatory agencies and insurance providers. If the Company is not able to comply with its contractual obligations, the suppliers, regulatory agencies and insurance providers may draw on the pertinent bank (refer to note 17 ). The Company has sold finance receivables to financial institutions while continuing to service the receivables. The Company records these sales by removing finance receivables from the consolidated balance sheets and recording gains and losses in the consolidated statement of operations (refer to note 7). MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements. The consolidated financial statements of the Company are prepared in conformity with generally accepted accounting principles in the United States (U.S. GAAP). The preparation of the accompanying consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions about future events. These estimates and the underlying assumptions affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities and reported amounts of revenues and expenses. Such estimates include revenue recognition, the valuation of trade and financing receivables, inventories, goodwill, intangible assets, other long-lived assets, legal contingencies, guarantee obligations, and assumptions used in the calculation of income taxes, pension and post-retirement benefits and customer incentives, among others. These estimates and assumptions are based on management’s best estimates and judgment. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors. Management monitors the economic conditions and other factors and will adjust such estimates and assumptions when facts and circumstances dictate. As future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. The Company’s significant accounting policies are described in note 1 to the consolidated financial statements, which is contained in Item 8 of this annual report on Form 10-K. Management believes that, of its significant accounting policies, its policies concerning revenue recognition, allowances for credit losses, inventory reserves, goodwill, long-lived assets, taxes on income, contingencies and pensions and post-retirement benefits are the most critical because they are affected significantly by judgments, assumptions and estimates. Additional information regarding these policies is included below. Revenue Recognition. Revenue is measured based on consideration specified in a contract with a customer and excludes amounts collected on behalf of third parties. The amount of consideration can vary depending on discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties, or other similar items contained in the contract with the customer of which generally these variable consideration components represents minimal amount of net sales. The Company recognizes revenue when it satisfies a performance obligation by transferring control over a product or service to a customer. The Company's payment terms vary depending on the individual contracts and are generally fixed fee. The Company recognizes advance payments and billings in excess of revenue recognized as deferred revenue. In certain contracts where services are provided prior to billing, the Company recognizes a contract asset within trade receivables and other current assets. Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction and that are collected by the Company from a customer are excluded from revenue. The Company recognizes shipping and handling fees billed when products are shipped or delivered to a customer and includes such amounts in net sales. Although infrequent, shipping and handling associated with outbound freight after control over a product has transferred to a customer is not a separate performance obligation, rather is accounted for as a fulfillment cost. Third-party freight payments are recorded in cost of sales. The Company includes a warranty in connection with certain contracts with customers, which are not considered to be separate performance obligations. The Company provides its customers a manufacturer’s warranty and records, at the time of the sale, a corresponding estimated liability for potential warranty costs. For additional information on product warranty refer to note 9. The Company also has extended warranty and service contracts available for its customers, which are recognized as separate performance obligations. Revenue is recognized on these contracts ratably as the Company has a stand-ready obligation to provide services when or as needed by the customer. This input method is the most accurate assessment of progress toward completion the Company can apply. Product revenue is recognized at the point in time that the customer obtains control of the product, which could be upon delivery or upon completion of installation services, depending on contract terms. The Company’s software licenses are functional in nature (the IP has significant stand-alone functionality); as such, the revenue recognition of distinct software license sales is at the point in time that the customer obtains control of the rights granted by the license. Professional services integrate the commercial solution with the customer's existing infrastructure and helps define the optimal user experience, improve business processes, refine existing staffing models and deploy technology to meet branch and store automation objectives. Revenue from professional services are recognized over time, because the customer simultaneously receives and consumes the benefits of the Company’s performance as the services are performed or when the Company’s performance creates an asset with no alternative use and the Company has an enforceable right to payment for performance completed to date. Generally revenue will be recognized using an input measure, typically costs incurred. The typical contract length for service is generally one year and is billed and paid in advance except for installations, among others. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Services may be sold separately or in bundled packages. For bundled packages, the Company accounts for individual services separately if they are distinct. A distinct service is separately identifiable from other items in the bundled package if a customer can benefit from it on its own or with other resources that are readily available to the customer. The consideration (including any discounts) is allocated between separate services or distinct obligations in a bundle based on their stand-alone selling prices. The stand-alone selling prices are determined based on the prices at which the Company separately sells the products or services. For items that are not sold separately, the Company estimates stand-alone selling prices using the cost plus expected margin approach. Revenue on service contracts is recognized ratably over time, generally using an input measure, as the customer simultaneously receives and consumes the benefits of the Company’s performance as the services are performed. In some circumstances, when global service supply chain services are not included in a term contract and rather billed as they occur, revenue on these billed work services are recognized at a point in time as transfer of control occurs. The following is a description of principal solutions offered within the Company's two main customer segments that generate the Company's revenue. Banking Products. Products for banking customers consist of cash recyclers and dispensers, intelligent deposit terminals, teller automation tools and kiosk technologies, as well as physical security solutions. The Company provides its banking customers front-end applications for consumer connection points and back-end platforms that manage channel transactions, operations and integration and facilitate omnichannel transactions, endpoint monitoring, remote asset management, customer marketing, merchandise management and analytics. These offerings include highly configurable, API enabled software that automates legacy banking transactions across channels. Services. The Company provides its banking customers product-related services which include proactive monitoring and rapid resolution of incidents through remote service capabilities or an on-site visit. First and second line maintenance, preventive maintenance and on-demand services keep the distributed assets of the Company's customers up and running through a standardized incident management process. Managed services and outsourcing consists of the end-to-end business processes, solution management, upgrades and transaction processing. The Company also provides a full array of cash management services, which optimizes the availability and cost of physical currency across the enterprise through efficient forecasting, inventory and replenishment processes. Retail Products. The retail product portfolio includes modular, integrated and mobile POS and SCO terminals that meet evolving automation and omnichannel requirements of consumers. Supplementing the POS system is a broad range of peripherals, including printers, scales and mobile scanners, as well as the cash management portfolio which offers a wide range of banknote and coin processing systems. Also in the portfolio, the Company provides SCO terminals and ordering kiosks which facilitate an efficient and user-friendly purchasing experience. The Company’s hybrid product line can alternate from an attended operator to self-checkout with the press of a button as traffic conditions warrant throughout the business day. The Company's platform software is installed within retail data centers to facilitate omnichannel transactions, endpoint monitoring, remote asset management, customer marketing, merchandise management and analytics. Services. The Company provides its retail customers product-related services which include on-demand services and professional services. Diebold Nixdorf AllConnect Services for retailers include maintenance and availability services to continuously improve retail self-service fleet availability and performance. These include: total implementation services to support both current and new store concepts; managed mobility services to centralize asset management and ensure effective, tailored mobile capability; monitoring and advanced analytics providing operational insights to support new growth opportunities; and store life-cycle management to proactively monitors store IT endpoints and enable improved management of internal and external suppliers and delivery organizations. Inventory Reserves. At each reporting period, the Company identifies and writes down its excess and obsolete inventories to net realizable value based on usage forecasts, order volume and inventory aging. With the development of new products, the Company also rationalizes its product offerings and will write-down discontinued product to the lower of cost or net realizable value. The Company’s significant accounting policies and inventories are described in notes 1 and 5. Acquisitions and Divestitures. Acquisitions are accounted for using the purchase method of accounting. This method requires the Company to record assets and liabilities of the business acquired at their estimated fair market values as of the acquisition date. Any excess cost of the acquisition over the fair value of the net assets acquired is recorded as goodwill. The Company generally uses valuation specialists to perform appraisals and assist in the determination of the fair values of the assets acquired and liabilities MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) assumed. These valuations require management to make estimates and assumptions that are critical in determining the fair values of the assets and liabilities. For all divestitures, the Company considers assets to be held for sale when management approves and commits to a formal plan to actively market the assets for sale at a price reasonable in relation to their estimated fair value, the assets are available for immediate sale in their present condition, an active program to locate a buyer and other actions required to complete the sale have been initiated, the sale of the assets is probable and expected to be completed within one year (or, if it is expected that others will impose conditions on the sale of the assets that will extend the period required to complete the sale, that a firm purchase commitment is probable within one year) and it is unlikely that significant changes will be made to the plan. Upon designation as held for sale, the Company records the assets at the lower of their carrying value or their estimated fair value, reduced for the cost to dispose of the assets, and ceases to record depreciation expense on the assets. Assets and liabilities are reclassified as held for sale in the period the held for sale criteria are met. As of December 31, 2019, the Company had $233.3 and $113.4 of current assets and liabilities held for sale, respectively, primarily related to non-core businesses in Europe and Asia Pacific. Goodwill. Goodwill is the cost in excess of the net assets of acquired businesses (refer to note 8). The Company tests all existing goodwill at least annually as of October 31 for impairment on a reporting unit basis. The Company tests for interim impairment between annual tests if an event occurs or circumstances change that would more likely than not reduce the carrying value of a reporting unit below its reported amount. Beginning with the second quarter of 2018, the Company’s reportable operating segments are based on the conclusion of the assessment on the following solutions: Eurasia Banking, Americas Banking and Retail with comparative periods reclassified for consistency. Each year, the Company may elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. In evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount, the Company considers the following events and circumstances, among others, if applicable: (a) macroeconomic conditions such as general economic conditions, limitations on accessing capital or other developments in equity and credit markets; (b) industry and market considerations such as competition, multiples or metrics and changes in the market for the Company's products and services or regulatory and political environments; (c) cost factors such as raw materials, labor or other costs; (d) overall financial performance such as cash flows, actual and planned revenue and earnings compared with actual and projected results of relevant prior periods; (e) other relevant events such as changes in key personnel, strategy or customers; (f) changes in the composition of a reporting unit's assets or expected sales of all or a portion of a reporting unit; and (g) any sustained decrease in share price. If the Company's qualitative assessment indicates that it is more likely than not that the fair value of a reporting unit is less than its carrying value, or if management elects to perform a quantitative assessment of goodwill, an impairment test is used to identify potential goodwill impairment and measure the amount of any impairment loss to be recognized. The Company compares the fair value of each reporting unit with its carrying value and recognizes an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. The fair value of the reporting units is determined based upon a combination of the income valuation and market approach in valuation methodology. The income approach uses discounted estimated future cash flows, whereas the market approach or guideline public company method utilizes market data of similar publicly traded companies. The fair value of the reporting unit is defined as the price that would be received to sell the net assets or transfer the net liabilities in an orderly transaction between market participants at the assessment date. The techniques used in the Company's qualitative assessment incorporate a number of assumptions that the Company believes to be reasonable and to reflect market conditions forecast at the assessment date. Assumptions in estimating future cash flows are subject to a high degree of judgment. The Company makes all efforts to forecast future cash flows as accurately as possible with the information available at the time the forecast is made. To this end, the Company evaluates the appropriateness of its assumptions as well as its overall forecasts by comparing projected results of upcoming years with actual results of preceding years and validating that differences therein are reasonable. Key assumptions, all of which are Level 3 inputs, relate to price trends, material costs, discount rate, customer demand and the long-term growth and foreign exchange rates. A number of benchmarks from independent industry and other economic publications were also used. Changes in assumptions and estimates after the assessment date may lead to an outcome where impairment charges would be required in future periods. Specifically, actual results may vary from the Company’s forecasts and such variations may be material and unfavorable, thereby triggering the need for future impairment tests where the conclusions may differ in reflection of prevailing market conditions. Long-Lived Assets. Impairment of long-lived assets is recognized when events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. If the expected future undiscounted cash flows are less than the carrying amount of the asset, an impairment loss is recognized at that time to reduce the asset to the lower of its fair value or its net book value. The Company tests all existing indefinite-lived intangibles at least annually for impairment as of October 31. Taxes on Income. Deferred taxes are provided on an asset and liability method, whereby deferred tax assets are recognized for deductible temporary differences, operating loss carry-forwards and tax credits. Deferred tax liabilities are recognized for taxable MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) temporary differences and undistributed earnings in certain jurisdictions. Deferred tax assets are reduced by a valuation allowance when, based upon the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Determination of a valuation allowance involves estimates regarding the timing and amount of the reversal of taxable temporary differences, expected future taxable income and the impact of tax planning strategies. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment. The Company operates in numerous taxing jurisdictions and is subject to examination by various federal, state and foreign jurisdictions for various tax periods. Additionally, the Company has retained tax liabilities and the rights to tax refunds in connection with various acquisitions and divestitures of businesses. The Company’s income tax positions are based on research and interpretations of the income tax laws and rulings in each of the jurisdictions in which the Company does business. Due to the subjectivity of interpretations of laws and rulings in each jurisdiction, the differences and interplay in tax laws between those jurisdictions, as well as the inherent uncertainty in estimating the final resolution of complex tax audit matters, the Company’s estimates of income tax liabilities may differ from actual payments or assessments. The Company assesses its position with regard to tax exposures and records liabilities for these uncertain tax positions and any related interest and penalties, when the tax benefit is not more likely than not realizable. The Company has recorded an accrual that reflects the recognition and measurement process for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. Additional future income tax expense or benefit may be recognized once the positions are effectively settled. At the end of each interim reporting period, the Company estimates the effective tax rate expected to apply to the full fiscal year. The estimated effective tax rate contemplates the expected jurisdiction where income is earned, as well as tax planning alternatives. Current and projected growth in income in higher tax jurisdictions may result in an increasing effective tax rate over time. If the actual results differ from estimates, the Company may adjust the effective tax rate in the interim period if such determination is made. Contingencies. Liabilities for loss contingencies arising from claims, assessments, litigation, fines, and penalties and other sources are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated. Legal costs incurred in connection with loss contingencies are expensed as incurred. There is no liability recorded for matters in which the liability is not probable and reasonably estimable. Attorneys in the Company's legal department monitor and manage all claims filed against the Company and review all pending investigations. Generally, the estimate of probable loss related to these matters is developed in consultation with internal and outside legal counsel representing the Company. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The Company attempts to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments, or fines, after appeals, differ from the estimates, the future results may be materially impacted. Adjustments to the initial estimates are recorded when a change in the estimate is identified. Pensions and Other Post-retirement Benefits. Annual net periodic expense and benefit liabilities under the Company’s defined benefit plans are determined on an actuarial basis. Assumptions used in the actuarial calculations have a significant impact on plan obligations and expense. Members of the management investment committee periodically review the actual experience compared with the more significant assumptions used and make adjustments to the assumptions, if warranted. The discount rate is determined by analyzing the average return of high-quality (i.e., AA-rated), fixed-income investments and the year-over-year comparison of certain widely used benchmark indices as of the measurement date. The expected long-term rate of return on plan assets is determined using the plans’ current asset allocation and their expected rates of return based on a geometric averaging over 20 years. The rate of compensation increase assumptions reflects the Company’s long-term actual experience and future and near-term outlook. Pension benefits are funded through deposits with trustees. Other post-retirement benefits are not funded and the Company’s policy is to pay these benefits as they become due. The following table represents assumed healthcare cost trend rates at December 31: The healthcare trend rates for the postemployment benefits plans in the U.S. are reviewed based upon the results of actual claims experience. The Company used initial healthcare cost trends of 6.5 percent and 6.5 percent in 2019 and 2018, respectively, with an ultimate trend rate of 5.0 percent reach in 2025. Assumed healthcare cost trend rates have a modest effect on the amounts reported for the healthcare plans. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Assumed healthcare cost trend rates have a significant effect on the amounts reported for the healthcare plans. A one-percentage-point change in assumed healthcare cost trend rates would have the following effects: During 2019, the Society of Actuaries released new mortality tables (Pri-2012) and projection scales (MP-2019) resulting from recent studies measuring mortality rates for various groups of individuals. As of December 31, 2019, the Company adopted for the pension plan in the U.S., the use of the Pri-2012 mortality tables and the MP-2019 mortality projection scales. For the plans outside the U.S., the mortality tables used are those either required or customary for local accounting and/or funding purposes. RECENTLY ISSUED ACCOUNTING GUIDANCE Refer to note 1 for information on recently issued accounting guidance. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) FORWARD-LOOKING STATEMENT DISCLOSURE In this annual report on Form 10-K, statements that are not reported financial results or other historical information are “forward-looking statements.” Forward-looking statements give current expectations or forecasts of future events and are not guarantees of future performance. These forward-looking statements include, but are not limited to, statements regarding the Company's expected future performance (including expected results of operations and financial guidance) future financial condition, operating results, strategy and plans. Forward-looking statements may be identified by the use of the words “anticipates,” “expects,” “intends,” “plans,” “will,” “believes,” “estimates,” “potential,” “target,” “predict,” “project,” “seek,” and variations thereof or similar expressions. These statements are used to identify forward-looking statements. These forward-looking statements reflect the current views of the Company with respect to future events and involve significant risks and uncertainties that could cause actual results to differ materially. Although the Company believes that these forward-looking statements are based upon reasonable assumptions regarding, among other things, the economy, its knowledge of its business, and key performance indicators that impact the Company, these forward-looking statements involve risks, uncertainties and other factors that may cause actual results to differ materially from those expressed in or implied by the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. Some of the risks, uncertainties and other factors that could cause actual results to differ materially from those expressed in or implied by the forward-looking statements include, but are not limited to: • the outcome of the appraisal proceedings initiated in connection with the implementation of the DPLTA with the former Diebold Nixdorf AG and the merger/squeeze-out; • the Company's ability to achieve benefits from its cost-reduction initiatives and other strategic initiatives, such as DN Now, including its planned restructuring actions, as well as its business process outsourcing initiative; • the success of the Company’s new products, including its DN Series line; • the Company's ability to comply with the covenants contained in the agreements governing its debt; • the Company's ability to successfully refinance its debt when necessary or desirable; • the ultimate outcome of the Company’s pricing, operating and tax strategies applied to former Diebold Nixdorf AG and the ultimate ability to realize cost reductions and synergies; • the Company's ability to successfully operate its strategic alliances in China; • changes in political, economic or other factors such as currency exchange rates, inflation rates, recessionary or expansive trends, taxes and regulations and laws affecting the worldwide business in each of the Company's operations; • the Company’s reliance on suppliers and any potential disruption to the Company’s global supply chain; • the impact of market and economic conditions, including any additional deterioration and disruption in the financial and service markets, including the bankruptcies, restructurings or consolidations of financial institutions, which could reduce our customer base and/or adversely affect our customers' ability to make capital expenditures, as well as adversely impact the availability and cost of credit; • interest rate and foreign currency exchange rate fluctuations, including the impact of possible currency devaluations in countries experiencing high inflation rates; • the acceptance of the Company's product and technology introductions in the marketplace; • competitive pressures, including pricing pressures and technological developments; • changes in the Company's relationships with customers, suppliers, distributors and/or partners in its business ventures; • the effect of legislative and regulatory actions in the U.S. and internationally and the Company’s ability to comply with government regulations; • the impact of a security breach or operational failure on the Company's business; • the Company's ability to successfully integrate other acquisitions into its operations; • the Company's success in divesting, reorganizing or exiting non-core and/or non-accretive businesses; • the Company's ability to maintain effective internal controls; • changes in the Company's intention to further repatriate cash and cash equivalents and short-term investments residing in international tax jurisdictions, which could negatively impact foreign and domestic taxes; • unanticipated litigation, claims or assessments, as well as the outcome/impact of any current/pending litigation, claims or assessments; • the investment performance of the Company's pension plan assets, which could require the Company to increase its pension contributions, and significant changes in healthcare costs, including those that may result from government action; and • the amount and timing of repurchases of the Company's common shares, if any. Except to the extent required by applicable law or regulation, the Company undertakes no obligation to update these forward-looking statements to reflect future events or circumstances or to reflect the occurrence of unanticipated events.

<s>[INST] During 2019, Diebold Nixdorf: Successfully amended and extended the vast majority of the Company's $787.0 revolving credit facility and term A loans from December 23, 2020 to April 30, 2022 Completed the merger squeezeout of Diebold Nixdorf AG, the Company's German public subsidiary, which has streamlined and simplified the Company's corporate structure Elected four new independent members to the Company's Board of Directors, continuing to refresh the board to align with the Company's strategy and opportunities Won a threeyear, multimillion dollar agreement with a European DIY retailer to refresh the endtoend customer checkout experience in more than 600 stores spanning 12 countries Executed a fiveyear agreement valued at more than $60.0 with one of the world’s largest fuel and convenience retailers to deploy a new, centralized card acceptance platform. The contract includes software licenses, professional and maintenance services for stores in 10 European markets Won Windows 10 ATM product upgrades with several financial institutions, including an agreement with 1) KeyBank to digitally transform more than 1,400 selfservice devices with DN Vynamic™ Software, and 2) a major Belgian bank to upgrade more than 2,400 devices and cash recyclers to Windows 10, leveraging DN AllConnect ServicesSM and the DN Vynamic software suite Launched the DN Series™ family of selfservice solutions designed to enable multiple capabilities that support financial institutions' efforts to transform their branch environment, improve performance and differentiate their user experience Secured a $17.0 win at Banco Itau Unibanco in Brazil to transform its branch network and increase automation via cash recyclers, fullfunction ATMs and maintenance services Won a new frame agreement with Commerzbank in Germany for several hundred ATMs with a multiyear software and services maintenance contract Benefited from solid growth in SCO demand from a number of European customers, including a $7.0 contract with U.K.based retailer, CoOp, for more than 400 selfcheckout terminals and related services Renewed a multiyear managed services contract with H&M, a global fashion retailer, providing an integrated solution supporting its global stores with an allinone POS system, DN Vynamic Software and DN AllConnect Services Reached an agreement with Dave & Buster’s, a leading U.S.based dining and entertainment chain, to provide a selfservice solution at locations nationwide built around Diebold Nixdorf's newest Ktwo interactive kiosk Signed a multimillion dollar global agreement with Citibank for Vynamic software and DN Series ATMs Won a multiyear ATMasaService agreement in Belgium with JoFiCo to update and maintain approximately 1,560 ATMs Selected by a top U.S. financial institution to provide approximately 20,000 Vynamic software marketing licenses and associated services Secured a multimillion dollar contract with Swisslos for 5,000 allinone POS terminals Signed a comprehensive solutions contract, valued at nearly $10.0, with one of the largest banks in the Philippines to upgrade its ATM fleet to Windows 10 OVERVIEW Management’s discussion and analysis should be read in conjunction with the consolidated financial statements and accompanying notes that appear elsewhere in this annual report on Form 10K. For additional information regarding general information regarding the Company, its business, strategy, competitors and operations, refer to Item 1 of this annual report on Form 10K. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS as of December 31, 2019 DIEBOLD NIXDORF, INCORPORATED AND SUBSIDIARIES (unaudited) (in millions, except per share amounts) Business Drivers The business drivers of the Company's future performance include, but are not limited to: Demand for services on distributed IT assets such as ATMs, POS and SCO, including managed services and professional services Timing of system upgrades [/INST] Positive. </s>

PUBLIC SERVICE ENTERPRISE GROUP INC

2015-02-26

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) This combined MD&A is separately filed by Public Service Enterprise Group Incorporated (PSEG), Public Service Electric and Gas Company (PSE&G) and PSEG Power LLC (Power). Information contained herein relating to any individual company is filed by such company on its own behalf. PSE&G and Power each make representations only as to itself and make no representations whatsoever as to any other company. PSEG's business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: • PSE&G, our public utility company which primarily provides electric transmission services and distribution of electric energy and natural gas, implements demand response and energy efficiency programs and invests in solar generation in New Jersey, and • Power, our wholesale energy supply company that integrates its nuclear, fossil and renewable generating asset operations with its wholesale energy, fuel supply, energy trading and marketing and risk management activities primarily in the Northeast and Mid-Atlantic United States. PSEG's other direct wholly owned subsidiaries are: PSEG Energy Holdings L.L.C. (Energy Holdings), which earns its revenues primarily from its portfolio of lease investments; PSEG Long Island LLC (PSEG LI), which effective January 1, 2014, operates the Long Island Power Authority's (LIPA) transmission and distribution (T&D) system under a contractual agreement; and PSEG Services Corporation (Services), which provides us and these operating subsidiaries with certain management, administrative and general services at cost. Our business discussion in Part I, Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Part I, Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2014 and key factors that we expect will drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2014 AND FUTURE OUTLOOK 2014 Overview Our business plan seeks to achieve growth while managing risks. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: • Growing our utility operations through continued investment in T&D infrastructure projects with greater diversity of regulatory oversight, and • Maintaining a reliable generation fleet with the flexibility to utilize a diverse mix of fuels to allow us to respond to market volatility and capitalize on opportunities as they arise in the locations in which we operate. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2014 and 2013 are presented below: Our $275 million 2014 over 2013 increase in Net Income was due primarily to higher transmission revenues at PSE&G and mark-to-market gains in 2014 as compared to losses in 2013 and higher volumes of gas sales under the BGSS contract and to third party customers at Power. In addition, the increase was also due to lower Operations and Maintenance (O&M) costs at PSE&G and Power, principally related to a reduction in pension and other postretirement employee benefit (OPEB) costs. These factors were partially offset by lower volumes of electricity sold under the BGS contract and higher fuel costs incurred to generate electricity at Power. For a more detailed discussion of our financial results, see Results of Operations. At PSE&G, our regulated utility, we continued to invest capital in T&D infrastructure projects aimed at maintaining the reliability of our service to our customers. PSE&G’s results for 2014 reflect the favorable impacts from these investments as well as a slowly improving economy. Effective January 1, 2014, PSE&G's formula rate increased our annual transmission revenues by approximately $171 million. In October 2014, we filed our 2015 Formula Rate Update with the Federal Energy Regulatory Commission (FERC) for approximately $182 million in increased annual transmission revenues which went into effect on January 1, 2015. Each year, transmission revenues are adjusted to reflect items such as updating estimates used in the filing with actual data. The adjustment for 2015 will include the impact of the extension of bonus depreciation, which was enacted after the filing was made, and is estimated to reduce our 2015 revenue increase as filed by approximately $21 million. Over the past few years, these types of investments have altered the business mix of our overall results of operations to reflect a higher percentage contribution by PSE&G. Power’s results benefited from access to natural gas supplies through its existing firm pipeline transportation contracts during the cold weather experienced in the first quarter of 2014. Power manages these contracts for the benefit of PSE&G’s customers through the BGSS arrangement. The contracts are sized to ensure delivery of a reliable gas supply to PSE&G customers on peak winter days. When pipeline capacity beyond the customers’ needs is available, Power can use it to make third party sales and supply gas to its generating units in New Jersey. Power’s 2014 results were unfavorably impacted by an extended refueling outage at Salem Unit 2. A planned refueling outage began on April 12, 2014 but was extended due to repairs to the reactor coolant pump turning vanes. Salem Unit 2 returned to service on July 14, 2014. Regulatory, Legislative and Other Developments In our pursuit of operational excellence, financial strength and disciplined investment, we closely monitor significant regulatory and legislative developments. Transmission planning rules and wholesale power market design are of particular importance to our results and we continue to advocate for policies and rules that promote fair and efficient electricity markets. Transmission Planning The FERC’s rule under Order 1000 altered the right of first refusal (ROFR) previously held by incumbent utilities to build all transmission within their respective service territories. Our challenge to the rule itself was rejected by the federal court. However, the FERC's action presents opportunities for us to construct transmission outside of our service territory as long as the applicable rules are clear to all participating transmission developers. In April 2013, PJM Interconnection, L.L.C. (PJM) initiated a solicitation process pursuant to Order 1000 to review technical solutions to improve the operational performance in the Artificial Island area, consisting of our Salem and Hope Creek nuclear generation facilities. PJM has not yet made a decision in this process. On January 30, 2015, PSE&G filed a complaint against PJM at the FERC, arguing that PJM had failed to follow its rules during this process and requesting that the FERC order PJM to do so. If the FERC grants this complaint, the FERC could order PJM to re-start the entire process or make changes to the rules governing future competitive solicitations. PJM filed with the FERC, and the FERC has recently accepted, a new “multi-driver” category of transmission projects, which projects may include a combination of reliability, economic and public policy elements. Changes to the factors used in making determinations in the PJM project planning and cost-allocation processes could have significant implications for the types of projects selected and the utility customers ultimately charged for the costs of such new transmission facilities. See Part I, Item 1. Business-Federal Regulation-Transmission Regulation-Transmission Policy Developments. Wholesale Power Market Design Capacity market design, including the Reliability Pricing Model (RPM), remains an important focus for us. In May 2014, a federal court issued a rule that vacated a FERC Order in which the FERC had determined that demand response (DR) providers should receive full market compensation for power and held that the FERC has no jurisdiction over DR. A subsequent challenge to the participation of DR as a resource in the PJM capacity market is pending at the FERC as is a filing made by PJM at the FERC that would remove DR as a supply resource in upcoming auctions. In addition, PJM has filed at the FERC to reset the demand curve for the RPM, which FERC subsequently accepted. We generally supported PJM’s approach in the filing but sought rehearing on certain issues, including the proper level of labor costs required to build new generation in New Jersey, which is pending. Further, in December 2014, PJM filed at the FERC its proposal for a capacity performance product to include generators, DR and energy efficiency providers who would certify as to availability during emergency conditions, as a supplement to base capacity and with enhanced performance-based incentives and penalties. The implications of these developments could be significant for the capacity market. See Part I, Item 1. Business-Regulatory Issues-Federal Regulation-Capacity Market Issues-PJM for additional information. Under the PJM capacity auction conducted in May 2014, Power cleared 8,693 MW of its generating capacity at an average price of $164.61 MW-day for the 2017-2018 delivery period, a price consistent with what has been realized in the past three auctions. For a more detailed discussion on the RPM capacity auction, refer to Part I, Item 1. Business-Federal Regulation-Capacity Market Issues-PJM. In 2014, appeals to challenge the federal court rulings that the New Jersey Long-Term Capacity Agreement Pilot Program Act to subsidize above-market new generation and a similar action taken by Maryland were unconstitutional and null and void were each denied. The appellants subsequently sought review at the U.S. Supreme Court and the U.S. Supreme Court has not yet acted. For additional information, refer to Part I, Item 1. Business-Regulatory Issues-Federal Regulation-Capacity Market Issues-Long-Term Capacity Agreement Pilot Program Act. A critical aspect of our wholesale energy marketing business is the continued retention of market-based rate (MBR) authority from the FERC for our operating subsidiaries that engage in such activities. On October 14, 2014, the FERC issued an Order that accepted our triennial market power update, concluding that our submission satisfied its requirements for retention of MBR authority. Environmental Regulation We also advocate for the development and implementation of fair and reasonable rules by the U.S. Environmental Protection Agency (EPA) and state environmental regulators. On May 19, 2014, the EPA released the final Clean Water Act Section 316(b) rule on cooling water intake that establishes new requirements for the regulation of cooling water intakes at existing power plants and industrial facilities with a design flow of more than two million gallons of water per day. Eight of Power’s generating facilities and three of its jointly-owned generating facilities are subject to the rule. As adopted by the EPA, the rule requires that cooling water intake structures reflect the best technology available for minimizing adverse environmental impacts, primarily by reducing the amount of fish and shellfish that are impinged or entrained at a cooling water intake structure. Under this standard, power facilities have the flexibility to select one of several options as their method of compliance. However, the EPA has structured the rule so that each state will continue to consider renewal permits for existing power facilities on a case by case basis, and will require facilities to conduct a wide range of studies related to impingement mortality and entrainment and submit the results with their permit applications. A federal court challenge to the EPA rule is pending. We are unable to predict the outcome that these permitting decisions may take and the effect, if any, that they may have on us although such impacts could be material. See Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities and Part I, Item 1. Business-Environmental Matters-Water Pollution Control for additional information. In June 2014, the EPA issued a proposed greenhouse gas emissions regulation for existing power plants. The regulation establishes state-specific emission rate targets based on implementation of the best system of emission reduction. States may choose these or other methodologies to achieve the necessary reductions of carbon dioxide emissions. The EPA had requested comment on many aspects of the proposal and therefore, the final rule may look considerably different than the proposal. We continue to work with state and federal regulators, as well as industry partners, to determine the potential impact of the regulation. See Part I, Item 1. Business-Environmental Matters-Climate Change for additional information. In addition, Clean Air Act (CAA) regulations governing hazardous air pollutants under the EPA's Maximum Achievable Control Technology rules are also of significance; however, we believe our generation business remains well-positioned for such air pollution control regulations if and when they are implemented. Other Developments In recent years we have been impacted by severe weather conditions, including Hurricane Irene in 2011 and Superstorm Sandy in 2012, the latter storm resulting in the highest level of customer outages in our history. For more detailed information, refer to Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities-Superstorm Sandy. We have begun work in our gas and electric distribution systems to improve resiliency. The New Jersey Board of Public Utilities (BPU) approved the settlement of our Energy Strong Proposal in a total amount of $1.22 billion. The settlement provides for cost recovery at a 9.75% rate of return on equity on the first $1.0 billion of the investment, plus associated allowance for funds used during construction, through an accelerated recovery mechanism. We will seek recovery of the remaining $220 million of investment in PSE&G's next base rate case, which is to be filed no later than November 1, 2017. We filed our initial Energy Strong cost recovery petition, seeking BPU approval to recover in base rates an estimated annual revenue increase of $1.1 million effective March 1, 2015. This increase represents capitalized Energy Strong electric investment costs in service through November 30, 2014. For additional information, refer to Part I, Item 1. Business-Regulatory Issues-State Regulation-Energy Strong Program. In September 2014, the BPU approved substantially our entire request for a determination that our storm related costs, in the total amount of $366 million, were prudently incurred and recoverable in a future base rate proceeding, subject to offset for the amount of insurance proceeds received. For additional information, refer to Item 8. Financial Statements and Supplementary Data-Note 5. Regulatory Assets and Liabilities. On January 1, 2014, we commenced operation of the LIPA T&D system under a twelve-year contract with opportunity to extend for an additional eight years. In addition, in January 2015, Power assumed responsibility for fuel procurement and power management services to LIPA under separate agreements. In the first and second quarters of 2014, Power discovered and further investigated (i) incorrect calculations for certain components of its cost-based bids for its New Jersey fossil generating units in the PJM energy market and (ii) differences in the quantity of energy that Power offered into the energy market for its fossil peaking units from the amount for which Power was compensated in the capacity market for those units. We informed the FERC, PJM and the PJM Independent Market Monitor of these issues, and have corrected these errors. Power has an ongoing process of implementing improved procedures to help mitigate the risk of similar issues occurring in the future. In the third quarter of 2014, the FERC Staff initiated a preliminary, non-public staff investigation into the matter. This investigation could result in the FERC seeking disgorgement of any over-collected amounts, civil penalties and non-financial remedies. It is not possible at this time to reasonably estimate the ultimate impact or predict any resulting penalties, other costs associated with this matter, or the applicability of mitigating factors. For more detailed information regarding this matter, refer to Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities-FERC Compliance. Operational Excellence We emphasize operational performance while developing opportunities in both our competitive and regulated businesses. Flexibility in our generating fleet has allowed us to take advantage of market opportunities presented during the year as we remain diligent in managing costs. In 2014, our • diverse fuel mix and dispatch flexibility allowed us to generate approximately 54,000 GWh, while addressing unit outages and balancing fuel availability and price volatility, • Bergen 1 and 2 and Linden 1 Units and our combined cycle gas turbine fleet overall achieved record generation, • Hope Creek Unit achieved its second best generation ever, • construction of transmission and solar projects proceeded on schedule and within budget, and • utility ranked highest in electric and gas service business customer satisfaction among large utilities in the eastern United States. Financial Strength Our financial strength is predicated on a solid balance sheet, positive cash flow and reasonable risk-adjusted returns on increased investment. Our financial position remained strong during 2014 as we: • had cash on hand of $402 million as of December 31, 2014, • extended the expiration dates of PSEG's $500 million and Power's $1.6 billion five-year credit facilities from 2017 to 2019, and maintained substantial liquidity, • maintained solid investment grade credit ratings, and • paid an annual dividend of $1.48 and increased our indicated annual dividend for 2015 to $1.56 per share. We expect to be able to fund our transmission projects required under PJM's reliability program, our Energy Strong program and other projects with internally generated cash and external debt financing. Disciplined Investment We utilize rigorous investment criteria when deploying capital and seek to invest in areas that complement our existing business and provide reasonable risk-adjusted returns. These areas include upgrading our energy infrastructure, responding to trends in environmental protection and providing new energy supplies in domestic markets with growing demand. In 2014 we: • placed into service our 230 kV Burlington-Camden and 230 kV North Central Reliability transmission projects, • made additional investments in transmission infrastructure projects, • continued to execute our existing BPU-approved utility programs, • completed installation of equipment to increase output and improve efficiency at our Linden combined cycle gas generating plant and continue to plan for the installation of such equipment at our Bergen 2 and Bethlehem Energy Center (BEC) combined cycle gas units, • completed the physical upgrades for the extended power uprate at Peach Bottom Unit 2, • acquired an equity interest with an expected investment of $100 million-$120 million in the approximately 110 mile PennEast Pipeline to transport natural gas from eastern Pennsylvania to New Jersey, and • acquired rights to solar energy facilities located near El Paso, Texas and Burlington, Vermont, totaling 16.6 MWdc which became operational in late 2014 and a 12.9 MWdc solar energy facility located near Waldorf, Maryland which we expect to be operational before June 2015. Future Outlook Our future success will depend on our ability to continue to maintain strong operational and financial performance in a slow-moving economy and a cost-constrained environment, to capitalize on or otherwise address appropriately regulatory and legislative developments that impact our business and to respond to the issues and challenges described below. In order to do this, we must continue to • focus on controlling costs while maintaining safety and reliability and complying with applicable standards and requirements, • successfully manage our energy obligations and re-contract our open supply positions, • execute our capital investment program, including our Energy Strong program and other investments for growth that yield contemporaneous and reasonable risk-adjusted returns, while enhancing the resiliency of our infrastructure and maintaining the reliability of the service we provide to our customers, • advocate for measures to ensure the implementation by PJM and the FERC of market design rules that continue to promote fair and efficient electricity markets, • engage multiple stakeholders, including regulators, government officials, customers and investors, and • successfully operate the LIPA T&D system. For 2015 and beyond, the key issues and challenges we expect our business to confront include: • regulatory and political uncertainty, both with regard to future energy policy, design of energy and capacity markets, transmission policy and environmental regulation, as well as with respect to the outcome of any legal, regulatory or other proceeding, settlement, investigation or claim, applicable to us and/or the energy industry, • uncertainty in the slowly improving national and regional economic recovery, continuing customer conservation efforts, changes in energy usage patterns and evolving technologies, which impact customer behaviors and demand, • the continuing potential for sustained lower natural gas and electricity prices, both at market hubs and at locations where we operate, and • delays and other obstacles that might arise in connection with the construction of our T&D projects, including in connection with permitting and regulatory approvals. RESULTS OF OPERATIONS (A) PSE&G's results in 2012 include after-tax expenses of $24 million for O&M costs and Power's results in 2014, 2013 and 2012 include after-tax expenses of $17 million, $32 million and $39 million, respectively, for O&M costs net of insurance recoveries in 2013 and 2012, due to severe damage caused by Superstorm Sandy. See Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities. (B) Other includes after-tax activities at the parent company, PSEG LI and Energy Holdings as well as intercompany eliminations. The 2014 year-over-year increase in our Net Income was driven primarily by: • mark-to-market (MTM) gains in 2014 resulting from a decrease in prices on forward positions, as compared to MTM losses in 2013, • higher sales volumes under the basic gas supply service (BGSS) contract due to colder average temperatures in the 2014 winter heating season, • higher volumes of gas sold to third party customers, • higher revenues due to increased investments in transmission projects, and • lower O&M expense at PSE&G and Power, largely due to a reduction in pension and OPEB costs. These increases were partially offset by • lower volumes of electricity sold under Power's basic generation service (BGS) contracts resulting from serving fewer tranches in 2014, and • higher generation costs due to higher fuel costs. The 2013 year-over-year decrease in our Net Income was driven by: • lower volumes of electricity sold under Power's BGS contracts at lower average prices, • lower volumes of wholesale load contracts in the PJM and New England (NE) regions, • unfavorable amounts related to the MTM activity, discussed below, • higher generation costs due to higher fuel costs, • higher planned outage and maintenance costs at certain of our fossil and nuclear plants, partially offset by cost control measures, • the absence of the gain on the Dynegy leveraged lease settlement in 2012, and • higher Income Tax Expense due to the absence of tax benefits related to the settlement of the 1997-2006 IRS audits in 2012 (see Item 8. Financial Statements and Supplementary Data-Note 19. Income Taxes). These decreases were largely offset by • higher capacity revenues in the PJM region resulting from higher average prices as well as higher generation sold primarily in the PJM region, • higher average gas prices on increased sales to third party customers, and • higher revenues due to increased investments in transmission projects. Our results include the realized gains, losses and earnings on Power’s Nuclear Decommissioning Trust (NDT) Fund and other related NDT activity. Net realized gains, interest and dividend income and other costs related to the NDT Fund are recorded in Other Income and Deductions, and impairments on certain NDT securities are recorded as Other-Than-Temporary Impairments. Interest accretion expense on Power's nuclear Asset Retirement Obligation (ARO) is recorded in Operation and Maintenance Expense and the depreciation related to the ARO asset is recorded in Depreciation and Amortization Expense. In 2014 and 2012, we restructured portions of our NDT Fund and realized gains of $65 million and $59 million, respectively. Our results also include the after-tax impacts of non-trading MTM activity, which consist of the financial impact from positions with forward delivery dates. The combined after-tax impact on Net Income for the years ended December 31, 2014, 2013 and 2012 include the changes related to NDT Fund and MTM activity shown in the chart below: PSEG Our results of operations are primarily comprised of the results of operations of our principal operating subsidiaries, Power and PSE&G, excluding charges related to intercompany transactions, which are eliminated in consolidation. For additional information on intercompany transactions, see Item 8. Financial Statements and Supplementary Data-Note 23. Related-Party Transactions. The 2014 amounts in the preceding table for Operating Revenues and O&M Costs each include $389 million for Servco. These amounts represent the O&M pass-through costs for the Long Island operations, the full reimbursement of which is reflected in Operating Revenues. See Item 8. Financial Statements and Supplementary Data-Note 3. Variable Interest Entities for further explanation. The following discussions for Power and PSE&G provide a detailed explanation of their respective variances. PSE&G Year Ended December 31, 2014 as compared to 2013 Operating Revenues increased $111 million due primarily to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $88 million due primarily to an increase in transmission revenues. • Transmission revenues were $138 million higher due to increased investments in transmission projects. • Gas distribution revenues decreased $5 million due primarily to lower Weather Normalization Clause (WNC) revenue of $32 million due to more normal weather compared to the prior year, lower Transitional Energy Facilities Assessment (TEFA) revenue of $22 million due to elimination of the TEFA tax effective January 1, 2014, lower Capital Infrastructure Program (CIP) related revenue of $11 million, partially offset by higher sales volumes of $54 million, and higher revenue from Solar and Energy Efficiency Recovery Charges (formerly RRC and currently Green Program Recovery Charges (GPRC)) of $6 million. • Electric distribution revenues decreased $45 million due primarily to a $45 million decrease due to elimination of the TEFA tax in 2014, lower sales volumes of $17 million and lower CIP related revenue of $5 million, partially offset by higher GPRC of $22 million. Clause Revenues decreased $51 million due primarily to lower Societal Benefit Charges (SBC) of $32 million, lower Securitization Transition Charge (STC) revenues of $18 million, and lower Margin Adjustment Clause (MAC) of $7 million, partially offset by higher Solar Pilot Recovery Charge (SPRC) of $6 million. The changes in SBC, STC, MAC and SPRC amounts were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, Depreciation and Amortization and Interest Expense. PSE&G does not earn margin on SBC, STC, MAC or SPRC collections. Commodity Revenue increased $68 million due to higher Electric and Gas revenues. This is entirely offset with increased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Electric revenues increased $22 million due primarily to $64 million in higher BGS revenues, partially offset by $42 million in lower revenues from the sale of Non-Utility Generation (NUG) energy and collections of Non-Utility Generation Charges (NGC) due primarily to lower prices. BGS sales increased 2% due primarily to weather. • Gas revenues increased $46 million due to higher BGSS volumes of $93 million, partially offset by lower BGSS prices of $47 million. The average price of natural gas was 5% lower in 2014 than in 2013. Other Operating Revenues increased $6 million due primarily to increased revenues from our appliance repair business and miscellaneous electric operating revenues. Operating Expenses Energy Costs increased $68 million. This is entirely offset by Commodity Revenue. • Electric costs increased $22 million or 1% due to $75 million of increased deferred cost recovery, $30 million in higher BGS volumes and a $2 million increase in NUG prices, partially offset by $78 million in lower NUG volumes and $7 million from lower BGS prices. BGS volume increased 2% due to customer migration from third party suppliers (TPS). • Gas costs increased $46 million or 5% due to $93 million or 10% in higher sales volumes due primarily to weather, partially offset by $47 million or 5% in lower prices. Operation and Maintenance decreased $81 million, of which the most significant components were decreases of • $73 million in pension and other postretirement benefits (OPEB) expenses, and • $21 million in costs related to SBC, GPRC and CIP, • partially offset by a $12 million net increase in operational expenses due primarily to increases in storm related costs of $8 million, wages of $6 million and transmission related costs of $2 million, partially offset by a $4 million decrease in general operating expenses, and • a $1 million increase in gas bad debt expense. Depreciation and Amortization increased $34 million due primarily to increases of • $47 million in additional plant in service, and • $2 million in software amortization, • partially offset by a $15 million decrease in amortization of Regulatory Assets. Taxes Other Than Income Taxes decreased $68 million due to the elimination of the TEFA tax in 2014. Other Income and (Deductions) net increase of $7 million was due primarily to increases of • $7 million in Allowance for Funds Used During Construction, and • $1 million in solar loan interest income, • partially offset by a $1 million decrease in Rabbi Trust interest and gains. Interest Expense decreased $16 million primarily due to decreases of • $16 million due to partial redemption of securitization debt in 2014, • $25 million due to maturities of $725 million in 2013, and • $5 million due to maturities of $500 million in 2014, • partially offset by an increase of $14 million due to the issuance of $1,250 million of debt in 2014, and • an increase of $17 million due to the issuance of $1,500 million of debt in 2013. Income Tax Expense increased $68 million due primarily to higher pre-tax income. Year ended December 31, 2013 as compared to 2012 Operating Revenues increased $29 million due primarily to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $223 million due primarily to an increase in transmission revenues. • Transmission revenues were $184 million higher due to increased investments in transmission projects. • Gas distribution revenues increased $24 million due primarily to higher sales volumes of $70 million, higher CIP related revenue of $23 million and higher revenue from Solar and Energy Efficiency Recovery Charges of $5 million, partially offset by lower WNC revenue of $67 million due to more normal weather compared to the prior year and lower TEFA revenue of $7 million due to a lower TEFA rate. • Electric distribution revenues increased $15 million due primarily to higher GPRC of $37 million and higher CIP related revenue of $11 million, partially offset by lower TEFA revenue of $23 million due to a lower TEFA rate and lower sales volumes of $10 million. Clause Revenues increased $110 million due primarily to STC revenues of $51 million, higher SBC of $47 million and a higher SPRC of $11 million. The changes in STC, SBC and SPRC amounts were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, Depreciation and Amortization and Interest Expense. PSE&G does not earn margin on STC, SBC or SPRC collections. Commodity Revenue decreased $318 million due to lower Electric and Gas revenues. This is entirely offset as savings in Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Electric revenues decreased $308 million due primarily to $169 million in lower BGS revenues and $139 million in lower revenues from the sale of NUG energy and collections of NGC due primarily to lower prices. BGS sales decreased 4% due primarily to customer migration to TPS and weather. • Gas revenues decreased $10 million due to lower BGSS prices of $121 million, partially offset by higher BGSS volumes of $111 million. The average price of natural gas was 12% lower in 2013 than in 2012. Other Operating Revenues increased $14 million due primarily to increased revenues from our appliance repair business and miscellaneous electric operating revenues. Operating Expenses Energy Costs decreased $318 million. This is entirely offset by Commodity Revenue. • Electric costs decreased $308 million or 14% due to $214 million in lower BGS and NUG volumes, $35 million of lower BGS prices, and $59 million for decreased deferred cost recovery. BGS and NUG volumes decreased 10% due primarily to customer migration to TPS. • Gas costs decreased $10 million or 1% due to $121 million or 12% in lower prices, partially offset by $111 million or 11% in higher sales volumes due primarily to weather. Operation and Maintenance increased $131 million, of which the most significant components were increases of • $131 million in costs related to SBC, GPRC and CIP, • $24 million in transmission related costs, and • $10 million in appliance service costs, • partially offset by the absence of $40 million in transmission and distribution storm damages in 2012, • a $10 million decrease in pension and OPEB expenses, and • an $11 million decrease in gas bad debt expense. Depreciation and Amortization increased $94 million due primarily to increases of • $59 million in amortization of Regulatory Assets, and • $33 million in additional plant in service. Taxes Other Than Income Taxes decreased $30 million due to a lower TEFA rate, partially offset by higher sales volumes for gas. Other Income and (Deductions) net increase of $4 million was due primarily to • a $5 million increase in solar loan interest income, • partially offset by a $1 million decrease in Rabbi Trust interest and gains. Interest Expense experienced no material change. Income Tax Expense increased $74 million due primarily to higher pre-tax income and the absence of tax benefits related to the settlement of the 1997-2006 IRS audits in 2012. Power Year Ended December 31, 2014 as compared to 2013 Operating Revenues increased $371 million due to changes in generation, gas supply and other operating revenues. Generation Revenues increased $263 million due primarily to • higher revenues of $366 million due primarily to MTM gains in 2014 resulting from a decrease in prices on forward positions and higher energy volumes sold in the New York and New England (NE) regions, and • a net increase of $27 million due primarily to higher volumes on wholesale load contracts in the PJM region, offset in part by lower wholesale load volumes in the NE region, • partially offset by a decrease of $89 million due to lower volumes of electricity sold as a result of serving fewer tranches in 2014 under our BGS contracts and lower average pricing, and • a net decrease of $41 million due primarily to a decrease in operating reserve revenue, partially offset by higher ancillary revenue in the PJM region. Gas Supply Revenues increased $93 million due primarily to • a net increase of $44 million in sales under the BGSS contract, substantially comprised of higher sales volumes due to colder average temperatures during the 2014 winter heating season, partially offset by lower average gas prices, and • a net increase of $49 million due to higher sales volumes to third party customers. Other Operating Revenues increased $15 million due to transition fees related to fuel management and power supply management contracts with LIPA. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs increased $251 million due to • Generation costs increased $252 million due primarily to higher fuel costs, reflecting higher average realized natural gas prices, the unfavorable MTM impact from lower average natural gas prices on forward positions and the utilization of higher volumes of gas and oil. These increased costs were partially offset by lower congestion costs in the PJM region. • Gas costs decreased $1 million related to a decrease of $137 million in average gas inventory costs, substantially offset by $136 million of higher volumes sold under the BGSS contract and to third party customers due to colder average temperatures during the 2014 winter heating season. Operation and Maintenance decreased $38 million due primarily to • lower pension and OPEB costs of $42 million, • a decrease of $15 million due primarily to the outage of our 100%-owned Hope Creek nuclear facility in the fall of 2013, which was partially offset by the extension of our 57%-owned nuclear Salem Unit 2 refueling outage in 2014, and • a decrease of $27 million due to lower storm costs related to Superstorm Sandy, • partially offset by an increase of $40 million related primarily to higher planned outage and maintenance costs at our fossil plants, including maintenance and installation of upgraded technology at our Linden combined cycle gas generating plant and outages at our Keystone and Hudson facilities. Depreciation and Amortization increased $19 million due primarily to a higher depreciable fossil and nuclear asset base. Income from Equity Method Investments experienced no material change. Other Income (Deductions) increased $65 million due primarily to higher realized gains from the NDT Fund due to the restructuring of the portfolio in 2014. Other-Than-Temporary Impairments increased $8 million due to an increase in impairments of the NDT Fund. Interest Expense increased $6 million due primarily to the issuance of a $250 million 2.45% Senior Note and a $250 million 4.30% Senior Note in November 2013, partially offset by the maturity of $300 million of 2.50% Senior Notes in April 2013. Income Tax Expense increased $72 million in 2014 due primarily to higher pre-tax income. Year ended December 31, 2013 as compared to 2012 Operating Revenues increased $190 million due to changes in generation and supply revenues. Generation Revenues increased $102 million due primarily to • an increase of $341 million due to higher capacity revenues resulting from higher average auction prices and an increase in operating reserve revenues in PJM, and • higher net revenues of $36 million due primarily to higher generation sold in the PJM and NE regions partly offset by higher MTM losses in 2013 resulting from an increase in prices on forward positions in the PJM and NE regions, • partially offset by a decrease of $155 million due primarily to lower volumes of electricity sold under our BGS contracts and lower average pricing, and • a net decrease of $120 million due to lower volumes on wholesale load contracts in the PJM and NE regions. Gas Supply Revenues increased $88 million due primarily to • a net increase of $40 million in sales under the BGSS contract, substantially comprised of higher sales volumes due to colder average temperatures during the 2013 winter heating season, partially offset by lower average gas prices, and • a net increase of $48 million due primarily to higher average gas prices and higher sales volumes to third party customers. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs increased $115 million due to • Generation costs increased $75 million due primarily to $84 million of higher fuel costs, reflecting higher average realized natural gas prices, higher nuclear fuel costs and the utilization of higher volumes of coal and oil, partially offset by lower average coal prices and lower average unrealized natural gas prices on forward positions. • Gas costs increased $40 million, principally related to obligations under the BGSS contract, reflecting higher sales volumes in 2013 due to colder average temperatures during the 2013 winter heating season and higher volumes on third party sales, partially offset by lower average gas inventory costs. Operation and Maintenance increased $97 million due primarily to • higher planned outage and maintenance costs in 2013, mainly at our gas-fired BEC plant in New York, Bergen gas-fired plant in New Jersey, Linden gas-fired plant in New Jersey and 23%-owned Conemaugh coal-fired plant in Pennsylvania, partially offset by lower storm costs in 2013, and • higher outage costs at our nuclear generating facilities, primarily at our 100%-owned Hope Creek station. Depreciation and Amortization increased $31 million due primarily to a higher depreciable asset base at Fossil and Nuclear, including placing into service the new gas-fired peaking units at Kearny, New Jersey and New Haven, Connecticut in June 2012, completion of the steam path retrofit upgrade at our co-owned Peach Bottom Unit 2 in October 2012, and placing two solar facilities into service in the fourth quarter of 2012. In addition, an update to the nuclear asset retirement obligation became effective in November 2012, causing higher depreciation in 2013. Income from Equity Method Investments experienced no material change. Other Income (Deductions) decreased $6 million due primarily to lower NDT Fund realized gains in 2013, partially offset by lower NDT Fund realized losses in 2013. In addition, we recognized a loss on the extinguishment of debt in 2012. Other-Than-Temporary Impairments decreased $6 million due to lower impairments on the NDT Fund in 2013. Interest Expense decreased $16 million due primarily to a decrease of $23 million resulting from the maturity of $300 million of 2.50% of Senior Notes in April 2013, and the early redemptions of $250 million of 5.00% medium term notes and various tax-exempt bonds in December 2012, partially offset by higher interest costs of $6 million in 2013 since interest capitalization ceased for our Kearny and New Haven gas-fired peaking projects on their June 2012 in-service date. Income Tax Expense decreased $14 million in 2013 due primarily to lower pre-tax income. LIQUIDITY AND CAPITAL RESOURCES The following discussion of our liquidity and capital resources is on a consolidated basis, noting the uses and contributions, where material, of our two direct major operating subsidiaries. Financing Methodology We expect our capital requirements to be met through internally generated cash flows and external financings, consisting of short-term debt for working capital needs and long-term debt for capital investments. PSE&G’s sources of external liquidity include a $600 million multi-year syndicated credit facility. PSE&G’s commercial paper program is the primary vehicle for meeting seasonal, intra-month and temporary working capital needs. PSE&G does not engage in any intercompany borrowing or lending. PSE&G maintains back-up facilities in an amount sufficient to cover the commercial paper and letters of credit outstanding. PSE&G’s dividend payments to PSEG are consistent with its capital structure objectives which have been established to maintain investment grade credit ratings. PSE&G’s long-term financing plan is designed to replace maturities, fund a portion of its capital program and manage short-term debt balances. Generally, PSE&G uses either secured medium-term notes or first mortgage bonds to raise long-term capital. PSEG, Power, Energy Holdings, PSEG LI and Services participate in a corporate money pool, an aggregation of daily cash balances designed to efficiently manage their respective short-term liquidity needs. Servco does not participate in the corporate money pool. Servco's short-term liquidity needs are met through an account funded and owned by LIPA. PSEG’s sources of external liquidity include multi-year syndicated credit facilities totaling $1 billion. These facilities are available to back-stop PSEG’s commercial paper program, issue letters of credit and for general corporate purposes. These facilities may also be used to provide support to PSEG's subsidiaries. PSEG’s credit facilities and the commercial paper program are available to support PSEG working capital needs or to temporarily fund growth opportunities in advance of obtaining permanent financing. From time to time, PSEG may make equity contributions or provide credit support to its subsidiaries. Power’s sources of external liquidity include $2.6 billion of syndicated multi-year credit facilities. Additionally, from time to time, Power maintains bilateral credit agreements designed to enhance its liquidity position. Power has $100 million of bilateral credit agreements that are scheduled to expire in September 2015. Credit capacity is primarily used to provide collateral in support of Power's forward energy sale and forward fuel purchase contracts as the market prices for energy and fuel fluctuate, and to meet potential collateral postings in the event of a credit rating downgrade below investment grade. Power’s dividend payments to PSEG are also designed to be consistent with its capital structure objectives which have been established to maintain investment grade credit ratings and provide sufficient financial flexibility. Generally, Power issues senior unsecured debt to raise long-term capital. Operating Cash Flows We expect our operating cash flows combined with cash on hand and financing activities to be sufficient to fund capital expenditures and shareholder dividend payments. For the year ended December 31, 2014, our operating cash flow increased by $2 million. For the year ended December 31, 2013, our operating cash flow increased by $371 million. The net changes were primarily due to net changes from our subsidiaries as discussed below and tax payments at the parent company and Energy Holdings. PSE&G PSE&G’s operating cash flow increased $188 million from $1,645 million to $1,833 million for the year ended December 31, 2014, as compared to 2013, due primarily to • higher earnings, • an increase of $188 million due to an increase from a net change in regulatory deferrals, primarily related to over collections of BGSS gas costs, the over collection of gas revenues due to the Gas Weather Normalization clause and GPRC rate recoveries, • an increase of $83 million due to decrease in employee benefit plan funding, • partially offset by $199 million related to higher tax payments. PSE&G’s operating cash flow increased $389 million from $1,256 million to $1,645 million for the year ended December 31, 2013, as compared to 2012, due primarily to • higher earnings, • an increase of $134 million due to an increase from a net change in regulatory deferrals, primarily related to over collections of BGSS gas costs and the collection of prior year deficiency revenues under the Gas Weather Normalization clause mechanism, and • a decrease of $47 million in benefit plan funding, • partially offset by $114 million related to higher tax payments. Power Power’s operating cash flow increased $78 million from $1,347 million to $1,425 million for the year ended December 31, 2014, as compared to 2013, primarily resulting from • lower tax payments, • partially offset by increase of $87 million in payments to counterparties, and • a decrease of $11 million due to collection of counterparty receivables. Power’s operating cash flow decreased $106 million from $1,453 million to $1,347 million for the year ended December 31, 2013, as compared to 2012, primarily resulting from • lower earnings, and • higher tax payments, • partially offset by a decrease of $73 million related to margin deposits, and • a decrease of $26 million in employee benefit plan funding. Short-Term Liquidity We continually monitor our liquidity and seek to add capacity as needed to meet our liquidity requirements. Each of our credit facilities is restricted as to availability and use to the specific companies as listed below; however, if necessary, the PSEG facilities can also be used to support our subsidiaries’ liquidity needs. Our total credit facilities and available liquidity as of December 31, 2014 were as follows: As of December 31, 2014, our credit facility capacity was in excess of our projected maximum liquidity requirements over our 12 month planning horizon. Our maximum liquidity requirements are based on stress scenarios that incorporate changes in commodity prices and the potential impact of Power losing its investment grade credit rating. PSE&G’s credit facility primary use is to support its Commercial Paper Program under which as of December 31, 2014, no amounts were outstanding. Most of our credit facilities expire in 2018 and 2019. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities and Note 13. Schedule of Consolidated Debt. Long-Term Debt Financing PSE&G has $300 million of 2.70%, Series G Medium Term Notes maturing in May 2015. Power has a $300 million of 5.50% Senior Notes maturing in December 2015. For a discussion of our long-term debt transactions during 2014 and into 2015, see Item 8. Financial Statements and Supplementary Data-Note 13. Schedule of Consolidated Debt. Debt Covenants Our credit agreements contain maximum debt to equity ratios and other restrictive covenants and conditions to borrowing. We are currently in compliance with all of our debt covenants. Continued compliance with applicable financial covenants will depend upon our future financial position, level of earnings and cash flows, as to which no assurances can be given. In addition, under its First and Refunding Mortgage (Mortgage), PSE&G may issue new First and Refunding Mortgage Bonds against previous additions and improvements, provided that its ratio of earnings to fixed charges calculated in accordance with its Mortgage is at least 2 to 1, and/or against retired Mortgage Bonds. As of December 31, 2014, PSE&G’s Mortgage coverage ratio was 5.6 to 1 and the Mortgage would permit up to approximately $3.8 billion aggregate principal amount of new Mortgage Bonds to be issued against additions and improvements to its property. Default Provisions Our bank credit agreements and indentures contain various default provisions that could result in the potential acceleration of payment under the defaulting company’s agreement. We have not defaulted under these agreements. PSEG’s bank credit agreements contain cross default provisions under which events at Power or PSE&G, including payment defaults, bankruptcy events, the failure to satisfy certain final judgments or other events of default under their financing agreements, would each constitute an event of default. Under the bank credit agreements, it would be an event of default if both PSE&G and Power cease to be wholly owned by PSEG. There are no cross default provisions to affiliates in PSE&G’s or Power’s credit agreements or indentures. Ratings Triggers Our debt indentures and credit agreements do not contain any material ‘ratings triggers’ that would cause an acceleration of the required interest and principal payments in the event of a ratings downgrade. However, in the event of a downgrade, any one or more of the affected companies may be subject to increased interest costs on certain bank debt and certain collateral requirements. In the event that we are not able to affirm representations and warranties on credit agreements, lenders would not be required to make loans. In accordance with BPU requirements under the BGS contracts, PSE&G is required to maintain an investment grade credit rating. If PSE&G were to lose its investment grade rating, it would be required to file a plan to assure continued payment for the BGS requirements of its customers. PSE&G is the servicer for the bonds issued by PSE&G Transition Funding LLC and PSE&G Transition Funding II LLC. Cash collected by PSE&G to service these bonds is commingled with PSE&G’s other cash until it is remitted to the bond trustee each month. If PSE&G were to lose its investment grade rating, PSE&G would be required to remit collected cash daily to the bond trustee. PSE&G is prohibited from advancing its own funds to make payments related to such bonds. Fluctuations in commodity prices or a deterioration of Power’s credit rating to below investment grade could increase Power’s required margin postings under various agreements entered into in the normal course of business. Power believes it has sufficient liquidity to meet the required posting of collateral which would likely result from a credit rating downgrade at today’s market prices. Common Stock Dividends On February 17, 2015, our Board of Directors approved a $0.39 per share common stock dividend for the first quarter of 2015. This reflects an indicated annual dividend rate of $1.56 per share. We expect to continue to pay cash dividends on our common stock; however, the declaration and payment of future dividends to holders of our common stock will be at the discretion of the Board of Directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our businesses, alternate investment opportunities, legal requirements, regulatory constraints, industry practice and other factors that the Board of Directors deems relevant. Credit Ratings If the rating agencies lower or withdraw our credit ratings, such revisions may adversely affect the market price of our securities and serve to materially increase our cost of capital and limit access to capital. Credit Ratings shown are for securities that we typically issue. Outlooks are shown for Corporate Credit Ratings (S&P) and Issuer Credit Ratings (Moody’s and Fitch) and can be Stable, Negative, or Positive. There is no assurance that the ratings will continue for any given period of time or that they will not be revised by the rating agencies, if, in their respective judgments, circumstances warrant. Each rating given by an agency should be evaluated independently of the other agencies' ratings. The ratings should not be construed as an indication to buy, hold or sell any security. In May 2014, Moody’s published updated research reports on PSEG, PSE&G and Power and the existing ratings and outlooks were unchanged. In May 2014, S&P published updated research reports and revised the outlook to positive from stable for PSEG’s Corporate Credit Rating. S&P also affirmed the senior unsecured rating of BBB+ at Power and mortgage bond rating of A at PSE&G. In October 2014, Fitch affirmed the ratings and outlooks for PSEG, PSE&G and Power. (A) Moody’s ratings range from Aaa (highest) to C (lowest) for long-term securities and P1 (highest) to NP (lowest) for short-term securities. (B) S&P ratings range from AAA (highest) to D (lowest) for long-term securities and A1 (highest) to D (lowest) for short-term securities. The Corporate Credit Rating outlook does not apply to PSEG’s or PSE&G’s Commercial Paper Rating or PSE&G’s Mortgage Bond rating. (C) Fitch ratings range from AAA (highest) to D (lowest) for long-term securities and (highest) to D (lowest) for short-term securities. Other Comprehensive Income For the year ended December 31, 2014, we had Other Comprehensive Loss of $188 million on a consolidated basis. Other Comprehensive Loss was due primarily to a $173 million increase in our consolidated liability for pension and postretirement benefits and a $27 million decrease in net unrealized gains related to Available-for-Sale Securities, and was partially offset by $12 million of unrealized gains on derivative contracts accounted for as hedges. See Item 8. Financial Statements and Supplementary Data-Note 20. Accumulated Other Comprehensive Income (Loss), Net of Tax for additional information. CAPITAL REQUIREMENTS It is expected that all of our capital requirements over the next three years will come from a combination of internally generated funds and external debt financing. Projected capital construction and investment expenditures, excluding nuclear fuel purchases, for the next three years are presented in the table below. These amounts are subject to change, based on various factors. We will continue to approach non-regulated solar and other renewables investments opportunistically, seeking projects that will provide attractive risk-adjusted returns for our shareholders. PSE&G PSE&G’s projections for future capital expenditures include material additions and replacements to its transmission and distribution systems to meet expected growth and to manage reliability. As project scope and cost estimates develop, PSE&G will modify its current projections to include these required investments. PSE&G’s projected expenditures for the various items reported above are primarily comprised of the following: • Reliability Enhancements-investments made to maintain the reliability and efficiency of the system or function. • Facility Replacement-investments made to replace systems or equipment in kind. • Support Facilities-ancillary equipment needed to support the business lines, such as computers, office furniture and buildings and structures housing support personnel or equipment/inventory. • New Business-investments made in support of new business (e.g. to add new customers). • Environmental/Regulatory-investments made in response to environmental, regulatory or legal mandates. • Renewables-investments made in response to regulatory or legal mandates relating to renewable energy. In 2014, PSE&G made $2,170 million of capital expenditures, including $2,164 million of investment in plant, primarily for transmission and distribution system reliability and $6 million in solar loan investments. This does not include expenditures for cost of removal, net of salvage, of $98 million, which are included in operating cash flows. Power Power’s projected expenditures for the various items listed above are primarily comprised of the following: • Baseline-investments to replace major parts and enhance operational performance. • Environmental/Regulatory-investments made in response to environmental, regulatory or legal mandates. • Fossil Growth Opportunities-investments associated with upgrades to increase efficiency and output at combined cycle plants. • Nuclear Expansion-investments associated with certain Nuclear capital projects, primarily at existing facilities designed to increase operating output. • Solar Expansion-investments associated with the construction of utility-scale photovoltaic facilities. In 2014, Power made $460 million of capital expenditures, excluding $166 million for nuclear fuel, primarily related to various projects at Fossil and Nuclear. Disclosures about Long-Term Maturities, Contractual and Commercial Obligations and Certain Investments The following table reflects our contractual cash obligations and other commercial commitments in the respective periods in which they are due. In addition, the table summarizes anticipated recourse and non-recourse debt maturities for the years shown. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 13. Schedule of Consolidated Debt. The table below does not reflect any anticipated cash payments for pension obligations due to uncertain timing of payments or liabilities for uncertain tax positions since we are unable to reasonably estimate the timing of liability payments in individual years beyond 12 months due to uncertainties in the timing of the effective settlement of tax positions. See Item 8. Financial Statements and Supplementary Data-Note 19. Income Taxes for additional information. OFF-BALANCE SHEET ARRANGEMENTS Power Power issues guarantees in conjunction with certain of its energy contracts. See Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities for further discussion. Other Through Energy Holdings, we have investments in leveraged leases that are accounted for in accordance with GAAP Accounting for Leases. Leveraged lease investments generally involve three parties: an owner/lessor, a creditor and a lessee. In a typical leveraged lease arrangement, the lessor purchases an asset to be leased. The purchase price is typically financed 80% with debt provided by the creditor and the balance comes from equity funds provided by the lessor. The creditor provides long-term financing to the transaction secured by the property subject to the lease. Such long-term financing is non-recourse to the lessor and is not presented on our Consolidated Balance Sheets. In the event of default, the leased asset, and in some cases the lessee, secures the loan. As a lessor, Energy Holdings has ownership rights to the property and rents the property to the lessees for use in their business operations. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 6. Long-Term Investments. In the event that collection of the minimum lease payments to be received by Energy Holdings is no longer reasonably assured, the accounting treatment for some of the leases may change. In such cases, Energy Holdings may deem that a lessee has a high probability of defaulting on the lease obligation, and would reclassify the lease from a leveraged lease to an operating lease and would consider the need to record an impairment of its investment. Should this event occur, the fair value of the underlying asset and the associated debt would be recorded on the Consolidated Balance Sheets instead of the net equity investment in the lease. CRITICAL ACCOUNTING ESTIMATES Under GAAP, many accounting standards require the use of estimates, variable inputs and assumptions (collectively referred to as estimates) that are subjective in nature. Because of this, differences between the actual measure realized versus the estimate can have a material impact on results of operations, financial position and cash flows. We have determined that the following estimates are considered critical to the application of rules that relate to the respective businesses. Accounting for Pensions PSEG sponsors several qualified and nonqualified pension plans covering PSEG’s and its participating affiliates’ current and former employees who meet certain eligibility criteria. The market-related value of plan assets held for the qualified pension plan is equal to the fair value of these assets as of year-end. The plan assets are comprised of investments in both debt and equity securities which are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. We calculate pension costs using various economic and demographic assumptions. Assumptions and Approach Used: Economic assumptions include the discount rate and the long-term rate of return on trust assets. Demographic assumptions include projections of future mortality rates, pay increases and retirement patterns. The discount rate used to calculate pension obligations is determined as of December 31 each year, our measurement date. The discount rate used to determine year-end obligations is also used to develop the following year’s net periodic pension cost. In selecting the annual discount rate to calculate benefit obligations, we utilize a hypothetical portfolio of high quality corporate bonds with cash flows that match the benefit plan liability. The composite yield on the hypothetical bond portfolio reflects the rate at which the obligations could effectively be settled. Our expected rate of return on plan assets reflects current asset allocations, historical long-term investment performance and an estimate of future long-term returns by asset class and long-term inflation assumptions. Based on the above assumptions, we have estimated net periodic pension expense of approximately $55 million, net of amounts capitalized. We utilize a corridor approach that reduces the volatility of reported pension expense /income. The corridor requires differences between actuarial assumptions and plan results be deferred and amortized as part of expense/income. This occurs only when the accumulated differences exceed 10% of the greater of the pension benefit obligation or the fair value of plan assets as of each year-end. The excess would be amortized over the average remaining service period of the active employees, which is approximately eight years. Effect if Different Assumptions Used: As part of the business planning process, we have modeled future costs assuming an 8.00% rate of return and a 4.20% discount rate for 2015. Actual future pension expense/income and funding levels will depend on future investment performance, changes in discount rates, market conditions, funding levels relative to our projected benefit obligation and accumulated benefit obligation and various other factors related to the populations participating in the pension plans. The following chart reflects the sensitivities associated with a change in certain assumptions. The effects of the assumption changes shown below solely reflect the impact of that specific assumption. See

<s>[INST] PSEG's business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: PSE&G, our public utility company which primarily provides electric transmission services and distribution of electric energy and natural gas, implements demand response and energy efficiency programs and invests in solar generation in New Jersey, and Power, our wholesale energy supply company that integrates its nuclear, fossil and renewable generating asset operations with its wholesale energy, fuel supply, energy trading and marketing and risk management activities primarily in the Northeast and MidAtlantic United States. PSEG's other direct wholly owned subsidiaries are: PSEG Energy Holdings L.L.C. (Energy Holdings), which earns its revenues primarily from its portfolio of lease investments; PSEG Long Island LLC (PSEG LI), which effective January 1, 2014, operates the Long Island Power Authority's (LIPA) transmission and distribution (T&D) system under a contractual agreement; and PSEG Services Corporation (Services), which provides us and these operating subsidiaries with certain management, administrative and general services at cost. Our business discussion in Part I, Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Part I, Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2014 and key factors that we expect will drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2014 AND FUTURE OUTLOOK 2014 Overview Our business plan seeks to achieve growth while managing risks. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: Growing our utility operations through continued investment in T&D infrastructure projects with greater diversity of regulatory oversight, and Maintaining a reliable generation fleet with the flexibility to utilize a diverse mix of fuels to allow us to respond to market volatility and capitalize on opportunities as they arise in the locations in which we operate. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2014 and 2013 are presented below: Our $275 million 2014 over 2013 increase in Net Income was due primarily to higher transmission revenues at PSE&G and marktomarket gains in 2014 as compared to losses in 2013 and higher volumes of gas sales under the BGSS contract and to third party customers at Power. In addition, the increase was also due to lower Operations and Maintenance (O&M) costs at PSE&G and Power, principally related to a reduction in pension and other postretirement employee benefit (OPEB) costs. These factors were partially offset by lower volumes of electricity sold under the BGS contract and higher fuel costs incurred to generate electricity at Power. For a more detailed discussion of our financial results, see Results of Operations. At PSE&G, our regulated utility, we continued to invest capital in T&D infrastructure projects aimed at maintaining the reliability of our service to our customers. PSE&G’s results for 2014 reflect the favorable impacts from these investments as well as a slowly improving economy. Effective January 1, 2014, PSE&G's formula rate increased our annual transmission revenues by approximately $171 million. In October 2014, we filed our 2015 Formula Rate Update with the Federal Energy Regulatory Commission (FERC) for approximately $182 million in increased annual transmission revenues which went into effect on January 1, 2015. Each year, transmission revenues are adjusted to [/INST] Positive. </s>

PUBLIC SERVICE ENTERPRISE GROUP INC

2016-02-26

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) This combined MD&A is separately filed by Public Service Enterprise Group Incorporated (PSEG), Public Service Electric and Gas Company (PSE&G) and PSEG Power LLC (Power). Information contained herein relating to any individual company is filed by such company on its own behalf. PSE&G and Power each make representations only as to itself and make no representations whatsoever as to any other company. PSEG's business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: • PSE&G, our public utility company which is engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in solar generation projects and has implemented energy efficiency and demand response programs in New Jersey, which are regulated by the BPU, and • Power, our multi-regional, wholesale energy supply company that integrates its generating asset operations and gas supply commitments with its wholesale energy, fuel supply and energy transacting functions primarily in the Northeast and Mid-Atlantic United States through its principal direct wholly owned subsidiaries. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA), and the states in which they operate. PSEG's other direct wholly owned subsidiaries are: PSEG Energy Holdings L.L.C. (Energy Holdings), which earns its revenues primarily from its portfolio of lease investments; PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority's (LIPA) transmission and distribution (T&D) system under a contractual agreement; and PSEG Services Corporation (Services), which provides us and these operating subsidiaries with certain management, administrative and general services at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2015 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2015 AND FUTURE OUTLOOK 2015 Overview Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: • growing our utility operations through continued investment in T&D and other infrastructure projects, and • maintaining and expanding a reliable generation fleet with the flexibility to utilize a diverse mix of fuels which allows us to respond to market volatility and capitalize on opportunities as they arise. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2015 and 2014 are presented below: Our $161 million 2015 over 2014 increase in Net Income was due primarily to higher transmission revenues at PSE&G, higher mark-to-market (MTM) gains and lower generation costs driven by lower natural gas and coal prices at Power and insurance recoveries of Superstorm Sandy costs, primarily at Power. These increases were partially offset by higher pension and other postretirement benefit (OPEB) costs and lower capacity revenues and Nuclear Decommissioning Trust (NDT) activity at Power. For a more detailed discussion of our financial results, see Results of Operations. During 2015, we grew earnings, maintained cash flows and sustained a strong balance sheet. We effectively deployed capital without the need for additional equity, while our solid credit ratings aided our ability to access capital and credit markets. The greater emphasis on capital spending for projects on which we receive contemporaneous returns at PSE&G, our regulated utility, in recent years has yielded strong results and allowed us to increase our dividend. These actions to transition our business to meet market conditions and investor expectations reflect our multi-year, long-term approach to managing our company. Our focus has been to invest capital in T&D and other infrastructure projects aimed at maintaining service reliability to our customers and bolstering our system resiliency. At Power, our merchant generator, we strive to improve performance and reduce costs in order to enhance the value of our generation fleet in light of low gas prices, environmental considerations and competitive market forces that reward efficiency and reliability. At PSE&G, in 2015 we continued to make investments and seek recovery on such investments made to improve the resiliency of our gas and electric distribution system as part of our Energy Strong program that was approved by the BPU in 2014. As approved, the Energy Strong program provides for up to $1.2 billion of investment, with cost recovery at a 9.75% rate of return on equity on the first $1.0 billion of the investment, plus associated allowance for funds used during construction, through an accelerated recovery mechanism. We will seek recovery of up to $220 million of investment in PSE&G's next base rate case, which is to be filed no later than November 1, 2017. In November 2015, the BPU approved our settlement with the BPU Staff and the New Jersey Division of Rate Counsel regarding PSE&G’s Gas System Modernization Program (GSMP) through which we will invest $905 million over three years to modernize PSE&G's gas systems. The order provides for cost recovery at a 9.75% rate of return on equity on the first $650 million of the investment through an accelerated recovery mechanism. PSE&G will seek recovery of the remaining $255 million of investment in its next base rate case. For additional information, see Item 1. Business-Regulatory Issues-State Regulation. Effective January 1, 2015, PSE&G's formula rate increased our annual transmission revenues by approximately $182 million. Each year, we file estimated transmission revenues subject to true up with actual current year data. The true-up adjustment for 2015, which will be filed in the Spring of 2016, will primarily include the impact on rate base of the extension of bonus depreciation, which was enacted after the filing was made, and is estimated to reduce our 2015 annual revenue increase by approximately $21 million. In October 2015, we filed our 2016 Annual Formula Rate Update with FERC, which will provide $146 million in increased annual transmission revenues effective January 1, 2016. Our 2016 transmission revenues will be adjusted for the impact of the continued extension of bonus depreciation, which was enacted after our 2016 filing was made, and is estimated to reduce our 2016 revenues as filed by approximately $27 million. Over the past few years, these types of investments have altered our business mix to reflect a higher percentage contribution by PSE&G. During 2015, Power successfully improved its performance for both nuclear and fossil operations, with continued upgrades in efficiency and output, while mitigating environmental impacts. Power’s results benefited from access to natural gas supplies through its existing firm pipeline transportation contracts. Power manages these contracts for the benefit of PSE&G’s customers through the basic gas supply service (BGSS) arrangement. The contracts are sized to ensure delivery of a reliable gas supply to PSE&G customers on peak winter days. When pipeline capacity beyond the customers’ needs is available, Power can use it to make third party sales and supply gas to its generating units in New Jersey. Power’s strategic hedging practices and ability to use market conditions to its advantage help it to balance some of the volatility of the merchant power business. Three recent investments reflect our recognition of the value of opportunistic growth in the Power business. In June 2015, we acquired a development project to construct a 755 MW gas-fired combined cycle generating station (Keys Energy Center) in Maryland with completion expected in 2018 at an estimated investment of $825 million - $875 million. In August 2015, we announced our plan to construct Sewaren 7, a new 540 MW dual-fueled combined cycle generating plant in Woodbridge, New Jersey, scheduled to be in-service for the summer of 2018 at an estimated investment of $625 million - $675 million. The Sewaren 7 plant will replace Sewaren Units 1, 2, 3 and 4. In February 2016, we announced our plan to build Bridgeport Harbor Station 5 (BH5), a 485 MW gas-fired combined cycle generating plant on our existing Bridgeport Harbor station site in Bridgeport, Connecticut scheduled to be in-service for the summer of 2019 at an estimated investment of more than $550 million. These additions to our fleet expand our geographic diversity and are expected to contribute to the overall efficiency of operations. In the PJM capacity auction held in August 2015 for the 2018-2019 delivery year, Power cleared 8,634 MW of its generating capacity at an average price of $215 MW-day. The capacity that Power cleared for the 2018-2019 delivery year included Sewaren 7 and Keys Energy Center generation plants. In the two prior PJM capacity auctions covering the 2016-2017 and 2017-2018 delivery years, Power cleared approximately 8,700 MW at average prices of $172 MW-day and $177 MW-day, respectively. In The ISO-NE auction held in February 2016, Power cleared BH5 at an average price of $232 MW-day for the 2019-2020 delivery year. Regulatory, Legislative and Other Developments In our pursuit of operational excellence, financial strength and disciplined investment, we closely monitor and engage with stakeholders on significant regulatory and legislative developments. Transmission planning rules and wholesale power market design are of particular importance to our results and we continue to advocate for policies and rules that promote fair and efficient electricity markets. Transmission Planning FERC’s rule under Order 1000 altered the right of first refusal (ROFR) previously held by incumbent utilities to build transmission within their respective service territories, creating the potential that new transmission projects in our service territory could be assigned to third parties rather than PSE&G. Order 1000 also presents opportunities for us to construct transmission outside of our service territory. In April 2013, PJM Interconnection, L.L.C. (PJM) initiated a solicitation process to allow both incumbents and non-incumbents the opportunity to submit transmission project proposals to address identified high voltage issues at Artificial Island in New Jersey. In August 2015, PJM awarded PSE&G three components of the transmission project, estimated by PJM to cost approximately $126 million. PSE&G has accepted construction responsibility, subject to reaching agreement with PJM on a reasonable cost estimate. Discussions are ongoing with PJM regarding the cost estimate for PSE&G’s portion of the work. See Item 1. Business-Regulatory Issues-Federal Regulation-Transmission Regulation for additional information. There are several matters pending before FERC that concern the allocation of costs associated with transmission projects being constructed by PSE&G. Regardless of how these proceedings are resolved, PSE&G's ability to recover the costs of these projects will not be affected. However, the result of these proceedings could ultimately impact the amount of costs borne by ratepayers in New Jersey and may cause increased scrutiny regarding PSE&G's future capital investments. In addition, Power, as a basic generation service (BGS) supplier, submits bids into the auction and obtains an obligation to provide services that include specified transmission costs. If the allocation of the costs associated with the transmission projects were to increase these transmission costs, BGS suppliers may be entitled to an adjustment. However, suppliers may not be able to recoup these adjustments immediately as they are subject to BPU approval. We do not believe that these matters will have a material effect on Power's financial statements. Wholesale Power Market Design Capacity market design, including the Reliability Pricing Model (RPM) in PJM, remains an important focus for us. In May 2014, a federal court issued a rule that vacated a FERC Order in which FERC had determined that demand response (DR) providers should receive full market compensation for power and held that FERC has no jurisdiction over DR. In January 2016, the U.S. Supreme Court overturned the federal court’s decision which removed any risk to DR’s participation in the energy and capacity markets. In a separate development of significance to the wholesale capacity market, in December 2014 PJM filed at FERC its proposal for a capacity performance (CP) product to include generators, DR and energy efficiency providers, which will be required to perform during emergency conditions, as a supplement to the base capacity product. The proposal included enhanced performance-based incentives and penalties. In June 2015, FERC conditionally accepted the proposal and the CP mechanism was implemented for the 2015 capacity auction noted above. We believe that the auction pricing adequately reflects the increased costs that could result from operating under more stringent rules for generation availability. Based on the auction results, the CP mechanism appears to have provided the opportunity for enhanced capacity market revenue streams for Power, but future impacts cannot be assured. Further, there may be requirements for additional investment and there are additional performance risks. Applications for rehearing of FERC's capacity performance order are pending. See Item 1. Business-Regulatory Issues-Federal Regulation-Capacity Market Issues for additional information. We have also been actively involved both through stakeholder processes and through filings at FERC in seeking improvements to the rules for setting prices for energy in the day-ahead and real-time markets administered by PJM and other system operators. A November 2015 development which we view as positive involves both a notice of proposed rulemaking on dispatch intervals and scarcity pricing and a separate order directing the system operators to submit reports on five other price formation issues. We believe that, if implemented, these changes will improve energy price formation in the future. See Item 1. Business-Regulatory Issues-Federal Regulation-Price Formation Initiatives for additional information. An emerging issue in PJM involves the impact of subsidized existing generation on RPM market outcomes. These subsidies would likely enable the affected generators to submit reduced bids into PJM capacity markets that are not reflective of their actual costs of operation and may prevent uneconomic generating facilities from retiring. Either of these conditions could artificially suppress capacity market prices, especially given that PJM’s currently effective “minimum offer price rule” (MOPR) would not apply to these plants because it only applies to new gas-fired units. See Item 1. Business-Regulatory Issues-Federal Regulation-Capacity Market Issues for additional information. Environmental Regulation We continue to advocate for the development and implementation of fair and reasonable rules by the EPA and state environmental regulators. In particular, section 316(b) of the Federal Water Pollution Control Act (FWPCA) requires that cooling water intake structures, which are a significant part of the generation of electricity at steam-electric generating stations, reflect the best technology available for minimizing adverse environmental impacts. Implementation of Section 316(b) could adversely impact future nuclear and fossil operations and costs. In June 2015, the New Jersey Department of Environmental Protection (NJDEP) issued a draft New Jersey Pollutant Discharge Elimination System (NJPDES) permit governing cooling water intake structures for Salem. The draft permit does not require installation of cooling towers and allows Salem to continue to operate utilizing the existing once-through cooling water system with certain required system modifications. The NJDEP may make revisions before issuing the final permit which is expected during the first half of 2016. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities. In October 2015, the EPA published the Clean Power Plan (CPP), a greenhouse gas (GHG) emissions regulation under the Clean Air Act (CAA) for existing power plants. The regulation establishes state-specific emission targets based on implementation of the best systems of emission reduction. Each state must submit a compliance plan to the EPA by September 6, 2016 or seek a two-year extension to September 6, 2018. We continue to work with FERC and other federal and state regulators, as well as industry partners, to determine the potential impact of these regulations. Numerous states, including New Jersey and several industry groups, filed petitions for review with the D.C. Court to challenge the CPP. In addition, the petitioners sought a stay of the rule. On January 21, 2016, the D.C. Court declined to stay the CPP. However, on February 9, 2016, the U.S. Supreme Court stayed the rule pending further review of the case. The U.S. Supreme Court’s decision to stay the implementation of the CPP will delay deadlines for submission of state requests for extensions and final plans. If the CPP is upheld, new deadlines will need to be established and the effective date of the compliance period may be impacted. See Item 1. Business-Environmental Matters-Climate Change for additional information. CAA regulations governing hazardous air pollutants under the EPA's Maximum Achievable Control Technology rules are also of significance; however, we believe our generation business remains well-positioned for such regulations if and when they are implemented. In addition, state environmental regulations governing emissions from power plants also have a significant impact on our operations. In the second quarter of 2015, we retired 1,545 MW of fully depreciated combustion turbine capacity that would not be able to comply with the more stringent emission standards for high electric demand day units (HEDD) under the New Jersey HEDD regulations for nitrous oxide, which reduces our capacity revenues. We are subject to liability under environmental laws for the costs of remediating environmental contamination of property now or formerly owned by us and of property contaminated by hazardous substances that we generated. In particular, the historic operations of PSEG companies and the operations of numerous other companies along the Passaic and Hackensack Rivers are alleged by Federal and State agencies to have discharged substantial contamination into the Passaic River/Newark Bay Complex in violation of various statutes. We are also currently involved in a number of proceedings relating to sites where other hazardous substances may have been discharged and may be subject to additional proceedings in the future, and the costs of any such remediation efforts could be material. For further information regarding the matters described above as well as other matters that may impact our financial condition and results of operations, see Item 1. Business-Environmental Matters, Item 3. Legal Proceedings, and Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities. FERC Compliance The FERC Staff has initiated a preliminary non-public investigation regarding errors in the calculation of certain components of Power's cost-based bids for its New Jersey fossil generating units in the PJM energy market and the quantity of energy that Power offered into the energy market for its fossil peaking units compared to the amounts for which Power was compensated in the capacity market for those units. This investigation is ongoing. The amounts of potential disgorgement and other potential penalties that we may incur span a wide range depending on the success of our legal arguments. If our legal arguments do not prevail, in whole or in part with FERC or in a judicial challenge that we may choose to pursue, it is likely that Power would record losses that would be material to PSEG's and Power's results of operations in the quarterly and annual periods in which they are recorded. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities. Bonus Depreciation In December 2015, Congress passed the Protecting Americans from Tax Hikes Act of 2015 (Tax Act). The Tax Act includes an extension of the bonus depreciation rules. For federal tax purposes, bonus depreciation allows a tax deduction equal to the applicable percentage of qualifying assets that are placed in service during the applicable year. The extension of bonus depreciation associated with changes under the Tax Act is expected to reduce the rate of growth in PSE&G’s rate base given an anticipated increase in deferred taxes; it is also expected to have a significant cash benefit over the next several years. For more detailed information, refer to Item 8. Financial Statements and Supplementary Data-Note 19. Income Taxes. Change in Accounting Estimate At the end of 2015, we changed the approach used to measure future service and interest costs for pension and other post-retirement benefits. For 2015 and prior, we calculated service and interest costs utilizing a single weighted-average discount rate derived from the yield curve used to measure the plan obligations. For 2016 and beyond, we have elected to calculate service and interest costs by applying the specific spot rates along that yield curve to the plans’ liability cash flows. We believe the new approach provides a more precise measurement of service and interest costs by aligning the timing of the plans’ liability cash flows to the corresponding spot rates on the yield curve. This change does not affect the measurement of the plan obligations. As a change in accounting estimate, this change will be reflected prospectively. We estimate this will reduce 2016 pension and OPEB expense by approximately $34 million and $13 million, respectively, net of amounts capitalized. Operational Excellence We emphasize operational performance while developing opportunities in both our competitive and regulated businesses. Flexibility in our generating fleet has allowed us to take advantage of market opportunities presented during the year as we remain diligent in managing costs. In 2015, our • total nuclear fleet achieved an average capacity factor of 90%, • nuclear output increased by 3.1% and combined cycle output by 11.4%, (including record performance at the Linden Units 1 and 2 and the Bethlehem Energy Center (BEC) combined cycle units) as compared to the same period in 2014, • diverse fuel mix and dispatch flexibility allowed us to generate approximately 55 TWh while addressing unit outages and balancing fuel availability and price volatility, and • utility ranked highest in electric and gas service business customer satisfaction among large utilities in the eastern United States and was recognized as the most reliable utility in the Mid-Atlantic region. Financial Strength Our financial strength is predicated on a solid balance sheet, positive cash flow and reasonable risk-adjusted returns on increased investment. Our financial position remained strong during 2015 as we: • had cash on hand of $394 million as of December 31, 2015, • maintained solid investment grade credit ratings, • extended the expiration dates for approximately $2.0 billion of five-year credit facilities for PSEG, PSE&G and Power from 2018 to 2020, • received cash federal tax benefits from the extension of bonus depreciation, and • increased our indicative annual dividend for 2015 to $1.56 per share. We expect to be able to fund our transmission projects required under PJM's reliability program, Energy Strong distribution program, GSMP, Keys Energy Center, Sewaren 7, BH5 and other planned projects, without the issuance of new equity. Disciplined Investment We utilize rigorous investment criteria when deploying capital and seek to invest in areas that complement our existing business and provide reasonable risk-adjusted returns. These areas include upgrading our energy infrastructure, responding to trends in environmental protection and providing new energy supplies in domestic markets with growing demand. In 2015, we commenced construction of the Keys Energy Center in Maryland and Sewaren 7 in New Jersey, each of which generating station cleared in the 2018/2019 capacity auction. In addition, we: • placed into service the final phase of our 500 kV Susquehanna-Roseland and 230 kV Mickleton-Gloucester-Camden transmission projects, • made additional investments in transmission infrastructure projects, • secured approval to extend three Energy Efficiency Economic Stimulus subprograms to allow for additional capital expenditures and administrative expenses to provide energy efficiency assistance to hospitals, healthcare facilities and residential multi-family housing units, • received approval for our GSMP and continued to execute our Energy Strong and other existing BPU-approved utility programs, • completed the power ascension for the extended power uprate at our co-owned Peach Bottom 2 and 3 nuclear stations, • completed installation of equipment to increase output and improve efficiency at our Bergen 2 combined cycle gas unit similar to our 2014 installation at our Linden plant, and • placed into service a 13 MW-direct current (dc) solar energy facility near Waldorf, Maryland, acquired and placed into service a 25 MW-dc solar energy facility near San Francisco, California and acquired a 63 MW-dc solar energy project near Salt Lake City, Utah which is expected to be in-service by the end of 2016. In January 2016, we acquired a 26 MW-dc solar energy project in Martin County, North Carolina and expect commercial operation by July 2016. In February 2016, we acquired a 36 MW-dc solar energy project in Larimer County, Colorado and expect commercial operation by the fourth quarter of 2016. In February 2016, we announced our plan to commence construction of BH5 in 2017, with operations expected to begin in mid-2019. See Financial Results above for additional information. Future Outlook Our future success will depend on our ability to continue to maintain strong operational and financial performance in a slow-moving economy and a cost-constrained environment with low gas prices, to capitalize on or otherwise address appropriately regulatory and legislative developments that impact our business and to respond to the issues and challenges described below. In order to do this, we must continue to: • focus on controlling costs while maintaining safety and reliability and complying with applicable standards and requirements, • successfully manage our energy obligations and re-contract our open supply positions, • execute our utility capital investment program, including our Energy Strong program, GSMP and other investments for growth that yield contemporaneous and reasonable risk-adjusted returns, while enhancing the resiliency of our infrastructure and maintaining the reliability of the service we provide to our customers, • effectively manage construction of our Keys Energy Center, Sewaren 7 and other generation projects, • advocate for measures to ensure the implementation by PJM and FERC of market design and transmission planning rules that continue to promote fair and efficient electricity markets, • engage multiple stakeholders, including regulators, government officials, customers and investors, and • successfully operate the LIPA T&D system and manage LIPA's fuel supply and generation dispatch obligations. For 2016 and beyond, the key issues and challenges we expect our business to confront include: • regulatory and political uncertainty, both with regard to future energy policy, design of energy and capacity markets, transmission policy and environmental regulation, as well as with respect to the outcome of any legal, regulatory or other proceeding, settlement, investigation or claim, applicable to us and/or the energy industry, • FERC Staff’s continuing investigation of certain of Power’s New Jersey fossil generating unit bids in the PJM energy market, • uncertainty in the slowly improving national and regional economic recovery, continuing customer conservation efforts, changes in energy usage patterns and evolving technologies, which impact customer behaviors and demand, • the potential for continued reductions in demand and sustained lower natural gas and electricity prices, both at market hubs and the locations where we operate, and • delays and other obstacles that might arise in connection with the construction of our T&D, generation and other development projects, including in connection with permitting and regulatory approvals. Our primary investment opportunities are in two areas: our regulated utility business and our merchant power business. We continually assess a broad range of strategic options to maximize long-term stockholder value. In assessing our options, we consider a wide variety of factors, including the performance and prospects of our businesses; the views of investors, regulators and rating agencies; our existing indebtedness and restrictions it imposes; and tax considerations, among other things. Strategic options available to us include: • the acquisition, construction or disposition of transmission and distribution facilities and/or generation units, • the disposition or reorganization of our merchant generation business or other existing businesses or the acquisition of new businesses, • the expansion of our geographic footprint, • continued or expanded participation in solar, demand response and energy efficiency programs, and • investments in capital improvements and additions, including the installation of environmental upgrades and retrofits, improvements to system resiliency and modernizing existing infrastructure. There can be no assurance, however, that we will successfully develop and execute any of the strategic options noted above, or any additional options we may consider in the future. The execution of any such strategic plan may not have the expected benefits or may have unexpected adverse consequences. RESULTS OF OPERATIONS (A) Power's results in 2015 include an after-tax insurance recovery for Superstorm Sandy of $102 million. Power's 2014 and 2013 results include after-tax expenses of $17 million and $32 million, respectively, for Operation and Maintenance (O&M) costs net of insurance recoveries in 2013, due to severe damage caused by Superstorm Sandy. See Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities. (B) Other includes after-tax activities at the parent company, PSEG LI and Energy Holdings as well as intercompany eliminations. The 2015 year-over-year increase in our Net Income was driven primarily by: • higher revenues due to increased investments in transmission projects, • lower generation costs due to lower fuel costs, primarily reflecting lower natural gas and coal prices, • higher MTM gains in 2015, and • insurance recoveries of Superstorm Sandy costs, primarily at Power. These increases were partially offset by: • lower capacity revenues resulting from lower average auction prices coupled with lower ancillary and operating reserve revenues in the PJM region, • lower realized gains and higher other-than-temporary impairments related to the NDT Fund, and • higher pension and OPEB costs, net of amounts capitalized. The 2014 year-over-year increase in our Net Income was driven by: • MTM gains in 2014 resulting from a decrease in prices on forward positions, as compared to MTM losses in 2013, • higher sales volumes under the BGSS contract due to colder average temperatures in the 2014 winter heating season, • higher volumes of gas sold to third party customers, • higher revenues due to increased investments in transmission projects, and • lower O&M expense at PSE&G and Power, largely due to a reduction in pension and OPEB costs, net of amounts capitalized. These increases were partially offset by: • lower volumes of electricity sold under Power's BGS contracts resulting from serving fewer tranches in 2014, and • higher generation costs due to higher fuel costs. Our results include the realized gains, losses and earnings on Power’s NDT Fund and other related NDT activity. Realized gains and losses, interest and dividend income and other costs related to the NDT Fund are recorded in Other Income (Deductions), and impairments on certain NDT securities are recorded as Other-Than-Temporary Impairments. Interest accretion expense on Power's nuclear Asset Retirement Obligation (ARO) is recorded in O&M Expense and the depreciation related to the ARO asset is recorded in Depreciation and Amortization Expense. In 2014, we restructured portions of our NDT Fund and realized a pre-tax gain of $65 million. Our results also include the after-tax impacts of non-trading MTM activity, which consist of the financial impact from positions with forward delivery dates. The combined after-tax impact on Net Income for the years ended December 31, 2015, 2014 and 2013 include the changes related to NDT Fund and MTM activity shown in the chart below: PSEG Our results of operations are primarily comprised of the results of operations of our principal operating subsidiaries, PSE&G and Power, excluding charges related to intercompany transactions, which are eliminated in consolidation. For additional information on intercompany transactions, see Item 8. Financial Statements and Supplementary Data-Note 23. Related-Party Transactions. The 2015 and 2014 amounts in the preceding table for Operating Revenues and O&M costs each include $375 million and $389 million, respectively, for Servco. These amounts represent the O&M pass-through costs for the Long Island operations, the full reimbursement of which is reflected in Operating Revenues. See Item 8. Financial Statements and Supplementary Data-Note 3. Variable Interest Entities for further explanation. The following discussions for PSE&G and Power provide a detailed explanation of their respective variances. PSE&G Year Ended December 31, 2015 as compared to 2014 Operating Revenues decreased $130 million due primarily to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $212 million due primarily to an increase in transmission revenues. • Transmission revenues were $164 million higher due to increased investments in transmission projects. • Electric distribution revenues increased $31 million due primarily to higher sales volumes due to weather. • Gas distribution revenues increased $17 million due primarily to higher Weather Normalization Clause (WNC) revenue of $35 million due to warmer weather in 2015 compared to 2014, partially offset by $18 million due to lower sales volumes. Clause Revenues decreased $154 million due primarily to lower Securitization Transition Charge (STC) revenues of $86 million, lower Societal Benefit Charges (SBC) of $31 million, lower Margin Adjustment Clause (MAC) of $29 million, and lower Solar Pilot Recovery Charges (SPRC) of $8 million. The changes in STC, SBC, MAC and SPRC amounts were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, Depreciation and Amortization and Interest Expense. PSE&G does not earn margin on STC, SBC, MAC or SPRC collections. Commodity Revenue decreased $187 million due to lower Gas revenues, partially offset by higher Electric revenues. This is entirely offset with decreased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Gas revenues decreased $266 million due primarily to lower BGSS prices of $295 million, partially offset by $29 million from higher sales volumes. The average price of natural gas was 29% lower to the customer in 2015 than in 2014. • Electric revenues increased $79 million due primarily to $120 million in higher net BGS revenues, comprised of $166 million from higher sales volumes, partially offset by lower prices of $46 million. BGS sales volume increased due primarily to weather. The BGS net revenue increase was partially offset by $41 million in lower revenues from the sale of Non-Utility Generation (NUG) energy and collections of Non-Utility Generation Charges (NGC) due primarily to lower prices. Operating Expenses Energy Costs decreased $187 million. This is entirely offset by Commodity Revenue. Operation and Maintenance increased $2 million, primarily due to increases of • $33 million in pension and OPEB expenses, net of amounts capitalized, • $13 million in transmission operating expenses, • $7 million in gas bad debt expense, and • a $49 million net increase due primarily to various increases, including information technology expenditures, wages, appliance service costs and preventative maintenance, • almost entirely offset by a $90 million net reduction in costs related to various clause mechanisms, GPRC and the Capital Infrastructure Program (CIP), and • $10 million of insurance recovery proceeds. Depreciation and Amortization decreased $14 million due primarily to a $69 million decrease in amortization of Regulatory Assets, partially offset by an increase in depreciation of $55 million due to additional plant in service. Other Income (Deductions) net increase of $17 million in Allowance for Funds Used During Construction. Interest Expense increased $3 million primarily due to increases of • $12 million due to net issuances in the latter half of 2014, and • $9 million due to net issuances in 2015, • partially offset by a decrease of $17 million due to the redemption of securitization debt in 2015. Income Tax Expense increased $21 million due primarily to higher pre-tax income. Year Ended December 31, 2014 as compared to 2013 Operating Revenues increased $111 million due primarily to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $88 million due primarily to an increase in transmission revenues. • Transmission revenues were $138 million higher due to increased investments in transmission projects. • Gas distribution revenues decreased $5 million due primarily to lower WNC revenue of $32 million due to more normal weather compared to the prior year, lower Transitional Energy Facilities Assessment (TEFA) revenue of $22 million due to elimination of TEFA tax effective January 1, 2014, lower CIP related revenue of $11 million, partially offset by higher sales volumes of $54 million, and higher revenue from GPRC of $6 million. • Electric distribution revenues decreased $45 million due primarily to a $45 million decrease due to the elimination of the TEFA tax in 2014, lower sales volumes of $17 million and lower CIP related revenue of $5 million, partially offset by higher GPRC of $22 million. Clause Revenues decreased $51 million due primarily to lower SBC of $32 million and lower STC revenues of $18 million. The changes in clause revenue amounts were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, Depreciation and Amortization and Interest Expense. PSE&G does not earn margin on clause revenue collections. Commodity Revenues increased $68 million due to lower Electric and Gas revenues. This is entirely offset with increased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Electric revenues increased $22 million due primarily to $64 million in higher BGS revenues, partially offset by $42 million in lower revenues from the sale of NUG energy and collections of NGC due primarily to lower prices. BGS sales increased 2% due primarily to weather. • Gas revenues increased $46 million due to higher BGSS volumes of $93 million, partially offset by lower BGSS prices of $47 million. The average price of natural gas was 5% lower in 2014 than in 2013. Other Operating Revenues increased $6 million due primarily to increased revenues from our appliance repair business and miscellaneous electric operating revenues. Operating Expenses Energy Costs increased $68 million. This is entirely offset by Commodity Revenues. Operation and Maintenance decreased $81 million, of which the most significant components were decreases of • $73 million in pension and OPEB expenses, net of amounts capitalized, and • $21 million in costs related to clause mechanisms, GPRC and CIP, • partially offset by a $13 million net increase in operational expenses due primarily to an increase in storm related costs of $8 million. Depreciation and Amortization increased $34 million due primarily to increases of $47 million in additional plant in service partially offset by a $15 million decrease in amortization of Regulatory Assets. Taxes Other Than Income Taxes decreased $68 million due to the elimination of the TEFA tax in 2014. Interest Expense decreased $16 million primarily due to decreases of • $16 million due to partial redemption of securitization debt of in 2014, • $25 million due to maturities of $725 million in 2013, and • $5 million due to maturities of $500 million in 2014, • partially offset by an increase of $14 million due to the issuance of $1,250 million of debt in 2014, and • an increase of $17 million due to the issuance of $1,500 million of debt in 2013. Income Tax Expense increased $68 million due primarily to higher pre-tax income. Power Year Ended December 31, 2015 as compared to 2014 Operating Revenues decreased $506 million due to changes in generation, gas supply and other operating revenues. Generation Revenues decreased $172 million due primarily to • a decrease of $192 million due primarily to lower capacity revenues resulting from lower average auction prices and the retirement of older peaking units in June 2015, coupled with lower ancillary and operating reserve revenues in the PJM region, and • lower net revenues of $73 million due primarily to lower energy volumes sold in the New England (NE) region and lower average realized prices in the NE and New York (NY) regions, partially offset by higher energy volumes sold in the NY and PJM regions. Also included in the net decrease is $22 million due to lower MTM gains in 2015. • partially offset by an increase of $56 million due primarily to higher volumes of electricity sold under wholesale load contracts in the PJM and NE regions coupled with higher average prices in the NE region, and • an increase of $37 million due primarily to higher volumes of electricity sold under the BGS contract at higher average prices. Gas Supply Revenues decreased $336 million due primarily to • a net decrease of $214 million in sales under the BGSS contract, substantially comprised of lower average sales prices, and • a decrease of $122 million on sales to third party customers, of which $93 million was due to lower average sales prices and $29 million to lower volumes sold. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs decreased $597 million due to • Generation costs decreased $254 million due primarily to lower fuel costs of $330 million reflecting lower average realized natural gas and coal prices and the utilization of lower volumes of oil and coal. MTM gains in 2015 as compared to MTM losses in 2014 resulted in a $66 million decrease. These decreased costs were partially offset by higher congestion costs in the PJM region of $140 million. • Gas costs decreased $343 million mainly related to a decrease in average gas costs on both obligations under the BGSS contract and sales to third parties. Operation and Maintenance decreased $129 million due primarily to • a decrease of $145 million due to insurance recoveries received in 2015 related to Superstorm Sandy, and • a net decrease of $61 million related to our fossil plants, largely due to higher costs incurred in 2014 for planned outage costs, including maintenance and installation of upgraded technology at our Linden combined cycle gas generating plant, partially offset by planned outage costs in 2015 at our BEC generating plant and installation of upgraded technology at our combined cycle Bergen plant, • partially offset by an increase of $51 million at our nuclear facilities, primarily due to higher planned outage costs at our 100%-owned Hope Creek and 50%-owned Peach Bottom 3 nuclear plants in 2015 as compared to our 57%-owned Salem nuclear unit 2 in 2014, and • a $30 million increase due to higher pension and OPEB costs, net of amounts capitalized. Other Income (Deductions) decreased $73 million due primarily to lower net realized gains from the NDT Fund, partially offset by a $28 million insurance recovery related to Superstorm Sandy. Other-Than-Temporary Impairments increased $33 million due primarily to an increase in impairments of equity securities in the NDT Fund. Income Tax Expense increased $20 million in 2015 due primarily to higher pre-tax income. Year Ended December 31, 2014 as compared to 2013 Operating Revenues increased $371 million due to changes in generation, gas supply and other operating revenues. Generation Revenues increased $263 million due primarily to • higher revenues of $366 million due primarily to MTM gains in 2014 resulting from a decrease in prices on forward positions and higher energy volumes sold in the NY and NE regions, and • a net increase of $27 million due primarily to higher volumes on wholesale load contracts in the PJM region, offset in part by lower wholesale load volumes in the NE region, • partially offset by a decrease of $89 million due to lower volumes of electricity sold as a result of serving fewer tranches in 2014 under our BGS contracts and lower average pricing, and • a net decrease of $41 million due primarily to a decrease in operating reserve revenue, partially offset by higher ancillary revenue in the PJM region. Gas Supply Revenues increased $93 million due primarily to • a net increase of $44 million in sales under the BGSS contract, substantially comprised of higher sales volumes due to colder average temperatures during the 2014 winter heating season, partially offset by lower average gas prices, and • a net increase of $49 million due to higher sales volumes to third party customers. Other Operating Revenues increased $15 million due to transition fees related to fuel management and power supply management contracts with LIPA. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs increased $251 million due to • Generation costs increased $252 million due primarily to higher fuel costs, reflecting higher average realized natural gas prices, the unfavorable MTM impact from lower average natural gas prices on forward positions and the utilization of higher volumes of gas and oil. These increased costs were partially offset by lower congestion costs in the PJM region. • Gas costs decreased $1 million related to a decrease of $137 million in average gas inventory costs, substantially offset by $136 million of higher volumes sold under the BGSS contract and to third party customers due to colder average temperatures during the 2014 winter heating season. Operation and Maintenance decreased $38 million due primarily to • lower pension and OPEB costs, net of amounts capitalized of $42 million, • a decrease of $15 million due primarily to the outage of our 100%-owned Hope Creek nuclear facility in the fall of 2013, which was partially offset by the extension of our 57%-owned nuclear Salem Unit 2 refueling outage in 2014, and • a decrease of $27 million due to lower storm costs related to Superstorm Sandy, • partially offset by an increase of $40 million related primarily to higher planned outage and maintenance costs at our fossil plants, including maintenance and installation of upgraded technology at our Linden combined cycle gas generating plant and outages at our Keystone and Hudson facilities. Depreciation and Amortization increased $19 million due primarily to a higher depreciable fossil and nuclear asset base. Other Income (Deductions) increased $65 million due primarily to higher realized gains from the NDT Fund due to the restructuring of the portfolio in 2014. Other-Than-Temporary Impairments increased $8 million due to an increase in impairments of the NDT Fund. Interest Expense increased $6 million due primarily to the issuance of a $250 million 2.45% Senior Note and a $250 million 4.30% Senior Note in November 2013, partially offset by the maturity of $300 million of 2.50% Senior Notes in April 2013. Income Tax Expense increased $72 million in 2014 due primarily to higher pre-tax income. LIQUIDITY AND CAPITAL RESOURCES The following discussion of our liquidity and capital resources is on a consolidated basis, noting the uses and contributions, where material, of our two direct major operating subsidiaries. Financing Methodology We expect our capital requirements to be met through internally generated cash flows and external financings, consisting of short-term debt for working capital needs and long-term debt for capital investments. PSE&G’s sources of external liquidity include a $600 million multi-year syndicated credit facility. PSE&G’s commercial paper program is the primary vehicle for meeting seasonal, intra-month and temporary working capital needs. PSE&G does not engage in any intercompany borrowing or lending arrangements. PSE&G maintains back-up facilities in an amount sufficient to cover the commercial paper and letters of credit outstanding. PSE&G’s dividend payments to PSEG are consistent with its capital structure objectives which have been established to maintain investment grade credit ratings. PSE&G’s long-term financing plan is designed to replace maturities, fund a portion of its capital program and manage short-term debt balances. Generally, PSE&G uses either secured medium-term notes or first mortgage bonds to raise long-term capital. PSEG, Power, Energy Holdings, PSEG LI and Services participate in a corporate money pool, an aggregation of daily cash balances designed to efficiently manage their respective short-term liquidity needs. Servco does not participate in the corporate money pool. Servco's short-term liquidity needs are met through an account funded and owned by LIPA. PSEG’s sources of external liquidity may include the issuance of long-term debt securities and the incurrence of additional indebtedness under credit facilities. Our current sources of external liquidity include multi-year syndicated credit facilities totaling $1 billion. These facilities are available to back-stop PSEG’s commercial paper program, issue letters of credit and for general corporate purposes. These facilities may also be used to provide support to PSEG's subsidiaries. PSEG’s credit facilities and the commercial paper program are available to support PSEG working capital needs or to temporarily fund growth opportunities in advance of obtaining permanent financing. PSEG also has a $500 million term loan credit agreement that is scheduled to expire in November 2017. From time to time, PSEG may make equity contributions or provide credit support to its subsidiaries. Power’s sources of external liquidity include $2.6 billion of syndicated multi-year credit facilities. Additionally, from time to time, Power maintains bilateral credit agreements designed to enhance its liquidity position. Credit capacity is primarily used to provide collateral in support of Power's forward energy sale and forward fuel purchase contracts as the market prices for energy and fuel fluctuate, and to meet potential collateral postings in the event of a credit rating downgrade below investment grade. Power’s dividend payments to PSEG are also designed to be consistent with its capital structure objectives which have been established to maintain investment grade credit ratings and provide sufficient financial flexibility. Generally, Power issues senior unsecured debt to raise long-term capital. Operating Cash Flows We expect our operating cash flows combined with cash on hand and financing activities to be sufficient to fund capital expenditures and shareholder dividend payments. For the year ended December 31, 2015, our operating cash flow increased by $759 million. For the year ended December 31, 2014, our operating cash flow increased by $2 million. The net changes were primarily due to net changes from our subsidiaries as discussed below and higher tax payments in 2014 at the parent company and Energy Holdings. PSE&G PSE&G’s operating cash flow increased $292 million from $1,833 million to $2,125 million for the year ended December 31, 2015, as compared to 2014, due primarily to • higher earnings, • a $311 million reduction in tax payments, and • an increase of $102 million due to higher customer billings in the fourth quarter of 2014 primarily as a result of increased usage due to weather, • partially offset by a decrease of $250 million related to a change in regulatory deferrals, primarily driven by the return of prior year overcollections to customers for BGSS gas costs, Gas WNC charges and BGS costs. PSE&G’s operating cash flow increased $188 million from $1,645 million to $1,833 million for the year ended December 31, 2014, as compared to 2013, due primarily to • higher earnings, • an increase of $188 million due to an increase from a net change in regulatory deferrals, primarily related to over collections of BGSS gas costs, the over collection of gas revenues due to the Gas WNC and GPRC rate recoveries, and • an increase of $83 million due to decrease in employee benefit plan funding, • partially offset by $199 million related to higher tax payments. Power Power’s operating cash flow increased $281 million from $1,425 million to $1,706 million for the year ended December 31, 2015, as compared to 2014, primarily resulting from • higher earnings, • a decrease in margin deposit requirements of $144 million, and • a $78 million increase from net collection of counterparty receivables, • partially offset by an increase of $325 million in tax payments. Power’s operating cash flow increased $78 million from $1,347 million to $1,425 million for the year ended December 31, 2014, as compared to 2013, primarily resulting from • lower tax payments, • partially offset by increase of $87 million in payments to counterparties, and • a decrease of $11 million due to collection of counterparty receivables. Short-Term Liquidity We continually monitor our liquidity and seek to add capacity as needed to meet our liquidity requirements. Each of our credit facilities is restricted as to availability and use to the specific companies as listed below; however, if necessary, the PSEG facilities can also be used to support our subsidiaries’ liquidity needs. Our total credit facilities and available liquidity as of December 31, 2015 were as follows: As of December 31, 2015, our credit facility capacity was in excess of our projected maximum liquidity requirements over our 12 month planning horizon. Our maximum liquidity requirements are based on stress scenarios that incorporate changes in commodity prices and the potential impact of Power losing its investment grade credit rating. PSEG’s credit facilities are available to back-stop its Commercial Paper Program and issue letters of credit under which as of December 31, 2015, $211 million of Commercial Paper was outstanding. PSE&G's credit facility primary use is to support its Commercial Paper Program under which as of December 31, 2015, $153 million was outstanding. Most of our credit facilities expire in 2019 and 2020. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities and Note 13. Schedule of Consolidated Debt. Long-Term Debt Financing PSE&G had $171 million of 6.75% Mortgage Bonds mature in January 2016. Power has $303 million of 5.32% Senior Notes and $250 million of 2.75% maturing in September 2016. For a discussion of our long-term debt transactions during 2015 and into 2016, see Item 8. Financial Statements and Supplementary Data-Note 13. Schedule of Consolidated Debt. Debt Covenants Our credit agreements contain maximum debt to equity ratios and other restrictive covenants and conditions to borrowing. We are currently in compliance with all of our debt covenants. Continued compliance with applicable financial covenants will depend upon our future financial position, level of earnings and cash flows, as to which no assurances can be given. In addition, under its First and Refunding Mortgage (Mortgage), PSE&G may issue new First and Refunding Mortgage Bonds against previous additions and improvements, provided that its ratio of earnings to fixed charges calculated in accordance with its Mortgage is at least 2 to 1, and/or against retired Mortgage Bonds. As of December 31, 2015, PSE&G’s Mortgage coverage ratio was 3.87 to 1 and the Mortgage would permit up to approximately $4.0 billion aggregate principal amount of new Mortgage Bonds to be issued against additions and improvements to its property. Default Provisions Our bank credit agreements and indentures contain various, customary default provisions that could result in the potential acceleration of indebtedness under the defaulting company’s agreement. We have not defaulted under these agreements. In particular, PSEG’s bank credit agreements contain provisions under which certain events, including an acceleration of material indebtedness under PSE&G’s and Power’s respective financing agreements, a failure by PSE&G or Power to satisfy certain final judgments and certain bankruptcy events by PSE&G or Power, that would constitute an event of default under the PSEG bank credit agreements. Under the PSEG bank credit agreements, it would also be an event of default if either PSE&G or Power ceases to be wholly owned by PSEG. The PSE&G and Power bank credit agreements include similar default provisions; however such provisions only relate to the respective borrower under such agreement and its subsidiaries and do not contain cross default provisions to each other. The PSE&G and Power bank credit agreements do not include cross default provisions relating to PSEG. There are no cross default provisions in PSEG’s or PSE&G’s indentures. Power’s indenture includes cross default provisions similar to those described above for PSEG; however, such provisions only relate to Power’s subsidiaries and do not cross default to PSEG or PSE&G. Ratings Triggers Our debt indentures and credit agreements do not contain any material ‘ratings triggers’ that would cause an acceleration of the required interest and principal payments in the event of a ratings downgrade. However, in the event of a downgrade, any one or more of the affected companies may be subject to increased interest costs on certain bank debt and certain collateral requirements. In the event that we are not able to affirm representations and warranties on credit agreements, lenders would not be required to make loans. In accordance with BPU requirements under the BGS contracts, PSE&G is required to maintain an investment grade credit rating. If PSE&G were to lose its investment grade rating, it would be required to file a plan to assure continued payment for the BGS requirements of its customers. Fluctuations in commodity prices or a deterioration of Power’s credit rating to below investment grade could increase Power’s required margin postings under various agreements entered into in the normal course of business. Power believes it has sufficient liquidity to meet the required posting of collateral which would likely result from a credit rating downgrade at today’s market prices. Common Stock Dividends On February 16, 2016, our Board of Directors approved a $0.41 per share common stock dividend for the first quarter of 2016. This reflects an indicative annual dividend rate of $1.64 per share. We expect to continue to pay cash dividends on our common stock; however, the declaration and payment of future dividends to holders of our common stock will be at the discretion of the Board of Directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our businesses, alternate investment opportunities, legal requirements, regulatory constraints, industry practice and other factors that the Board of Directors deems relevant. Credit Ratings If the rating agencies lower or withdraw our credit ratings, such revisions may adversely affect the market price of our securities and serve to materially increase our cost of capital and limit access to capital. Credit Ratings shown are for securities that we typically issue. Outlooks are shown for Corporate Credit Ratings (S&P) and Issuer Credit Ratings (Moody’s) and can be Stable, Negative, or Positive. There is no assurance that the ratings will continue for any given period of time or that they will not be revised by the rating agencies, if, in their respective judgments, circumstances warrant. Each rating given by an agency should be evaluated independently of the other agencies' ratings. The ratings should not be construed as an indication to buy, hold or sell any security. In May 2015, Moody’s published research reports on PSEG, PSE&G and Power and the existing ratings and outlooks were unchanged. In May 2015, S&P published updated research reports and revised the outlook to stable from positive for PSEG’s Corporate Credit Rating and Power’s Senior Notes. S&P also affirmed the senior unsecured rating of BBB+ at Power and the mortgage bond rating of A at PSE&G. In September 2015, Moody's published an updated research report on PSEG and revised the outlook to positive from stable. In September and October 2015, Fitch published full rating reports on PSEG and Power leaving ratings and outlooks unchanged. In October 2015, PSEG ended a contractual agreement with Fitch to provide credit rating services for PSEG, PSE&G and Power. In January 2016, S&P published updated research reports on PSEG and PSE&G and the existing ratings and outlooks were unchanged. (A) Moody’s ratings range from Aaa (highest) to C (lowest) for long-term securities and P1 (highest) to NP (lowest) for short-term securities. (B) S&P ratings range from AAA (highest) to D (lowest) for long-term securities and A1 (highest) to D (lowest) for short-term securities. The Corporate Credit Rating outlook does not apply to PSEG's or PSE&G's Commercial Paper Rating or PSE&G's Mortgage Bond rating. Other Comprehensive Income For the year ended December 31, 2015, we had Other Comprehensive Loss of $12 million on a consolidated basis. Other Comprehensive Loss was due primarily to a $27 million decrease in net unrealized gains related to Available-for-Sale Securities and $10 million of unrealized losses on derivative contracts accounted for as hedges, partially offset by a $25 million decrease in our consolidated liability for pension and postretirement benefits. See Item 8. Financial Statements and Supplementary Data-Note 20. Accumulated Other Comprehensive Income (Loss), Net of Tax for additional information. CAPITAL REQUIREMENTS It is expected that all of our capital requirements over the next three years will come from a combination of internally generated funds and external debt financing. Projected capital construction and investment expenditures, excluding nuclear fuel purchases, for the next three years are presented in the table below. These projections include Allowance for Funds Used During Construction and Interest Capitalized During Construction for PSE&G and Power, respectively. These amounts are subject to change, based on various factors. We will continue to approach non-regulated solar and other renewable investments opportunistically, seeking projects that will provide attractive risk-adjusted returns for our shareholders. PSE&G PSE&G’s projections for future capital expenditures include material additions and replacements to its transmission and distribution systems to meet expected growth and to manage reliability. As project scope and cost estimates develop, PSE&G will modify its current projections to include these required investments. PSE&G’s projected expenditures for the various items reported above are primarily comprised of the following: • Transmission-investments focused on reliability improvements and replacement of aging infrastructure. • Baseline-investments for new business, reliability improvements, and replacement of defective equipment. • Energy Strong-Electric and Gas Distribution reliability investment program focused on system hardening and resiliency. • Gas System Modernization Program-Gas Distribution investment program to replace aging infrastructure. • Solar/Energy Efficiency-investments associated with grid-connected solar, solar loan programs, and customer energy efficiency programs. In 2015, PSE&G made $2,692 million of capital expenditures, primarily for transmission and distribution system reliability. This does not include expenditures for cost of removal, net of salvage, of $120 million, which are included in operating cash flows. Power Power’s projected expenditures for the various items listed above are primarily comprised of the following: • Baseline-investments to replace major parts and enhance operational performance. • Environmental/Regulatory-investments made in response to environmental, regulatory or legal mandates. • Fossil Growth Opportunities-investments associated with new construction, including Keys Energy Center, Sewaren 7 and BH5, and with upgrades to increase efficiency and output at combined cycle plants. • Nuclear Expansion-investments associated with certain Nuclear capital projects, primarily at existing facilities designed to increase operating output. • Solar Growth Opportunities-investments associated with the construction of utility-scale photovoltaic facilities. In 2015, Power made $881 million of capital expenditures, excluding $236 million for nuclear fuel, primarily related to various projects at Fossil and Nuclear. Disclosures about Long-Term Maturities, Contractual and Commercial Obligations and Certain Investments The following table reflects our contractual cash obligations and other commercial commitments in the respective periods in which they are due. In addition, the table summarizes anticipated recourse and non-recourse debt maturities for the years shown. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 13. Schedule of Consolidated Debt. The table below does not reflect any anticipated cash payments for pension obligations due to uncertain timing of payments or liabilities for uncertain tax positions since we are unable to reasonably estimate the timing of liability payments in individual years beyond 12 months due to uncertainties in the timing of the effective settlement of tax positions. See Item 8. Financial Statements and Supplementary Data-Note 19. Income Taxes for additional information. OFF-BALANCE SHEET ARRANGEMENTS Power Power issues guarantees in conjunction with certain of its energy contracts. See Item 8. Financial Statements and Supplementary Data-Note 12. Commitments and Contingent Liabilities for further discussion. Other Through Energy Holdings, we have investments in leveraged leases that are accounted for in accordance with GAAP Accounting for Leases. Leveraged lease investments generally involve three parties: an owner/lessor, a creditor and a lessee. In a typical leveraged lease arrangement, the lessor purchases an asset to be leased. The purchase price is typically financed 80% with debt provided by the creditor and the balance comes from equity funds provided by the lessor. The creditor provides long-term financing to the transaction secured by the property subject to the lease. Such long-term financing is non-recourse to the lessor and is not presented on our Consolidated Balance Sheets. In the event of default, the leased asset, and in some cases the lessee, secures the loan. As a lessor, Energy Holdings has ownership rights to the property and rents the property to the lessees for use in their business operations. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 6. Long-Term Investments and Note 7. Financing Receivables. In the event that collection of the minimum lease payments to be received by Energy Holdings is no longer reasonably assured, Energy Holdings may deem that a lessee has a high probability of defaulting on the lease obligation, and would consider the need to record an impairment of its investment. In the event the lease is ultimately rejected by a Bankruptcy Court, the fair value of the underlying asset and the associated debt would be recorded on the Consolidated Balance Sheets instead of the net equity investment in the lease. CRITICAL ACCOUNTING ESTIMATES Under GAAP, many accounting standards require the use of estimates, variable inputs and assumptions (collectively referred to as estimates) that are subjective in nature. Because of this, differences between the actual measure realized versus the estimate can have a material impact on results of operations, financial position and cash flows. We have determined that the following estimates are considered critical to the application of rules that relate to the respective businesses. Accounting for Pensions PSEG sponsors several qualified and nonqualified pension plans covering PSEG’s and its participating affiliates’ current and former employees who meet certain eligibility criteria. The market-related value of plan assets held for the qualified pension plan is equal to the fair value of these assets as of year-end. The plan assets are comprised of investments in both debt and equity securities which are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. We calculate pension costs using various economic and demographic assumptions. Assumptions and Approach Used: Economic assumptions include the discount rate and the long-term rate of return on trust assets. Demographic assumptions include projections of future mortality rates, pay increases and retirement patterns. The discount rate used to calculate pension obligations is determined as of December 31 each year, our measurement date. The discount rate is determined by developing a spot rate curve based on the yield to maturity of a universe of high quality corporate bonds with similar maturities to the plan obligations. The spot rates are used to discount the estimated plan distributions. The discount rate is the single equivalent rate that produces the same result as the full spot rate curve. At the end of 2015, we changed the approach used to measure future service and interest costs for pension benefits. For 2015 and prior, we calculated service and interest costs utilizing a single weighted-average discount rate derived from the yield curve used to measure the plan obligations. For 2016 and beyond, we have elected to calculate service and interest costs by applying the specific spot rates along that yield curve to the plans’ liability cash flows. We believe the new approach provides a more precise measurement of service and interest costs by aligning the timing of the plans’ liability cash flows to the corresponding spot rates on the yield curve. This change does not affect the measurement of the plan obligations. As a change in accounting estimate, this change will be reflected prospectively. We estimate this will reduce 2016 pension expense by approximately $47 million or $34 million, net of amounts capitalized, as compared to the 2016 amount that would have been derived from applying our 2015 and prior years' methodology. Our expected rate of return on plan assets reflects current asset allocations, historical long-term investment performance and an estimate of future long-term returns by asset class and long-term inflation assumptions. Based on the above assumptions, we have estimated net periodic pension expense in 2016 of approximately $56 million or $40 million, net of amounts capitalized. We utilize a corridor approach that reduces the volatility of reported pension expense/income. The corridor requires differences between actuarial assumptions and plan results be deferred and amortized as part of expense/income. This occurs only when the accumulated differences exceed 10% of the greater of the pension benefit obligation or the fair value of plan assets as of each year-end. The excess would be amortized over the average remaining service period of the active employees, which is approximately eight years. Effect if Different Assumptions Used: As part of the business planning process, we have modeled future costs assuming an 8.00% rate of return and a 4.54% discount rate for 2016. Actual future pension expense/income and funding levels will depend on future investment performance, changes in discount rates, market conditions, funding levels relative to our projected benefit obligation and accumulated benefit obligation and various other factors related to the populations participating in the pension plans. The following chart reflects the sensitivities associated with a change in certain assumptions. The effects of the assumption changes shown below solely reflect the impact of that specific assumption. See

<s>[INST] PSEG's business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: PSE&G, our public utility company which is engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in solar generation projects and has implemented energy efficiency and demand response programs in New Jersey, which are regulated by the BPU, and Power, our multiregional, wholesale energy supply company that integrates its generating asset operations and gas supply commitments with its wholesale energy, fuel supply and energy transacting functions primarily in the Northeast and MidAtlantic United States through its principal direct wholly owned subsidiaries. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA), and the states in which they operate. PSEG's other direct wholly owned subsidiaries are: PSEG Energy Holdings L.L.C. (Energy Holdings), which earns its revenues primarily from its portfolio of lease investments; PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority's (LIPA) transmission and distribution (T&D) system under a contractual agreement; and PSEG Services Corporation (Services), which provides us and these operating subsidiaries with certain management, administrative and general services at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2015 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2015 AND FUTURE OUTLOOK 2015 Overview Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: growing our utility operations through continued investment in T&D and other infrastructure projects, and maintaining and expanding a reliable generation fleet with the flexibility to utilize a diverse mix of fuels which allows us to respond to market volatility and capitalize on opportunities as they arise. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2015 and 2014 are presented below: Our $161 million 2015 over 2014 increase in Net Income was due primarily to higher transmission revenues at PSE&G, higher marktomarket (MTM) gains and lower generation costs driven by lower natural gas and coal prices at Power and insurance recoveries of Superstorm Sandy costs, primarily at Power. These increases were partially offset by higher pension and other postretirement benefit (OPEB) costs and lower capacity revenues and Nuclear Decommissioning Trust (NDT) activity at Power. For a more detailed discussion of our financial results, see Results of Operations. During 2015, we grew earnings, maintained cash flows and sustained a strong balance sheet. We effectively deployed capital without the need for additional equity, while our solid credit ratings aided our ability to access capital and credit markets. The greater emphasis on capital spending for projects on which we receive contemporaneous returns at PSE&G, our regulated utility, in recent years has yielded strong results and allowed us to increase our dividend. These actions to transition our business to meet market conditions and investor expectations [/INST] Negative. </s>

PUBLIC SERVICE ENTERPRISE GROUP INC

2017-02-27

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) This combined MD&A is separately filed by Public Service Enterprise Group Incorporated (PSEG), Public Service Electric and Gas Company (PSE&G) and PSEG Power LLC (Power). Information contained herein relating to any individual company is filed by such company on its own behalf. PSE&G and Power each make representations only as to itself and make no representations whatsoever as to any other company. PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: • PSE&G-which is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in solar generation projects and has implemented energy efficiency and demand response programs in New Jersey, which are regulated by the BPU, and • Power-which is a multi-regional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses through competitive energy sales in well-developed energy markets and fuel supply functions primarily in the Northeast and Mid-Atlantic United States through its principal direct wholly owned subsidiaries. In addition, Power owns and operates solar generation in various states. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries include PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement (OSA); and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2016 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2016 AND FUTURE OUTLOOK 2016 Overview Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: • improving utility operations through growth in investment in T&D and other infrastructure projects designed to enhance system reliability and resiliency and to meet customer expectations and public policy objectives, • maintaining and expanding a reliable generation fleet with the flexibility to utilize a diverse mix of fuels which allows us to respond to market volatility and capitalize on opportunities as they arise. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2016 and 2015 are presented below: Our 2016 over 2015 decrease in Net Income was due primarily to charges related to the early retirement of our Hudson and Mercer units, mark-to-market (MTM) losses in 2016 as compared to gains in 2015, lower volumes of electricity and gas sold at lower average realized sales prices, lower capacity and operating reserve revenues, storm insurance recoveries received primarily by Power in 2015 related to Superstorm Sandy, and charges in 2016 related to investments in certain leveraged leases at Energy Holdings. These decreases were partially offset by higher transmission revenues, lower generation costs and higher costs incurred at Power for planned outages in 2015, and higher management fee revenues at PSEG LI pursuant to the OSA. For a more detailed discussion of our financial results, see Results of Operations. During 2016, we maintained a strong balance sheet. We continued to effectively deploy capital without the need for additional equity, while our solid credit ratings aided our ability to access capital and credit markets. The greater emphasis on capital spending for projects on which we receive contemporaneous returns at PSE&G, our regulated utility, in recent years has yielded strong results, which when combined with the cash flow generated by Power, our merchant generator and power marketer, has allowed us to increase our dividend. These actions to transition our business to meet market conditions and investor expectations reflect our multi-year, long-term approach to managing our company. Our focus has been to invest capital in T&D and other infrastructure projects aimed at maintaining service reliability to our customers and bolstering our system resiliency. At Power, we strive to improve performance and reduce costs in order to enhance the value of our generation fleet in light of low gas prices, environmental considerations and competitive market forces that reward efficiency and reliability. At PSE&G, we continue to invest in transmission projects that focus on reliability improvements and replacement of aging infrastructure. We also continue to make investments to improve the resiliency of our gas and electric distribution system as part of our Energy Strong program that was approved by the BPU in 2014 and to seek recovery on such investments. We also commenced modernizing PSE&G’s gas distribution systems as part of our Gas System Modernization Program (GSMP) that was approved by the BPU in late 2015. Over the past few years, these types of investments have altered our business mix to reflect a higher percentage of earnings contribution by PSE&G. In 2017, as a result of our Energy Strong Order from the BPU, we will be required to file a distribution base rate case proceeding. We cannot predict the impact such proceeding will have on our distribution business. Despite the unseasonable warm winter weather patterns in 2016, Power’s results benefited from access to natural gas supplies through existing firm pipeline transportation contracts. Power manages these contracts for the benefit of PSE&G’s customers through the BGSS arrangement. The contracts are sized to provide for delivery of a reliable gas supply to PSE&G customers on peak winter days. When pipeline capacity beyond the customers’ needs is available, Power can use it to make third-party sales and supply gas to its generating units in New Jersey. Alternatively, gas supply and pipeline capacity constraints could adversely impact our ability to meet the needs of our utility customers and generating units. Power’s hedging practices and ability to capitalize on market opportunities help it to balance some of the volatility of the merchant power business. More than half of Power’s expected gross margin in the upcoming year relates to our hedging strategy, our expected revenues from the capacity market mechanisms and certain ancillary service payments such as reactive power. Our investments in the latter half of 2015 and early 2016 in Keys Energy Center (Keys), Sewaren 7 and Bridgeport Harbor Station 5 (BH5) reflect our recognition of the value of opportunistic growth in the Power business. See Item 1. Business-Power for additional information on major growth projects. These additions to our fleet both expand our geographic diversity and adjust our fuel mix and are expected to contribute to the overall efficiency of operations. Since 2013, several nuclear generating stations in the United States have closed or announced early retirement due to economic reasons, or have announced as being at risk for early retirement. This situation is generally due to low natural gas prices resulting from the growth of shale gas production since 2007, the continuing cost of regulatory compliance for nuclear facilities and both federal and state-level policies that provide credits to renewable energy such as wind and solar, but do not apply to nuclear generating stations. These trends have significantly reduced the revenues to nuclear generating stations while simultaneously raising the unit cost of production. This may result in the electric generation industry experiencing a shift from nuclear generation to natural gas-fired generation, creating greater reliance on natural gas pipelines for delivery and less diversity of the generation fleet. If trends noted above continue or worsen, our nuclear generating units could cease being economically competitive which may cause us to retire such units prior to the end of their useful lives. The costs associated with any such retirement, which may include, among other things, accelerated depreciation and amortization or impairment charges, accelerated asset retirement costs, severance costs and environmental remediation costs, could be material. We continue to advocate for sound policies that recognize nuclear power as a source of clean energy and an important part of a diverse and reliable energy portfolio. Regulatory, Legislative and Other Developments In our pursuit of operational excellence, financial strength and disciplined investment, we closely monitor and engage with stakeholders on significant regulatory and legislative developments. Transmission planning rules and wholesale power market design are of particular importance to our results and we continue to advocate for policies and rules that promote fair and efficient electricity markets. Transmission Planning In April 2013, PJM initiated its first “open window” solicitation process to allow both incumbents and non-incumbents the opportunity to submit transmission project proposals to address identified high voltage issues in New Jersey. In February 2016, FERC issued an order granting PSE&G’s request that it be permitted to seek recovery of 100% of its portion of the project’s costs to address identified high voltage issues at Artificial Island in New Jersey if the project is canceled for reasons beyond PSE&G’s control. In April 2016, PSE&G accepted construction responsibility for the three components of the project that PJM assigned to it, based on having reached agreement with PJM regarding an estimate for the project base cost of $273 million, plus risk and contingency for a total project cost of up to $340 million. In August 2016, PJM announced that it had suspended the Artificial Island transmission project and would be performing a comprehensive analysis to support a future course of action. PJM will submit its final recommendation to the PJM Board at the April 2017 Board meeting. In April 2016, PJM filed at FERC to incorporate a voltage threshold into PJM’s Regional Transmission Expansion Plan (RTEP) process to exempt, except under certain circumstances, reliability violations on facilities below 200 kV from PJM’s proposal window process. We generally support this reform as a measure to improve the efficiency of the open window procedure that will permit transmission developers to focus on the projects most likely to benefit from a competitive process. There are several matters pending before FERC that concern the allocation of costs associated with transmission projects being constructed by PSE&G. Regardless of how these proceedings are resolved, PSE&G’s ability to recover the costs of these projects will not be affected. However, the result of these proceedings could ultimately impact the amount of costs borne by ratepayers in New Jersey and may cause increased scrutiny regarding PSE&G’s future capital investments. In addition, as a basic generation service (BGS) supplier, Power provides services that include specified transmission costs. If the allocation of the costs associated with the transmission projects were to increase these BGS-related transmission costs, BGS suppliers may be entitled to an adjustment, subject to BPU approval. We do not believe that these matters will have a material effect on Power’s business or results of operations. Several complaints have been filed and several remain pending at FERC against transmission owners around the country, challenging those transmission owners’ base return on equity (ROE). Certain of those complaints have resulted in decisions and others have been settled, resulting in reductions of those transmission owners’ base ROEs. While we are not the subject of a challenge to the ROE employed in PSE&G’s transmission formula rate, the results of these other proceedings could set precedents for other transmission owners with formula rates in place, including PSE&G. Wholesale Power Market Design Capacity market design, including the Reliability Pricing Model (RPM) in PJM, remains an important focus for us. In June 2015, FERC conditionally accepted a proposal from PJM for a capacity performance product to include generators, Demand Response and energy efficiency providers, which will be required to perform during emergency conditions, as a supplement to the base capacity product. The proposal included enhanced performance-based incentives and penalties. We believe that the auction pricing adequately reflects the increased costs that could result from operating under more stringent rules for generation availability. Based on the auction results, the capacity performance mechanism appears to have provided the opportunity for enhanced capacity market revenue streams for Power, but future impacts cannot be assured. Further, there may be requirements for additional investment and there are additional performance and financial risks. Appeals of FERC’s capacity performance orders are pending. In May 2016, PJM announced the results of the RPM capacity auction for the 2019-2020 delivery year. Power cleared 8,895 MW of its generating capacity at an average price of $116 per MW-day for the 2019-2020 delivery period. Of the cleared capacity, Power believes that nearly all is compliant with PJM’s capacity performance requirements. In the two prior capacity auctions covering the 2017-2018 and 2018-2019 delivery years, Power cleared approximately 8,700 MW at average prices of $177 per MW-day and $215 per MW-day, respectively. Prices in the most recent auction reflect PJM’s downwardly-revised demand forecast, changes in the capacity emergency transfer limits due to transmission expansion and the effects of both the new generation and uncleared generation from the prior year’s auction. As a result of the efforts of certain entities in PJM to obtain financial support arrangements from their state commission, a group of suppliers requested that FERC direct PJM to expand the currently effective “minimum offer price rule” to apply to certain existing units seeking subsidies. The suppliers’ request was intended to avoid a scenario where the subsidized generators would submit bids into the PJM capacity market that did not reflect their actual costs of operation and could artificially suppress capacity market prices. We are currently awaiting FERC action on the suppliers’ request and cannot predict the outcome of the proceeding. See Item 1. Business-Federal Regulation for additional information. Environmental Regulation We continue to advocate for the development and implementation of fair and reasonable rules by the EPA and state environmental regulators. In particular, section 316(b) of the Federal Water Pollution Control Act (FWPCA) requires that cooling water intake structures, which are a significant part of the generation of electricity at steam-electric generating stations, reflect the best technology available for minimizing adverse environmental impacts. Implementation of Section 316(b) and related state regulations could adversely impact future nuclear and fossil operations and costs. The U.S. Supreme Court’s February 2016 decision to stay the implementation of the Clean Power Plan (CPP), a greenhouse gas emissions regulation under the Clean Air Act (CAA) for existing power plants, will delay deadlines for submission of state requests for extensions and final plans. If the CPP is upheld, new deadlines will need to be established and the effective date of the compliance period may be impacted. We are subject to liability under environmental laws for the costs of remediating environmental contamination of property now or formerly owned by us and of property contaminated by hazardous substances that we generated. In particular, the historic operations of PSEG companies and the operations of numerous other companies along the Passaic and Hackensack Rivers are alleged by Federal and State agencies to have discharged substantial contamination into the Passaic River/Newark Bay Complex in violation of various statutes. We are also currently involved in a number of proceedings relating to sites where other hazardous substances may have been discharged and may be subject to additional proceedings in the future, and the costs of any such remediation efforts could be material. For further information regarding the matters described above as well as other matters that may impact our financial condition and results of operations, see Item 8. Financial Statements and Supplementary Data-Note 13. Commitments and Contingent Liabilities. FERC Compliance Since September 2014, FERC Staff has been conducting a preliminary non-public investigation regarding errors in the calculation of certain components of Power’s cost-based bids for its New Jersey fossil generating units in the PJM energy market and the quantity of energy that Power offered into the energy market for its fossil peaking units compared to the amounts for which Power was compensated in the capacity market for those units. This investigation is ongoing. The amounts of potential disgorgement and other potential penalties that we may incur span a wide range depending on the success of our legal arguments. If our legal arguments do not prevail, in whole or in part with FERC or in a judicial challenge that we may choose to pursue, it is likely that Power would record losses that would be material to PSEG’s and Power’s results of operations in the quarterly and annual periods in which they are recorded. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 13. Commitments and Contingent Liabilities. Early Retirement of Hudson and Mercer Units In October 2016, Power determined it will cease generation operations of the existing coal/gas units at the Hudson and Mercer generating stations on June 1, 2017. The exact timing of the early retirement of these units may be impacted by operational and other conditions that could subsequently arise. The decision to retire the Hudson and Mercer units will have a material effect on PSEG’s and Power’s results of operations. In 2016, PSEG and Power recognized pre-tax charges in Energy Costs and Operation and Maintenance (O&M) of $62 million and $53 million, respectively, related to coal inventory adjustments, capacity penalties, materials and supplies inventory reserve adjustments for parts that cannot be used at other generating units, employee-related severance benefits costs and construction work in progress impairments, among other shut down items. In addition to these charges, Power recognized incremental Depreciation and Amortization during 2016 of $555 million ($571 million in total) and expects to recognize an additional $931 million ($958 million in total) in 2017 due to the significant shortening of the expected economic useful lives of Hudson and Mercer. Additional employee-related salary continuance and severance costs and various miscellaneous costs may also be incurred during the period prior to retirement. Finally, Power currently anticipates using the sites for alternative industrial activity. However, if Power determines not to use the sites for alternative industrial activity, the early retirement of the units at such sites would trigger obligations under certain environmental regulations, including possible remediation. The amounts for any such remediation are neither currently probable nor estimable but may be material. For additional information, including our estimated costs through 2017, see Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements. The primary factors considered during our annual five-year strategic planning process that contributed to the decision to retire these units early include significant declines in revenues and margin caused by a sustained period of depressed wholesale power prices and reduced capacity factors caused by lower natural gas prices making coal generation less economically competitive than natural gas-fired generation. Despite experiencing recent warmer than normal weather in PJM this summer, Power did not experience the usual increase in electricity prices in PJM as it had in past hot summers. This trend has a further adverse economic impact to these units because they generally dispatch and earn energy margin on peak hot and cold days. In addition, the upcoming PJM capacity auction in May 2017 will be the first to require all generating units to meet the increased operating performance standards of PJM’s new capacity performance construct. Power determined that the costs to upgrade the existing units at the Hudson and Mercer stations to be able to comply with these higher reliability standards are too significant and not economic given current market conditions. In addition, PSEG and Power continue to monitor their other coal assets, including the Keystone and Conemaugh generating stations, to ensure their economic viability through the end of their designated useful lives and their continued classification as held for use. The precise timing of a change in useful lives may be dependent upon events out of PSEG’s and Power’s control and may impact our ability to operate or maintain these assets in the future. These generating stations may be impacted by factors such as environmental legislation, co-owner capital requirements and continued depressed wholesale power prices or capacity factors, among other things. Any early retirement or change in the classification as held for use of our remaining coal units may have a material adverse impact on PSEG’s and Power’s future financial results. Leveraged Lease Impairments During the third quarter of 2016, Energy Holdings completed its annual review of estimated residual values embedded in the NRG REMA, LLC (REMA) leveraged leases. The outcome indicated that the revised residual value estimates were lower than the recorded residual values and the decline was deemed to be other than temporary due to the adverse economic conditions experienced by coal generation in PJM, as discussed in Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements, negatively impacting the economic outlook of the leased assets. As a result, a pre-tax write-down of $137 million was reflected in Operating Revenues in the quarter ended September 30, 2016, calculated by comparing the gross investment in the leases before and after the revised residual estimates. During the fourth quarter of 2016, Energy Holdings recorded a $10 million pre-tax charge in Operating Revenues reflecting its best estimate of loss as a result of the current liquidity issues facing REMA. There can be no assurance that a continuation or worsening of the adverse economic conditions would not lead to additional write-downs at any of our other generation units in our leveraged lease portfolio, and such write-downs could be material. Additional facilities in our leveraged lease portfolio include the Joliet and Shawville generating facilities, which were converted to use natural gas. However, these units may have higher operating costs and fuel consumption as well as longer start-up times compared to newer combined cycle gas units. As a result, these facilities may not be as economically competitive as newer combined cycle gas units and could continue to be adversely impacted by the same economic conditions experienced by coal generation facilities, which could require Energy Holdings to write down the residual value of the leveraged leases associated with these facilities. Further, REMA’s parent company, GenOn Energy, Inc. (GenOn), reported in August 2016 that it did not expect to have sufficient liquidity to repay their senior unsecured notes due in June 2017. Although all lease payments are current, PSEG cannot predict the outcome of GenOn’s efforts to restructure its portfolio and improve its liquidity and the possible related impact on REMA. PSEG continues to monitor any changes to REMA’s and GenOn’s status and potential impacts on Energy Holdings’ lease investments, which could include further write-downs of the values of Energy Holdings’ leveraged leases. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 8. Financing Receivables. Salem Operations The previously announced bolt replacement at Salem Unit 1 was completed and the unit returned to service on July 30, 2016. We expect to continue to inspect and replace degraded bolts at both Salem units over the next several refueling outage cycles. We are participating with the Electric Power Research Institute, the Nuclear Energy Institute and other operators of similarly-designed pressurized water reactors in developing a strategy to maintain the long-term health of the reactor vessel internals. Extension of the Salem Unit 1 outage into July and an unplanned outage at Salem Unit 2 due to a transformer failure currently under investigation reduced output from the Salem units in the third quarter. This was partially offset by increased production at our Hope Creek and Peach Bottom units. As a result, our nuclear capacity factor for the year ended December 31, 2016 was 86.9%. Pension Plan Merger As of December 31, 2016, PSEG merged its three qualified defined benefit pension plans (excluding Servco plans) into one plan, thereby also merging all of the pension plans’ assets. As a result, we estimate that in 2017, the total net periodic benefit costs are expected to decrease by approximately $72 million or $48 million, net of amounts capitalized, as compared to the 2017 amounts that would have been recognized had the plans not been merged. This is due to the amortization period for gains and losses for the merged plan resulting in lower amortization than that of the individual plans. No changes were made to the benefit formulas, vesting provisions, or to the employees covered by the plans. Pension and Other Postretirement Benefits-Change in Accounting Estimate At the end of 2015, we changed the approach used to measure future service and interest costs for pension and other post-retirement benefits. For 2015 and prior, we calculated service and interest costs utilizing a single weighted-average discount rate derived from the yield curve used to measure the plan obligations. For 2016 and beyond, we have elected to calculate service and interest costs by applying the specific spot rates along that yield curve to the plans’ liability cash flows. We believe the new approach provides a more precise measurement of service and interest costs by aligning the timing of the plans’ liability cash flows to the corresponding spot rates on the yield curve. This change did not affect the measurement of the plan obligations. As a change in accounting estimate, this change was reflected prospectively. We reduced 2016 pension and OPEB expense by approximately $34 million and $13 million, respectively, net of amounts capitalized. Operational Excellence We emphasize operational performance while developing opportunities in both our competitive and regulated businesses. Flexibility in our generating fleet has allowed us to take advantage of opportunities in a rapidly evolving market as we remain diligent in managing costs. In 2016, our • diverse fuel mix and dispatch flexibility allowed us to generate approximately 52 terra-watt hours while addressing fuel availability and price volatility and compensating for the extended outages at our Salem units, • combined cycle fleet produced 16 terawatt hours at an average capacity factor of 57%, and • utility was recognized for the fifteenth consecutive year as the most reliable utility in the Mid-Atlantic region. Financial Strength Our financial strength is predicated on a solid balance sheet, positive operating cash flow and reasonable risk-adjusted returns on increased investment. Our financial position remained strong during 2016 as we: • maintained sufficient liquidity, • maintained solid investment grade credit ratings, and • increased our indicative annual dividend for 2016 to $1.64 per share. We expect to be able to fund our planned capital requirements, as described in Liquidity and Capital Resources, without the issuance of new equity. Disciplined Investment We utilize rigorous investment criteria when deploying capital and seek to invest in areas that complement our existing business and provide reasonable risk-adjusted returns. These areas include upgrading our energy infrastructure, responding to trends in environmental protection and providing new energy supplies in domestic markets with growing demand. In 2016, we • made additional investments in transmission infrastructure projects, • began executing our GSMP and continued executing Energy Strong and other existing BPU-approved utility programs, • commenced construction of our Keys and Sewaren 7 generation projects for targeted commercial operation in 2018 and announced our plan to construct BH5 and commence operations in mid-2019, and • acquired solar energy projects totaling 248 MW-direct current (dc), of which 177 MW dc are already in-service, primarily in North Carolina, Colorado and Utah. The remaining MW dc are scheduled to be in-service by the fourth quarter of 2017. Future Outlook Our future success will depend on our ability to continue to maintain strong operational and financial performance in a slow-growing economy and a cost-constrained environment with low gas prices, to capitalize on or otherwise address appropriately regulatory and legislative developments that impact our business and to respond to the issues and challenges described below. In order to do this, we must continue to: • focus on controlling costs while maintaining safety and reliability and complying with applicable standards and requirements, • successfully manage our energy obligations and re-contract our open supply positions in response to changes in demand, • execute our utility capital investment program, including our Energy Strong program, GSMP and other investments for growth that yield contemporaneous and reasonable risk-adjusted returns, while enhancing the resiliency of our infrastructure and maintaining the reliability of the service we provide to our customers, • effectively manage construction of our Keys, Sewaren 7, BH5 and other generation projects, • advocate for measures to ensure the implementation by PJM and FERC of market design and transmission planning rules that continue to promote fair and efficient electricity markets, • engage multiple stakeholders, including regulators, government officials, customers and investors, and • successfully operate the LIPA T&D system and manage LIPA’s fuel supply and generation dispatch obligations. For 2017 and beyond, the key issues and challenges we expect our business to confront include: • regulatory and political uncertainty, both with regard to future energy policy, design of energy and capacity markets, transmission policy and environmental regulation, as well as with respect to the outcome of any legal, regulatory or other proceeding, settlement, investigation or claim, applicable to us and/or the energy industry, • fair and timely rate relief from the BPU and FERC for recovery of costs and return on investments, including with respect to our distribution base rate case which must be filed with the BPU no later than November 1, 2017, • the potential for comprehensive tax reform, particularly in light of public statements by the current U.S. administration and key members of Congress, • uncertainty in the national and regional economic recovery, continuing customer conservation efforts, changes in energy usage patterns and evolving technologies, which impact customer behaviors and demand, • the potential for continued reductions in demand and sustained lower natural gas and electricity prices, both at market hubs and the locations where we operate, • the impact of lower natural gas prices and increasing environmental compliance costs on the competitiveness of our nuclear and remaining coal-fired generation plants, and the potential for retirement of such plants earlier than their current useful lives, • delays and other obstacles that might arise in connection with the construction of our T&D, generation and other development projects, including in connection with permitting and regulatory approvals, • maintaining a diverse mix of fuels to mitigate risks associated with fuel price volatility and market demand cycles, and • FERC Staff’s continuing investigation of certain of Power’s New Jersey fossil generating unit bids in the PJM energy market. Our primary investment opportunities are in two areas: our regulated utility business and our merchant power business. We continually assess a broad range of strategic options to maximize long-term stockholder value. In assessing our options, we consider a wide variety of factors, including the performance and prospects of our businesses; the views of investors, regulators and rating agencies; our existing indebtedness and restrictions it imposes; and tax considerations, among other things. Strategic options available to us include: • the acquisition, construction or disposition of transmission and distribution facilities and/or generation units, • the disposition or reorganization of our merchant generation business or other existing businesses or the acquisition or development of new businesses, • the expansion of our geographic footprint, • continued or expanded participation in solar, demand response and energy efficiency programs, and • investments in capital improvements and additions, including the installation of environmental upgrades and retrofits, improvements to system resiliency, modernizing existing infrastructure and participation in transmission projects through FERC’s “open window” solicitation process. In 2016, Power announced its intention to develop a retail platform to sell physical electricity and natural gas, which we believe would complement our existing wholesale marketing business. Power was granted licenses in 2016 to sell both electricity and gas in the states of New Jersey and Pennsylvania. There can be no assurance, however, that we will successfully develop and execute any of the strategic options noted above, or any additional options we may consider in the future. The execution of any such strategic plan may not have the expected benefits or may have unexpected adverse consequences. RESULTS OF OPERATIONS (A) Power’s results in 2016 includes after-tax expenses of $396 million related to the early retirement of its Hudson and Mercer coal/gas generation plants. See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements for additional information. Power’s results in 2015 include an after-tax insurance recovery for Superstorm Sandy of $102 million. (B) Other includes after-tax activities at the parent company, PSEG LI and Energy Holdings as well as intercompany eliminations. Energy Holdings recorded after-tax charges totaling $92 million related to its investments in NRG REMA, LLC’s leveraged leases in 2016. See Item 8. Financial Statements and Supplementary Data-Note 7. Long-Term Investments and Note 8. Financing Receivables for further information. Our results include the realized gains, losses and earnings on Power’s NDT Fund and other related NDT activity. Realized gains and losses, interest and dividend income and other costs related to the NDT Fund are recorded in Other Income (Deductions), and impairments on certain NDT securities are recorded as Other-Than-Temporary Impairments. Interest accretion expense on Power’s nuclear ARO is recorded in O&M Expense and the depreciation related to the ARO asset is recorded in Depreciation and Amortization Expense. In 2014, we restructured portions of our NDT Fund and realized a pre-tax gain of $65 million. Our results also include the after-tax impacts of non-trading MTM activity, which consist of the financial impact from positions with forward delivery dates. The combined after-tax impact on Net Income for the years ended December 31, 2016, 2015 and 2014 include the changes related to NDT Fund and MTM activity shown in the chart below: (A) Net of tax (expense) benefit of $(5) million, $(16) million and $(70) million for the years ended December 31, 2016, 2015 and 2014, respectively. (B) Net of tax (expense) benefit of $68 million, $(65) million and $(45) million for the years ended December 31, 2016, 2015 and 2014, respectively. The 2016 year-over-year decrease in our Net Income was driven primarily by: • charges related to the early retirement of two coal/gas generation units at Power (See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements), • MTM losses in 2016 as compared to MTM gains in 2015, • lower volumes of energy sold at lower average realized sales prices, • lower capacity and operating reserve revenues in PJM, • higher 2016 congestion costs in PJM due primarily to realized gains on financial transmission rights (FTR) in PJM in the prior year due to extremely cold weather, • lower volumes of gas sold at lower average prices under the Basic Gas Supply Service (BGSS) contract, • insurance recoveries received primarily by Power in 2015 related to Superstorm Sandy, and • an impairment related to investments in certain leveraged leases at Energy Holdings (See Item 8. Financial Statements and Supplementary Data-Note 8. Financing Receivables). These decreases were partially offset by: • lower generation costs driven by lower fuel costs, particularly for natural gas, and reduced generation output at Power, •higher costs incurred at Power for planned outages in 2015, • higher transmission revenues, and • higher management fee revenues at PSEG LI pursuant to the OSA. The 2015 year-over-year increase in our Net Income was driven by: • higher transmission revenues, • lower generation costs due to lower fuel costs, primarily reflecting lower natural gas and coal prices, • higher MTM gains in 2015, and • insurance recoveries of Superstorm Sandy costs, primarily at Power. These increases were partially offset by: • lower capacity revenues resulting from lower average auction prices coupled with lower ancillary and operating reserve revenues in the PJM region, • lower realized gains and higher other-than-temporary impairments related to the NDT Fund, and • higher pension and OPEB costs, net of amounts capitalized. PSEG Our results of operations are primarily comprised of the results of operations of our principal operating subsidiaries, PSE&G and Power, excluding charges related to intercompany transactions, which are eliminated in consolidation. For additional information on intercompany transactions, see Item 8. Financial Statements and Supplementary Data-Note 24. Related-Party Transactions. The 2016, 2015 and 2014 amounts in the preceding table for Operating Revenues and O&M costs each include $410 million, $375 million and $389 million, respectively, for Servco. These amounts represent the O&M pass-through costs for the Long Island operations, the full reimbursement of which is reflected in Operating Revenues. See Item 8. Financial Statements and Supplementary Data-Note 4. Variable Interest Entities for further explanation. The following discussions for PSE&G and Power provide a detailed explanation of their respective variances. PSE&G Year Ended December 31, 2016 as compared to 2015 Operating Revenues decreased $415 million due to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $191 million due primarily to an increase in transmission revenues. • Transmission revenues were $223 million higher due to higher revenue requirements calculated through our transmission formula rate, primarily to recover required investments. • Electric distribution revenues decreased $27 million due primarily to $47 million in lower collections of Green Program Recovery Charges (GPRC), partially offset by an $18 million increase in Energy Strong revenues. • Gas distribution revenues decreased $5 million due to a decrease of $43 million due to lower sales volumes and $7 million in lower collections of GPRC. These decreases were partially offset by higher Weather Normalization Clause (WNC) revenues of $25 million due to warmer weather in 2016 compared to 2015 and $20 million due to the inclusion of Energy Strong in base rates. Clause Revenues decreased $445 million due to lower Securitization Transition Charge (STC) revenues of $419 million, lower Societal Benefit Charges (SBC) of $33 million, and lower Solar Pilot Recovery Charges (SPRC) of $8 million. These decreases were partially offset by higher Margin Adjustment Clause (MAC) revenues of $15 million. The changes in STC, SBC, SPRC and MAC amounts were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, Depreciation and Amortization and Interest Expense. PSE&G does not earn margin on STC, SBC, SPRC or MAC collections. Commodity Revenues decreased $155 million due to lower Electric and Gas revenues. This is entirely offset with decreased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Electric revenues decreased $136 million due to $73 million in lower collections of Non-Utility Generation Charges (NGC) due primarily to lower prices, $42 million in lower revenues from the sale of Non-Utility Generation (NUG) energy and $21 million in lower BGS revenues primarily due to lower sales volumes. • Gas revenues decreased $19 million due to $80 million from lower sales volumes, partially offset by higher BGSS prices of $61 million. Operating Expenses Energy Costs decreased $155 million. This is entirely offset by Commodity Revenues. Operation and Maintenance decreased $85 million due to • a $98 million net reduction related to various clause mechanisms and GPRC, and • a $13 million decrease in pension and OPEB expenses, net of amounts capitalized, • partially offset by $10 million of insurance recovery proceeds in 2015, • a $10 million increase in vegetation management costs, and • a $6 million net increase due primarily to transmission and distribution corrective maintenance and appliance service costs. Depreciation and Amortization decreased $327 million due primarily to a $396 million net decrease in amortization of Regulatory Assets, partially offset by an increase in depreciation of $65 million due additional plant placed into service in 2016. Interest Expense increased $9 million due to increases of • $14 million due to net debt issuances in 2015, and • $13 million due to net debt issuances in 2016, • partially offset by a decreases of $11 million due to the redemption of securitization debt in 2015 and • $7 million of higher interest related to BGSS in 2015. Income Tax Expense increased $45 million due primarily to higher pre-tax income partially offset by changes in the reserve for uncertain tax positions and flow through items. Year Ended December 31, 2015 as compared to 2014 Operating Revenues decreased $130 million due to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $212 million due primarily to an increase in transmission revenues. • Transmission revenues were $164 million higher due to higher revenue requirements calculated through our transmission formula rate, primarily to recover required investments. • Electric distribution revenues increased $31 million due primarily to higher sales volumes due to weather. • Gas distribution revenues increased $17 million due to higher WNC revenues of $35 million due to warmer weather in 2015 compared to 2014, partially offset by $18 million due to lower sales volumes. Clause Revenues decreased $154 million due to lower STC revenues of $86 million, lower SBC of $31 million, lower MAC of $29 million, and lower SPRC of $8 million. The changes in STC, SBC, MAC and SPRC amounts were entirely offset by decreases in the amortization of Regulatory Assets and related costs in O&M, Depreciation and Amortization and Interest Expense. PSE&G does not earn margin on STC, SBC, MAC or SPRC collections. Commodity Revenues decreased $187 million due to lower Gas revenues, partially offset by higher Electric revenues. This is entirely offset with decreased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Gas revenues decreased $266 million due to lower BGSS prices of $295 million, partially offset by $29 million from higher sales volumes. The average price of natural gas was 29% lower to the customer in 2015 than in 2014. • Electric revenues increased $79 million due to $120 million in higher net BGS revenues, comprised of $166 million from higher sales volumes, partially offset by lower prices of $46 million. BGS sales volume increased due primarily to weather. The BGS net revenue increase was partially offset by $41 million in lower revenues from the sale of NUG energy and the collections of NGC due primarily to lower prices. Operating Expenses Energy Costs decreased $187 million. This is entirely offset by Commodity Revenues. Operation and Maintenance increased $2 million, of which the most significant components were increases of • $33 million in pension and OPEB expenses, net of amounts capitalized, • $13 million in transmission operating expenses, • $7 million in gas bad debt expense, and • a $49 million net increase due to various increases, including information technology expenditures, wages, appliance service costs and preventative maintenance, • almost entirely offset by a $90 million net reduction related to various clause mechanisms, GPRC and the Capital Infrastructure Program, and • $10 million of insurance recovery proceeds. Depreciation and Amortization decreased $14 million due to a $69 million decrease in amortization of Regulatory Assets, partially offset by an increase in depreciation of $55 million due to additional plant in service. Other Income (Deductions) net increase of $17 million in AFUDC. Interest Expense increased $3 million due primarily to increases of • $12 million due to net debt issuances in the latter half of 2014, and • $9 million due to net debt issuances in 2015, • partially offset by a decrease of $17 million due to the redemption of securitization debt in 2015. Income Tax Expense increased $21 million due primarily to higher pre-tax income. Power Year Ended December 31, 2016 as compared to 2015 Operating Revenues decreased $905 million due to changes in generation, gas supply and other operating revenues. Generation Revenues decreased $714 million due primarily to • a decrease of $317 million due to MTM losses in 2016 as compared to MTM gains in 2015. Of this amount, $199 million was due to changes in forward power prices resulting in lower MTM gains this year compared to last year. Also contributing to the decrease was $118 million of higher gains on positions reclassified to realized upon settlement this year compared to last year, • a decrease of $298 million in energy sales volumes in the PJM, NE and NY regions due primarily to milder weather in 2016 and lower average realized prices, • a decrease of $80 million in capacity revenue primarily in the PJM region due to the retirement of older peaking units in June 2015, and • a decrease of $49 million due to lower operating reserve revenues in the PJM region due to less congestion and lower prices, • partially offset by a net increase of $19 million due primarily to higher volumes of electricity sold under wholesale load contracts in the PJM and NE regions, partially offset by lower average prices, and • a net increase of $8 million due to new solar projects beginning commercial operations. Gas Supply Revenues decreased $191 million due primarily to • a decrease of $183 million in sales under the BGSS contract due primarily to lower average sales prices and a decrease in sales volumes due to warmer average temperatures in the 2016 heating season, and • a decrease of $9 million due to MTM losses in 2016 due to changes in forward prices. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs decreased $164 million due to Generation costs decreased $95 million due primarily to • lower fuel costs of $288 million reflecting lower average realized prices for natural gas and the utilization of lower volumes of fuel, • partially offset by a net increase of $143 million primarily due to realized gains on FTRs in PJM in the prior year due to extremely cold weather, and • a $62 million charge associated with the announced early retirement of the Mercer and Hudson units, primarily related to a coal inventory write-down. Gas costs decreased $69 million due to • a decrease of $101 million related to sales under the BGSS contract due primarily to lower average gas costs and a decrease in volumes sold due to warmer average temperatures during the 2016 winter heating season, • partially offset by an increase of $32 million related to sales to third parties due primarily to higher average gas costs and an increase in volumes sold. Operation and Maintenance increased $86 million due to • $145 million of insurance recoveries received in 2015 related to Superstorm Sandy, and • $53 million of charges related to the early retirement of the Hudson and Mercer units, • partially offset by a net decrease of $73 million related to our fossil plants, largely due to higher costs incurred in 2015 for our planned major outages at the Bethlehem Energy Center and Bergen generating plants, • a net decrease of $31 million related to our nuclear plants due primarily to lower planned outage costs at our 100%-owned Hope Creek plant and our 57%-owned Salem Unit 1 plant, and • an $8 million decrease due to lower pension and OPEB costs. Depreciation and Amortization increased $590 million due primarily to • $555 million of accelerated depreciation due to the early retirement of the Hudson and Mercer units, • a $24 million increase due primarily to a higher nuclear asset base, and • $5 million of higher depreciation due to new solar projects. Other Income (Deductions) decreased $52 million due primarily to $28 million of insurance recoveries received in 2015 related to Superstorm Sandy and $38 million of lower net realized gains from the NDT Fund in 2016, partially offset by $10 million of lower purchased tax credits in 2016. Other-Than-Temporary Impairments decreased $25 million due to lower impairments of equity securities in the NDT Fund in 2016. Interest Expense decreased $37 million due to • $27 million of interest capitalized for the construction of three new fossil stations: Bridgeport Harbor 5, Sewaren 7 and Keys Energy Center, and • a $15 million decrease due to the maturity of 5.50% of Senior Notes in December 2015, • partially offset by an increase of $5 million due to net debt issuances in 2016. Income Tax Expense decreased $572 million in 2016 due primarily to a pre-tax loss in 2016 as compared to pre-tax income in 2015. Year Ended December 31, 2015 as compared to 2014 Operating Revenues decreased $506 million due to changes in generation, gas supply and other operating revenues. Generation Revenues decreased $172 million due to • a decrease of $192 million due primarily to lower capacity revenues resulting from lower average auction prices and the retirement of older peaking units in June 2015, coupled with lower ancillary and operating reserve revenues in the PJM region, and • lower net revenues of $73 million due primarily to lower energy volumes sold in the NE region and lower average realized prices in the NE and NY regions, partially offset by higher energy volumes sold in the NY and PJM regions. Also included in the net decrease is $22 million due to lower MTM gains in 2015. • partially offset by an increase of $56 million due primarily to higher volumes of electricity sold under wholesale load contracts in the PJM and NE regions coupled with higher average prices in the NE region, and • an increase of $37 million due primarily to higher volumes of electricity sold under the BGS contract at higher average prices. Gas Supply Revenues decreased $336 million due to • a net decrease of $214 million in sales under the BGSS contract, substantially comprised of lower average sales prices, and • a decrease of $122 million on sales to third-party customers, of which $93 million was due to lower average sales prices and $29 million to lower volumes sold. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs decreased $597 million due to • Generation costs decreased $254 million due primarily to lower fuel costs of $330 million reflecting lower average realized natural gas and coal prices and the utilization of lower volumes of oil and coal. MTM gains in 2015 as compared to MTM losses in 2014 resulted in a $66 million decrease. These decreased costs were partially offset by higher congestion costs in the PJM region of $140 million. • Gas costs decreased $343 million mainly related to a decrease in average gas costs on both obligations under the BGSS contract and sales to third parties. Operation and Maintenance decreased $129 million due primarily to • a decrease of $145 million due to insurance recoveries received in 2015 related to Superstorm Sandy, and • a net decrease of $61 million related to our fossil plants, largely due to higher costs incurred in 2014 for planned outage costs, including maintenance and installation of upgraded technology at our Linden combined cycle gas generating plant, partially offset by planned outage costs in 2015 at our BEC generating plant and installation of upgraded technology at our combined cycle Bergen plant, • partially offset by an increase of $51 million at our nuclear facilities, primarily due to higher planned outage costs at our 100%-owned Hope Creek and 50%-owned Peach Bottom 3 nuclear plants in 2015 as compared to our 57%-owned Salem nuclear unit 2 in 2014, and • a $30 million increase due to higher pension and OPEB costs, net of amounts capitalized. Other Income (Deductions) decreased $73 million due primarily to lower net realized gains from the NDT Fund, partially offset by a $28 million insurance recovery related to Superstorm Sandy. Other-Than-Temporary Impairments increased $33 million due primarily to an increase in impairments of equity securities in the NDT Fund. Income Tax Expense increased $20 million in 2015 due primarily to higher pre-tax income. LIQUIDITY AND CAPITAL RESOURCES The following discussion of our liquidity and capital resources is on a consolidated basis, noting the uses and contributions, where material, of our two direct major operating subsidiaries. Financing Methodology We expect our capital requirements to be met through internally generated cash flows and external financings, consisting of short-term debt for working capital needs and long-term debt for capital investments. PSE&G’s sources of external liquidity include a $600 million multi-year syndicated credit facility. PSE&G uses internally generated cash flow and its commercial paper program to meet seasonal, intra-month and temporary working capital needs. PSE&G does not engage in any intercompany borrowing or lending arrangements. PSE&G maintains back-up facilities in an amount sufficient to cover the commercial paper and letters of credit outstanding. PSE&G’s dividend payments to/capital contributions from PSEG are consistent with its capital structure objectives which have been established to maintain investment grade credit ratings. PSE&G’s long-term financing plan is designed to replace maturities, fund a portion of its capital program and manage short-term debt balances. Generally, PSE&G uses either secured medium-term notes or first mortgage bonds to raise long-term capital. PSEG, Power, Energy Holdings, PSEG LI and Services participate in a corporate money pool, an aggregation of daily cash balances designed to efficiently manage their respective short-term liquidity needs. Servco does not participate in the corporate money pool. Servco’s short-term liquidity needs are met through an account funded and owned by LIPA. PSEG’s sources of external liquidity may include the issuance of long-term debt securities and the incurrence of additional indebtedness under credit facilities. Our current sources of external liquidity include multi-year syndicated credit facilities totaling $1 billion. These facilities are available to back-stop PSEG’s commercial paper program, issue letters of credit and for general corporate purposes. These facilities may also be used to provide support to PSEG’s subsidiaries. PSEG’s credit facilities and the commercial paper program are available to support PSEG working capital needs or to temporarily fund growth opportunities in advance of obtaining permanent financing. PSEG also has a $500 million term loan credit agreement that is scheduled to expire in November 2017. From time to time, PSEG may make equity contributions or provide credit support to its subsidiaries. Power’s sources of external liquidity include $2.6 billion of syndicated multi-year credit facilities. Additionally, from time to time, Power maintains bilateral credit agreements designed to enhance its liquidity position. Credit capacity is primarily used to provide collateral in support of Power’s forward energy sale and forward fuel purchase contracts as the market prices for energy and fuel fluctuate, and to meet potential collateral postings in the event that Power is downgraded to below investment grade by S&P or Moody’s. Power’s dividend payments to PSEG are also designed to be consistent with its capital structure objectives which have been established to maintain investment grade credit ratings and provide sufficient financial flexibility. Generally, Power issues senior unsecured debt to raise long-term capital. Operating Cash Flows We expect our operating cash flows combined with cash on hand and financing activities to be sufficient to fund capital expenditures and shareholder dividend payments. For the year ended December 31, 2016, our operating cash flow decreased by $608 million. For the year ended December 31, 2015, our operating cash flow increased by $759 million. The net changes were primarily due to net changes from our subsidiaries as discussed below. PSE&G PSE&G’s operating cash flow decreased $231 million from $2,125 million to $1,894 million for the year ended December 31, 2016, as compared to 2015, due primarily to a decrease from lower collections for securitization debt principal repayments which were $259 million in 2015, a decrease of $249 million in cash receipts from customers due to lower sales driven by warmer winter weather in 2016 compared to 2015, a decrease of $90 million related to a change in regulatory deferrals, primarily driven by net returns to customers in 2016 related to 2015 overcollections, partially offset by higher bill credits and $74 million in increased vendor payments. These amounts were partially offset by higher earnings and higher tax refunds in 2016. PSE&G’s operating cash flow increased $292 million from $1,833 million to $2,125 million for the year ended December 31, 2015, as compared to 2014, due primarily to higher earnings, a $311 million reduction in tax payments, and an increase of $102 million due to higher customer billings in the fourth quarter of 2014 primarily as a result of increased usage due to weather. These increases were partially offset by a decrease of $250 million related to a change in regulatory deferrals, primarily driven by the return of prior year overcollections to customers for BGSS gas costs, Gas WNC charges and BGS costs. Power Power’s operating cash flow decreased $451 million from $1,706 million to $1,255 million for the year ended December 31, 2016, as compared to 2015, primarily resulting from lower earnings, an increase in margin deposit requirements of $198 million, and a $134 million decrease from net collection of counterparty receivables, partially offset by a reduction in tax payments. Power’s operating cash flow increased $281 million from $1,425 million to $1,706 million for the year ended December 31, 2015, as compared to 2014, primarily resulting from higher earnings, a decrease in margin deposit requirements of $144 million, and a $78 million increase from net collection of counterparty receivables. These amounts were partially offset by an increase of $325 million in tax payments. Short-Term Liquidity We continually monitor our liquidity and seek to add capacity as needed to meet our liquidity requirements. Each of our credit facilities is restricted as to availability and use to the specific companies as listed below; however, if necessary, the PSEG facilities can also be used to support our subsidiaries’ liquidity needs. Our total credit facilities and available liquidity as of December 31, 2016 were as follows: As of December 31, 2016, our credit facility capacity was in excess of our projected maximum liquidity requirements over our 12 month planning horizon. Our maximum liquidity requirements are based on stress scenarios that incorporate changes in commodity prices and the potential impact of Power losing its investment grade credit rating from S&P or Moody’s, which would represent a three level downgrade from its current S&P or Moody’s ratings. In the event of a deterioration of Power’s credit rating certain of Power’s agreements allow the counterparty to demand further performance assurance. The potential additional collateral that we would be required to post under these agreements if Power were to lose its investment grade credit rating was approximately $783 million and $864 million as of December 31, 2016 and 2015, respectively. The early retirement of Power’s Hudson and Mercer coal/gas generation units is not expected to have a material impact on Power’s debt covenant ratios or its ability to obtain credit facilities. See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements. For additional information, see Item 8.Financial Statements and Supplementary Data-Note 14. Debt and Credit Facilities. Long-Term Debt Financing PSEG has a floating rate $500 million term loan maturing in November 2017. For a discussion of our long-term debt transactions during 2016 and into 2017, see Item 8. Financial Statements and Supplementary Data-Note 14. Debt and Credit Facilities. Debt Covenants Our credit agreements contain maximum debt to equity ratios and other restrictive covenants and conditions to borrowing. We are currently in compliance with all of our debt covenants. Continued compliance with applicable financial covenants will depend upon our future financial position, level of earnings and cash flows, as to which no assurances can be given. In addition, under its First and Refunding Mortgage (Mortgage), PSE&G may issue new First and Refunding Mortgage Bonds against previous additions and improvements, provided that its ratio of earnings to fixed charges calculated in accordance with its Mortgage is at least 2 to 1, and/or against retired Mortgage Bonds. As of December 31, 2016, PSE&G’s Mortgage coverage ratio was 4.2 to 1 and the Mortgage would permit up to approximately $5.7 billion aggregate principal amount of new Mortgage Bonds to be issued against additions and improvements to its property. Default Provisions Our bank credit agreements and indentures contain various, customary default provisions that could result in the potential acceleration of indebtedness under the defaulting company’s agreement. In particular, PSEG’s bank credit agreements contain provisions under which certain events, including an acceleration of material indebtedness under PSE&G’s and Power’s respective financing agreements, a failure by PSE&G or Power to satisfy certain final judgments and certain bankruptcy events by PSE&G or Power, that would constitute an event of default under the PSEG bank credit agreements. Under the PSEG bank credit agreements, it would also be an event of default if either PSE&G or Power ceases to be wholly owned by PSEG. The PSE&G and Power bank credit agreements include similar default provisions; however such provisions only relate to the respective borrower under such agreement and its subsidiaries and do not contain cross default provisions to each other. The PSE&G and Power bank credit agreements do not include cross default provisions relating to PSEG. There are no cross acceleration provisions in PSEG’s or PSE&G’s indentures. However, PSEG’s existing notes include a cross acceleration provision that may be triggered upon the acceleration of more than $75 million of indebtedness incurred by PSEG. Such provision does not extend to an acceleration of indebtedness by any of PSEG’s subsidiaries. Power’s indenture includes a cross acceleration provision similar to that described above for PSEG’s existing notes except that such provision may be triggered upon the acceleration of more than $50 million of indebtedness incurred by Power or any of its subsidiaries. Such provision does not cross accelerate to PSEG, any of PSEG’s subsidiaries (other than Power and its subsidiaries), PSE&G or any of PSE&G’s subsidiaries. Ratings Triggers Our debt indentures and credit agreements do not contain any material ‘ratings triggers’ that would cause an acceleration of the required interest and principal payments in the event of a ratings downgrade. However, in the event of a downgrade, any one or more of the affected companies may be subject to increased interest costs on certain bank debt and certain collateral requirements. In the event that we are not able to affirm representations and warranties on credit agreements, lenders would not be required to make loans. In accordance with BPU requirements under the BGS contracts, PSE&G is required to maintain an investment grade credit rating. If PSE&G were to lose its investment grade rating, it would be required to file a plan to assure continued payment for the BGS requirements of its customers. Fluctuations in commodity prices or a deterioration of Power’s credit rating to below investment grade could increase Power’s required margin postings under various agreements entered into in the normal course of business. Power believes it has sufficient liquidity to meet the required posting of collateral which would likely result from a credit rating downgrade to below investment grade by S&P or Moody’s at today’s market prices. Common Stock Dividends On February 21, 2017, our Board of Directors approved a $0.43 per share common stock dividend for the first quarter of 2017. This reflects an indicative annual dividend rate of $1.72 per share. We expect to continue to pay cash dividends on our common stock; however, the declaration and payment of future dividends to holders of our common stock will be at the discretion of the Board of Directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our businesses, alternate investment opportunities, legal requirements, regulatory constraints, industry practice and other factors that the Board of Directors deems relevant. For additional information related to cash dividends on our common stock, see Item 8. Financial Statements and Supplementary Data-Note 22. Earnings Per Share (EPS) and Dividends. Credit Ratings If the rating agencies lower or withdraw our credit ratings, such revisions may adversely affect the market price of our securities and serve to materially increase our cost of capital and limit access to capital. Credit Ratings shown are for securities that we typically issue. Outlooks are shown for Corporate Credit Ratings (S&P) and Issuer Credit Ratings (Moody’s) and can be Stable, Negative, or Positive. There is no assurance that the ratings will continue for any given period of time or that they will not be revised by the rating agencies, if, in their respective judgments, circumstances warrant. Each rating given by an agency should be evaluated independently of the other agencies’ ratings. The ratings should not be construed as an indication to buy, hold or sell any security. In January 2016, S&P published updated research reports on PSEG and PSE&G and the existing ratings and outlooks were unchanged. In June 2016, Moody’s published credit opinions on Power and PSE&G and the existing ratings and outlooks were unchanged. In June 2016, S&P published an updated research report on Power and the existing rating and outlook were unchanged. In September 2016, Moody’s published an updated research report on PSEG and the existing rating and outlook were unchanged. (A) Moody’s ratings range from Aaa (highest) to C (lowest) for long-term securities and P1 (highest) to NP (lowest) for short-term securities. (B) S&P ratings range from AAA (highest) to D (lowest) for long-term securities and A1 (highest) to D (lowest) for short-term securities. Other Comprehensive Income For the year ended December 31, 2016, we had Other Comprehensive Income of $32 million on a consolidated basis. Other Comprehensive Income was due primarily to a $42 million increase in net unrealized gains related to Available-for-Sale Securities and $2 million of unrealized gains on derivative contracts accounted for as hedges, partially offset by a decrease of $12 million in our consolidated liability for pension and postretirement benefits. See Item 8. Financial Statements and Supplementary Data-Note 21. Accumulated Other Comprehensive Income (Loss), Net of Tax for additional information. CAPITAL REQUIREMENTS We expect that all of our capital requirements over the next three years will come from a combination of internally generated funds and external debt financing. Projected capital construction and investment expenditures, excluding nuclear fuel purchases, for the next three years are presented in the table below. These projections include Allowance for Funds Used During Construction and Interest Capitalized During Construction for PSE&G and Power, respectively. These amounts are subject to change, based on various factors. Amounts shown below for Energy Strong, GSMP and Solar/Energy Efficiency programs are for currently approved programs. We intend to continue to invest in infrastructure modernization and will seek to extend these and related programs as appropriate. We will also continue to approach potential growth investments for Power opportunistically, seeking projects that will provide attractive risk-adjusted returns for our shareholders. PSE&G PSE&G’s projections for future capital expenditures include material additions and replacements to its transmission and distribution systems to meet expected growth and to manage reliability. As project scope and cost estimates develop, PSE&G will modify its current projections to include these required investments. PSE&G’s projected expenditures for the various items reported above are primarily comprised of the following: • Transmission-investments focused on reliability improvements and replacement of aging infrastructure. • Distribution-investments for new business, reliability improvements, and replacement of equipment that has reached the end of its useful life. • Energy Strong-Electric and Gas Distribution reliability investment program focused on system hardening and resiliency. • Gas System Modernization Program-Gas Distribution investment program to replace aging infrastructure. • Solar/Energy Efficiency-investments associated with grid-connected solar, solar loan programs, and customer energy efficiency programs. In August 2016, PSE&G filed a petition with the BPU requesting approval of the $268 million investment and an associated cost recovery mechanism to develop a project where PSE&G would rebuild New Jersey Transit’s Mason substation and related facilities in Kearny, NJ. This is not included in PSE&G’s projected capital expenditures. In 2016, PSE&G made $2,816 million of capital expenditures, primarily for transmission and distribution system reliability. This does not include expenditures for cost of removal, net of salvage, of $131 million, which are included in operating cash flows. Power Power’s projected expenditures for the various items listed above are primarily comprised of the following: • Baseline-investments to replace major parts and enhance operational performance. • Environmental/Regulatory-investments made in response to environmental, regulatory or legal mandates. • Fossil Growth Opportunities-investments associated with new construction, including Keys Energy Center, Sewaren 7 and BH5, and with upgrades to increase efficiency and output at combined cycle plants. • Nuclear Expansion-investments associated with certain nuclear capital projects, primarily at existing facilities designed to increase operating output. • Solar Growth Opportunities-investments associated with the construction of utility-scale photovoltaic facilities. In 2016, Power made $1,136 million of capital expenditures, excluding $207 million for nuclear fuel, primarily related to various projects at Fossil, Solar and Nuclear. Disclosures about Contractual Obligations The following table reflects our contractual cash obligations in the respective periods in which they are due. In addition, the table summarizes anticipated debt maturities for the years shown. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 14. Debt and Credit Facilities. The table below does not reflect any anticipated cash payments for pension obligations due to uncertain timing of payments or liabilities for uncertain tax positions since we are unable to reasonably estimate the timing of liability payments in individual years beyond 12 months due to uncertainties in the timing of the effective settlement of tax positions. See Item 8. Financial Statements and Supplementary Data-Note 20. Income Taxes for additional information. OFF-BALANCE SHEET ARRANGEMENTS PSEG and Power issue guarantees, primarily in conjunction with certain of Power’s energy contracts. See Item 8. Financial Statements and Supplementary Data-Note 13. Commitments and Contingent Liabilities for further discussion. Through Energy Holdings, we have investments in leveraged leases that are accounted for in accordance with GAAP Accounting for Leases. Leveraged lease investments generally involve three parties: an owner/lessor, a creditor and a lessee. In a typical leveraged lease arrangement, the lessor purchases an asset to be leased. The purchase price is typically financed 80% with debt provided by the creditor and the balance comes from equity funds provided by the lessor. The creditor provides long-term financing to the transaction secured by the property subject to the lease. Such long-term financing is non-recourse to the lessor and is not presented on our Consolidated Balance Sheets. In the event of default, the leased asset, and in some cases the lessee, secures the loan. As a lessor, Energy Holdings has ownership rights to the property and rents the property to the lessees for use in their business operations. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 7. Long-Term Investments and Note 8. Financing Receivables. In the event that collection of the minimum lease payments to be received by Energy Holdings is no longer reasonably assured, Energy Holdings may deem that a lessee has a high probability of defaulting on the lease obligation, and would consider the need to record an impairment of its investment. In the event the lease is ultimately rejected by the lessee in a Bankruptcy Court proceeding, the fair value of the underlying asset and the associated debt would be recorded on the Consolidated Balance Sheets instead of the net equity investment in the lease. CRITICAL ACCOUNTING ESTIMATES Under GAAP, many accounting standards require the use of estimates, variable inputs and assumptions (collectively referred to as estimates) that are subjective in nature. Because of this, differences between the actual measure realized versus the estimate can have a material impact on results of operations, financial position and cash flows. We have determined that the following estimates are considered critical to the application of rules that relate to the respective businesses. Accounting for Pensions PSEG sponsors qualified and nonqualified pension plans covering PSEG’s and its participating affiliates’ current and former employees who meet certain eligibility criteria. The market-related value of plan assets held for the qualified pension plan is equal to the fair value of these assets as of year-end. The plan assets are comprised of investments in both debt and equity securities which are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. We calculate pension costs using various economic and demographic assumptions. Assumptions and Approach Used: Economic assumptions include the discount rate and the long-term rate of return on trust assets. Demographic assumptions include projections of future mortality rates, pay increases and retirement patterns. The discount rate used to calculate pension obligations is determined as of December 31 each year, our measurement date. The discount rate is determined by developing a spot rate curve based on the yield to maturity of a universe of high quality corporate bonds with similar maturities to the plan obligations. The spot rates are used to discount the estimated plan distributions. The discount rate is the single equivalent rate that produces the same result as the full spot rate curve. At the end of 2015, we changed the approach used to measure future service and interest costs for pension benefits. See Item 8. Financial Statements and Supplementary Data-Note 12. Pension and Other Postretirement Benefits (OPEB) and Savings Plans for additional information. Our expected rate of return on plan assets reflects current asset allocations, historical long-term investment performance and an estimate of future long-term returns by asset class, long-term inflation assumptions and a premium for active management. Based on the above assumptions, we have estimated net periodic pension expense in 2017 of approximately $3 million or $6 million, net of amounts capitalized. We utilize a corridor approach that reduces the volatility of reported pension expense/income. The corridor requires differences between actuarial assumptions and plan results be deferred and amortized as part of expense/income. This occurs only when the accumulated differences exceed 10% of the greater of the pension benefit obligation or the fair value of plan assets as of each year-end. The excess would be amortized over the average remaining service period of the active employees, which is approximately thirteen years. As of December 31, 2016, PSEG merged its three qualified defined benefit pension plans (excluding Servco plans) into one plan, thereby also merging all of the pension plans’ assets. As a result, we estimate that in 2017, the total net periodic benefit costs are expected to decrease by approximately $72 million or $48 million, net of amounts capitalized, as compared to the 2017 amounts that would have been recognized had the plans not been merged. This is due to the amortization period for gains and losses for the merged plan resulting in lower amortization than that of the individual plans. No changes were made to the benefit formulas, vesting provisions, or to the employees covered by the plans. Effect if Different Assumptions Used: As part of the business planning process, we have modeled future costs assuming a 7.80% expected rate of return and a 4.29% discount rate for 2017. Actual future pension expense/income and funding levels will depend on future investment performance, changes in discount rates, market conditions, funding levels relative to our projected benefit obligation and accumulated benefit obligation and various other factors related to the populations participating in the pension plans. The following chart reflects the sensitivities associated with a change in certain assumptions. The effects of the assumption changes shown below solely reflect the impact of that specific assumption. See

<s>[INST] PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: PSE&Gwhich is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in solar generation projects and has implemented energy efficiency and demand response programs in New Jersey, which are regulated by the BPU, and Powerwhich is a multiregional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses through competitive energy sales in welldeveloped energy markets and fuel supply functions primarily in the Northeast and MidAtlantic United States through its principal direct wholly owned subsidiaries. In addition, Power owns and operates solar generation in various states. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries include PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement (OSA); and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2016 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2016 AND FUTURE OUTLOOK 2016 Overview Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: improving utility operations through growth in investment in T&D and other infrastructure projects designed to enhance system reliability and resiliency and to meet customer expectations and public policy objectives, maintaining and expanding a reliable generation fleet with the flexibility to utilize a diverse mix of fuels which allows us to respond to market volatility and capitalize on opportunities as they arise. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2016 and 2015 are presented below: Our 2016 over 2015 decrease in Net Income was due primarily to charges related to the early retirement of our Hudson and Mercer units, marktomarket (MTM) losses in 2016 as compared to gains in 2015, lower volumes of electricity and gas sold at lower average realized sales prices, lower capacity and operating reserve revenues, storm insurance recoveries received primarily by Power in 2015 related to Superstorm Sandy, and charges in 2016 related to investments in certain leveraged leases at Energy Holdings. These decreases were partially offset by higher transmission revenues, lower generation costs and higher costs incurred at Power for planned outages in 2015, and higher management fee revenues at PSEG LI pursuant to the OSA. For a more detailed discussion of our financial results, see Results of Operations. During 2016, [/INST] Positive. </s>

PUBLIC SERVICE ENTERPRISE GROUP INC

2018-02-26

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) This combined MD&A is separately filed by Public Service Enterprise Group Incorporated (PSEG), Public Service Electric and Gas Company (PSE&G) and PSEG Power LLC (Power). Information contained herein relating to any individual company is filed by such company on its own behalf. PSE&G and Power each make representations only as to itself and make no representations whatsoever as to any other company. PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: • PSE&G-which is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in solar generation projects and energy efficiency and related programs in New Jersey, which are regulated by the BPU, and • Power-which is a multi-regional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses and fuel supply functions through competitive energy sales in well-developed energy markets primarily in the Northeast and Mid-Atlantic United States through its principal direct wholly owned subsidiaries. In addition, Power owns and operates solar generation in various states. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries are: PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement (OSA); PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2017 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2017 AND FUTURE OUTLOOK 2017 Overview Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: • improving utility operations through growth in investment in T&D and other infrastructure projects designed to enhance system reliability and resiliency and to meet customer expectations and public policy objectives, and • maintaining and expanding a reliable generation fleet with the flexibility to utilize a diverse mix of fuels which allows us to respond to market volatility and capitalize on opportunities as they arise. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2017 and 2016 are presented below: Our 2017 over 2016 increase in Net Income was due primarily to the favorable impacts of new tax legislation at Power and Energy Holdings in 2017, discussed below, partially offset by higher charges in 2017 related to the early retirement of our Hudson and Mercer units. Higher transmission revenues in 2017 at PSE&G, lower charges in 2017 related to investments in certain leveraged leases at Energy Holdings and lower plant outage costs at Power, partially offset by lower volumes of electricity sold at lower average prices, also contributed to the increase in Net Income. For a more detailed discussion of our financial results, see Results of Operations. During 2017, we maintained a strong balance sheet. We continued to effectively deploy capital without the need for additional equity, while our solid credit ratings aided our ability to access capital and credit markets. The greater emphasis on capital spending for projects on which we receive contemporaneous returns at PSE&G, our regulated utility, in recent years has yielded strong results, which when combined with the cash flow generated by Power, our merchant generator and power marketer, has allowed us to increase our dividend. These actions to transition our business to meet market conditions and investor expectations reflect our multi-year, long-term approach to managing our company. Our focus has been to invest capital in T&D and other infrastructure projects aimed at maintaining service reliability to our customers and bolstering our system resiliency. At Power, we strive to improve performance and reduce costs in order to enhance the value of our generation fleet in light of low gas prices, environmental considerations and competitive market forces that reward efficiency and reliability. At PSE&G, we continue to invest in transmission projects that focus on reliability improvements and replacement of aging infrastructure. We also continue to make investments to improve the resiliency of our gas and electric distribution system as part of our Energy Strong program that was approved by the BPU in 2014 and to seek recovery on such investments. We are modernizing PSE&G’s gas distribution systems as part of our Gas System Modernization Program (GSMP) that was approved by the BPU in late 2015. In July 2017, we filed a petition with the BPU for a GSMP II program, an extension of GSMP to continue to modernize our gas system, through which PSE&G has proposed investing $2.7 billion over five years beginning in 2019. This matter is pending. We believe the petition is consistent with the Infrastructure Investment Program (IIP) regulations that the BPU approved in December 2017. In August 2017, the BPU approved PSE&G’s petition for an Energy Efficiency 2017 Program (EE 2017) to extend three existing energy efficiency subprograms (multi-family, direct install and hospital efficiency) and establish two new residential energy efficiency offerings. The EE 2017 allows for $69 million of additional investment and $16 million of additional administrative and information technology costs. The EE 2017 was added as the eleventh component of the Green Program Recovery Charges (GPRC) rate effective September 1, 2017. Over the past few years, these types of investments have altered our business mix to reflect a higher percentage of earnings contribution by PSE&G. In January 2018, PSE&G filed a distribution base rate case as required by the BPU as a condition of approval of its Energy Strong Program. The filing requests an approximate one percent increase in revenues and seeks to recover investments made to strengthen electric and gas distribution systems. In its filing, PSE&G requested that these rates take into account a reduction in the revenue requirement as a result of the federal corporate income tax rate reduction from 35% to 21% provided in new tax legislation enacted in December 2017 (Tax Act), including a one-time credit for estimated excess income taxes collected between January 1, 2018 and the time new rates go into effect, and the flow-back to customers of certain additional tax benefits. PSE&G anticipates the new base rates will take effect in the fourth quarter of 2018. Separately, in January 2018, the BPU issued an order commencing a proceeding to ensure that the rate revenue resulting from expenses relating to taxes reflected in rates but no longer owed as the result of the Tax Act shall be passed onto the ratepayers. The BPU directed New Jersey utilities (including PSE&G) to make filings by March 2, 2018 setting forth interim rates to be effective April 1, 2018, reflecting the new federal corporate tax rate, and to subsequently file proposed final rates, effective July 1, 2018, incorporating all other effects of the Tax Act. This proceeding is currently pending. As a result of the enactment of the Tax Act, various state regulatory authorities, including the BPU, have taken action to ensure that excess federal income taxes previously collected in rates are returned to ratepayers. We have made filings to adjust the revenue requirement in certain of our rate matters as a result of the change in federal income tax rate. We continue to assess whether any further action needs to be taken by the company at this time. For additional information on our specific filings, see Item 8. Financial Statements and Supplementary Data-Note 6. Regulatory Assets and Liabilities. Power manages its existing firm pipeline transportation contracts for the benefit of PSE&G’s customers through the basic gas supply service (BGSS) arrangement. The contracts are sized to provide for delivery of a reliable gas supply to PSE&G customers on peak winter days. When pipeline capacity beyond the customers’ needs is available, Power may use it to make third-party sales and supply gas to its generating units in New Jersey. Alternatively, gas supply and pipeline capacity constraints could adversely impact our ability to meet the needs of our utility customers and generating units. Power’s hedging practices and ability to capitalize on market opportunities help it to balance some of the volatility of the merchant power business. More than half of Power’s expected gross margin in 2018 relates to our hedging strategy, our expected revenues from the capacity market mechanisms and certain ancillary service payments such as reactive power. Our investments in Keys Energy Center (Keys), Sewaren 7 and Bridgeport Harbor Station 5 (BH5) reflect our recognition of the value of opportunistic growth in the Power business. See Item 1. Business-Power for additional information on major growth projects. These additions to our fleet both expand our geographic diversity and adjust our fuel mix and are expected to contribute to the overall efficiency of operations. Since 2013, several nuclear generating stations in the United States have closed or announced early retirement due to economic reasons, or have announced being at risk for early retirement. Most recently, in February 2018, Exelon, a co-owner of the Salem units, announced its intention to accelerate the closure of its Oyster Creek nuclear plant located in New Jersey, one year earlier than previously planned for economic reasons. These closures and retirements are generally due to the decline in market prices of energy, resulting from low natural gas prices driven by the growth of shale gas production since 2007, the continuing cost of regulatory compliance and enhanced security for nuclear facilities, both federal and state-level policies that provide financial incentives to construct renewable energy such as wind and solar and the failure to adequately compensate nuclear generating stations for the attributes they bring similar to renewable energy production. These trends have significantly reduced the revenues of nuclear generating stations while limiting their ability to reduce the unit cost of production. This may result in the electric generation industry experiencing a further shift from nuclear generation to natural gas-fired generation, creating less diversity of the generation fleet. If any or all of the Salem and Hope Creek units were shut down, it would significantly alter New Jersey’s energy supply predominately by increasing New Jersey’s reliance on natural gas generation. Such a decrease in fuel diversity could also increase the market’s vulnerability to price fluctuations and power disruptions in times of high demand. The New Jersey Legislature is assessing legislation that would provide a safety net in order to prevent the loss of environmental attributes from nuclear generating stations. We cannot predict whether the legislation will be enacted or, if enacted, whether our nuclear generating stations in New Jersey will be selected or whether the legislation will provide a sufficient safety net for the continued operation of nuclear generating stations in New Jersey. In the ordinary course, management, and in the case of the Salem units the co-owner, each makes a number of decisions that impact the operation of our nuclear units beyond the current year, including whether and to what extent these units participate in RPM capacity auctions, commitments relating to refueling outages and significant capital expenditures, and decisions regarding our hedging arrangements. When considering whether to make these future commitments, management’s decisions will primarily be influenced by the financial outlook of the units, including the progress, timing and continued outlook for enactment of proposed legislation in the state of New Jersey. If market prices continue to be depressed and legislation is not enacted that adequately compensates nuclear generating stations for their attributes, Power anticipates it will no longer be covering its costs nor be adequately compensated for its market and operational risks at the Salem and Hope Creek nuclear units and would anticipate retiring these units early. The costs associated with any such retirement, which may include, among other things, accelerated depreciation and amortization or impairment charges, accelerated asset retirement costs, severance costs, environmental remediation costs and additional funding of the Nuclear Decommissioning Trust Fund (NDT) would be material to both PSEG and Power. Regulatory, Legislative and Other Developments In our pursuit of operational excellence, financial strength and disciplined investment, we closely monitor and engage with stakeholders on significant regulatory and legislative developments. Transmission planning rules and wholesale power market design are of particular importance to our results and we continue to advocate for policies and rules that promote fair and efficient electricity markets. Transmission Planning There are several matters pending before FERC and the U. S. Court of Appeals for the District of Columbia Circuit that concern the allocation of costs associated with transmission projects being constructed by PSE&G. Regardless of how these proceedings are resolved, PSE&G’s ability to recover the costs of these projects will not be affected. However, the result of these proceedings could ultimately impact the amount of costs borne by ratepayers in New Jersey. In addition, as a basic generation service (BGS) supplier, Power provides services that include specified transmission costs. If the allocation of the costs associated with the transmission projects were to increase these BGS-related transmission costs, BGS suppliers may be entitled to recovery, subject to BPU approval. We do not believe that these matters will have a material effect on Power’s business or results of operations. Several complaints have been filed and several remain pending at FERC against transmission owners around the country, challenging those transmission owners’ base return on equity (ROE). Certain of those complaints have resulted in decisions and others have been settled, resulting in reductions of those transmission owners’ base ROEs. The results of these other proceedings could set precedents for other transmission owners with formula rates in place, including PSE&G. Wholesale Power Market Design Capacity market design, including the Reliability Pricing Model (RPM) in PJM, remains an important focus for us. During 2015, PJM implemented a new “Capacity Performance” (CP) mechanism that created a more robust capacity product with enhanced incentives for performance during emergency conditions and significant penalties for non-performance. The CP product was implemented fully in the May 2017 RPM auction for the 2020-2021 Delivery Year. Subsequent to its implementation, FERC approved changes to the CP construct that will enhance the participation of intermittent and demand response resources (seasonal resources). However, two complaints remain pending that ask FERC to investigate the rules governing the participation of seasonal resources and extend the participation of the base resources for future auctions. In May 2017, PJM announced the results of the RPM capacity auction for the 2020-2021 Delivery Year. Power cleared approximately 7,800 MW of its generating capacity at an average price of $174 per MW-day for the 2020-2021 delivery period. In the two prior capacity auctions covering the 2019-2020 and 2018-2019 delivery years, Power cleared approximately 8,900 MW at an average price of $116 per MW-day and approximately 8,700 MW at an average price of $215 per MW-day, respectively. Prices in the most recent auction reflect PJM’s downwardly-revised demand forecast, changes in the emergency transfer limits due to transmission expansion and the effects of both the new generation and uncleared generation from the prior year’s auction. As a result of the efforts of certain entities in PJM to obtain financial support arrangements from their state commissions, a group of suppliers requested that FERC direct PJM to expand the currently effective “minimum offer price rule” to apply to certain existing units seeking subsidies. The suppliers’ request was intended to avoid a scenario where the subsidized generators would submit bids into the PJM capacity market that did not reflect their actual costs of operation and could artificially suppress capacity market prices. We are currently awaiting FERC action on the suppliers’ request and cannot predict the outcome of the proceeding. In June 2017, PJM issued an energy price formation proposal to address a flaw in the energy market in which energy prices during off-peak periods often do not reflect the production costs of generators during these periods even though they are serving load. PJM’s proposal would allow large, inflexible units to set price. If placed into effect, this proposal will improve price formation by ensuring that the marginal costs of units serving load will be better reflected in clearing prices. We cannot predict the outcome of this matter. See Item 1. Business-Federal Regulation for additional information. Distribution The BPU has enacted IIP regulations that allow utilities to construct, install, or remediate utility plant and facilities related to reliability, resiliency, and/or safety to support the provision of safe and adequate service. Under these regulations, utilities can seek authority to make specified infrastructure investments in programs extending for up to five years with accelerated cost recovery mechanisms. The BPU characterized the IIP regulations as a regulatory initiative intended to create a financial incentive for utilities to accelerate the level of investment needed to promote the timely rehabilitation and replacement of certain non-revenue producing infrastructure that enhances reliability, resiliency, and/or safety. Environmental Regulation We continue to advocate for the development and implementation of fair and reasonable rules by the EPA and state environmental regulators. In particular, section 316(b) of the Federal Water Pollution Control Act requires that cooling water intake structures, which are a significant part of the generation of electricity at steam-electric generating stations, reflect the best technology available for minimizing adverse environmental impacts. Implementation of Section 316(b) and related state regulations could adversely impact future nuclear and fossil operations and costs. In March 2017, the President of the United States issued an Executive Order that instructed the EPA to review the New Source Performance Standards that establish emissions standards for CO2 for certain new fossil power plants, and the Clean Power Plan (CPP), a greenhouse gas emissions regulation under the Clean Air Act for existing power plants that establishes state-specific emission rate targets based on implementation of the best system of emission reduction. In October 2017, the EPA Administrator signed a proposed repeal of the CPP. The EPA Administrator concluded that the CPP exceeds the EPA’s statutory authority by considering measures that are beyond the control of the owners of the affected sources (fossil fuel-fired electric generating units). The EPA is considering rulemaking to replace the CPP. PSEG cannot assess the impact of any such rulemaking on its business and future results of operations at this time. We are subject to liability under environmental laws for the costs of remediating environmental contamination of property now or formerly owned by us and of property contaminated by hazardous substances that we generated. In particular, the historic operations of PSEG companies and the operations of numerous other companies along the Passaic and Hackensack Rivers are alleged by Federal and State agencies to have discharged substantial contamination into the Passaic River/Newark Bay Complex in violation of various statutes. We are also currently involved in a number of proceedings relating to sites where other hazardous substances may have been discharged and may be subject to additional proceedings in the future, and the costs of any such remediation efforts could be material. For further information regarding the matters described above, as well as other matters that may impact our financial condition and results of operations, see Item 8. Financial Statements and Supplementary Data-Note 13. Commitments and Contingent Liabilities. FERC Compliance Since September 2014, FERC Staff has been conducting a preliminary non-public investigation regarding errors in the calculation of certain components of Power’s cost-based bids for its New Jersey fossil generating units in the PJM energy market and the quantity of energy that Power offered into the energy market for its fossil peaking units compared to the amounts for which Power was compensated in the capacity market for those units. While considerable uncertainty remains as to the final resolution of these matters, based upon developments in the investigation in the first quarter of 2017, Power believes the disgorgement and interest costs related to the cost-based bidding matter may range between approximately $35 million and $135 million, depending on the legal interpretation of the principles under the PJM Tariff, plus penalties. Since no point within this range is more likely than any other, Power has accrued the low end of this range of $35 million by recording an additional pre-tax charge to income of $10 million during the three months ended March 31, 2017. PSEG is unable to reasonably estimate the range of possible loss, if any, for the quantity of energy offered matter or the penalties that FERC would impose relating to either the cost-based bidding or quantity of energy matter. However, any of these amounts could be individually material to PSEG and Power. We cannot predict the final outcome of these matters. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 13. Commitments and Contingent Liabilities. Early Retirement of Hudson and Mercer Units On June 1, 2017, Power completed its previously announced retirement of the generation operations of the existing coal/gas units at the Hudson and Mercer generating stations. The decision to retire the Hudson and Mercer units had a material effect on PSEG’s and Power’s results of operations in 2016 and continued to adversely impact their results of operations in 2017. As of June 1, 2017, Power completed recognition of the incremental Depreciation and Amortization (D&A) of $938 million ($964 million in total) due to the significant shortening of the expected economic useful lives of Hudson and Mercer. During 2017, Energy Costs of $15 million and Operation and Maintenance (O&M) of $23 million were also incurred. See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements for additional information. Power is exploring various opportunities with these sites, including using the sites for alternative industrial activity or the disposition of one or both of the sites. If Power determines not to use the sites for alternative industrial activity, the early retirement of the units at such sites would trigger obligations under certain environmental regulations, including possible remediation. The amounts for any such remediation are neither currently probable nor estimable but may be material. In addition, PSEG and Power continue to monitor their other coal assets, including the Keystone and Conemaugh generating stations, to assess their economic viability through the end of their designated useful lives and their continued classification as held for use. The precise timing of a change in useful lives may be dependent upon events out of PSEG’s and Power’s control and may impact their ability to operate or maintain certain assets in the future. These generating stations may be impacted by factors such as environmental legislation, co-owner capital requirements and continued depressed wholesale power prices or capacity factors, among other things. Any early retirement or change in the classification as held for use of our remaining coal units may have a material adverse impact on PSEG’s and Power’s future financial results. Leveraged Lease Impairments GenOn Energy, Inc. (GenOn) and certain of its subsidiaries filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code on June 14, 2017. NRG REMA, LLC (REMA) was not included in the GenOn bankruptcy filing. GenOn is currently engaged in a balance sheet restructuring, which will take an undetermined time to complete. PSEG cannot predict the outcome of GenOn’s efforts to restructure its balance sheet and improve its liquidity. During the first quarter of 2017, due to continuing liquidity issues facing REMA, economic challenges facing coal generation in PJM, and based upon an ongoing review of available alternatives as well as discussions with REMA management, Energy Holdings recorded an additional $55 million pre-tax charge for its current best estimate of loss relating to its REMA leveraged lease receivables, which was reflected in Operating Revenues. During the second quarter of 2017, Energy Holdings recorded an additional $22 million pre-tax charge for its current best estimate of loss related to lease receivables due to collectability of payments ($15 million) and economics impacting the residual value ($7 million) of certain leased assets. PSEG continues to monitor any changes to REMA’s and GenOn’s status and potential impacts on Energy Holdings’ lease investments, which could include further write-downs of the values of Energy Holdings’ leveraged lease receivables, and continue to discuss the situation with various parties relevant to this matter. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 7. Long-Term Investments and Note 8. Financing Receivables. There can be no assurance that a continuation or worsening of the adverse economic conditions would not lead to additional write-downs at any of our other generation units in our leveraged lease portfolio, and such write-downs could be material. Additional facilities in our leveraged lease portfolio include the Joliet and Powerton generating facilities. Similar to Shawville, Joliet was recently converted to use natural gas. Converted natural gas units such as Shawville and Joliet may have higher operating costs and fuel consumption as well as longer start-up times compared to newer combined cycle gas units. Powerton is a coal-fired generating facility in Illinois. Each of these three facilities may not be as economically competitive as newer combined cycle gas units and could continue to be adversely impacted by the same economic conditions experienced by other less efficient natural gas and coal generation facilities, which could require Energy Holdings to write down the residual value of the leveraged lease receivables associated with these facilities. Tax Legislation In December 2017, the U.S. government enacted comprehensive tax legislation (Tax Act), which, among other things, decreased the statutory U.S. corporate income tax rate from a maximum of 35% to 21%, effective January 1, 2018, and made certain changes to bonus depreciation rules. As a result of the enacted reduction in the statutory U.S. corporate income tax rate, as well as other aspects of the Tax Act, we have recorded a one-time, non-cash earnings benefit of $745 million, including $588 million related to Power and $147 million related to Energy Holdings. This benefit is primarily due to the remeasurement of deferred tax balances. In addition, PSE&G had excess deferred taxes of approximately $2.1 billion as of December 31, 2017 and recorded an approximate $2.9 billion revenue impact of these excess deferred taxes as Regulatory Liabilities where it is probable that refunds will be made to customers in future rates. The amount and timing of any such refund cannot be determined at this time. Beginning in 2018, PSEG, on a consolidated basis, will incur lower income tax expense resulting in a decrease in its projected effective income tax rate. This is also expected to increase PSEG’s and Power’s net income. To the extent allowed under the Tax Act, Power’s operating cash flows will reflect the full expensing of capital investments for income tax purposes. PSEG and Power expect that the interest on their debt will continue to be fully tax deductible albeit at a lower tax rate. For PSE&G, the Tax Act is expected to lead to lower customer rates due to lower income tax expense recoveries and the refund of deferred income tax regulatory liabilities, partially offset by the impacts of higher rate base. The impact of the lower federal income tax rate on PSE&G was reflected in PSE&G’s recently filed distribution base rate case and its transmission formula rate filings. The Tax Act is generally expected to result in lower operating cash flows for PSE&G resulting from the elimination of bonus depreciation, partially offset by higher revenues due to the higher rate base. The full impact of these and other provisions of the Tax Act cannot be determined at this time. The impact of the Tax Act may differ from these estimates, possibly materially, due to, among other things, changes in interpretations and assumptions PSEG has made, guidance that may be issued and actions PSEG may take as a result of the Tax Act. For additional information, see Note 20. Income Taxes. Operational Excellence We emphasize operational performance while developing opportunities in both our competitive and regulated businesses. Flexibility in our generating fleet has allowed us to take advantage of opportunities in a rapidly evolving market as we remain diligent in managing costs. In 2017, our • diverse fuel mix and dispatch flexibility allowed us to generate approximately 51 terra-watt hours while addressing fuel availability and price volatility, • total nuclear fleet achieved an average capacity factor of 94%, and • utility was recognized for the sixteenth consecutive year as the most reliable utility in the Mid-Atlantic region. Financial Strength Our financial strength is predicated on a solid balance sheet, positive operating cash flow and reasonable risk-adjusted returns on increased investment. Our financial position remained strong during 2017 as we: • maintained sufficient liquidity, • maintained solid investment grade credit ratings, and • increased our indicative annual dividend for 2017 to $1.72 per share. We expect to be able to fund our planned capital requirements, as described in Liquidity and Capital Resources, and manage the impacts of the Tax Act without the issuance of new equity. Disciplined Investment We utilize rigorous investment criteria when deploying capital and seek to invest in areas that complement our existing business and provide reasonable risk-adjusted returns. These areas include upgrading our energy infrastructure, responding to trends in environmental protection and providing new energy supplies in domestic markets with growing demand. In 2017, we • made additional investments in transmission infrastructure projects, • continued to execute our GSMP, Energy Strong, Energy Efficiency, solar and other existing BPU-approved utility programs, • continued construction of our Keys and Sewaren 7 generation projects for targeted commercial operation in 2018 and commenced construction of our BH5 generation project for targeted commercial operation in mid-2019, and • acquired six solar energy projects in various states totaling 88 MW-direct current (dc), for a total of 414 MW (dc) of installed capacity in 14 states throughout the U.S. Future Outlook Our future success will depend on our ability to continue to maintain strong operational and financial performance in a slow-growing economy and a cost-constrained environment with low gas prices, to capitalize on or otherwise address appropriately regulatory and legislative developments that impact our business and to respond to the issues and challenges described below. In order to do this, we must continue to: • focus on controlling costs while maintaining safety and reliability and complying with applicable standards and requirements, • successfully manage our energy obligations and re-contract our open supply positions in response to changes in demand, • execute our utility capital investment program, including our Energy Strong program, GSMP and other investments for growth that yield contemporaneous and reasonable risk-adjusted returns, while enhancing the resiliency of our infrastructure and maintaining the reliability of the service we provide to our customers, and obtain approval for extension of these programs, • effectively manage construction of our Keys, Sewaren 7, BH5 and other generation projects, • advocate for measures to ensure the implementation by PJM and FERC of market design and transmission planning rules that continue to promote fair and efficient electricity markets, • engage multiple stakeholders, including regulators, government officials, customers and investors, and • successfully operate the LIPA T&D system and manage LIPA’s fuel supply and generation dispatch obligations. For 2018 and beyond, the key issues and challenges we expect our business to confront include: • regulatory and political uncertainty, both with regard to future energy policy, design of energy and capacity markets, transmission policy and environmental regulation, as well as with respect to the outcome of any legal, regulatory or other proceeding, settlement, investigation or claim, applicable to us and/or the energy industry, • fair and timely rate relief from the BPU and FERC for recovery of costs and return on investments, including with respect to our distribution base rate case which was filed with the BPU in January 2018, • continuing discussions regarding the restructuring of GenOn and REMA and its potential impact on the value of our Keystone, Conemaugh and Shawville leveraged leases, • the continuing impact of the Tax Act, • uncertainty in the national and regional economic recovery, continuing customer conservation efforts, changes in energy usage patterns and evolving technologies, which impact customer behaviors and demand, • the potential for continued reductions in demand and sustained lower natural gas and electricity prices, both at market hubs and the locations where we operate, • the impact of lower natural gas prices and increasing environmental compliance costs on the competitiveness of our nuclear and remaining coal-fired generation plants, and the potential for retirement of such plants earlier than their current useful lives, • delays and other obstacles that might arise in connection with the construction of our T&D, generation and other development projects, including in connection with permitting and regulatory approvals, • maintaining a diverse mix of fuels to mitigate risks associated with fuel price volatility and market demand cycles, and • FERC Staff’s continuing investigation of certain of Power’s New Jersey fossil generating unit bids in the PJM energy market. Our primary investment opportunities are in two areas: our regulated utility business and our merchant power business. We continually assess a broad range of strategic options to maximize long-term stockholder value. In assessing our options, we consider a wide variety of factors, including the performance and prospects of our businesses; the views of investors, regulators and rating agencies; our existing indebtedness and restrictions it imposes; and tax considerations, among other things. Strategic options available to us include: • the acquisition, construction or disposition of T&D facilities and/or generation units, • the disposition or reorganization of our merchant generation business or other existing businesses or the acquisition or development of new businesses, • the expansion of our geographic footprint, • continued or expanded participation in solar, demand response and energy efficiency programs, and • investments in capital improvements and additions, including the installation of environmental upgrades and retrofits, improvements to system resiliency, modernizing existing infrastructure and participation in transmission projects through FERC’s “open window” solicitation process. Power is developing a retail energy business to sell energy, which we believe complements our existing wholesale marketing business. Power began these marketing activities in 2017 and has been granted retail energy supplier licenses in New Jersey, Pennsylvania and Maryland. There can be no assurance, however, that we will successfully develop and execute any of the strategic options noted above, or any additional options we may consider in the future. The execution of any such strategic plan may not have the expected benefits or may have unexpected adverse consequences. RESULTS OF OPERATIONS (A) Power’s results in 2017 and 2016 include after-tax expenses of $577 million and $396 million, respectively, related to the early retirement of its Hudson and Mercer coal/gas generation plants. See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements for additional information. Power’s results in 2015 include an after-tax insurance recovery for Superstorm Sandy of $102 million. (B) Results in 2017 include the non-cash net income benefit of $745 million, including $588 million related to Power and $147 million related to Energy Holdings, resulting from the remeasurement of deferred tax liabilities required due to the enactment of the Tax Act in December 2017. (C) Other includes after-tax activities at the parent company, PSEG LI and Energy Holdings as well as intercompany eliminations. Energy Holdings recorded after-tax charges totaling $45 million and $92 million related to its investments in REMA’s leveraged leases in 2017 and 2016. See Item 8. Financial Statements and Supplementary Data-Note 7. Long-Term Investments and Note 8. Financing Receivables for further information. Our results include the realized gains, losses and earnings on Power’s Nuclear Decommissioning Trust (NDT) Fund and other related NDT activity. Realized gains and losses, interest and dividend income and other costs related to the NDT Fund are recorded in Other Income (Deductions), and impairments on certain NDT securities are recorded as Other-Than-Temporary Impairments. Interest accretion expense on Power’s nuclear Asset Retirement Obligation (ARO) is recorded in O&M Expense and the depreciation related to the ARO asset is recorded in D&A Expense. Our results also include the after-tax impacts of non-trading mark-to-market (MTM) activity, which consist of the financial impact from positions with forward delivery dates. The combined after-tax impact on Net Income for the years ended December 31, 2017, 2016 and 2015 include the changes related to NDT Fund and MTM activity shown in the chart below: (A) Net of tax (expense) benefit of $(72) million, $(5) million and $(16) million for the years ended December 31, 2017, 2016 and 2015, respectively. (B) Net of tax (expense) benefit of $68 million, $68 million and $(65) million for the years ended December 31, 2017, 2016 and 2015, respectively. The 2017 year-over-year increase in our Net Income was driven primarily by: • non-cash net income benefits related to new tax legislation (See Item 8. Financial Statements and Supplementary Data-Note 20. Income Taxes) at Power and Energy Holdings, • higher transmission revenues, • higher net NDT gains in 2017, and • lower charges related to investments in certain leveraged leases at Energy Holdings (See Item 8. Financial Statements and Supplementary Data-Note 8. Financing Receivables). These increases were partially offset by: • higher charges related to the early retirement of two coal/gas generation units at Power (See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements), and • lower volumes of energy sold at lower average realized sales prices under the BGS contracts and in the PJM and New England regions. The 2016 year-over-year decrease in our Net Income was driven primarily by: • charges related to the early retirement of two coal/gas generation units at Power (See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements), • MTM losses in 2016 as compared to MTM gains in 2015, • lower volumes of energy sold at lower average realized sales prices, • lower capacity and operating reserve revenues in PJM, • higher 2016 congestion costs in PJM due primarily to realized gains on financial transmission rights (FTR) in PJM in the prior year due to extremely cold weather, • lower volumes of gas sold at lower average prices under the BGSS contract, • insurance recoveries received primarily by Power in 2015 related to Superstorm Sandy, and • an impairment related to investments in certain leveraged leases at Energy Holdings (See Item 8. Financial Statements and Supplementary Data-Note 8. Financing Receivables). These decreases were partially offset by: • lower generation costs driven by lower fuel costs, particularly for natural gas, and reduced generation output at Power, •higher costs incurred at Power for planned outages in 2015, • higher transmission revenues, and • higher management fee revenues at PSEG LI pursuant to the OSA. PSEG Our results of operations are primarily comprised of the results of operations of our principal operating subsidiaries, PSE&G and Power, excluding charges related to intercompany transactions, which are eliminated in consolidation. For additional information on intercompany transactions, see Item 8. Financial Statements and Supplementary Data-Note 24. Related-Party Transactions. The 2017, 2016 and 2015 amounts in the preceding table for Operating Revenues and O&M costs each include $438 million, $410 million and $375 million, respectively, for Servco. These amounts represent the O&M pass-through costs for the Long Island operations, the full reimbursement of which is reflected in Operating Revenues. See Item 8. Financial Statements and Supplementary Data-Note 4. Variable Interest Entity for further explanation. The Income Tax Benefit in 2017 includes the non-cash benefit resulting from the remeasurement of deferred tax liabilities required due to the enactment of the Tax Act in December 2017. The following discussions for PSE&G and Power provide a detailed explanation of their respective variances. PSE&G Year Ended December 31, 2017 as compared to 2016 Operating Revenues increased $13 million due to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $166 million due primarily to an increase in transmission revenues. • Transmission revenues were $152 million higher due to higher revenue requirements calculated through our transmission formula rate, primarily to recover required investments. • Gas distribution revenues increased $30 million due to a $16 million increase due to Energy Strong, $10 million from inclusion of the GSMP in base rates, $4 million in higher collections of GPRC and an increase of $2 million due to higher sales volumes. These increases were partially offset by lower Weather Normalization Clause (WNC) revenues of $2 million. • Electric distribution revenues decreased $16 million due primarily to a $28 million decrease in sales volume and $14 million in lower collections of GPRC, partially offset by a $26 million increase in Energy Strong revenues. Clause Revenues increased $47 million due to the absence of the return in 2016 to customers of overcollections of Securitization Transition Charge (STC) revenues of $59 million and higher Margin Adjustment Clause (MAC) revenues of $4 million. These increases were partially offset by lower Societal Benefit Charges (SBC) of $17 million. The changes in STC, MAC and SBC amounts were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, D&A and Interest Expense. PSE&G does not earn margin on STC, SBC, Solar Pilot Recovery Charges (SPRC) or MAC collections. Commodity Revenues decreased $204 million due to lower Electric revenues partially offset by higher Gas revenues. This decrease is entirely offset with decreased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Electric revenues decreased $274 million due to $199 million in lower BGS revenues reflecting $109 million from lower sales volumes and $90 million from lower prices, $61 million in lower collections of Non-Utility Generation Charges (NGC) due primarily to lower prices and $14 million in lower revenues from the decreased sales volume of Non-Utility Generation (NUG) energy. • Gas revenues increased $70 million due to higher BGSS prices of $68 million and $2 million from higher sales volumes. Operating Expenses Energy Costs decreased $204 million. This is entirely offset by Commodity Revenues. Operation and Maintenance decreased $41 million due to • a $28 million net reduction related to various clause mechanisms and GPRC expenditures, • a $15 million decrease in appliance service costs, and • a $7 million net decrease in pension and OPEB expenses, net of amounts capitalized, • partially offset by a $9 million net increase in other operating expenses. Depreciation and Amortization increased $120 million due primarily to a $61 million net increase in amortization of Regulatory Assets, including the absence of the STC liability that ended in 2016, and an increase in depreciation of $59 million due to additional plant placed into service in 2017. Other Income (Deductions) increased $8 million due primarily to a $7 million increase in Allowance for Funds Used During Construction (AFUDC). Interest Expense increased $14 million primarily due to • $11 million due to net long-term debt issuances in 2016 and $9 million due to net long-term debt issuances in 2017, partially offset by • a decrease of $6 million due to clause-related interest for BGSS in 2016. Income Tax Expense increased $48 million due primarily to higher pre-tax income. Year Ended December 31, 2016 as compared to 2015 Operating Revenues decreased $415 million due to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $191 million due primarily to an increase in transmission revenues. • Transmission revenues were $223 million higher due to higher revenue requirements calculated through our transmission formula rate, primarily to recover required investments. • Electric distribution revenues decreased $27 million due primarily to $47 million in lower collections of GPRC, partially offset by an $18 million increase in Energy Strong revenues. • Gas distribution revenues decreased $5 million due to a decrease of $43 million due to lower sales volumes and $7 million in lower collections of GPRC. These decreases were partially offset by higher WNC revenues of $25 million due to warmer weather in 2016 compared to 2015 and $20 million due to the inclusion of Energy Strong in base rates. Clause Revenues decreased $445 million due to lower STC revenues of $419 million, lower SBC of $33 million and lower SPRC of $8 million. These decreases were partially offset by higher MAC revenues of $15 million. The changes in STC, SBC, SPRC and MAC amounts were entirely offset by changes in the amortization of related costs (Regulatory Assets) in O&M, D&A and Interest Expense. PSE&G does not earn margin on STC, SBC, SPRC or MAC collections. Commodity Revenues decreased $155 million due to lower Electric and Gas revenues. This is entirely offset with decreased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Electric revenues decreased $136 million due to $73 million in lower collections of NGC due primarily to lower prices, $42 million in lower revenues from the sale of NUG energy and $21 million in lower prices BGS revenues primarily due to lower sales volumes. • Gas revenues decreased $19 million due to $80 million from lower sales volumes, partially offset by higher BGSS prices of $61 million. Operating Expenses Energy Costs decreased $155 million. This is entirely offset by Commodity Revenues. Operation and Maintenance decreased $85 million due to • a $98 million net reduction related to various clause mechanisms and GPRC, and • a $13 million decrease in pension and OPEB expenses, net of amounts capitalized, • partially offset by $10 million of insurance recovery proceeds in 2015, • a $10 million increase in vegetation management costs, and • a $6 million net increase due primarily to T&D corrective maintenance and appliance service costs. Depreciation and Amortization decreased $327 million due primarily to a $396 million net decrease in amortization of Regulatory Assets, partially offset by an increase in depreciation of $65 million due to additional plant in service in 2016. Interest Expense increased $9 million due to increases of • $14 million due to net debt issuances in 2015, and • $13 million due to net debt issuances in 2016, • partially offset by a decrease of $11 million due to the redemption of securitization debt in 2015, and • $7 million of higher interest related to BGSS in 2015. Income Tax Expense increased $45 million due primarily to higher pre-tax income partially offset by changes in the reserve for uncertain tax positions and flow through items. Power Year Ended December 31, 2017 as compared to 2016 Operating Revenues decreased $93 million due to changes in generation, gas supply and other operating revenues. Generation Revenues decreased $204 million due primarily to • a decrease of $126 million in energy sales in the PJM and New England (NE) regions due primarily to lower average realized prices, • a decrease of $100 million in electricity sold under our BGS contracts due primarily to lower volumes coupled with lower prices, • a decrease of $24 million in revenue expected to be returned to ratepayers associated with excess federal income tax previously collected by Power’s subsidiary, PSEG New Haven LLC, due to the change in federal tax rates effective January 1, 2018, • a decrease of $18 million in operating reserves in the PJM region, • a charge of $10 million due to an increase in the FERC accrual related to the PJM bidding matter, • a decrease of $7 million due to higher MTM losses in 2017 as compared to 2016. Of this amount, $120 million was due to increased forward prices, partially offset by a decrease of $113 million due to lower gains on positions reclassified to realized upon settlement in 2017 as compared to 2016, • partially offset by a net increase of $53 million due primarily to higher volumes of electricity sold under wholesale load contracts in the PJM and NE regions, • a net increase of $18 million in capacity revenues in the PJM and NE regions due to increases in cleared capacity and capacity auction prices, and • an increase of $11 million due to higher sales related to new solar projects. Gas Supply Revenues increased $110 million due primarily to • an increase of $67 million in sales under the BGSS contract, of which $40 million was due to higher average sales prices coupled with a $27 million increase in sales volumes due to periods of colder weather in the heating season, • a net increase of $24 million due to higher MTM gains in 2017 as compared to 2016, and • an increase of $19 million related to sales to third parties, of which $48 million was due to higher average sales prices, partially offset by $29 million of lower volumes sold. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs decreased $3 million due to Generation costs decreased $69 million due primarily to • a net decrease of $83 million primarily due to lower congestion costs in PJM due to lower rates coupled with less volumes, partially offset by higher transmission charges due to higher rates, • a net decrease of $50 million due to charges associated with the announced early retirement of the Mercer and Hudson units in 2016, primarily related to lower coal inventory write-downs in 2017, partially offset by additional retirement costs incurred in 2017, • partially offset by higher fuel costs of $31 million reflecting higher average realized prices for natural gas coupled with the utilization of higher volumes of coal, partially offset by the utilization of lower volumes of gas, • an increase of $17 million due to MTM losses in 2017 as compared to MTM gains in 2016, and • a net increase of $16 million primarily due to an increase in the volume of energy purchases in the NE region to serve load obligations. Gas costs increased $66 million due to • an increase of $50 million related to sales under the BGSS contract, of which $31 million was due to higher average gas costs, coupled with a $19 million increase in volumes sold due to periods of colder weather in the heating season, and • an increase of $16 million related to sales to third parties, of which $44 million was due to higher average gas costs, partially offset by a $28 million decrease in volumes sold. Operation and Maintenance decreased $105 million due to • a $72 million decrease at our fossil plants, due primarily to the retirement of the Hudson and Mercer units and higher planned outage costs in 2016, • a $35 million net decrease related to our nuclear plants due primarily to lower labor-related expenses and outage costs, • an $8 million net decrease due to lower pension and OPEB costs, • partially offset by $5 million of costs related to new solar plants placed into service in 2017. Depreciation and Amortization increased $387 million due primarily to • $346 million of higher depreciation for Hudson and Mercer, primarily due to the accelerated expense related to the early retirement of those units, • a $15 million increase due to the accelerated retirement date for the Bridgeport Harbor unit 3, • an $11 million increase due primarily to a higher nuclear asset base, and • $11 million of higher depreciation due to new solar projects. Other Income (Deductions) increased $112 million due primarily to higher net realized gains from the NDT Fund in 2017. Other-Than-Temporary Impairments decreased $16 million due to lower impairments of equity securities in the NDT Fund in 2017. Interest Expense decreased $34 million due primarily to • a $24 million decrease due to higher interest capitalized for the construction of three new fossil stations: BH5, Sewaren 7 and Keys, and • a net $7 million decrease due to debt maturities in September 2016, partially offset by a debt issuance in June 2016. Income Tax Expense decreased $668 million due primarily to the one-time benefit recorded as a result of the remeasurement of deferred tax balances required due to the enactment of the Tax Act in December 2017. Year Ended December 31, 2016 as compared to 2015 Operating Revenues decreased $905 million due to changes in generation, gas supply and other operating revenues. Generation Revenues decreased $714 million due primarily to • a decrease of $317 million due to MTM losses in 2016 as compared to MTM gains in 2015. Of this amount, $199 million was due to changes in forward power prices resulting in lower MTM gains in 2016 compared to 2015. Also contributing to the decrease was $118 million of higher gains on positions reclassified to realized upon settlement in 2016 compared to 2015, • a decrease of $298 million in energy sales volumes in the PJM, NE and NY regions due primarily to milder weather in 2016 and lower average realized prices, • a decrease of $80 million in capacity revenue primarily in the PJM region due to the retirement of older peaking units in June 2015, and • a decrease of $49 million due to lower operating reserve revenues in the PJM region due to less congestion and lower prices, • partially offset by a net increase of $19 million due primarily to higher volumes of electricity sold under wholesale load contract in the PJM and NE regions, partially offset by lower average prices, and • a net increase of $8 million due to new solar projects beginning commercial operations. Gas Supply Revenues decreased $191 million due primarily to • a decrease of $183 million in sales under the BGSS contract due primarily to lower average sales prices and a decrease in sales volumes due to warmer average temperatures in the 2016 heating season, and • a decrease of $9 million due to MTM losses in 2016 due to changes in forward prices. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs decreased $164 million due to Generation costs decreased $95 million due primarily to • lower fuel costs of $288 million reflecting lower average realized prices for natural gas and the utilization of lower volumes of fuel, • partially offset by a net increase of $143 million primarily due to realized gains on FTRs in PJM in 2015 due to extremely cold weather, and • a $62 million charge associated with the announced early retirement of the Mercer and Hudson units, primarily related to a coal inventory write-down. Gas costs decreased $69 million due to • a decrease of $101 million related to sales under the BGSS contract due primarily to lower average gas costs and a decrease in volumes sold due to warmer average temperatures during the 2016 winter heating season, • partially offset by an increase of $32 million related to sales to third parties due primarily to higher average gas costs and an increase in volumes sold. Operation and Maintenance increased $86 million due to • $145 million of insurance recoveries received in 2015 related to Superstorm Sandy, and • $53 million of charges related to the early retirement of the Hudson and Mercer units, • partially offset by a net decrease of $73 million related to our fossil plants, largely due to higher costs incurred in 2015 for our planned major outages at the Bethlehem Energy Center and Bergen generating plants, • a net decrease of $31 million related to our nuclear plants due primarily to lower planned outage costs at our 100%-owned Hope Creek plant and our 57%-owned Salem Unit 1 plant, and • an $8 million decrease due to lower pension and OPEB costs. Depreciation and Amortization increased $590 million due primarily to • $555 million of accelerated depreciation due to the early retirement of the Hudson and Mercer units, • a $24 million increase due primarily to a higher nuclear asset base, and • $5 million of higher depreciation due to new solar projects Other Income (Deductions) decreased $52 million due primarily to $28 million of insurance recoveries received in 2015 related to Superstorm Sandy and $38 million of lower net realized gains from the NDT Fund in 2016, partially offset by $10 million of lower purchased tax credits in 2016. Other-Than-Temporary Impairments decreased $25 million due to lower impairments of equity securities in the NDT Fund in 2016. Interest Expense decreased $37 million due to • $27 million of interest capitalized for the construction of three new fossil stations: Bridgeport Harbor 5, Sewaren 7 and Keys Energy Center, and • a $15 million decrease due to the maturity of 5.50% of Senior Notes in December 2015, • partially offset by an increase of $5 million due to net debt issuances in 2016. Income Tax Expense decreased $572 million in 2016 due primarily to a pre-tax loss in 2016 as compared to pre-tax income in 2015. LIQUIDITY AND CAPITAL RESOURCES The following discussion of our liquidity and capital resources is on a consolidated basis, noting the uses and contributions, where material, of our two direct major operating subsidiaries. Financing Methodology We expect our capital requirements to be met through internally generated cash flows and external financings, consisting of short-term debt for working capital needs and long-term debt for capital investments. PSE&G’s sources of external liquidity include a $600 million multi-year revolving credit facility. PSE&G uses internally generated cash flow and its commercial paper program to meet seasonal, intra-month and temporary working capital needs. PSE&G does not engage in any intercompany borrowing or lending arrangements. PSE&G maintains back-up facilities in an amount sufficient to cover the commercial paper and letters of credit outstanding. PSE&G’s dividend payments to/capital contributions from PSEG are consistent with its capital structure objectives which have been established to maintain investment grade credit ratings. PSE&G’s long-term financing plan is designed to replace maturities, fund a portion of its capital program and manage short-term debt balances. Generally, PSE&G uses either secured medium-term notes or first mortgage bonds to raise long-term capital. PSEG, Power, Energy Holdings, PSEG LI and Services participate in a corporate money pool, an aggregation of daily cash balances designed to efficiently manage their respective short-term liquidity needs. PSEG LI’s subsidiary, Long Island Electric Utility Servco, LLC (Servco), does not participate in the corporate money pool. Servco’s short-term liquidity needs are met through an account funded and owned by LIPA. PSEG’s sources of external liquidity may include the issuance of long-term debt securities and the incurrence of additional indebtedness under credit facilities. Our current sources of external liquidity include multi-year revolving credit facilities totaling $1.5 billion. These facilities are available to back-stop PSEG’s commercial paper program, issue letters of credit and for general corporate purposes. These facilities may also be used to provide support to PSEG’s subsidiaries. PSEG’s credit facilities and the commercial paper program are available to support PSEG working capital needs or to temporarily fund growth opportunities in advance of obtaining permanent financing. PSEG also has a $700 million term loan credit agreement that is scheduled to expire in June 2019. From time to time, PSEG may make equity contributions or provide credit support to its subsidiaries. Power’s sources of external liquidity include $2.1 billion of multi-year revolving credit facilities. Additionally, from time to time, Power maintains bilateral credit agreements designed to enhance its liquidity position. Credit capacity is primarily used to provide collateral in support of Power’s forward energy sale and forward fuel purchase contracts as the market prices for energy and fuel fluctuate, and to meet potential collateral postings in the event that Power is downgraded to below investment grade by S&P or Moody’s. Power’s dividend payments to PSEG are also designed to be consistent with its capital structure objectives which have been established to maintain investment grade credit ratings and provide sufficient financial flexibility. Generally, Power issues senior unsecured debt to raise long-term capital. Operating Cash Flows We expect our operating cash flows combined with cash on hand and financing activities to be sufficient to fund capital expenditures and shareholder dividend payments. For the year ended December 31, 2017, our operating cash flow decreased by $50 million. For the year ended December 31, 2016, our operating cash flow decreased by $608 million. The net changes were primarily due to net tax payments at PSEG and its other subsidiaries in 2017 offset by net changes from our subsidiaries as discussed below. PSE&G PSE&G’s operating cash flow decreased $55 million from $1,894 million to $1,839 million for the year ended December 31, 2017, as compared to 2016, due primarily to lower tax refunds and a decrease of $50 million related to a change in regulatory deferrals. These amounts were partially offset by higher earnings and $30 million in decreased vendor payments. PSE&G’s operating cash flow decreased $231 million from $2,125 million to $1,894 million for the year ended December 31, 2016, as compared to 2015, due primarily to a decrease from lower collections for securitization debt principal repayments which were $259 million in 2015, a decrease of $249 million in cash receipts from customers due to lower sales driven by warmer winter weather in 2016 compared to 2015, a decrease of $90 million related to a change in regulatory deferrals, primarily driven by net returns to customers in 2016 related to 2015 overcollections, partially offset by higher bill credits and $74 million in increased vendor payments. These amounts were partially offset by higher earnings and higher tax refunds in 2016. Power Power’s operating cash flow increased $71 million from $1,255 million to $1,326 million for the year ended December 31, 2017, as compared to 2016, primarily resulting from a decrease of $61 million in payments to counterparties, a $26 million increase from higher net collections of counterparty receivables, and higher earnings. These amounts were partially offset by higher tax payments and an increase in margin deposit requirements of $14 million. Power’s operating cash flow decreased $451 million from $1,706 million to $1,255 million for the year ended December 31, 2016, as compared to 2015, primarily resulting from lower earnings, an increase in margin deposit requirements of $198 million, and a $134 million decrease from net collection of counterparty receivables, partially offset by a reduction in tax payments. Short-Term Liquidity We continually monitor our liquidity and seek to add capacity as needed to meet our liquidity requirements. Each of our credit facilities is restricted as to availability and use to the specific companies as listed below; however, if necessary, the PSEG facilities can also be used to support our subsidiaries’ liquidity needs. Our total credit facilities and available liquidity as of December 31, 2017 were as follows: As of December 31, 2017, our credit facility capacity was in excess of our projected maximum liquidity requirements over our 12-month planning horizon. Our maximum liquidity requirements are based on stress scenarios that incorporate changes in commodity prices and the potential impact of Power losing its investment grade credit rating from S&P or Moody’s, which would represent a three level downgrade from its current S&P or Moody’s ratings. In the event of a deterioration of Power’s credit rating certain of Power’s agreements allow the counterparty to demand further performance assurance. The potential additional collateral that we would be required to post under these agreements if Power were to lose its investment grade credit rating was approximately $848 million and $783 million as of December 31, 2017 and 2016, respectively. The early retirement of Power’s Hudson and Mercer coal/gas generation units did not have a material impact on Power’s debt covenant ratios or its ability to obtain credit facilities. See Item 8. Financial Statements and Supplementary Data-Note 3. Early Plant Retirements. For additional information, see Item 8.Financial Statements and Supplementary Data-Note 14. Debt and Credit Facilities. Long-Term Debt Financing PSE&G has $400 million of 5.30% Medium Term Notes maturing in May 2018 and $350 million of 2.30% Medium Term Notes maturing in September 2018. Power has $250 million of 2.45% Senior Notes maturing in November 2018. For a discussion of our long-term debt transactions during 2017 and into 2018, see Item 8. Financial Statements and Supplementary Data-Note 14. Debt and Credit Facilities. Debt Covenants Our credit agreements contain maximum debt to equity ratios and other restrictive covenants and conditions to borrowing. We are currently in compliance with all of our debt covenants. Continued compliance with applicable financial covenants will depend upon our future financial position, level of earnings and cash flows, as to which no assurances can be given. In addition, under its First and Refunding Mortgage (Mortgage), PSE&G may issue new First and Refunding Mortgage Bonds against previous additions and improvements, provided that its ratio of earnings to fixed charges calculated in accordance with its Mortgage is at least 2 to 1, and/or against retired Mortgage Bonds. As of December 31, 2017, PSE&G’s Mortgage coverage ratio was 5.2 to 1 and the Mortgage would permit up to approximately $6.9 billion aggregate principal amount of new Mortgage Bonds to be issued against additions and improvements to its property. Default Provisions Our bank credit agreements and indentures contain various, customary default provisions that could result in the potential acceleration of indebtedness under the defaulting company’s agreement. In particular, PSEG’s bank credit agreements contain provisions under which certain events, including an acceleration of material indebtedness under PSE&G’s and Power’s respective financing agreements, a failure by PSE&G or Power to satisfy certain final judgments and certain bankruptcy events by PSE&G or Power, that would constitute an event of default under the PSEG bank credit agreements. Under the PSEG bank credit agreements, it would also be an event of default if either PSE&G or Power ceases to be wholly owned by PSEG. The PSE&G and Power bank credit agreements include similar default provisions; however, such provisions only relate to the respective borrower under such agreement and its subsidiaries and do not contain cross default provisions to each other. The PSE&G and Power bank credit agreements do not include cross default provisions relating to PSEG. There are no cross acceleration provisions in PSEG’s or PSE&G’s indentures. However, PSEG’s existing notes include a cross acceleration provision that may be triggered upon the acceleration of more than $75 million of indebtedness incurred by PSEG. Such provision does not extend to an acceleration of indebtedness by any of PSEG’s subsidiaries. Power’s indenture includes a cross acceleration provision similar to that described above for PSEG’s existing notes except that such provision may be triggered upon the acceleration of more than $50 million of indebtedness incurred by Power or any of its subsidiaries. Such provision does not cross accelerate to PSEG, any of PSEG’s subsidiaries (other than Power and its subsidiaries), PSE&G or any of PSE&G’s subsidiaries. Ratings Triggers Our debt indentures and credit agreements do not contain any material ‘ratings triggers’ that would cause an acceleration of the required interest and principal payments in the event of a ratings downgrade. However, in the event of a downgrade, any one or more of the affected companies may be subject to increased interest costs on certain bank debt and certain collateral requirements. In the event that we are not able to affirm representations and warranties on credit agreements, lenders would not be required to make loans. In accordance with BPU requirements under the BGS contracts, PSE&G is required to maintain an investment grade credit rating. If PSE&G were to lose its investment grade rating, it would be required to file a plan to assure continued payment for the BGS requirements of its customers. Fluctuations in commodity prices or a deterioration of Power’s credit rating to below investment grade could increase Power’s required margin postings under various agreements entered into in the normal course of business. Power believes it has sufficient liquidity to meet the required posting of collateral which would likely result from a credit rating downgrade to below investment grade by S&P or Moody’s at today’s market prices. Common Stock Dividends On February 20, 2018, our Board of Directors approved a $0.45 per share of common stock dividend for the first quarter of 2018. This reflects an indicative annual dividend rate of $1.80 per share. We expect to continue to pay cash dividends on our common stock; however, the declaration and payment of future dividends to holders of our common stock will be at the discretion of the Board of Directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our businesses, alternate investment opportunities, legal requirements, regulatory constraints, industry practice and other factors that the Board of Directors deems relevant. For additional information related to cash dividends on our common stock, see Item 8. Financial Statements and Supplementary Data-Note16. Earnings Per Share (EPS) and Dividends. Credit Ratings If the rating agencies lower or withdraw our credit ratings, such revisions may adversely affect the market price of our securities and serve to materially increase our cost of capital and limit access to capital. Credit Ratings shown are for securities that we typically issue. Outlooks are shown for Corporate Credit Ratings (S&P) and Issuer Credit Ratings (Moody’s) and can be Stable, Negative, or Positive. There is no assurance that the ratings will continue for any given period of time or that they will not be revised by the rating agencies, if, in their respective judgments, circumstances warrant. Each rating given by an agency should be evaluated independently of the other agencies’ ratings. The ratings should not be construed as an indication to buy, hold or sell any security. In April 2017, S&P published updated research and affirmed the ratings and outlooks on PSEG and PSE&G. In June 2017, S&P published updated research on Power and the rating and outlook remained unchanged. In July 2017, Moody’s upgraded PSEG’s senior unsecured rating to Baa1 from Baa2 and revised its outlook to Stable from Positive. Also in July, Moody’s affirmed the ratings at PSE&G and Power. (A) Moody’s ratings range from Aaa (highest) to C (lowest) for long-term securities and P1 (highest) to NP (lowest) for short-term securities. (B) S&P ratings range from AAA (highest) to D (lowest) for long-term securities and A1 (highest) to D (lowest) for short-term securities. Other Comprehensive Income For the year ended December 31, 2017, we had Other Comprehensive Income of $34 million on a consolidated basis. Other Comprehensive Income was due primarily to a $44 million increase in net unrealized gains related to Available-for-Sale Securities, partially offset by a decrease of $8 million in our consolidated liability for pension and postretirement benefits and $2 million of unrealized losses on derivative contracts accounted for as hedges. See Item 8. Financial Statements and Supplementary Data-Note 21. Accumulated Other Comprehensive Income (Loss), Net of Tax for additional information. CAPITAL REQUIREMENTS We expect that all of our capital requirements over the next three years will come from a combination of internally generated funds and external debt financing. Projected capital construction and investment expenditures, excluding nuclear fuel purchases, for the next three years are presented in the table below. These projections include Allowance for Funds Used During Construction and Interest Capitalized During Construction for PSE&G and Power, respectively. These amounts are subject to change, based on various factors. Amounts shown below for Energy Strong, GSMP and Solar/Energy Efficiency programs are for currently approved programs. We intend to continue to invest in infrastructure modernization and will seek to extend these and related programs as appropriate. We will also continue to approach potential growth investments for Power opportunistically, seeking projects that will provide attractive risk-adjusted returns for our shareholders. PSE&G PSE&G’s projections for future capital expenditures include material additions and replacements to its transmission and distribution systems to meet expected growth and to manage reliability. As project scope and cost estimates develop, PSE&G will modify its current projections to include these required investments. PSE&G’s projected expenditures for the various items reported above are primarily comprised of the following: • Transmission-investments focused on reliability improvements and replacement of aging infrastructure. • Distribution-investments for new business, reliability improvements, and replacement of equipment that has reached the end of its useful life. • Energy Strong-Electric and Gas Distribution reliability investment program focused on system hardening and resiliency. • Gas System Modernization Program-Gas Distribution investment program to replace aging infrastructure. • Solar/Energy Efficiency-investments associated with grid-connected solar, solar loan programs, and customer energy efficiency programs. In November 2017, the BPU issued an order approving PSE&G’s net investment of $100 million to rebuild New Jersey Transit’s Mason electric distribution substation and related facilities in Kearny, New Jersey. This project is expected to be completed in December 2021. In July 2017, PSE&G filed a petition with the BPU requesting approval of the $2.7 billion next phase of the Gas System Modernization Program (GSMP II) and associated cost recovery mechanism. The GSMP II program will enable PSE&G to continue to accelerate the replacement of its aging cast-iron and unprotected steel gas pipes. This matter is currently pending before the BPU and is not included in the PSE&G’s projected capital expenditures above. In 2017, PSE&G made $2,919 million of capital expenditures, primarily for transmission and distribution system reliability. This does not include expenditures for cost of removal, net of salvage, of $107 million, which are included in operating cash flows. Power Power’s projected expenditures for the various items listed above are primarily comprised of the following: • Baseline-investments to replace major parts and enhance operational performance. • Fossil Growth Opportunities-investments associated with new construction, including Keys, Sewaren 7 and BH5, and with upgrades to increase efficiency and output at combined cycle plants. • Other-includes investments made in response to environmental, regulatory and legal mandates and other capital projects. In 2017, Power made $1,040 million of capital expenditures, excluding $191 million for nuclear fuel, primarily related to various projects at Fossil, Solar and Nuclear. Disclosures about Contractual Obligations The following table reflects our contractual cash obligations in the respective periods in which they are due. In addition, the table summarizes anticipated debt maturities for the years shown. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 14. Debt and Credit Facilities. The table below does not reflect any anticipated cash payments for pension obligations due to uncertain timing of payments or liabilities for uncertain tax positions since we are unable to reasonably estimate the timing of liability payments in individual years beyond 12 months due to uncertainties in the timing of the effective settlement of tax positions. See Item 8. Financial Statements and Supplementary Data-Note 20. Income Taxes for additional information. OFF-BALANCE SHEET ARRANGEMENTS PSEG and Power issue guarantees, primarily in conjunction with certain of Power’s energy contracts. See Item 8. Financial Statements and Supplementary Data-Note 13. Commitments and Contingent Liabilities for further discussion. Through Energy Holdings, we have investments in leveraged leases that are accounted for in accordance with GAAP Accounting for Leases. Leveraged lease investments generally involve three parties: an owner/lessor, a creditor and a lessee. In a typical leveraged lease arrangement, the lessor purchases an asset to be leased. The purchase price is typically financed 80% with debt provided by the creditor and the balance comes from equity funds provided by the lessor. The creditor provides long-term financing to the transaction secured by the property subject to the lease. Such long-term financing is non-recourse to the lessor and is not presented on our Consolidated Balance Sheets. In the event of default, the leased asset, and in some cases the lessee, secures the loan. As a lessor, Energy Holdings has ownership rights to the property and rents the property to the lessees for use in their business operations. For additional information, see Item 8. Financial Statements and Supplementary Data-Note 7. Long-Term Investments and Note 8. Financing Receivables. In the event that collection of the minimum lease payments to be received by Energy Holdings is no longer reasonably assured, Energy Holdings may deem that a lessee has a high probability of defaulting on the lease obligation, and would consider the need to record an impairment of its investment. In the event the lease is ultimately rejected by the lessee in a Bankruptcy Court proceeding, the fair value of the underlying asset and the associated debt would be recorded on the Consolidated Balance Sheets instead of the net equity investment in the lease. CRITICAL ACCOUNTING ESTIMATES Under GAAP, many accounting standards require the use of estimates, variable inputs and assumptions (collectively referred to as estimates) that are subjective in nature. Because of this, differences between the actual measure realized versus the estimate can have a material impact on results of operations, financial position and cash flows. We have determined that the following estimates are considered critical to the application of rules that relate to the respective businesses. Accounting for Pensions PSEG sponsors qualified and nonqualified pension plans covering PSEG’s and its participating affiliates’ current and former employees who meet certain eligibility criteria. The market-related value of plan assets held for the qualified pension plan is equal to the fair value of these assets as of year-end. The plan assets are comprised of investments in both debt and equity securities which are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. We calculate pension costs using various economic and demographic assumptions. Assumptions and Approach Used: Economic assumptions include the discount rate and the long-term rate of return on trust assets. Demographic assumptions include projections of future mortality rates, pay increases and retirement patterns. The discount rate used to calculate pension obligations is determined as of December 31 each year, our measurement date. The discount rate is determined by developing a spot rate curve based on the yield to maturity of a universe of high quality corporate bonds with similar maturities to the plan obligations. The spot rates are used to discount the estimated plan distributions. The discount rate is the single equivalent rate that produces the same result as the full spot rate curve. Our expected rate of return on plan assets reflects current asset allocations, historical long-term investment performance and an estimate of future long-term returns by asset class, long-term inflation assumptions and a premium for active management. Based on the above assumptions, we have estimated a net periodic pension credit in 2018 of approximately $(36) million, or $(87) million, net of amounts capitalized. We utilize a corridor approach that reduces the volatility of reported pension expense/income. The corridor requires differences between actuarial assumptions and plan results be deferred and amortized as part of expense/income. This occurs only when the accumulated differences exceed 10% of the greater of the pension benefit obligation or the fair value of plan assets as of each year-end. The excess would be amortized over the average remaining service period of the active employees, which is approximately thirteen years. Effect if Different Assumptions Used: As part of the business planning process, we have modeled future costs assuming a 7.80% expected rate of return and a 3.73% discount rate for 2018. Actual future pension expense/income and funding levels will depend on future investment performance, changes in discount rates, market conditions, funding levels relative to our projected benefit obligation and accumulated benefit obligation and various other factors related to the populations participating in the pension plans. The following chart reflects the sensitivities associated with a change in certain assumptions. The effects of the assumption changes shown below solely reflect the impact of that specific assumption. See

<s>[INST] PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: PSE&Gwhich is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in solar generation projects and energy efficiency and related programs in New Jersey, which are regulated by the BPU, and Powerwhich is a multiregional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses and fuel supply functions through competitive energy sales in welldeveloped energy markets primarily in the Northeast and MidAtlantic United States through its principal direct wholly owned subsidiaries. In addition, Power owns and operates solar generation in various states. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries are: PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement (OSA); PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2017 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2017 AND FUTURE OUTLOOK 2017 Overview Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives, including: improving utility operations through growth in investment in T&D and other infrastructure projects designed to enhance system reliability and resiliency and to meet customer expectations and public policy objectives, and maintaining and expanding a reliable generation fleet with the flexibility to utilize a diverse mix of fuels which allows us to respond to market volatility and capitalize on opportunities as they arise. Financial Results The results for PSEG, PSE&G and Power for the years ended December 31, 2017 and 2016 are presented below: Our 2017 over 2016 increase in Net Income was due primarily to the favorable impacts of new tax legislation at Power and Energy Holdings in 2017, discussed below, partially offset by higher charges in 2017 related to the early retirement of our Hudson and Mercer units. Higher transmission revenues in 2017 at PSE&G, lower charges in 2017 related to investments in certain leveraged leases at Energy Holdings and lower plant outage costs at Power, partially offset by lower volumes of electricity sold at lower average prices, also contributed to the increase in Net Income. For a more detailed discussion of our financial results, see Results of Operations. During 2017, we maintained a strong balance sheet. We continued to effectively deploy capital without the need for additional equity, while our solid credit ratings aided our ability to access capital and credit markets. The greater emphasis [/INST] Negative. </s>

PUBLIC SERVICE ENTERPRISE GROUP INC

2019-02-28

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) This combined MD&A is separately filed by Public Service Enterprise Group Incorporated (PSEG), Public Service Electric and Gas Company (PSE&G) and PSEG Power LLC (Power). Information contained herein relating to any individual company is filed by such company on its own behalf. PSE&G and Power each make representations only as to itself and make no representations whatsoever as to any other company. PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: • PSE&G-which is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in regulated solar generation projects and energy efficiency and related programs in New Jersey, which are regulated by the BPU, and • Power-which is a multi-regional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses and fuel supply functions through competitive energy sales in well-developed energy markets primarily in the Northeast and Mid-Atlantic United States through its principal direct wholly owned subsidiaries. In addition, Power owns and operates solar generation in various states. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries are: PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement; PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2018 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2018 AND FUTURE OUTLOOK Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. PSE&G At PSE&G, our focus is on enhancing system reliability and resiliency, meeting customer expectations and supporting public policy objectives by investing capital in T&D infrastructure and clean energy projects. Over the past few years, our investments have altered our business mix to reflect a higher percentage of earnings contribution by PSE&G. Over the next five years, we expect to invest between $11 billion and $16 billion in our business which is expected to provide an annual rate base growth of 7%-9%. We completed our Energy Strong Program I (ES I) and essentially completed our Gas System Modernization Program I (GSMP I). See Item 1. Business-Business Operations and Strategy-PSE&G for a description of these programs. In May 2018, we received approval for our Gas System Modernization Program II (GSMP II), an expanded, five-year program to invest $1.9 billion beginning in 2019 to replace approximately 875 miles of cast iron and unprotected steel mains in addition to other improvements to the gas system. Approximately $1.6 billion will be recovered through periodic rate roll-ins, with the remaining $300 million to be recovered through a future base rate proceeding. As part of the settlement, PSE&G agreed to file a base rate proceeding no later than five years from the commencement of the program, to maintain a base level of gas distribution capital expenditures of $155 million per year and to achieve certain leak reduction targets. In June 2018, we filed for our Energy Strong Program II (ES II), a proposed five-year $2.5 billion program to harden, modernize and make our electric and gas distribution systems more resilient. The size and duration of ES II, as well as certain other elements of the program, are subject to BPU approval. The review process is expected to conclude in mid-2019. In October 2018, we filed our proposed Clean Energy Future (CEF) program with the BPU, a six-year estimated $3.6 billion investment covering four programs; (i) an Energy Efficiency (EE) program totaling $2.5 billion of investment designed to achieve energy efficiency targets required under New Jersey’s Clean Energy law; (ii) an Electric Vehicle (EV) infrastructure program; (iii) an Energy Storage (ES) program and (iv) an Energy Cloud (EC) program which will include installing approximately two million electric smart meters and associated infrastructure. The review process for the CEF-EE program is expected to conclude by the third quarter of 2019. The CEF-EV/ ES and CEF-EC programs will have separate procedural schedules. In November 2018, the New Jersey Division of Rate Counsel (Rate Counsel) filed a motion to dismiss the CEF-EC filing on the basis that the BPU announced a moratorium on electric distribution companies’ AMI program. In December 2018, Rate Counsel filed a motion to stay the CEF-EV/ES filing, arguing that the BPU should conclude other regulatory proceedings addressing EVs and ES, including the new Energy Master Plan and initiatives required by the Clean Energy Act, before it rules on PSE&G’s program. We opposed Rate Counsel’s motions, asking for the BPU to permit these filings to proceed. There is no timetable for the BPU to decide on Rate Counsel’s motions. Also, in October 2018, the BPU issued an Order approving the settlement of our distribution base rate proceeding with new rates effective November 1, 2018. The settlement resulted in a net reduction in overall annual revenues of approximately $13 million, comprised of a $212 million increase in base revenues, which includes the recovery of deferred storm costs, and the return of tax benefits largely due to tax reform of approximately $225 million. The Order provides for a distribution rate base of $9.5 billion, a 9.6% return on equity (ROE) for our distribution business and a 54% equity component of our capitalization structure. Power At Power, we strive to improve performance and reduce costs in order to optimize cash flow generation from our fleet in light of low wholesale power and gas prices, environmental considerations and competitive market forces that reward efficiency and reliability. Power continues to move its fleet toward improved efficiency and believes that its investment program enhances its competitive position with the addition of efficient, clean, reliable combined cycle gas turbine capacity. Our commitments for load, such as basic generation service (BGS) in New Jersey and other bilateral supply contracts, are backed by this generation or may be combined with the use of physical commodity purchases and financial instruments from the market to optimize the economic efficiency of serving our obligations. Power’s hedging practices and ability to capitalize on market opportunities help it to balance some of the volatility of the merchant power business. More than half of Power’s expected gross margin in 2018 relates to our hedging strategy, our expected revenues from the capacity market mechanisms and certain ancillary service payments such as reactive power. Our investments in Keys Energy Center (Keys), Sewaren 7 and Bridgeport Harbor Station Unit 5 (BH5) reflect our recognition of the value of opportunistic growth in the Power business. These additions to our fleet both expand our geographic diversity and adjust our fuel mix and enhance the environmental profile and overall efficiency of Power’s generation fleet. Operational Excellence We emphasize operational performance while developing opportunities in both our competitive and regulated businesses. Flexibility in our generating fleet has allowed us to take advantage of opportunities in a rapidly evolving market as we remain diligent in managing costs. In 2018, our • utility achieved continued strong reliability and customer satisfaction results, as well as comprehensive storm preparation and restoration efforts, and ongoing cost control, • diverse fuel mix and dispatch flexibility allowed us to generate approximately 56 terawatt hours while addressing fuel availability and price volatility, and • total nuclear fleet achieved a capacity factor of 91.4%. Financial Strength Our financial strength is predicated on a solid balance sheet, positive operating cash flow and reasonable risk-adjusted returns on increased investment. Our financial position remained strong during 2018 as we • maintained sufficient liquidity, • maintained solid investment grade credit ratings, and • increased our indicative annual dividend for 2018 to $1.80 per share. We expect to be able to fund our planned capital requirements, as described in Liquidity and Capital Resources, and the impacts of the Tax Cuts and Jobs Act of 2017 (Tax Act) without the issuance of new equity. For additional information on the impacts of the Tax Act, see Item 8. Note 7. Regulatory Assets and Liabilities and Note 21. Income Taxes. The financial results for PSEG, PSE&G and Power for the years ended December 31, 2018 and 2017 are presented below: Our 2018 over 2017 decrease in Net Income was due primarily to the one-time favorable impacts in 2017 of new tax legislation at Power and Holdings, discussed below, and the recognition in 2018 of net unrealized losses on NDT Fund equity securities at Power in accordance with new accounting guidance. The decrease was partially offset by charges in 2017 related to the early retirement of our Hudson and Mercer units, as well as a lower federal tax rate at Power and higher earnings from T&D investments and the favorable impact of new rates upon settlement of the distribution base rate proceeding, discussed above, at PSE&G. For a more detailed discussion of our financial results, see Results of Operations. Disciplined Investment We utilize rigorous criteria when deploying capital and seek to invest in areas that complement our existing business and provide reasonable risk-adjusted returns. These areas include upgrading our energy infrastructure, responding to trends in environmental protection and providing new energy supplies in domestic markets with growing demand. In 2018, we • made additional investments in T&D infrastructure projects, • continued to execute our GSMP I, Energy Efficiency and other existing BPU-approved utility programs, • received approval for our GSMP II program and filed our proposed ES II and CEF programs, and • commenced commercial operation of Sewaren 7 and Keys generation facilities and continued construction of our BH5 generation project, which is targeted for commercial operation in mid-2019. Regulatory, Legislative and Other Developments In our pursuit of operational excellence, financial strength and disciplined investment, we closely monitor and engage with stakeholders on significant regulatory and legislative developments. Transmission planning rules and wholesale power market design are of particular importance to our results and we continue to advocate for policies and rules that promote fair and efficient electricity markets. For additional information about regulatory, legislative and other developments that may affect the company, see Item 1. Business-Regulatory Issues. Transmission Planning There are several matters pending before FERC that may impact the allocation of costs associated with transmission projects, including those being constructed by PSE&G. Regardless of how these proceedings are resolved, PSE&G’s ability to recover the costs of these projects will not be affected. However, the result of these proceedings could ultimately impact the amount of costs borne by customers in New Jersey. In addition, as a BGS supplier, Power provides services that include specified transmission costs. If the allocation of the costs associated with the transmission projects were to increase these BGS-related transmission costs, BGS suppliers would be entitled to recovery, subject to BPU approval. We do not believe that these matters will have a material effect on Power’s business or results of operations. Several complaints have been filed and several remain pending at FERC against transmission owners around the country, challenging those transmission owners’ base ROE. Certain of those complaints have resulted in decisions and others have been settled, resulting in reductions of those transmission owners’ base ROEs. The results of these other proceedings could set precedents for other transmission owners with formula rates in place, including PSE&G. In October 2018, FERC issued an order establishing a new framework for determining whether a company’s ROE is unjust and unreasonable. FERC proposes to rely on financial models to establish a composite zone of reasonableness that will be used to determine whether an ROE complaint should be dismissed. If FERC determines that an ROE for a company is not just and reasonable, it intends to reset the ROE based on averaging the results of various financial models. We are still analyzing the potential impact of these methodologies and cannot predict the outcome of ongoing ROE proceedings. Wholesale Power Market Design In June 2018, FERC issued an order finding that PJM’s current capacity market is not just and reasonable because it enabled state-supported resources to bid below their costs which resulted in suppressed clearing prices. In particular, FERC found that nuclear generating units that receive zero emission certificate (ZEC) payments were of concern. Depending on the outcome of this matter, our generating stations could also be impacted. For additional information see Item 1. Business-Regulatory Issues-Federal Regulation. In February 2019, the PJM Board approved a filing to modify the curves used for pricing reserves with FERC. The reforms include a 30-minute reserve product in real-time, more dynamic reserve requirements to better capture operator actions taken to maintain reliability, and improvement to the curves used to price reserves during reserve shortage conditions. If placed into effect, this reform is expected to improve energy and reserve prices by ensuring that when operators commit resources to ensure reliability, the commitments are reflected in market clearing prices. However, this reform could result in lower capacity payments. There is no timeline for this type of filing and therefore we cannot predict when FERC will act on the filing or the outcome of this matter. In October 2018, PJM filed with FERC to revise the shape of the Variable Resource Requirement (VRR) curve that will be implemented for the capacity auction to be held in August 2019. The VRR curve is the administratively determined demand curve that serves as one of the key elements for establishing the amount of generation capacity to be procured in the auction. PJM contends that its proposal will lower capacity prices as compared to the currently effective VRR curve. PSEG protested PJM’s proposal on the grounds that it would result in understated prices for capacity relative to the cost of constructing a new reference generating unit and will result in prices that are unjust and unreasonable. This matter is pending before FERC and we cannot predict the outcome. Distribution Effective in January 2018, the BPU adopted Infrastructure Investment Program (IIP) regulations that encourage utilities to construct, install, or remediate utility plant and facilities related to reliability, resiliency, and/or safety to support the provision of safe and adequate service. Under these regulations, utilities can seek authority to make specified infrastructure investments in programs extending for up to five years with accelerated cost recovery mechanisms. The BPU characterized the IIP regulations as a regulatory initiative intended to create a financial incentive for utilities to accelerate the level of investment needed to promote the timely rehabilitation and replacement of certain traditional utility infrastructure that enhances reliability, resiliency, and/or safety. Since these regulations were adopted, the BPU approved our GSMP II and we filed our ES II and CEF-EC programs with the BPU. Environmental Regulation We continue to advocate for the development and implementation of fair and reasonable rules by the EPA and state environmental regulators. In particular, section 316(b) of the Clean Water Act requires that cooling water intake structures, which are a significant part of the generation of electricity at steam-electric generating stations, reflect the best technology available for minimizing adverse environmental impacts. Implementation of Section 316(b) and related state regulations could adversely impact future nuclear and fossil operations and costs. In August 2018, the EPA released the proposed Affordable Clean Energy (ACE) rule as a replacement for the EPA’s Clean Power Plan. The proposed ACE rule gives states great flexibility to evaluate specific heat rate improvement technologies and practices to be applied at coal-fired electric generating units. States have three years from the date of finalization to submit a plan that establishes a standard of performance that reflects the degree of emission limitation through the application of heat rate improvement technologies and practices. We cannot estimate the impact of this action on our business or results of operations at this time. We are also subject to liability under environmental laws for the costs of remediating environmental contamination of property now or formerly owned by us and of property contaminated by hazardous substances that we generated. In particular, the historic operations of PSEG companies and the operations of numerous other companies along the Passaic and Hackensack Rivers are alleged by Federal and State agencies to have discharged substantial contamination into the Passaic River/Newark Bay Complex in violation of various statutes. We are also currently involved in a number of proceedings relating to sites where other hazardous substances may have been discharged and may be subject to additional proceedings in the future, and the costs of any such remediation efforts could be material. In December 2018, the New Jersey Department of Environmental Protection proposed two rules that begin the state’s re-entry into the Regional Greenhouse Gas Initiative (RGGI). The first proposal is the mechanism rulemaking that establishes the state’s initial cap on greenhouse gas emissions of 18 million tons in 2020. The proposal follows the RGGI model rule with a cap that will decline three percent annually through 2030 to a final cap of 11.5 million tons. New Jersey is committed to a start date of January 1, 2020. The second proposal establishes the framework for how the state will spend the RGGI auction proceeds. We cannot estimate the impact of this action on our business or results of operations at this time. For further information regarding the matters described above, as well as other matters that may impact our financial condition and results of operations, see Item 8. Note 14. Commitments and Contingent Liabilities. Early Plant Retirements Nuclear In May 2018, the governor of New Jersey signed legislation, referred to as the ZEC legislation, that recognizes that nuclear power is a critical component of New Jersey’s clean energy portfolio and an important element of a diverse energy generation portfolio that currently meets approximately 40 percent of New Jersey’s electric power needs. The ZEC legislation creates a Zero Emission Certificate (ZEC) program to be administered by the BPU. The BPU subsequently established processes to evaluate applications by qualified nuclear plants and to review and approve changes to the New Jersey’s electric distribution companies’ tariffs to provide for the purchase of ZECs from selected nuclear plants and recover those ZEC payments through a non-bypassable distribution charge (ZEC charge) in the amount of $0.004 per kilowatt-hour (which is equivalent to approximately $10 per megawatt hour (MWh) in payments to selected nuclear plants. ZECs will be awarded to selected nuclear plants, if any, in April 2019 at which time ZEC revenue would commence and would continue for approximately three years. Nuclear plants receiving ZEC payments will be obligated to maintain operations, subject to exceptions specified in the ZEC legislation. The ZEC legislation requires nuclear plants to reapply for any subsequent three year periods. The ZEC payment may be adjusted by the BPU (a) at any time to offset environmental or fuel diversity payments that a selected nuclear plant may receive from another source or (b) at certain times specified in the ZEC legislation if the BPU determines that the purposes of the ZEC legislation can be achieved through a reduced charge that will nonetheless be sufficient to achieve the state’s air quality and other environmental objectives by preventing the retirement of nuclear plants. In December 2018, Power submitted applications to the BPU for the Salem 1 and 2 and Hope Creek nuclear plants. These were the only applications received by the BPU. As required, Power’s three applications each included a certification pursuant to which Power confirmed that each of the Salem 1, Salem 2 and Hope Creek plants will cease operations within three years absent a material financial change. Power’s submittal further attested that the nuclear plants are not expected to cover their costs and operating and market risks as defined in the ZEC legislation, absent a material financial change. As a result, absent a material financial change, Power will retire all three plants unless all of the plants receive ZECs. Power operates its nuclear plants as an interdependent fleet on a common site with shared costs and services, which allows them to achieve economies of scale. A decision to retire one nuclear plant would also adversely impact Power’s ability to attract and retain qualified employees at its remaining plants. Power believes that the retirement of any individual nuclear plant would have the effect of decreasing the scale of its nuclear operations; however, the complex nature of operating nuclear plants would not decrease the attention required from management for the safe operation of the remaining nuclear operations. As a result, Power’s decision to retire any nuclear plant would be made at the site level and would result in the retirement of all of these New Jersey nuclear plants. Given the anticipated timing of the BPU’s decision on which nuclear plants, if any, have been selected to receive ZECs, which is expected in April 2019, in March 2019 Power will submit to the PJM Independent Market Monitor and the PJM Office of Interconnection a request for a preliminary exception to PJM’s Reliability Pricing Model must-offer requirement with respect to Power’s interest for each of the Salem 1, Salem 2 and Hope Creek plants in connection with the 2022/2023 capacity auction expected to be held in August 2019. Power will also submit a deactivation notice to the extent that its filing deadline occurs prior to the award of ZECs by the BPU. If all of the Salem and Hope Creek plants are selected to receive ZECs, the preliminary exception and requested deactivation notice, as applicable, would be withdrawn. In the event that any of the Salem 1, Salem 2 and Hope Creek plants is not selected to receive ZEC payments in April 2019 by the BPU and do not otherwise experience a material financial change, Power will take all necessary steps to retire all of these plants at or prior to their refueling outages scheduled for the Fall 2019 in the case of Hope Creek, Spring 2020 in the case of Salem 2 and Fall 2020 in the case of Salem 1. Alternatively, if all of the Salem 1, Salem 2 and Hope Creek plants are selected to receive ZEC payments in April 2019 but the financial condition of the plants is materially adversely impacted by potential changes to the capacity market construct being considered by FERC (absent sufficient capacity revenues provided under a program approved by the BPU in accordance with a FERC authorized capacity mechanism), Power would still take all necessary steps to retire all of these plants. The costs and accounting charges associated with any such retirement, which may include, among other things, accelerated depreciation and amortization or impairment charges, potential penalties associated with the early termination of capacity obligations and fuel contracts, accelerated asset retirement costs, severance costs, environmental remediation costs and, in certain circumstances, potential additional funding of the Nuclear Decommissioning Trust (NDT) Fund, would be material to both PSEG and Power. Following any action to retire its nuclear plants, Power would take the necessary steps to satisfy its capacity obligations through 2022 with other assets in its fleet or through market purchases. Power intends to decommission any retired nuclear plant using the “SAFESTOR” process, which is a process approved by the NRC. As a result, Power believes adequate funds are available in the NDT Fund for the early retirement of the nuclear plants. To the extent another decommissioning process is employed, the NDT Fund would not be sufficient to cover the costs of decommissioning all the nuclear plants upon early retirement. Fossil In December 2018, Power completed the sale of the sites of the retired Hudson and Mercer units. Power transferred all land rights and structures on the sites to a third-party purchaser, along with the assumption of the environmental liabilities for the sites. As a result of the sale and transfer of liabilities, Power recorded a pre-tax gain in 2018 of $54 million in Operation and Maintenance (O&M) Expense. In addition, PSEG and Power continue to monitor their other coal assets, including their interest in the Keystone and Conemaugh generating stations, to assess their economic viability through the end of their designated useful lives and their continued classification as held for use. The precise timing of a change in useful lives may be dependent upon events out of PSEG’s and Power’s control and may impact their ability to operate or maintain certain assets in the future. These generating stations may be impacted by factors such as environmental legislation, co-owner capital requirements and continued depressed wholesale power prices or capacity factors, among other things. Any early retirement or change in the classification as held for use of our remaining coal units may have a material adverse impact on PSEG’s and Power’s future financial results. California Solar Facilities As part of its solar production portfolio, Power owns and operates two California-based solar facilities with an aggregate capacity of approximately 30 MW direct current whose output is sold to Pacific Gas and Electric Company (PG&E) under power purchase agreements (PPAs) with twenty year terms. The net book value of these solar facilities was approximately $57 million as of December 31, 2018. In January 2019, PG&E and its parent company PG&E Corporation filed for Chapter 11 bankruptcy protection. Power cannot predict the ultimate outcome that this bankruptcy proceeding will have on our ability to collect all of the future revenues from these facilities due under the PPAs; however, any adverse changes to the terms of Power’s PPAs as a result of this bankruptcy proceeding could result in the future impairment of these assets in amounts up to their current net book value. Offshore Wind In January 2018, the governor of New Jersey signed Executive Order No. 8 directing the BPU to begin the process of moving the state toward its 2030 goal of 3,500 MW of offshore wind energy generation. An initial solicitation was established for 1,100 MW of offshore wind, with bids due in December 2018. In connection with the bid submitted by Ocean Wind, LLC, a wholly owned subsidiary of Ørsted US Offshore Wind, referred to as the Ocean Wind project, PSEG agreed to provide energy management services and the potential lease of land for use in project development. We also retained an option to acquire an equity interest in the project. We expect to make a decision regarding an equity investment in the Ocean Wind project in the second half of 2019. Leveraged Leases In December 2018, NRG REMA, LLC (REMA) emerged from its in-court proceeding under Chapter 11 of the Bankruptcy Code. Upon emergence, PSEG received $31.5 million in cash in exchange for transferring the ownership interests in Keystone and Conemaugh to the debtholders of REMA and satisfaction of all other claims asserted against REMA, as well as certain amendments to the Shawville lease. The Shawville lease amendments, among other things, will allow REMA to express interest in a renewal on or after November 24, 2019. In addition, REMA has agreed to fund qualifying credit support up to $36 million. As a result of the restructuring, Energy Holdings recognized a pre-tax gain in Operating Revenues of approximately $12 million ($9 million after tax). In addition, the remaining deferred tax liabilities related to these lease investments were reclassified to current tax liabilities. PSEG expects to pay approximately $120 million to taxing authorities resulting from this restructuring activity. Additional facilities in our leveraged lease portfolio include the Joliet and Powerton generating facilities. Converted natural gas units such as Shawville and Joliet may have higher operating costs and fuel consumption, as well as longer start-up times, compared to newer combined cycle gas units. Powerton is a coal-fired generating facility in Illinois. Each of these three facilities may not be as economically competitive as newer combined cycle gas units and could continue to be adversely impacted by the same economic conditions experienced by other less efficient natural gas and coal generation facilities, which could require Energy Holdings to write down the residual value of the leveraged lease receivables associated with these facilities. Tax Legislation In December 2017, the Tax Act, among other things, decreased the statutory U.S. corporate income tax rate from a maximum of 35% to 21%, effective January 1, 2018, and made certain changes to bonus depreciation and interest disallowance rules. As a result of the Tax Act, we recorded a one-time, non-cash earnings benefit of $745 million in 2017, including $588 million related to Power and $147 million related to Energy Holdings. This benefit was primarily due to the remeasurement of deferred tax balances. In addition, PSE&G recorded excess deferred taxes of approximately $2.1 billion and recorded an approximate $2.9 billion revenue impact of these excess deferred taxes as Regulatory Liabilities. Beginning in 2018, PSEG, on a consolidated basis, is incurring lower income tax expense resulting in a decrease in its effective income tax rate that has led to an increase in PSEG’s and Power’s Net Income. To the extent allowed under the Tax Act, Power’s operating cash flows will reflect the full expensing of capital investments for income tax purposes. For PSE&G, the Tax Act has led to lower customer rates due to lower income tax expense recoveries and the BPU and FERC have approved our proposal to refund excess deferred income tax Regulatory Liabilities. See Item 8. Note 7. Regulatory Assets and Liabilities for additional information. The impact of the lower federal income tax rate on PSE&G was reflected in PSE&G’s distribution base rate proceeding and its 2018 transmission formula rate filings. The Tax Act is generally expected to result in lower operating cash flows for PSE&G resulting from the elimination of bonus depreciation, partially offset by higher revenues due to the higher rate base. In August 2018, the Internal Revenue Service (IRS) issued a Notice of Proposed Rulemaking (Notice) regarding the application of tax depreciation rules as amended by the Tax Act. While the Notice provides some guidance as to the application of the changes made by the Tax Act to the bonus depreciation rules, certain aspects remain unclear. Further, in November 2018 the IRS issued Proposed Regulations addressing the interest disallowance rules contained in the Tax Act. For non-regulated businesses, these rules set a cap on the amount of interest that can be deducted in a given year. Any amount that is disallowed can be carried forward indefinitely. For 2018, PSEG and Power expect that a portion of their interest will be disallowed in the current period but realized in future periods. However, certain aspects of the proposed regulations are unclear; therefore, we recorded taxes based on our interpretation of the relevant statute. We recorded amounts based on our interpretation of the Tax Act, the depreciation rules contained in the Notice and proposed interest disallowance regulations. Such amounts are subject to change based on several factors, including but not limited to, the IRS and state taxing authorities issuing final guidance and/or further clarification. Any further guidance or clarification could impact PSEG’s, PSE&G’s and Power’s financial statements. For additional information, see Item 8. Note 21. Income Taxes. As a result of the enactment of the Tax Act, various state regulatory authorities, including the BPU, have taken action to ensure that excess federal income taxes previously collected in rates are returned to customers. We adjusted the revenue requirement in certain of our rate matters as a result of the change in the federal income tax rate. See Item 8. Note 7. Regulatory Assets and Liabilities for additional information. In July 2018, the State of New Jersey made changes to its income tax laws, including imposing a temporary surtax on allocated corporate taxable income of 2.5% effective January 1, 2018 and 2019 and 1.5% in 2020 and 2021, as well as requiring corporate taxpayers to file in a combined reporting group as defined under New Jersey law starting in 2019. Both provisions include an exemption for public utilities. We believe PSE&G meets the definition of a public utility and, therefore, will not be impacted by the temporary surtax or be included in the combined reporting group. We expect these new provisions to unfavorably affect our non-utility business. In accordance with GAAP accounting for income taxes, deferred taxes are required to be measured at the enacted tax rate expected to apply to taxable income in the periods in which the deferred taxes are expected to settle. The newly enacted New Jersey tax legislation did not have a material impact on PSEG’s deferred income tax balance. Amendments to Other Postretirement Employee Benefit (OPEB) Plans In December 2018, PSEG amended certain provisions of its OPEB plans applicable to all current and future Medicare-eligible retirees and spouses who receive or will receive subsidized healthcare from PSEG. Effective January 1, 2021, the PSEG-sponsored Medicare-eligible plans will be replaced by a Medicare private exchange. For each Medicare-eligible retiree and spouse, PSEG will provide annual credits to a Health Reimbursement Arrangement, which can be used to pay for medical, prescription drug, and dental plan premiums, as well as certain out-of-pocket costs. The amendment resulted in a $559 million reduction in PSEG’s OPEB obligation as of December 31, 2018 and is expected to decrease net periodic benefit costs in 2019. Future Outlook Our future success will depend on our ability to continue to maintain strong operational and financial performance in an environment with low gas prices, to capitalize on or otherwise address regulatory and legislative developments that impact our business and to respond to the issues and challenges described below. In order to do this, we must continue to: • focus on controlling costs while maintaining safety, reliability and customer satisfaction and complying with applicable standards and requirements, • successfully manage our energy obligations and re-contract our open supply positions in response to changes in prices and demand, • obtain approval of and execute our utility capital investment program, including ES II, GSMP II, our CEF program and other investments for growth that yield contemporaneous and reasonable risk-adjusted returns, while enhancing the resiliency of our infrastructure and maintaining the reliability of the service we provide to our customers, • effectively manage construction of BH5 and our other generation projects, • advocate for measures to ensure the implementation by PJM and FERC of market design and transmission planning rules that continue to promote fair and efficient electricity markets, • engage multiple stakeholders, including regulators, government officials, customers and investors, and • successfully operate the LIPA T&D system and manage LIPA’s fuel supply and generation dispatch obligations. In addition to the risks described elsewhere in this Form 10-K for 2019 and beyond, the key issues and challenges we expect our business to confront include: • regulatory and political uncertainty, both with regard to future energy policy, design of energy and capacity markets, transmission policy and environmental regulation, as well as with respect to the outcome of any legal, regulatory or other proceedings, • the review by the BPU of our application to select our New Jersey nuclear generation units to receive payments under the ZEC program, • the continuing impacts of the Tax Act and changes in state tax laws, and • the impact of reductions in demand and lower natural gas and electricity prices and increasing environmental compliance costs. We continually assess a broad range of strategic options to maximize long-term stockholder value. In assessing our options, we consider a wide variety of factors, including the performance and prospects of our businesses; the views of investors, regulators, customers and rating agencies; our existing indebtedness and restrictions it imposes; and tax considerations, among other things. Strategic options available to us include: • the acquisition, construction or disposition of T&D facilities, clean energy investments and/or generation projects, including offshore wind opportunities, • the disposition or reorganization of our merchant generation business or other existing businesses or the acquisition or development of new businesses, • the expansion of our geographic footprint, including the operation of T&D facilities outside of our traditional service territory, and • investments in capital improvements and additions, including the installation of environmental upgrades and retrofits, improvements to system resiliency, modernizing existing infrastructure and participation in transmission projects through FERC’s “open window” solicitation process. There can be no assurance, however, that we will successfully develop and execute any of the strategic options noted above, or any additional options we may consider in the future. The execution of any such strategic plan may not have the expected benefits or may have unexpected adverse consequences. RESULTS OF OPERATIONS (A) Power’s results in 2018 include an after-tax gain of $39 million from the sale of its Hudson and Mercer coal/gas generation plants and after-tax expenses of $577 million and $396 million in 2017 and 2016, respectively, related to the early retirement of these generation plants. See Item 8. Note 4. Early Plant Retirements for additional information. (B) Results in 2017 include the non-cash net income benefit of $745 million, including $588 million related to Power and $147 million related to Energy Holdings, resulting from the remeasurement of deferred tax liabilities required due to the enactment of the Tax Act in December 2017. (C) Other includes after-tax activities at the parent company, PSEG LI and Energy Holdings as well as intercompany eliminations. Energy Holdings recorded after-tax charges totaling $5 million, $45 million and $92 million related to its investments in REMA’s leveraged leases in 2018, 2017 and 2016, respectively. See Item 8. Note 8. Long-Term Investments and Note 9. Financing Receivables for further information. Power’s results above include the NDT Fund activity and the impacts of non-trading commodity mark-to-market (MTM) activity, which consist of the financial impact from positions with future delivery dates. The variances in our Net Income attributable to changes related to the NDT Fund and MTM are shown in the following table: (A) NDT Fund Income (Expense) includes gains and losses on NDT securities which are recorded in Net Gains (Losses) on Trust Investments. See Item 8. Note 10. Trust Investments for additional information. NDT Fund Income (Expense) also includes interest and dividend income and other costs related to the NDT Fund recorded in Other Income (Deductions), interest accretion expense on Power’s nuclear Asset Retirement Obligation (ARO) recorded in O&M Expense and the depreciation related to the ARO asset recorded in Depreciation and Amortization (D&A) Expense. (B) Net of tax (expense) benefit of $54 million, $(72) million and $(5) million for the years ended December 31, 2018, 2017 and 2016, respectively. (C) Net of tax benefit of $33 million, $68 million and $68 million for the years ended December 31, 2018, 2017 and 2016, respectively. The 2018 year-over-year decrease in Net Income was driven largely by • non-cash Net Income benefits in 2017 related to new tax legislation (See Item 8. Note 21. Income Taxes) at Power and Energy Holdings, and • recognition in 2018 of net unrealized losses on equity securities in the NDT Fund in accordance with new accounting guidance effective January 1, 2018 (See Item 8. Note 2. Recent Accounting Standards and Note 10. Trust Investments), These decreases were partially offset by • accelerated depreciation in 2017 related to early retirement of our Hudson and Mercer coal/gas generation units at Power (See Item 8. Note 4. Early Plant Retirements), • the favorable impact at Power from the lower federal tax rate effective January 1, 2018, and • higher earnings due to investments in T&D programs and the favorable impact of new rates effective November 1, 2018 as a result of the BPU approval of our distribution base rate proceeding. The 2017 year-over-year increase in our Net Income was driven primarily by: • non-cash Net Income benefits related to new tax legislation (See Item 8. Note 21. Income Taxes) at Power and Energy Holdings, • higher transmission revenues, • higher net NDT gains in 2017, and • lower charges related to investments in certain leveraged leases at Energy Holdings (See Item 8. Note 8. Long-Term Investments). These increases were partially offset by: • higher charges related to the early retirement of our Hudson and Mercer coal/gas generation units at Power (See Item 8. Note 4. Early Plant Retirements), and • lower volumes of energy sold at lower average realized sales prices under the BGS contracts and in the PJM and New England regions. PSEG Our results of operations are primarily comprised of the results of operations of our principal operating subsidiaries, PSE&G and Power, excluding charges related to intercompany transactions, which are eliminated in consolidation. For additional information on intercompany transactions, see Item 8. Note 25. Related-Party Transactions. The 2018, 2017 and 2016 amounts in the preceding table for Operating Revenues and O&M costs each include $458 million, $438 million and $410 million, respectively, for PSEG LI’s subsidiary, Long Island Electric Utility Servco, LLC (Servco). These amounts represent the O&M pass-through costs for the Long Island operations, the full reimbursement of which is reflected in Operating Revenues. See Item 8. Note 5. Variable Interest Entity for further explanation. The Income Tax Benefit in 2017 includes the non-cash benefit resulting from the remeasurement of deferred tax liabilities required due to the enactment of the Tax Act in December 2017. The following discussions for PSE&G and Power provide a detailed explanation of their respective variances. PSE&G Year Ended December 31, 2018 as compared to 2017 Operating Revenues increased $147 million due to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $44 million. • Transmission revenues increased $180 million due to higher revenue requirements calculated through our transmission formula rate, primarily to recover required investments. • Gas distribution revenues increased $67 million due to $63 million from higher sales volumes, $36 million from the inclusion of the GSMP I in base rates, $25 million from an increase in the distribution tariff rates effective November 1, 2018 and $2 million in higher collections of Green Program Recovery Charges (GPRC). These increases were partially offset by lower Weather Normalization Clause (WNC) revenues of $31 million, a $26 million reduction for Tax Adjustment Credits (TAC) and a $2 million reduction in ES I collections. • Electric distribution revenues increased $62 million due primarily to a $49 million increase in sales volume, a $17 million increase in ES I collections, $6 million from an increase in the distribution tariff rates effective November 1, 2018 and $4 million in higher collections of GPRC. These increases were partially offset by a reduction of $14 million in TAC. • Transmission, electric distribution and gas distribution revenue requirements were $265 million lower as a result of rate reductions due to the Tax Act which reduced the corporate income tax rate. This decrease is offset in Income Tax Expense. Clause Revenues increased $2 million due to higher Societal Benefit Charges (SBC) of $14 million, and $2 million in higher Solar Pilot Recovery Charge (SPRC) collections, partially offset by decreases of $7 million in Margin Adjustment Clause (MAC) revenues and $7 million in TAC and GPRC deferrals. The changes in SBC, SPRC and MAC collections and TAC and GPRC deferrals were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, D&A and Interest and Tax Expense. PSE&G does not earn margin on SBC, SPRC or MAC collections or on TAC or GPRC deferrals. Commodity Revenues increased $99 million due to higher Electric revenues and higher Gas revenues. This increase is entirely offset with increased Energy Costs. PSE&G earns no margin on the provision of BGS and basic gas supply service (BGSS) to retail customers. • Electric revenues increased $73 million due to $67 million in higher net BGS revenues reflecting $148 million from higher BGS sales volumes partially offset by $81 million from lower prices, and $6 million in higher revenues from solar renewable energy credit (SREC) sales. • Gas revenues increased $26 million due to $65 million from higher BGSS sales volumes, which were partially offset by lower BGSS prices of $42 million, and $3 million in higher BGSS Asset Charges. Operating Expenses Energy Costs increased $99 million. This is entirely offset by Commodity Revenues. Operation and Maintenance increased $117 million, due to a $24 million increase in electric distribution maintenance expenditures, a $24 million increase in transmission maintenance expenditures, a $16 million increase in appliance service costs, a $12 million net increase for various clause mechanisms and GPRC expenditures, a $9 million increase in storm-related costs, an $8 million increase in gas distribution expenditures, a $6 million net increase in pension and OPEB expenses, net of amounts capitalized, a $3 million increase in damage claims, and a $15 million increase in other operating expenses. Depreciation and Amortization increased $85 million due primarily to an increase in depreciation of $81 million due to additional plant placed into service, a $7 million net increase in amortization of Regulatory Assets primarily due to the settlement of our base rate proceeding and an increase of $5 million in software amortization, partially offset by a $7 million increase in capitalized depreciation. Non-Operating Pension and OPEB Credits (Costs) reflect an increase of $67 million in credits primarily due to the adoption of new accounting guidance effective January 1, 2018 which no longer allows for the capitalization of any portion of these benefit costs. See Item 8. Note 2. Recent Accounting Standards. Other Income (Deductions) decreased $5 million due primarily to a $2 million decrease in the Allowance for Funds Used During Construction (AFUDC) and a $3 million decrease in solar loan interest. Interest Expense increased $30 million due primarily to increases of $16 million due to long-term debt issuances in May and December 2017, $8 million due to net long-term debt issuances in 2018 and $4 million in clause-related interest. Income Tax Expense decreased $219 million due primarily to the decrease in the federal statutory income tax rate from 35% in 2017 to 21% in 2018 and lower pretax income. Year Ended December 31, 2017 as compared to 2016 Operating Revenues increased $21 million due to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues increased $166 million due primarily to an increase in transmission revenues. • Transmission revenues were $152 million higher due to higher revenue requirements calculated through our transmission formula rate, primarily to recover required investments. • Gas distribution revenues increased $30 million due to a $16 million increase due to Energy Strong I, $10 million from inclusion of the GSMP I in base rates, $4 million in higher collections of GPRC and an increase of $2 million due to higher sales volumes. These increases were partially offset by lower WNC revenues of $2 million. • Electric distribution revenues decreased $16 million due primarily to a $28 million decrease in sales volume and $14 million in lower collections of GPRC, partially offset by a $26 million increase in Energy Strong I revenues. Clause Revenues increased $75 million due to the absence of the return in 2016 to customers of overcollections of Securitization Transition Charge (STC) revenues of $59 million, higher GPRC collections of $28 million and higher MAC revenues of $4 million. These increases were partially offset by lower SBC of $17 million. The changes in STC, GPRC, MAC and SBC amounts were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, D&A and Interest Expense. PSE&G does not earn margin on STC, GPRC, MAC or SBC collections. Commodity Revenues decreased $223 million due to lower Electric revenues partially offset by higher Gas revenues. This decrease is entirely offset with decreased Energy Costs. PSE&G earns no margin on the provision of BGS and BGSS to retail customers. • Electric revenues decreased $288 million due to $199 million in lower BGS revenues reflecting $109 million from lower sales volumes and $90 million from lower prices, $61 million in lower collections of Non-Utility Generation (NUG) Charges due primarily to lower prices, a $14 million decrease from sales of SRECs and $14 million in lower revenues from the decreased sales volume of NUG energy. • Gas revenues increased $65 million due to higher BGSS prices of $68 million and $2 million from higher sales volumes, partially offset by $5 million in lower BGSS Asset Charges. Operating Expenses Energy Costs decreased $223 million. This is entirely offset by Commodity Revenues. Operation and Maintenance decreased $7 million due primarily to a $15 million decrease in appliance service costs, partially offset by an $8 million net increase in other operating expenses. Depreciation and Amortization increased $120 million due primarily to a $61 million net increase in amortization of Regulatory Assets, including the absence of the STC liability that ended in 2016, and an increase in depreciation of $59 million due to additional plant placed into service in 2017. Non-Operating Pension and OPEB Credits (Costs) reflect a decrease in costs of $7 million due primarily to a decrease in the amortization of the net unrecognized actuarial pension loss, partially offset by the impacts of capitalization. Other Income (Deductions) increased $6 million due primarily to an increase in AFUDC. Interest Expense increased $14 million due primarily to an $11 million increase due to net long-term debt issuances in 2016 and $9 million due to net long-term debt issuances in 2017, partially offset by a decrease of $6 million due to clause-related interest for BGSS in 2016. Income Tax Expense increased $48 million due primarily to higher pre-tax income. Power Year Ended December 31, 2018 as compared to 2017 Operating Revenues increased $286 million due to changes in generation, gas supply and other operating revenues. Generation Revenues increased $199 million due primarily to • a net increase of $113 million due primarily to higher volumes of electricity sold under wholesale load contracts in the PJM region coupled with the commencement of commercial operations for Keys and Sewaren 7 in mid-2018, partially offset by lower average realized prices and higher purchases for wholesale load contracts in the PJM region, • a net increase of $110 million due to lower MTM net losses in 2018 as compared to 2017. Of this amount, there was a $153 million increase due to gains on positions reclassified to realized upon settlement, partially offset by a net decrease of $43 million due to changes in forward prices, • a net increase of $26 million in capacity revenues due primarily to increases in auction prices in the PJM region, • a net increase of $24 million resulting from a prior year reduction to revenue for excess federal income tax previously collected by Power’s subsidiary, PSEG New Haven LLC, from ratepayers due to the change in federal tax rates, and • a net increase of $7 million due to higher sales related to new solar projects, • partially offset by a decrease of $82 million in electricity sold under our BGS contracts due to lower prices and lower volumes. Gas Supply Revenues increased $87 million due primarily to • an increase of $61 million in sales under the BGSS contract, of which $53 million was due to increases in sales volumes as a result of periods of colder weather in the heating season, coupled with $8 million due to higher average sales prices, and • an increase of $42 million related to sales to third parties, of which $26 million was due to higher sales volumes and $16 million to higher average sales prices, • partially offset by a decrease of $16 million due to net MTM losses in 2018 compared to net gains in 2017. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs increased $284 million due to Generation costs increased $167 million due primarily to • higher fuel costs of $158 million reflecting utilization of higher volumes of gas and oil in the PJM region, primarily due to the commencement of commercial operations of Keys and Sewaren 7 fossil stations in mid-2018, coupled with higher prices of natural gas in the PJM and New York regions and higher coal costs in the PJM and New England (NE) regions, and • an increase of $40 million due to MTM losses in 2018 as compared to gains in 2017 due to changes in forward prices, • partially offset by a net decrease of $22 million primarily due to a decrease in the volume of energy purchased in the NE region to serve load obligations, and • a net decrease of $14 million due to charges primarily related to additional retirement costs incurred in 2017 associated with the early retirement of the Hudson and Mercer units. Gas costs increased $117 million due primarily to • an increase of $75 million related to sales under the BGSS contract due primarily to a $51 million increase in volumes sold due to periods of colder weather during the heating season in 2018 as compared to 2017, and $24 million of higher average gas costs, and • an increase of $38 million related to sales to third parties, of which $25 million was due to an increase in volumes sold coupled with $13 million due to higher average gas costs. Operation and Maintenance decreased $47 million due primarily to • a $67 million decrease at our fossil plants, due primarily to a pre-tax gain of $54 million on the sale of the Hudson and Mercer units in 2018 and associated shutdown costs incurred in 2017, partially offset by higher planned outage costs in 2018 associated with our various other fossil plants, • partially offset by a $22 million net increase at our nuclear facilities primarily due to higher planned outage costs at our 100%-owned Hope Creek nuclear plant in 2018 as compared to our 57%-owned Salem Unit 1 nuclear plant in 2017, coupled with higher accretion directly related to an increase in the nuclear ARO in 2017. Depreciation and Amortization decreased $914 million due primarily to • a $964 million decrease primarily due to accelerated depreciation recorded in 2017 for the early retirement of the Hudson and Mercer units, • partially offset by a $23 million increase due to Keys and Sewaren 7 fossil stations being placed into service, • an increase of $12 million in depreciation due to the increase in the nuclear ARO in late 2017, and • a $7 million increase in 2018 due primarily to a higher nuclear asset base from increased capitalized asset retirement costs. Net Gains (Losses) on Trust Investments decreased $265 million due primarily to • the inclusion in 2018 of $209 million of net unrealized losses on equity investments in the NDT Fund in accordance with new accounting guidance, and • a $64 million decrease in net realized gains on NDT Fund investments, • partially offset by a $12 million decrease in other-than-temporary impairments of equity securities in the NDT Fund. Non-Operating Pension and OPEB Credits (Costs) reflect an increase in credits of $7 million due primarily to an increase in the expected return on pension plan assets. Interest Expense increased $26 million due primarily to a $15 million increase due to a June 2018 debt issuance and $11 million in lower capitalized interest as a result of Keys and Sewaren 7 fossil stations being placed into service. Income Tax Expense increased $795 million due primarily to a one-time benefit recorded in 2017 as a result of the remeasurement of deferred tax balances and higher pre-tax income in 2018. This increase was partially offset by the favorable impacts in 2018 of a decrease in the federal statutory income tax rate from 35% in 2017 to 21% and the remeasurement of the reserve for uncertain tax positions in connection with a 2015 claim to carry back tax-defined nuclear decommissioning costs and the 2011 and 2012 federal tax audit. Year Ended December 31, 2017 as compared to 2016 Operating Revenues decreased $1 million due to changes in generation, gas supply and other operating revenues. Generation Revenues decreased $112 million due primarily to • a decrease of $100 million in electricity sold under our BGS contracts due primarily to lower volumes coupled with lower prices, • a decrease of $41 million in energy sales in the PJM and NE regions due primarily to lower average realized prices, • a decrease of $24 million in revenue expected to be returned to ratepayers associated with excess federal income tax previously collected by Power’s subsidiary, PSEG New Haven LLC, due to the change in federal tax rates effective January 1, 2018, • a decrease of $12 million in operating reserves in the PJM region, • a charge of $10 million due to an increase in the FERC accrual related to the PJM bidding matter, • a decrease of $7 million due to higher MTM losses in 2017 as compared to 2016. Of this amount, $120 million was due to increased forward prices, partially offset by a decrease of $113 million due to lower gains on positions reclassified to realized upon settlement in 2017 as compared to 2016, • partially offset by a net increase of $53 million due primarily to higher volumes of electricity sold under wholesale load contracts in the PJM and NE regions, • a net increase of $18 million in capacity revenues in the PJM and NE regions due to increases in cleared capacity and capacity auction prices, and • an increase of $11 million due to higher sales related to new solar projects. Gas Supply Revenues increased $110 million due primarily to • an increase of $67 million in sales under the BGSS contract, of which $40 million was due to higher average sales prices coupled with a $27 million increase in sales volumes due to periods of colder weather in the heating season, • a net increase of $24 million due to higher MTM gains in 2017 as compared to 2016, and • an increase of $19 million related to sales to third parties, of which $48 million was due to higher average sales prices, partially offset by $29 million of lower volumes sold. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet Power’s obligation under its BGSS contract with PSE&G. Energy Costs increased $89 million due to Gas costs increased $66 million due to • an increase of $50 million related to sales under the BGSS contract, of which $31 million was due to higher average gas costs, coupled with a $19 million increase in volumes sold due to periods of colder weather in the heating season, and • an increase of $16 million related to sales to third parties, of which $44 million was due to higher average gas costs, partially offset by a $28 million decrease in volumes sold. Generation costs increased $23 million due primarily to • higher fuel costs of $31 million reflecting higher average realized prices for natural gas coupled with the utilization of higher volumes of coal, partially offset by the utilization of lower volumes of gas, • an increase of $17 million due to MTM losses in 2017 as compared to MTM gains in 2016, • a net increase of $17 million primarily due to an increase in the volume of energy purchases in the NE region to serve load obligations, and • a net increase of $10 million primarily due to higher transmission charges resulting from higher rates, • partially offset by a net decrease of $50 million due to charges associated with the announced early retirement of the Mercer and Hudson units in 2016, primarily related to lower coal inventory write-downs in 2017, partially offset by additional retirement costs incurred in 2017. Operation and Maintenance decreased $93 million due to • a $72 million decrease at our fossil plants, due primarily to the retirement of the Hudson and Mercer units and higher planned outage costs in 2016, and • a $35 million net decrease at our nuclear facilities primarily due to lower planned outage costs at our 57%-owned Salem nuclear plants in 2017 as compared to our 100%-owned Hope Creek nuclear plant and Salem Unit 1 nuclear plant in 2016, • partially offset by a $5 million increase of costs related to new solar plants placed into service in 2017. Depreciation and Amortization increased $387 million due primarily to • $346 million of higher depreciation for Hudson and Mercer, primarily due to the accelerated expense related to the early retirement of those units, • a $15 million increase due to the accelerated retirement date for the Bridgeport Harbor unit 3, • an $11 million increase due primarily to a higher nuclear asset base, and • $11 million of higher depreciation due to new solar projects. Net Gains (Losses) on Trust Investments increased $131 million due primarily to a $113 million increase in net realized gains on NDT Fund investments and lower other-than-temporary impairments of equity securities of $16 million in the NDT Fund. Non-Operating Pension and OPEB Credits (Costs) reflect an increase in credits of $12 million due primarily to a decrease in the amortization of the net unrecognized actuarial pension loss. Interest Expense decreased $34 million due primarily to • a $24 million decrease due to higher interest capitalized for the construction of three new fossil stations: BH5, Sewaren 7 and Keys, and • a net $7 million decrease due to debt maturities in September 2016, partially offset by a debt issuance in June 2016. Income Tax Expense decreased $668 million due primarily to the one-time benefit recorded as a result of the remeasurement of deferred tax balances required due to the enactment of the Tax Act in December 2017. LIQUIDITY AND CAPITAL RESOURCES The following discussion of our liquidity and capital resources is on a consolidated basis, noting the uses and contributions, where material, of our two direct major operating subsidiaries. Financing Methodology We expect our capital requirements to be met through internally generated cash flows and external financings, consisting of short-term debt for working capital needs and long-term debt for capital investments. PSE&G’s sources of external liquidity include a $600 million multi-year revolving credit facility. PSE&G uses internally generated cash flow and its commercial paper program to meet seasonal, intra-month and temporary working capital needs. PSE&G does not engage in any intercompany borrowing or lending arrangements. PSE&G maintains back-up facilities in an amount sufficient to cover the commercial paper and letters of credit outstanding. PSE&G’s dividend payments to/capital contributions from PSEG are consistent with its capital structure objectives which have been established to maintain investment grade credit ratings. PSE&G’s long-term financing plan is designed to replace maturities, fund a portion of its capital program and manage short-term debt balances. Generally, PSE&G uses either secured medium-term notes or first mortgage bonds to raise long-term capital. PSEG, Power, Energy Holdings, PSEG LI and Services participate in a corporate money pool, an aggregation of daily cash balances designed to efficiently manage their respective short-term liquidity needs. Servco does not participate in the corporate money pool. Servco’s short-term liquidity needs are met through an account funded and owned by LIPA. PSEG’s sources of external liquidity may include the issuance of long-term debt securities and the incurrence of additional indebtedness under credit facilities. Our current sources of external liquidity include multi-year revolving credit facilities totaling $1.5 billion. These facilities are available to back-stop PSEG’s commercial paper program, issue letters of credit and for general corporate purposes. These facilities may also be used to provide support to PSEG’s subsidiaries. PSEG’s credit facilities and the commercial paper program are available to support PSEG working capital needs or to temporarily fund growth opportunities in advance of obtaining permanent financing. PSEG also has $1.1 billion of term loan credit agreements, of which $350 million is scheduled to expire in June 2019 and $700 million in November 2020. From time to time, PSEG may make equity contributions or provide credit support to its subsidiaries. Power’s sources of external liquidity include $2.1 billion of multi-year revolving credit facilities. Additionally, from time to time, Power maintains bilateral credit agreements designed to enhance its liquidity position. Credit capacity is primarily used to provide collateral in support of Power’s forward energy sale and forward fuel purchase contracts as the market prices for energy and fuel fluctuate, and to meet potential collateral postings in the event that Power is downgraded to below investment grade by Standard & Poor’s (S&P) or Moody’s. Power’s dividend payments to PSEG are also designed to be consistent with its capital structure objectives which have been established to maintain investment grade credit ratings and provide sufficient financial flexibility. Generally, Power issues senior unsecured debt to raise long-term capital. Operating Cash Flows We expect our operating cash flows combined with cash on hand and financing activities to be sufficient to fund capital expenditures and shareholder dividend payments. For the year ended December 31, 2018, our operating cash flow decreased by $347 million. For the year ended December 31, 2017, our operating cash flow decreased by $53 million. The net changes were primarily due to net changes from our subsidiaries as discussed below and net tax payments at Energy Holdings in 2018 as compared to tax refunds in 2017. PSE&G PSE&G’s operating cash flow increased $15 million from $1,838 million to $1,853 million for the year ended December 31, 2018, as compared to 2017, due primarily to an increase of $171 million relating to accounts receivable and unbilled revenues resulting from higher collections and lower prices and volumes in 2018 and higher earnings, offset by tax payments in 2018 as compared to tax refunds in 2017. PSE&G’s operating cash flow decreased $58 million from $1,896 million to $1,838 million for the year ended December 31, 2017, as compared to 2016, due primarily to lower tax refunds and a decrease of $50 million related to a change in regulatory deferrals. These amounts were partially offset by higher earnings and $30 million in decreased vendor payments. Power Power’s operating cash flow decreased $242 million from $1,326 million to $1,084 million for the year ended December 31, 2018, as compared to 2017, due to an increase in margin deposit requirements of $157 million, lower earnings, a decrease in fuels, materials and supplies of $81 million and an increase of $52 million in payments to counterparties, offset by tax refunds in 2018 as compared to tax payments in 2017, and a $96 million increase from net collections of counterparty receivables. Power’s operating cash flow increased $71 million from $1,255 million to $1,326 million for the year ended December 31, 2017, as compared to 2016, primarily resulting from a decrease of $61 million in payments to counterparties, a $26 million increase from higher net collections of counterparty receivables, and higher earnings. These amounts were partially offset by higher tax payments and an increase in margin deposit requirements of $14 million. Short-Term Liquidity PSEG meets its short-term liquidity requirements, as well as those of Power, primarily with cash and through the issuance of commercial paper. PSE&G maintains its own separate commercial paper program to meet its short-term liquidity requirements. Each commercial paper program is fully back-stopped by its own separate credit facilities. We continually monitor our liquidity and seek to add capacity as needed to meet our liquidity requirements. Each of our credit facilities is restricted as to availability and use to the specific companies as listed below; however, if necessary, the PSEG facilities can also be used to support our subsidiaries’ liquidity needs. Our total credit facilities and available liquidity as of December 31, 2018 were as follows: As of December 31, 2018, our credit facility capacity was in excess of our projected maximum liquidity requirements over our 12 month planning horizon. Our maximum liquidity requirements are based on stress scenarios that incorporate changes in commodity prices and the potential impact of Power losing its investment grade credit rating from S&P or Moody’s, which would represent a three level downgrade from its current S&P or Moody’s ratings. In the event of a deterioration of Power’s credit rating, certain of Power’s agreements allow the counterparty to demand further performance assurance. The potential additional collateral that we would be required to post under these agreements if Power were to lose its investment grade credit rating was approximately $857 million and $848 million as of December 31, 2018 and 2017, respectively. For additional information, see Item 8. Note 15. Debt and Credit Facilities. Long-Term Debt Financing During the next twelve months, PSEG has a $350 million floating rate term loan maturing in June 2019 and $400 million of 1.60% Senior Notes maturing in November 2019. PSE&G has $250 million of 1.80% Medium Term Notes maturing in June 2019 and $250 million of 2.00% Medium Term Notes maturing in August 2019. Power has a letter of credit backing $44 million of Pennsylvania Economic Development Financing Authority Variable Rate Demand Bonds which expires in November 2019. For a discussion of our long-term debt transactions during 2018, see Item 8. Note 15. Debt and Credit Facilities. Debt Covenants Our credit agreements contain maximum debt to equity ratios and other restrictive covenants and conditions to borrowing. We are currently in compliance with all of our debt covenants. Continued compliance with applicable financial covenants will depend upon our future financial position, level of earnings and cash flows, as to which no assurances can be given. In addition, under its First and Refunding Mortgage (Mortgage), PSE&G may issue new First and Refunding Mortgage Bonds against previous additions and improvements, provided that its ratio of earnings to fixed charges calculated in accordance with its Mortgage is at least 2 to 1, and/or against retired Mortgage Bonds. As of December 31, 2018, PSE&G’s Mortgage coverage ratio was 3.8 to 1 and the Mortgage would permit up to approximately $6.3 billion aggregate principal amount of new Mortgage Bonds to be issued against additions and improvements to its property. Default Provisions Our bank credit agreements and indentures contain various, customary default provisions that could result in the potential acceleration of indebtedness under the defaulting company’s agreement. In particular, PSEG’s bank credit agreements contain provisions under which certain events, including an acceleration of material indebtedness under PSE&G’s and Power’s respective financing agreements, a failure by PSE&G or Power to satisfy certain final judgments and certain bankruptcy events by PSE&G or Power, that would constitute an event of default under the PSEG bank credit agreements. Under the PSEG bank credit agreements, it would also be an event of default if either PSE&G or Power ceases to be wholly owned by PSEG. The PSE&G and Power bank credit agreements include similar default provisions; however, such provisions only relate to the respective borrower under such agreement and its subsidiaries and do not contain cross default provisions to each other. The PSE&G and Power bank credit agreements do not include cross default provisions relating to PSEG. Power’s bank credit agreements and outstanding notes also contain limitations on the incurrence of subsidiary debt and liens and certain of Power’s outstanding notes require Power to repurchase such notes upon certain change of control events. There are no cross acceleration provisions in PSEG’s or PSE&G’s indentures. However, PSEG’s existing notes include a cross acceleration provision that may be triggered upon the acceleration of more than $75 million of indebtedness incurred by PSEG. Such provision does not extend to an acceleration of indebtedness by any of PSEG’s subsidiaries. Power’s indenture includes a cross acceleration provision similar to that described above for PSEG’s existing notes except that such provision may be triggered upon the acceleration of more than $50 million of indebtedness incurred by Power or any of its subsidiaries. Such provision does not cross accelerate to PSEG, any of PSEG’s subsidiaries (other than Power and its subsidiaries), PSE&G or any of PSE&G’s subsidiaries. Ratings Triggers Our debt indentures and credit agreements do not contain any material “ratings triggers” that would cause an acceleration of the required interest and principal payments in the event of a ratings downgrade. However, in the event of a downgrade, any one or more of the affected companies may be subject to increased interest costs on certain bank debt and certain collateral requirements. In the event that we are not able to affirm representations and warranties on credit agreements, lenders would not be required to make loans. In accordance with BPU requirements under the BGS contracts, PSE&G is required to maintain an investment grade credit rating. If PSE&G were to lose its investment grade rating, it would be required to file a plan to assure continued payment for the BGS requirements of its customers. Fluctuations in commodity prices or a deterioration of Power’s credit rating to below investment grade could increase Power’s required margin postings under various agreements entered into in the normal course of business. Power believes it has sufficient liquidity to meet the required posting of collateral which would likely result from a credit rating downgrade to below investment grade by S&P or Moody’s at today’s market prices. Common Stock Dividends On February 19, 2019, our Board of Directors approved a $0.47 per share common stock dividend for the first quarter of 2019. This reflects an indicative annual dividend rate of $1.88 per share. We expect to continue to pay cash dividends on our common stock; however, the declaration and payment of future dividends to holders of our common stock will be at the discretion of the Board of Directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our businesses, alternate investment opportunities, legal requirements, regulatory constraints, industry practice and other factors that the Board of Directors deems relevant. For additional information related to cash dividends on our common stock, see Item 8. Note 23. Earnings Per Share (EPS) and Dividends. Credit Ratings If the rating agencies lower or withdraw our credit ratings, such revisions may adversely affect the market price of our securities and serve to materially increase our cost of capital and limit access to capital. Credit Ratings shown are for securities that we typically issue. Outlooks are shown for Corporate Credit Ratings (S&P) and Issuer Credit Ratings (Moody’s) and can be Stable, Negative, or Positive. There is no assurance that the ratings will continue for any given period of time or that they will not be revised by the rating agencies, if in their respective judgments, circumstances warrant. Each rating given by an agency should be evaluated independently of the other agencies’ ratings. The ratings should not be construed as an indication to buy, hold or sell any security. (A) Moody’s ratings range from Aaa (highest) to C (lowest) for long-term securities and P1 (highest) to NP (lowest) for short-term securities. (B) S&P ratings range from AAA (highest) to D (lowest) for long-term securities and A1 (highest) to D (lowest) for short-term securities. Other Comprehensive Income For the year ended December 31, 2018, we had Other Comprehensive Income of $28 million on a consolidated basis. Other Comprehensive Income was due primarily to an increase of $46 million related to pension and other postretirement benefits, partially offset by $17 million of net unrealized losses related to Available-for-Sale Securities and $1 million of unrealized losses on derivative contracts accounted for as hedges. See Item 8. Note 22. Accumulated Other Comprehensive Income (Loss), Net of Tax for additional information. CAPITAL REQUIREMENTS We expect that all of our capital requirements over the next three years will come from a combination of internally generated funds and external debt financing. Projected capital construction and investment expenditures, excluding nuclear fuel purchases, for the next three years are presented in the table below. These projections include AFUDC and Interest Capitalized During Construction for PSE&G and Power, respectively. These amounts are subject to change, based on various factors. Amounts shown below for GSMP and Solar/Energy Efficiency programs are for currently approved programs. We intend to continue to invest in infrastructure modernization and will seek to extend these and related programs as appropriate. We will also continue to approach potential growth investments for Power opportunistically, seeking projects that will provide attractive risk-adjusted returns for our shareholders. PSE&G PSE&G’s projections for future capital expenditures include material additions and replacements to its T&D systems to meet expected growth and to manage reliability. As project scope and cost estimates develop, PSE&G will modify its current projections to include these required investments. PSE&G’s projected expenditures for the various items reported above are primarily comprised of the following: • Transmission-investments focused on reliability improvements and replacement of aging infrastructure. • Distribution-investments for new business, reliability improvements, modernization and replacement of equipment that has reached the end of its useful life. • Gas System Modernization Program-Gas Distribution investment program to replace aging infrastructure. • Solar/Energy Efficiency-investments associated with grid-connected solar, solar loan programs and customer energy efficiency programs. In June 2018, we filed for our ES II, a proposed five-year $2.5 billion program to harden, modernize and make our electric and gas distribution systems more resilient. The size and duration of ES II, as well as certain other elements of the program, are subject to BPU approval. In October 2018, we filed our proposed CEF program with the BPU, a six-year estimated $3.6 billion investment program focused on achieving New Jersey’s energy efficiency targets, supporting electric vehicle infrastructure, deploying energy storage, and implementing an EC program which will include installing approximately two million electric smart meters and associated infrastructure. The size and duration of the CEF program, as well as certain other elements of the program, are subject to BPU approval. ES II and the CEF program are not included in PSE&G’s projected capital expenditures in the above table. In 2018, PSE&G made $2,901 million of capital expenditures, primarily for T&D system reliability. This does not include expenditures for cost of removal, net of salvage, of $160 million, which are included in operating cash flows. Power Power’s projected expenditures for the various items listed above are primarily comprised of the following: • Baseline-investments to replace major parts and enhance operational performance. • Growth Opportunities-investments associated with new construction, including BH5, and with upgrades to increase efficiency and output at combined cycle plants. • Other-includes investments made in response to environmental, regulatory and legal mandates and other capital projects. In 2018, Power made $815 million of capital expenditures, excluding $181 million for nuclear fuel, primarily related to various projects at Fossil and Nuclear. Disclosures about Contractual Obligations The following table reflects our contractual cash obligations in the respective periods in which they are due. In addition, the table summarizes anticipated debt maturities for the years shown. For additional information, see Item 8. Note 15. Debt and Credit Facilities. The table below does not reflect any anticipated cash payments for pension obligations due to uncertain timing of payments or liabilities for uncertain tax positions since we are unable to reasonably estimate the timing of liability payments in individual years beyond 12 months due to uncertainties in the timing of the effective settlement of tax positions. See Item 8. Note 21. Income Taxes for additional information. OFF-BALANCE SHEET ARRANGEMENTS PSEG and Power issue guarantees, primarily in conjunction with certain of Power’s energy contracts. See Item 8. Note 14. Commitments and Contingent Liabilities for further discussion. Through Energy Holdings, we have investments in leveraged leases that are accounted for in accordance with GAAP Accounting for Leases. Leveraged lease investments generally involve three parties: an owner/lessor, a creditor and a lessee. In a typical leveraged lease arrangement, the lessor purchases an asset to be leased. The purchase price is typically financed 80% with debt provided by the creditor and the balance comes from equity funds provided by the lessor. The creditor provides long-term financing to the transaction secured by the property subject to the lease. Such long-term financing is non-recourse to the lessor and is not presented on our Consolidated Balance Sheets. In the event of default, the leased asset, and in some cases the lessee, secures the loan. As a lessor, Energy Holdings has ownership rights to the property and rents the property to the lessees for use in their business operations. For additional information, see Item 8. Note 8. Long-Term Investments and Note 9. Financing Receivables. In the event that collection of the minimum lease payments to be received by Energy Holdings is no longer reasonably assured, Energy Holdings may deem that a lessee has a high probability of defaulting on the lease obligation and would consider the need to record an impairment of its investment. In the event the lease is ultimately rejected by the lessee in a Bankruptcy Court proceeding, the fair value of the underlying asset and the associated debt would be recorded on the Consolidated Balance Sheets instead of the net equity investment in the lease. CRITICAL ACCOUNTING ESTIMATES Under accounting principles generally accepted in the United States (GAAP), many accounting standards require the use of estimates, variable inputs and assumptions (collectively referred to as estimates) that are subjective in nature. Because of this, differences between the actual measure realized versus the estimate can have a material impact on results of operations, financial position and cash flows. We have determined that the following estimates are considered critical to the application of rules that relate to the respective businesses. Accounting for Pensions PSEG sponsors qualified and nonqualified pension plans covering PSEG’s and its participating affiliates’ current and former employees who meet certain eligibility criteria. The market-related value of plan assets held for the qualified pension plan is equal to the fair value of these assets as of year-end. The plan assets are comprised of investments in both debt and equity securities which are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. We calculate pension costs using various economic and demographic assumptions. Assumptions and Approach Used: Economic assumptions include the discount rate and the long-term rate of return on trust assets. Demographic assumptions include projections of future mortality rates, pay increases and retirement patterns. The discount rate used to calculate pension obligations is determined as of December 31 each year, our measurement date. The discount rate is determined by developing a spot rate curve based on the yield to maturity of a universe of high quality corporate bonds with similar maturities to the plan obligations. The spot rates are used to discount the estimated plan distributions. The discount rate is the single equivalent rate that produces the same result as the full spot rate curve. Our expected rate of return on plan assets reflects current asset allocations, historical long-term investment performance and an estimate of future long-term returns by asset class, long-term inflation assumptions and a premium for active management. Based on the above assumptions, we have estimated a net periodic pension expense in 2019 of approximately $49 million, or $11 million, net of amounts capitalized. We utilize a corridor approach that reduces the volatility of reported pension expense/income. The corridor requires differences between actuarial assumptions and plan results be deferred and amortized as part of expense/income. This occurs only when the accumulated differences exceed 10% of the greater of the pension benefit obligation or the fair value of plan assets as of each year-end. The excess would be amortized over the average remaining service period of the active employees, which is approximately fourteen years. Effect if Different Assumptions Used: As part of the business planning process, we have modeled future costs assuming a 7.80% expected rate of return and a 4.41% discount rate for 2019 expense. Actual future pension expense/income and funding levels will depend on future investment performance, changes in discount rates, market conditions, funding levels relative to our projected benefit obligation and accumulated benefit obligation and various other factors related to the populations participating in the pension plans. The following chart reflects the sensitivities associated with a change in certain assumptions. The effects of the assumption changes shown below solely reflect the impact of that specific assumption. See

<s>[INST] PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: PSE&Gwhich is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in regulated solar generation projects and energy efficiency and related programs in New Jersey, which are regulated by the BPU, and Powerwhich is a multiregional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses and fuel supply functions through competitive energy sales in welldeveloped energy markets primarily in the Northeast and MidAtlantic United States through its principal direct wholly owned subsidiaries. In addition, Power owns and operates solar generation in various states. Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission (NRC), the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries are: PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement; PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2018 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. EXECUTIVE OVERVIEW OF 2018 AND FUTURE OUTLOOK Our business plan is designed to achieve growth while managing the risks associated with fluctuating commodity prices and changes in customer demand. PSE&G At PSE&G, our focus is on enhancing system reliability and resiliency, meeting customer expectations and supporting public policy objectives by investing capital in T&D infrastructure and clean energy projects. Over the past few years, our investments have altered our business mix to reflect a higher percentage of earnings contribution by PSE&G. Over the next five years, we expect to invest between $11 billion and $16 billion in our business which is expected to provide an annual rate base growth of 7%9%. We completed our Energy Strong Program I (ES I) and essentially completed our Gas System Modernization Program I (GSMP I). See Item 1. BusinessBusiness Operations and StrategyPSE&G for a description of these programs. In May 2018, we received approval for our Gas System Modernization Program II (GSMP II), an expanded, fiveyear program to invest $1.9 billion beginning in 2019 to replace approximately 875 miles of cast iron and unprotected steel mains in addition to other improvements to the gas system. Approximately $1.6 billion will be recovered through periodic rate rollins, with the remaining $300 million to be recovered through a future base rate proceeding. As part of the settlement, PSE&G agreed to file a base rate proceeding no later than five years from the commencement of the program, to maintain a base level of gas distribution capital expenditures of $155 million per year and to achieve certain leak reduction targets. In June 2018, we filed for our Energy Strong Program II (ES II), a proposed fiveyear $2.5 billion program to harden, modernize and make our electric and gas distribution systems more resilient. [/INST] Positive. </s>

PUBLIC SERVICE ENTERPRISE GROUP INC

2020-02-26

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) This combined MD&A is separately filed by Public Service Enterprise Group Incorporated (PSEG), Public Service Electric and Gas Company (PSE&G) and PSEG Power LLC (PSEG Power). Information contained herein relating to any individual company is filed by such company on its own behalf. PSE&G and PSEG Power each make representations only as to itself and make no representations whatsoever as to any other company. PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: • PSE&G-which is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in regulated solar generation projects and energy efficiency and related programs in New Jersey, which are regulated by the BPU, and • PSEG Power-which is a multi-regional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses and fuel supply functions through competitive energy sales in well-developed energy markets primarily in the Northeast and Mid-Atlantic United States through its principal direct wholly owned subsidiaries. In addition, PSEG Power owns and operates solar generation in various states. PSEG Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission, the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries are: PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement; PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2019 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. For a discussion of 2017 items and year-over-year comparisons of changes in our financial condition and results of operations as of and for the years ended December 31, 2018 and December 31, 2017, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2018 (2018 Annual Report) as filed with the Securities and Exchange Commission on February 27, 2019. EXECUTIVE OVERVIEW OF 2019 AND FUTURE OUTLOOK Our business plan is designed to achieve growth while managing the risks associated with regulatory changes, fluctuating commodity prices and changes in customer demand. Over the past few years, our investments have altered our business mix to reflect a higher percentage of earnings contribution by PSE&G. PSE&G At PSE&G, our focus is on enhancing reliability and resiliency of our T&D system, meeting customer expectations and supporting public policy objectives by investing capital in T&D infrastructure and clean energy programs. For the five-year period ending December 31, 2024, PSE&G expects to invest between $11.5 billion to $15 billion, resulting in an expected compound annual rate base growth of 6.5% to 8%. These ranges are driven by certain unapproved investment programs, including the Clean Energy Future (CEF) and incremental reliability and resiliency investments anticipated in the 2024 timeframe that we intend to seek approval for under the third phase of existing infrastructure programs. See below for a description of the CEF program. In 2019, we commenced our BPU-approved Gas System Modernization Program II (GSMP II), an expanded, five-year program to invest $1.9 billion beginning in 2019 to replace approximately 875 miles of cast iron and unprotected steel mains in addition to other improvements to the gas system. Approximately $1.6 billion will be recovered through periodic rate roll-ins, with the remaining $300 million to be recovered through a future base rate proceeding. As part of the settlement approved by the BPU, PSE&G agreed to file a base rate proceeding no later than December 2023, to maintain a base level of gas distribution capital expenditures of $155 million per year and to achieve certain leak reduction targets. Also in 2019, the BPU approved our Energy Strong II Program, an $842 million program to harden, modernize and improve the resiliency of our electric and gas distribution systems. This program began in the fourth quarter of 2019 and is expected to be completed by the end of 2023. Approximately $692 million of the program will be recovered through periodic rate recovery filings, with the balance to be recovered in our next distribution base rate case, which is required to be filed no later than December 2023. In October 2018, we filed our proposed CEF program with the BPU, a six-year estimated $3.5 billion investment covering four programs; (i) an Energy Efficiency (EE) program totaling $2.5 billion of investment designed to achieve energy efficiency targets required under New Jersey’s Clean Energy law; (ii) an Electric Vehicle (EV) infrastructure program; (iii) an Energy Storage (ES) program and (iv) an Energy Cloud (EC) program which will include installing approximately two million electric smart meters and associated infrastructure. The BPU is reviewing the CEF-EE program concurrently with its efforts to complete a stakeholder process to define key terms and policy parameters regarding returns, amortization and lost revenue recovery related to implementing energy efficiency programs statewide. Additionally, the State released its Energy Master Plan in January 2020, which is supportive of energy efficiency but gives the BPU discretion in implementation between state-and utility-operated programs. In February 2020, PSE&G reached an agreement with parties in the CEF-EE matter which was approved by the BPU to (a) extend several existing EE programs for six months, with an additional $111 million investment over the course of the programs, and (b) extend the timeline for review of the CEF-EE filing through September 2020. In addition, the BPU has circulated to the parties procedural schedules for the proposed $1 billion investment in CEF-EC, CEF-EV and CEF-ES programs. We also continue to invest in transmission infrastructure in order to (i) maintain and enhance system integrity and grid reliability, grid security and safety, (ii) address an aging transmission infrastructure, (iii) leverage technology to improve the operation of the system, (iv) reduce transmission constraints, (v) meet growing demand and (vi) meet environmental requirements and standards set by various regulatory bodies. Our planned capital spending for transmission in 2020-2022 is $2.8 billion. PSEG Power At PSEG Power, we strive to improve performance and reduce costs in order to optimize cash flow generation from our fleet in light of low wholesale power and gas prices, environmental considerations and competitive market forces that reward efficiency and reliability. PSEG Power continues to move its fleet toward improved efficiency and believes that its recently completed investment program enhances its competitive position with the addition of efficient, clean, reliable combined cycle gas turbine capacity. In 2019, our natural gas fleet generated 23 terawatt hours and our nuclear fleet achieved a capacity factor of 88.7%. Our commitments for load, such as basic generation service (BGS) in New Jersey and other bilateral supply contracts, are backed by this generation or may be combined with the use of physical commodity purchases and financial instruments from the market to optimize the economic efficiency of serving our obligations. PSEG Power’s hedging practices and ability to capitalize on market opportunities help it to balance some of the volatility of the merchant power business. More than 70% of PSEG Power’s expected gross margin in 2020 relates to hedging of our energy margin, our expected revenues from the capacity market mechanisms, Zero Emission Certificate (ZEC) revenues that commenced in April 2019 and certain ancillary service payments such as reactive power. PSEG Power completed its 1,800 MW combined cycle gas turbine construction program with the addition of the Keys Energy Center (Keys) in Maryland and Sewaren 7 in New Jersey in 2018 and Bridgeport Harbor Station Unit 5 (BH5) in Connecticut in 2019. These additions to our fleet both expand our geographic diversity and adjust our fuel mix and enhance the environmental profile and overall efficiency of PSEG Power’s generation fleet. Operational Excellence We emphasize operational performance while developing opportunities in both our competitive and regulated businesses. Flexibility in our generating fleet has allowed us to take advantage of opportunities in a rapidly evolving market as we remain diligent in managing costs. In 2019, our • utility continued its efforts to control costs while maintaining strong operational performance, including being recognized by PA Consulting as the most reliable electric utility in the Mid-Atlantic region for the 18th consecutive year, and • our efficient combined cycle gas units benefited our capacity factor across the natural gas fleet and were readily available to operate when needed, all while diligently adhering to our cost control programs. Financial Strength Our financial strength is predicated on a solid balance sheet, positive operating cash flow and reasonable risk-adjusted returns on increased investment. Our financial position remained strong during 2019 as we • maintained sufficient liquidity, • maintained solid investment grade credit ratings, and • increased our annual dividend for 2019 to $1.88 per share. We expect to be able to fund our planned capital requirements, as described in Liquidity and Capital Resources, and the impacts of the Tax Cuts and Jobs Act of 2017 (Tax Act) without the issuance of new equity. For additional information on the impacts of the Tax Act, see Item 8. Note 7. Regulatory Assets and Liabilities and Note 22. Income Taxes. Financial Results As a result of the settlement of PSE&G’s distribution base rate proceeding in 2018, PSE&G’s overall 2019 annual revenues were reduced by approximately $13 million, comprised of a $212 million increase in base revenues, including recovery of deferred storm costs, offset by the return of tax benefits of approximately $225 million. The tax benefits include the flowback to customers in 2019 of excess accumulated deferred income taxes resulting from the reduction of the federal income tax rates provided in the Tax Act as well as the flowback of accumulated deferred income taxes from previously realized tax repair deductions and tax benefits from future tax repair deductions as realized. PSE&G also filed a revised 2019 Transmission Formula Rate Annual Update to include the refund of the approved excess deferred income tax benefits. The revised 2019 Annual Transmission Formula Rate, as filed with FERC in January 2019, decreased overall annual transmission revenues by approximately $54 million, and was offset by estimated true-up adjustments, resulting in a net decrease in 2019 transmission revenues of $19 million. PSE&G will file a final true-up to the 2019 Annual Transmission Formula Rate Update in the second quarter of 2020. The financial results for PSEG, PSE&G and PSEG Power for the years ended December 31, 2019 and 2018 are presented as follows: Our 2019 over 2018 increase in Net Income was due primarily to higher earnings from distribution rate relief and transmission and distribution investments at PSE&G, MTM and Nuclear Decommissioning Trust (NDT) Fund gains in 2019 as compared to losses in the prior year and ZEC revenues in 2019 at PSEG Power, and pension credits resulting from retiree medical plan benefit changes in 2019. These increases were partially offset by a loss on the sale in 2019 of PSEG Power’s ownership interests in two fossil plants. For a more detailed discussion of our financial results, see Results of Operations. The greater emphasis on capital spending in recent years for projects on which we receive contemporaneous returns at PSE&G has yielded strong results, which when combined with the cash flow generated by PSEG Power, has allowed us to meet customer needs, address market conditions and investor expectations, reflecting our long-term approach to managing our company. We continue our focus on operational excellence, financial strength and disciplined investment. These guiding principles have provided the base from which we have been able to execute our strategic initiatives. Disciplined Investment We utilize rigorous criteria when deploying capital and seek to invest in areas that complement our existing business and provide reasonable risk-adjusted returns. These areas include upgrading our energy infrastructure and improving our environmental footprint to align with public policy objectives. In 2019, we • made additional investments in T&D infrastructure projects on time and on budget, • continued to execute our Energy Efficiency and other existing BPU-approved utility programs, and • completed construction and placed into service our BH5 generation project, the final stage of our investment program in combined cycle gas turbines. Regulatory, Legislative and Other Developments In our pursuit of operational excellence, financial strength and disciplined investment, we closely monitor and engage with stakeholders on significant regulatory and legislative developments. Transmission planning rules and wholesale power market design are of particular importance to our results and we continue to advocate for policies and rules that promote fair and efficient electricity markets. For additional information about regulatory, legislative and other developments that may affect the company, see Item 1. Business-Regulatory Issues. Transmission Planning In March 2019, FERC issued a Notice of Inquiry (NOI) seeking comment on improvements to FERC’s electric transmission incentives policy to ensure that it appropriately encourages the development of the infrastructure needed to ensure grid reliability and reduce congestion to lower the cost of power for consumers. The NOI is intended to examine whether existing incentives, such as the 50 basis point adder for membership in the Regional Transmission Organization, should continue to be granted and whether new incentives should be established. In November 2019, FERC issued an order establishing a new Return on Equity (ROE) policy for reviewing existing transmission ROEs. FERC applied the methodology outlined in the new policy to two complaints filed against the Midcontinent Independent System Operator (MISO) transmission owners and found that the MISO transmission owners’ ROE was unjust and unreasonable and directed that the ROE be lowered. Other ROE complaints have been pending before FERC regarding the ISO New England Inc. Transmission Owners and utilities in other jurisdictions. In parallel to these proceedings, and in light of declining interest rates and other market conditions, over the past few years, several companies have negotiated settlements that have resulted in reduced ROEs. We continue to analyze the potential impact of these methodologies and cannot predict the outcome of ongoing ROE proceedings. An adverse change to PSE&G’s base transmission ROE or ROE incentives could be material. Wholesale Power Market Design In January 2020, New Jersey rejoined the Regional Greenhouse Gas Initiative (RGGI). As a result, generating plants operating in New Jersey, including those owned by PSEG Power, that emit carbon dioxide (CO2) emissions will be required to procure credits for each ton they emit. In response to RGGI, PJM initiated a process in 2019 to investigate the development of a carbon pricing mechanism that may mitigate the environmental and financial distortions that could occur when emissions “leak” from non-participating states to the RGGI states. If the process leads to a market solution, it could have a material impact on the value of PSEG Power’s generating fleet. In December 2019, FERC issued an order establishing new rules for PJM’s capacity market. In this new order, FERC extended the PJM Minimum Offer Price Rule (MOPR), which currently applies to new natural gas-fired generators, to include both new and existing resources that receive or are entitled to receive certain out-of-market payments, with certain exemptions. PSEG cannot at this time estimate the impact of the MOPR on resources that receive out-of-market payments or the markets generally. States that have clean energy programs designed to achieve public policy goals are not prevented from pursuing those programs by the expanded MOPR and could choose to utilize the existing Fixed Resource Requirement (FRR) approach authorized under the PJM tariff. Subsidized units that cannot clear in a Reliability Pricing Model (RPM) capacity auction because of the expanded MOPR could still count as capacity resources to a load serving entity using the FRR approach. PSEG Power’s New Jersey nuclear plants that receive ZEC payments will be subject to the new MOPR. However, the impact, if any, of the MOPR on the ability of the nuclear plants to clear in the RPM markets will depend on the level of the applicable generic offer floors as well as the offer floor levels that would be derived via a unit specific exception should one or more of the units elect that option. In addition, if one or more electric distribution zones in New Jersey (or another state) were to become FRR service areas, procurements needed for that area could provide an alternate means for nuclear units whose ability to clear in RPM auctions was affected by the MOPR to provide capacity within PJM. We cannot predict what impact those rules will have on the capacity market or our generating stations. In addition, we cannot predict whether there will be challenges to the FERC order and, if so, the impact of such challenges on the MOPR and other capacity market rules. Environmental Regulation We are subject to liability under environmental laws for the costs of remediating environmental contamination of property now or formerly owned by us and of property contaminated by hazardous substances that we generated. In particular, the historic operations of PSEG companies and the operations of numerous other companies along the Passaic and Hackensack Rivers are alleged by Federal and State agencies to have discharged substantial contamination into the Passaic River/Newark Bay Complex in violation of various statutes. We are also currently involved in a number of proceedings relating to sites where other hazardous substances may have been discharged and may be subject to additional proceedings in the future, and the costs of any such remediation efforts could be material. For further information regarding the matters described above, as well as other matters that may impact our financial condition and results of operations, see Item 8. Note 15. Commitments and Contingent Liabilities. Nuclear In April 2019, PSEG Power’s Salem 1, Salem 2 and Hope Creek nuclear plants were awarded ZECs by the BPU. Pursuant to a process established by the BPU, ZECs are purchased from selected nuclear plants and recovered through a non-bypassable distribution charge in the amount of $0.004 per kilowatt-hour used (which is equivalent to approximately $10 per megawatt hour generated in payments to selected nuclear plants (ZEC payment)). These nuclear plants are expected to receive ZEC revenue for approximately three years, through May 2022, and will be obligated to maintain operations during that period, subject to exceptions specified in the ZEC legislation. PSEG Power has and will continue to recognize revenue monthly as the nuclear plants generate electricity and satisfy their performance obligations. The ZEC legislation requires nuclear plants to reapply for any subsequent three year periods. The ZEC payment may be adjusted by the BPU (a) at any time to offset environmental or fuel diversity payments that a selected nuclear plant may receive from another source or (b) at certain times specified in the ZEC legislation if the BPU determines that the purposes of the ZEC legislation can be achieved through a reduced charge that will nonetheless be sufficient to achieve the state’s air quality and other environmental objectives by preventing the retirement of nuclear plants. The BPU’s decision awarding ZECs has been appealed by the Division of Rate Counsel. PSEG cannot predict the outcome of this matter. In the event that (i) the ZEC program is overturned or otherwise materially adversely modified through legal process, (ii) the terms and conditions of the subsequent period under the ZEC program, including the amount of ZEC payments that may be awarded, materially differ from those of the current ZEC period, or (iii) any of the Salem 1, Salem 2 and Hope Creek plants is not awarded ZEC payments by the BPU and does not otherwise experience a material financial change, PSEG Power will take all necessary steps to retire all of these plants subsequent to the initial ZEC period at or prior to a scheduled refueling outage. Alternatively, if all of the Salem 1, Salem 2 and Hope Creek plants are selected to continue to receive ZEC payments but the financial condition of the plants is materially adversely impacted by changes in commodity prices, FERC’s changes to the capacity market construct (absent sufficient capacity revenues provided under a program approved by the BPU in accordance with a FERC-authorized capacity mechanism), or, in the case of the Salem nuclear plants, decisions by the EPA and state environmental regulators regarding the implementation of Section 316(b) of the Clean Water Act and related state regulations, or other factors, PSEG Power would still take all necessary steps to retire all of these plants. Retirement of these plants would result in a material adverse impact on PSEG’s and PSEG Power’s financial results. Fossil In September 2019, PSEG Power completed the sale of its ownership interests in the Keystone and Conemaugh generation plants and related assets and liabilities. PSEG Power recorded a pre-tax loss on disposition of approximately $400 million in the second quarter of 2019 as the sale price was less than book value. PSEG Power has also announced the early retirement of its 383 MW coal unit in Bridgeport, Connecticut in 2021. Including this planned retirement in 2021, PSEG Power will have retired or exited through sales over 2,400 MW of coal-fired generation since 2017. California Solar Facilities As part of its solar production portfolio, PSEG Power owns and operates two California-based solar facilities with an aggregate capacity of approximately 30 MW direct current whose output is sold to Pacific Gas and Electric Company (PG&E) under power purchase agreements (PPAs) with twenty year terms. The net book value of these solar facilities was approximately $55 million as of December 31, 2019. In January 2019, PG&E and its parent company PG&E Corporation filed for Chapter 11 bankruptcy protection. PSEG Power cannot predict the ultimate outcome that this bankruptcy proceeding will have on our ability to collect all of the revenues from these facilities due under the PPAs; however, any adverse changes to the terms of PSEG Power’s PPAs as a result of this bankruptcy proceeding could result in the future impairment of these assets in amounts up to their current net book value. Offshore Wind In June 2019, the BPU selected Ørsted US Offshore Wind’s Ocean Wind project as the winning bid in New Jersey’s initial solicitation for 1,100 MW of offshore wind generation. In October 2019, PSEG exercised its option on Ørsted’s Ocean Wind project, resulting in a period of exclusive negotiation for PSEG to potentially acquire a 25% equity interest in the project, subject to negotiations toward a joint venture agreement, advanced due diligence and any required regulatory approvals. Leveraged Leases In December 2018, NRG REMA, LLC emerged from its in-court proceeding under Chapter 11 of the Bankruptcy Code. As a result of the restructuring, the remaining deferred tax liabilities related to the Keystone and Conemaugh lease investments were reclassified to current tax liabilities. PSEG realized the remaining tax liability related to the restructuring of approximately $85 million with the filing of the consolidated federal income tax return in December 2019. Additional facilities in our leveraged lease portfolio include the Shawville, Joliet and Powerton generating facilities. Converted natural gas units such as Shawville and Joliet may have higher operating costs and fuel consumption, as well as longer start-up times, compared to newer combined cycle gas units. Powerton is a coal-fired generating facility in Illinois. During the second quarter of 2019, Energy Holdings completed its annual review of estimated residual values embedded in the leveraged leases. The outcome indicated that the updated residual value estimate of the coal-fired Powerton lease was lower than the recorded residual value and the decline was deemed to be other than temporary as a result of expected future adverse market conditions. As a result, a pre-tax write-down of $58 million was reflected in Operating Revenues in the quarter ended June 30, 2019, calculated by comparing the gross investment in the leases before and after the revised residual estimates. Each of these three facilities may not be as economically competitive as newer combined cycle gas units and could continue to be adversely impacted by the same economic conditions experienced by other less efficient natural gas and coal generation facilities, which could require additional write-downs of the residual values of Energy Holdings’ leveraged lease receivables associated with these facilities. Tax Legislation For non-regulated businesses, the Tax Act enacted rules that set a cap on the amount of interest that can be deducted in a given year. Any amount that is disallowed can be carried forward indefinitely. For 2018 and 2019, a portion of PSEG’s and PSEG Power’s interest was disallowed but is expected to be realized in future periods. However, certain aspects of the law are unclear. Therefore, we recorded taxes in 2018 and 2019 based on our interpretation of the relevant statute. Amounts recorded under the Tax Act, such as depreciation and interest disallowance, are subject to change based on several factors, including but not limited to, the Internal Revenue Service and state taxing authorities issuing additional guidance and/or further clarification. Any further guidance or clarification could impact PSEG’s, PSE&G’s and PSEG Power’s financial statements. For additional information, see Item 8. Note 22. Income Taxes. In July 2018, the State of New Jersey made changes to its income tax laws, including imposing a temporary surtax of 2.5% effective January 1, 2018 and 2019 and 1.5% in 2020 and 2021, as well as requiring corporate taxpayers to file in a combined reporting group as defined under New Jersey law starting in 2019. Both provisions include an exemption for public utilities. We believe PSE&G meets the definition of a public utility and, therefore, will not be impacted by the temporary surtax or be included in the combined reporting group. There are certain aspects of the law that are not clear. We anticipate the State of New Jersey will be issuing clarifying guidance regarding combined reporting rules. Any further guidance or clarification could impact PSEG’s and PSEG Power’s financial statements. Future Outlook For more than a century, our mission has been to provide universal access to an around-the-clock supply of reliable, affordable power. Building on this mission, we believe in a future where customers universally use less energy, the energy they use is cleaner, and its delivery is more reliable and more resilient. In July 2019, we announced that we expect to cut carbon emissions at PSEG Power’s generation fleet by 80% by 2046, from 2005 levels. We have also announced our vision of attaining net-zero CO2 emissions by 2050, assuming advances in technology, public policy and customer behavior. Our future success will depend on our ability to continue to maintain strong operational and financial performance in an environment with low gas prices, to capitalize on or otherwise address regulatory and legislative developments that impact our business and to respond to the issues and challenges described below. In order to do this, we must continue to: • focus on controlling costs while maintaining safety, reliability and customer satisfaction and complying with applicable standards and requirements, • successfully manage our energy obligations and re-contract our open supply positions in response to changes in prices and demand, • obtain approval of and execute our utility capital investment program, including our CEF program and other investments that yield contemporaneous and reasonable risk-adjusted returns, while enhancing the resiliency of our infrastructure and maintaining the reliability of the service we provide to our customers, • advocate for the continuation of the ZEC program and measures to ensure the implementation by PJM, FERC and state regulators of market design and transmission planning rules that continue to promote fair and efficient electricity markets, including recognition of the cost of emissions, • engage multiple stakeholders, including regulators, government officials, customers and investors, and • successfully operate the LIPA T&D system and manage LIPA’s fuel supply and generation dispatch obligations. In addition to the risks described elsewhere in this Form 10-K for 2020 and beyond, the key issues and challenges we expect our business to confront include: • regulatory and political uncertainty, both with regard to future energy policy, design of energy and capacity markets, transmission policy and environmental regulation, as well as with respect to the outcome of any legal, regulatory or other proceedings, • the continuing impacts of the Tax Act and changes in state tax laws, and • the impact of reductions in demand and lower natural gas and electricity prices and increasing environmental compliance costs. We continually assess a broad range of strategic options to maximize long-term stockholder value. In assessing our options, we consider a wide variety of factors, including the performance and prospects of our businesses; the views of investors, regulators, customers and rating agencies; our existing indebtedness and restrictions it imposes; and tax considerations, among other things. Strategic options available to us include: • the acquisition, construction or disposition of T&D facilities, clean energy investments and/or generation projects, including offshore wind opportunities, • the disposition or reorganization of our merchant generation business or other existing businesses or the acquisition or development of new businesses, • the expansion of our geographic footprint, and • investments in capital improvements and additions, including the installation of environmental upgrades and retrofits, improvements to system resiliency, modernizing existing infrastructure and participation in transmission projects through FERC’s “open window” solicitation process. There can be no assurance, however, that we will successfully develop and execute any of the strategic options noted above, or any additional options we may consider in the future. The execution of any such strategic plan may not have the expected benefits or may have unexpected adverse consequences. RESULTS OF OPERATIONS (A) PSEG Power’s results in 2019 include an after-tax loss of $286 million related to the sale of PSEG Power’s ownership interests in the Keystone and Conemaugh fossil generation plants. PSEG Power’s results in 2018 include an after-tax gain of $39 million from the sale of its Hudson and Mercer coal/gas generation plants and after-tax expenses of $577 million in 2017 related to the early retirement of the Hudson and Mercer generation plants. See Item 8. Note 4. Early Plant Retirements/Asset Dispositions for additional information. (B) Results in 2017 include the non-cash net income benefit of $745 million, including $588 million related to PSEG Power and $147 million related to Energy Holdings, resulting from the remeasurement of deferred tax liabilities required due to the enactment of the Tax Act in December 2017. (C) Other includes after-tax activities at the parent company, PSEG LI and Energy Holdings as well as intercompany eliminations. Energy Holdings recorded after-tax charges totaling $32 million, $5 million and $45 million related to its investments in certain leveraged leases in 2019, 2018 and 2017, respectively. See Item 8. Note 9. Long-Term Investments and Note 10. Financing Receivables for further information. PSEG Power’s results above include the NDT Fund activity and the impacts of non-trading commodity mark-to-market (MTM) activity, which consist of the financial impact from positions with future delivery dates. The variances in our Net Income attributable to changes related to the NDT Fund and MTM are shown in the following table: (A) NDT Fund Income (Expense) includes gains and losses on NDT securities which are recorded in Net Gains (Losses) on Trust Investments. See Item 8. Note 11. Trust Investments for additional information. NDT Fund Income (Expense) also includes interest and dividend income and other costs related to the NDT Fund recorded in Other Income (Deductions), interest accretion expense on PSEG Power’s nuclear Asset Retirement Obligation (ARO) recorded in Operation & Maintenance (O&M) Expense and the depreciation related to the ARO asset recorded in Depreciation and Amortization (D&A) Expense. (B) Net of tax (expense) benefit of $(103) million, $54 million and $(72) million for the years ended December 31, 2019, 2018 and 2017, respectively. (C) Net of tax (expense) benefit of $(80) million, $33 million and $68 million for the years ended December 31, 2019, 2018 and 2017, respectively. Our 2019 $255 million year-over-year increase was driven primarily by • higher earnings due to investments in T&D programs and the favorable impact of new rates effective November 1, 2018 as a result of the BPU’s approval of our distribution base rate proceeding at PSE&G, • MTM gains in 2019 as compared to MTM losses in 2018 at PSEG Power, • net gains in 2019 as compared to losses on equity securities in the NDT Fund at PSEG Power, • the favorable impact of retiree medical plan benefit changes implemented in 2019, and • revenue from ZECs starting in mid-April 2019 at PSEG Power, • largely offset by a loss related to the sale of PSEG Power’s ownership interests in the Keystone and Conemaugh generation plants in 2019. PSEG Our results of operations are primarily comprised of the results of operations of our principal operating subsidiaries, PSE&G and PSEG Power, excluding charges related to intercompany transactions, which are eliminated in consolidation. For additional information on intercompany transactions, see Item 8. Note 26. Related-Party Transactions. The 2019, 2018 and 2017 amounts in the preceding table for Operating Revenues and O&M costs each include $490 million, $458 million and $438 million, respectively, for PSEG LI’s subsidiary, Long Island Electric Utility Servco, LLC (Servco). These amounts represent the O&M pass-through costs for the Long Island operations, the full reimbursement of which is reflected in Operating Revenues. See Item 8. Note 5. Variable Interest Entity for further explanation. The Income Tax Benefit in 2017 includes the non-cash benefit resulting from the remeasurement of deferred tax liabilities required due to the enactment of the Tax Act in December 2017. The following discussions for PSE&G and PSEG Power provide a detailed explanation of their respective variances. PSE&G Year Ended December 31, 2019 as compared to 2018 Operating Revenues increased $154 million due to changes in delivery, clause, commodity and other operating revenues. Delivery Revenues decreased $67 million. • Transmission revenues increased $97 million due to higher revenue requirements calculated through our transmission formula rate, primarily to recover required investments. • Gas distribution revenues increased $107 million due to $98 million from an increase in the distribution tariff rates effective November 1, 2018, $25 million from collection of the Gas System Modernization Program (GSMP) and GSMP II in base rates and an increase in Weather Normalization Charge (WNC) revenues of $1 million. These increases were partially offset by a $12 million decrease from lower sales volumes and $5 million in lower collections of Green Program Recovery Charges (GPRC). • Electric distribution revenues increased $67 million due primarily to $75 million from an increase in the distribution tariff rates effective November 1, 2018 and $16 million in higher collections of GPRC. These increases were partially offset by a $24 million decrease in sales volumes. • Transmission, electric distribution and gas distribution revenue requirements were $338 million lower as a result of rate reductions due to the flowback of excess deferred income tax liabilities and tax repair related accumulated deferred income taxes. This decrease is offset in Income Tax Expense. Clause Revenues decreased $2 million due to $11 million in Tax Adjustment Credits (TAC) and GPRC deferrals. These decreases were partially offset by $6 million in Margin Adjustment Clause (MAC) revenues, $2 million in higher Solar Pilot Recovery Charge (SPRC) collections and higher Societal Benefit Charges (SBC) of $1 million. The changes in TAC and GPRC Deferrals, MAC, SPRC and SBC collections were entirely offset by the amortization of related costs (Regulatory Assets) in O&M, D&A and Interest and Tax Expenses. PSE&G does not earn margin on TAC or GPRC deferrals or on MAC, SPRC or SBC collections. Commodity Revenues increased $98 million due to higher Gas revenues partially offset by lower Electric revenues. The changes in Commodity Revenues for both gas and electric are entirely offset by changes in Energy Costs. PSE&G earns no margin on the provision of basic gas supply service (BGSS) and BGS to retail customers. • Gas revenues increased $102 million due to higher BGSS prices of $83 million and higher BGSS sales volumes of $19 million. • Electric revenues decreased $4 million due to lower BGS sales volumes. Other Operating Revenues increased $125 million due primarily to ZEC revenues billed after the ZEC program was approved by the BPU in April 2019. See Item 8. Note 15. Commitments and Contingent Liabilities. The ZEC revenues are entirely offset by changes to Energy Costs. Operating Expenses Energy Costs increased $218 million. This is entirely offset by changes in Commodity Revenues and Other Operating Revenues. Operation and Maintenance increased $6 million due primarily to a $42 million net increase for various clause mechanisms and GPRC expenditures and a $4 million increase in injuries and damages. These increases were partially offset by a $19 million decrease in electric distribution maintenance expenditures, a $14 million decrease in transmission maintenance expenditures and a $6 million decrease in storm-related costs. Depreciation and Amortization increased $67 million due primarily to an increase in depreciation of $52 million due to additional plant placed into service, an $8 million increase due to new depreciation rates resulting from the distribution base rate settlement applied to assets held as of November 1, 2018 and a net $7 million increase from other factors. Non-Operating Pension and OPEB Credits (Costs) increased $91 million due primarily to a $103 million increase in the amortization of prior service credit mainly related to the December 2018 OPEB plan amendment and a $6 million decrease in interest cost, partially offset by a $17 million reduction in the expected return on plan assets. Interest Expense increased $28 million due primarily to increases of $18 million due to net long-term debt issuances in 2019 and $12 million due to net long-term debt issuances in 2018. Income Tax Expense decreased $251 million due primarily to the flowback of excess deferred income tax liabilities and tax repair-related accumulated deferred income taxes to ratepayers. Year Ended December 31, 2018 as compared to 2017 See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2018 Annual Report. PSEG Power Year Ended December 31, 2019 as compared to 2018 Operating Revenues increased $239 million due to changes in generation, gas supply and other operating revenues. Generation Revenues increased $312 million due primarily to • a net increase of $374 million due to MTM gains in 2019 as compared to MTM losses in 2018. Of this amount, there was a $340 million increase from changes in forward prices in 2019 as compared to 2018, coupled with a $34 million increase due to more gains on positions reclassified to realized upon settlement, and • an increase of $129 million due to ZEC revenues earned since mid-April 2019, • partially offset by a decrease of $112 million in electricity sold under our BGS contracts due to lower volumes and lower prices, • a net decrease of $63 million due primarily to lower average realized prices in the PJM, New England (NE), and New York (NY) regions coupled with lower volumes sold in the NY region, partially offset by higher volumes of electricity sold in the PJM and NE regions, and • a net decrease of $16 million in capacity revenues due primarily to decreases in auction prices in the PJM region, partially offset by the commencement of commercial operations of Keys and Sewaren 7 in mid-2018 and BH5 in June 2019. Gas Supply Revenues decreased $75 million due primarily to • a decrease of $107 million related to sales to third parties, primarily due to lower volumes sold and lower average sales prices, • partially offset by an increase of $27 million in sales under the BGSS contract, primarily due to higher average sales prices and higher volumes sold. Operating Expenses Energy Costs represent the cost of generation, which includes fuel costs for generation as well as purchased energy in the market, and gas purchases to meet PSEG Power’s obligation under its BGSS contract with PSE&G. Energy Costs decreased $79 million due to Gas costs decreased $52 million due primarily to • a net decrease of $90 million related to sales to third parties due primarily to lower volumes sold and lower average gas costs, • partially offset by a net increase of $40 million related to sales under the BGSS contract, primarily due to an increase in the average cost of gas. Generation costs decreased $27 million due primarily • a net decrease of $21 million due to lower MTM losses in 2019 as compared to 2018, and • a net decrease of $15 million due primarily to decreases in energy purchased in the NE region due to BH5 beginning commercial operations in June 2019, • partially offset by a net increase of $13 million in higher fuel costs reflecting utilization of higher volumes of gas at Keys, Sewaren 7 and BH5, coupled with higher prices of gas in the PJM region, partially offset by utilization of lower volumes and lower prices of gas in the NY region, lower prices of gas in the NE region, utilization of lower volumes of oil in the PJM region, and lower usage of coal at lower prices in the PJM and NE regions. Operation and Maintenance decreased $13 million due primarily to a decrease at our fossil plants, largely due to lower outage costs, decreased support costs and the sale of PSEG Power’s ownership interests in the Keystone and Conemaugh generation plants in September 2019. The decrease was partially offset by a goodwill impairment charge of $16 million for the write down of PSEG Power’s carrying value to fair value (see Note 12. Goodwill and Other Intangibles), increased costs related to the Keys and Sewaren 7 being placed into service in mid-2018 and increased property taxes. Depreciation and Amortization increased $23 million due primarily to Keys, Sewaren 7 and BH5 being placed into service, partially offset by the sale of PSEG Power’s ownership interests in the Keystone and Conemaugh generation plants. (Gain) Loss on Asset Dispositions reflects a $402 million loss in 2019 related to the sale of PSEG Power’s ownership interests in the Keystone and Conemaugh generation plants and a gain of $54 million in 2018 related to the sale of the Hudson and Mercer plants. Net Gains (Losses) on Trust Investments increased $393 million due primarily to a $405 million increase resulting from net unrealized gains in 2019 as compared to net unrealized losses in 2018 on equity investments in the NDT Fund, partially offset by a $16 million decrease in net realized gains on NDT Fund investments. Other Income (Deductions) increased $33 million primarily due to $26 million in less purchased net operating losses and higher interest and dividend income on NDT Fund investments. Non-Operating Pension and OPEB Credits (Costs) increased $6 million due to a $19 million increase in the amortization of prior service credit mainly related to the December 2018 OPEB plan amendment, a $5 million decrease in interest cost and a $3 million decrease in the amortization of the net unrecognized loss, largely offset by a $20 million decrease in the expected return on plan assets. Interest Expense increased $43 million due primarily to lower capitalized interest as a result of Keys and Sewaren 7 being placed into service in mid-2018 and BH5 being place into service in June 2019. Income Tax Expense increased $137 million due primarily to higher pre-tax income, including higher pre-tax income from the NDT qualified fund which is subject to an additional trust tax, and the favorable impact that resulted in 2018 from the remeasurement of the reserve for uncertain tax positions. Year Ended December 31, 2018 as compared to 2017 See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2018 Annual Report. LIQUIDITY AND CAPITAL RESOURCES The following discussion of our liquidity and capital resources is on a consolidated basis, noting the uses and contributions, where material, of our two direct major operating subsidiaries. Financing Methodology We expect our capital requirements to be met through internally generated cash flows and external financings, consisting of short-term debt for working capital needs and long-term debt for capital investments. PSE&G’s sources of external liquidity include a $600 million multi-year revolving credit facility. PSE&G uses internally generated cash flow and its commercial paper program to meet seasonal, intra-month and temporary working capital needs. PSE&G does not engage in any intercompany borrowing or lending arrangements. PSE&G maintains back-up facilities in an amount sufficient to cover the commercial paper and letters of credit outstanding. PSE&G’s dividend payments to/capital contributions from PSEG are consistent with its capital structure objectives which have been established to maintain investment grade credit ratings. PSE&G’s long-term financing plan is designed to replace maturities, fund a portion of its capital program and manage short-term debt balances. Generally, PSE&G uses either secured medium-term notes or first mortgage bonds to raise long-term capital. PSEG, PSEG Power, Energy Holdings, PSEG LI and Services participate in a corporate money pool, an aggregation of daily cash balances designed to efficiently manage their respective short-term liquidity needs. Servco does not participate in the corporate money pool. Servco’s short-term liquidity needs are met through an account funded and owned by LIPA. PSEG’s available sources of external liquidity may include the issuance of long-term debt securities and the incurrence of additional indebtedness under credit facilities. Our current sources of external liquidity include multi-year revolving credit facilities totaling $1.5 billion. These facilities are available to back-stop PSEG’s commercial paper program, issue letters of credit and for general corporate purposes. PSEG’s credit facilities and the commercial paper program are available to support PSEG working capital needs or to temporarily fund growth opportunities in advance of obtaining permanent financing. PSEG’s credit facilities are also available to make equity contributions or provide liquidity support to its subsidiaries. PSEG Power’s sources of external liquidity include $2.1 billion of multi-year revolving credit facilities. Additionally, from time to time, PSEG Power maintains bilateral credit agreements designed to enhance its liquidity position. Credit capacity is primarily used to provide collateral in support of PSEG Power’s forward energy sale and forward fuel purchase contracts as the market prices for energy and fuel fluctuate, and to meet potential collateral postings in the event that PSEG Power is downgraded to below investment grade by Standard & Poor’s (S&P) or Moody’s. PSEG Power’s dividend payments to PSEG are also designed to be consistent with its capital structure objectives which have been established to maintain investment grade credit ratings and provide sufficient financial flexibility. Generally, PSEG Power issues senior unsecured debt to raise long-term capital. Operating Cash Flows We expect our operating cash flows combined with cash on hand and financing activities to be sufficient to fund capital expenditures and shareholder dividend payments. For the year ended December 31, 2019, our operating cash flow increased by $466 million. The net changes were primarily due to net changes from our subsidiaries as discussed below. PSE&G PSE&G’s operating cash flow increased $182 million from $1,853 million to $2,035 million for the year ended December 31, 2019, as compared to 2018, due primarily to an increase of $178 million from recoveries of regulatory deferrals and tax refunds in 2019 as compared to tax payments in 2018, partially offset by $123 million in increased vendor payments. PSEG Power PSEG Power’s operating cash flow increased $395 million from $1,084 million to $1,479 million for the year ended December 31, 2019, as compared to 2018, due to a decrease in cash collateral requirements of $596 million, partially offset by an $83 million decrease from net collections of counterparty receivables, and lower tax refunds in 2019 as compared to 2018. Short-Term Liquidity PSEG meets its short-term liquidity requirements, as well as those of PSEG Power, primarily with cash and through the issuance of commercial paper. PSE&G maintains its own separate commercial paper program to meet its short-term liquidity requirements. Each commercial paper program is fully back-stopped by its own separate credit facilities. We continually monitor our liquidity and seek to add capacity as needed to meet our liquidity requirements. Each of our credit facilities is restricted as to availability and use to the specific companies as listed below; however, if necessary, the PSEG facilities can also be used to support our subsidiaries’ liquidity needs. Our total credit facilities and available liquidity as of December 31, 2019 were as follows: As of December 31, 2019, our credit facility capacity was in excess of our projected maximum liquidity requirements over our 12 month planning horizon. Our maximum liquidity requirements are based on stress scenarios that incorporate changes in commodity prices and the potential impact of PSEG Power losing its investment grade credit rating from S&P or Moody’s, which would represent a three level downgrade from its current S&P or Moody’s ratings. In the event of a deterioration of PSEG Power’s credit rating, certain of PSEG Power’s agreements allow the counterparty to demand further performance assurance. The potential additional collateral that we would be required to post under these agreements if PSEG Power were to lose its investment grade credit rating was approximately $974 million and $857 million as of December 31, 2019 and 2018, respectively. For additional information, see Item 8. Note 16. Debt and Credit Facilities. Long-Term Debt Financing During the next twelve months, • PSEG has a $700 million floating rate term loan maturing in November 2020, • PSE&G has $250 million of 3.50% Medium Term Notes (MTN) maturing in August 2020 and $9 million of 7.04% MTN maturing in November 2020, and • PSEG Power has $406 million of 5.13% Senior Notes maturing in April 2020. For a discussion of our long-term debt transactions during 2019, see Item 8. Note 16. Debt and Credit Facilities. Debt Covenants Our credit agreements contain maximum debt to equity ratios and other restrictive covenants and conditions to borrowing. We are currently in compliance with all of our debt covenants. Continued compliance with applicable financial covenants will depend upon our future financial position, level of earnings and cash flows, as to which no assurances can be given. In addition, under its First and Refunding Mortgage (Mortgage), PSE&G may issue new First and Refunding Mortgage Bonds against previous additions and improvements, provided that its ratio of earnings to fixed charges calculated in accordance with its Mortgage is at least 2 to 1, and/or against retired Mortgage Bonds. As of December 31, 2019, PSE&G’s Mortgage coverage ratio was 4.5 to 1 and the Mortgage would permit up to approximately $7.6 billion aggregate principal amount of new Mortgage Bonds to be issued against additions and improvements to its property. Default Provisions Our bank credit agreements and indentures contain various, customary default provisions that could result in the potential acceleration of indebtedness under the defaulting company’s agreement. In particular, PSEG’s bank credit agreements contain provisions under which certain events, including an acceleration of material indebtedness under PSE&G’s and PSEG Power’s respective financing agreements, a failure by PSE&G or PSEG Power to satisfy certain final judgments and certain bankruptcy events by PSE&G or PSEG Power, that would constitute an event of default under the PSEG bank credit agreements. Under the PSEG bank credit agreements, it would also be an event of default if either PSE&G or PSEG Power ceases to be wholly owned by PSEG. The PSE&G and PSEG Power bank credit agreements include similar default provisions; however, such provisions only relate to the respective borrower under such agreement and its subsidiaries and do not contain cross default provisions to each other. The PSE&G and PSEG Power bank credit agreements do not include cross default provisions relating to PSEG. PSEG Power’s bank credit agreements and outstanding notes also contain limitations on the incurrence of subsidiary debt and liens and certain of PSEG Power’s outstanding notes require PSEG Power to repurchase such notes upon certain change of control events. There are no cross-acceleration provisions in PSEG’s or PSE&G’s indentures. However, PSEG’s existing notes include a cross acceleration provision that may be triggered upon the acceleration of more than $75 million of indebtedness incurred by PSEG. Such provision does not extend to an acceleration of indebtedness by any of PSEG’s subsidiaries. PSEG Power’s indenture includes a cross acceleration provision similar to that described above for PSEG’s existing notes except that such provision may be triggered upon the acceleration of more than $50 million of indebtedness incurred by PSEG Power or any of its subsidiaries. Such provision does not cross accelerate to PSEG, any of PSEG’s subsidiaries (other than PSEG Power and its subsidiaries), PSE&G or any of PSE&G’s subsidiaries. Ratings Triggers Our debt indentures and credit agreements do not contain any material “ratings triggers” that would cause an acceleration of the required interest and principal payments in the event of a ratings downgrade. However, in the event of a downgrade, any one or more of the affected companies may be subject to increased interest costs on certain bank debt and certain collateral requirements. In the event that we are not able to affirm representations and warranties on credit agreements, lenders would not be required to make loans. In accordance with BPU requirements under the BGS contracts, PSE&G is required to maintain an investment grade credit rating. If PSE&G were to lose its investment grade rating, it would be required to file a plan to assure continued payment for the BGS requirements of its customers. Fluctuations in commodity prices or a deterioration of PSEG Power’s credit rating to below investment grade could increase PSEG Power’s required margin postings under various agreements entered into in the normal course of business. PSEG Power believes it has sufficient liquidity to meet the required posting of collateral which would likely result from a credit rating downgrade to below investment grade by S&P or Moody’s at today’s market prices. Common Stock Dividends On February 18, 2020, our Board of Directors approved a $0.49 per share common stock dividend for the first quarter of 2020. This reflects an indicative annual dividend rate of $1.96 per share. We expect to continue to pay cash dividends on our common stock; however, the declaration and payment of future dividends to holders of our common stock will be at the discretion of the Board of Directors and will depend upon many factors, including our financial condition, earnings, capital requirements of our businesses, alternate investment opportunities, legal requirements, regulatory constraints, industry practice and other factors that the Board of Directors deems relevant. For additional information related to cash dividends on our common stock, see Item 8. Note 24. Earnings Per Share (EPS) and Dividends. Credit Ratings If the rating agencies lower or withdraw our credit ratings, such revisions may adversely affect the market price of our securities and serve to materially increase our cost of capital and limit access to capital. Credit Ratings shown are for securities that we typically issue. Outlooks are shown for Issuer Credit Ratings (Moody’s) and Corporate Credit Ratings (S&P) and can be Stable, Negative, or Positive. There is no assurance that the ratings will continue for any given period of time or that they will not be revised by the rating agencies, if in their respective judgments, circumstances warrant. Each rating given by an agency should be evaluated independently of the other agencies’ ratings. The ratings should not be construed as an indication to buy, hold or sell any security. (A) Moody’s ratings range from Aaa (highest) to C (lowest) for long-term securities and P1 (highest) to NP (lowest) for short-term securities. (B) S&P ratings range from AAA (highest) to D (lowest) for long-term securities and A1 (highest) to D (lowest) for short-term securities. Other Comprehensive Income For the year ended December 31, 2019, we had Other Comprehensive Loss of $31 million on a consolidated basis. Other Comprehensive Loss was due primarily to a decrease of $58 million related to pension and other postretirement benefits, and $14 million of unrealized losses on derivative contracts accounted for as hedges, partially offset by $41 million of net unrealized gains related to Available-for-Sale Securities. See Item 8. Note 23. Accumulated Other Comprehensive Income (Loss), Net of Tax for additional information. CAPITAL REQUIREMENTS We expect that all of our capital requirements over the next three years will come from a combination of internally generated funds and external debt financing. Projected capital construction and investment expenditures, excluding nuclear fuel purchases, for the next three years are presented in the table below. These projections include Allowance for Funds Used During Construction and Interest Capitalized During Construction for PSE&G and PSEG Power, respectively. These amounts are subject to change, based on various factors. Amounts shown below for Gas System Modernization, Energy Strong and Clean Energy are for currently approved programs. We intend to continue to invest in infrastructure modernization and will seek to extend these and related programs as appropriate. We will also continue to approach potential growth investments for PSEG Power opportunistically, seeking projects that will provide attractive risk-adjusted returns for our shareholders. PSE&G PSE&G’s projections for future capital expenditures include material additions and replacements to its T&D systems to meet expected growth and to manage reliability. As project scope and cost estimates develop, PSE&G will modify its current projections to include these required investments. PSE&G’s projected expenditures for the various items reported above are primarily comprised of the following: • Transmission-investments focused on reliability improvements and replacement of aging infrastructure. • Distribution-investments for new business, reliability improvements, modernization and replacement of equipment that has reached the end of its useful life. • Gas System Modernization-gas distribution investment program to replace aging infrastructure. • Energy Strong-electric and gas distribution investment program focused on electric flood mitigation and replacing aging infrastructure. • Clean Energy-investments associated with grid-connected solar, solar loan programs and customer energy efficiency programs. In October 2018, we filed our proposed CEF program with the BPU, a six-year estimated $3.5 billion investment program focused on achieving New Jersey’s energy efficiency targets, supporting electric vehicle infrastructure, deploying energy storage, and implementing an EC program which will include installing approximately two million electric smart meters and associated infrastructure. The size and duration of the CEF program, as well as certain other elements of the program, are subject to BPU approval. The CEF program is not included in PSE&G’s projected capital expenditures in the above table. In 2019, PSE&G made $2,542 million of capital expenditures, primarily for T&D system reliability. This does not include expenditures for cost of removal, net of salvage, of $108 million, which are included in operating cash flows. PSEG Power PSEG Power’s projected expenditures for the various items listed above are primarily comprised of the following: • Baseline-investments to replace major parts and enhance operational performance. • Other-includes investments made in response to environmental, regulatory and legal mandates and other capital projects. In 2019, PSEG Power made $482 million of capital expenditures, excluding $125 million for nuclear fuel, primarily related to various projects at Fossil and Nuclear. Disclosures about Contractual Obligations The following table reflects our contractual cash obligations in the respective periods in which they are due. In addition, the table summarizes anticipated debt maturities for the years shown. For additional information, see Item 8. Note 16. Debt and Credit Facilities. The table below does not reflect any anticipated cash payments for pension obligations due to uncertain timing of payments or liabilities for uncertain tax positions since we are unable to reasonably estimate the timing of liability payments in individual years beyond 12 months due to uncertainties in the timing of the effective settlement of tax positions. See Item 8. Note 22. Income Taxes for additional information. OFF-BALANCE SHEET ARRANGEMENTS PSEG and PSEG Power issue guarantees, primarily in conjunction with certain of PSEG Power’s energy contracts. See Item 8. Note 15. Commitments and Contingent Liabilities for further discussion. Through Energy Holdings, we have investments in leveraged leases that are accounted for in accordance with accounting principles generally accepted in the United States (GAAP) for leases. Leveraged lease investments generally involve three parties: an owner/lessor, a creditor and a lessee. In a typical leveraged lease arrangement, the lessor purchases an asset to be leased. The purchase price is typically financed 80% with debt provided by the creditor and the balance comes from equity funds provided by the lessor. The creditor provides long-term financing to the transaction secured by the property subject to the lease. Such long-term financing is non-recourse to the lessor and is not presented on our Consolidated Balance Sheets. In the event of default, the leased asset, and in some cases the lessee, secures the loan. As a lessor, Energy Holdings has ownership rights to the property and rents the property to the lessees for use in their business operations. For additional information, see Item 8. Note 9. Long-Term Investments and Note 10. Financing Receivables. In the event that collection of the minimum lease payments to be received by Energy Holdings is no longer reasonably assured, Energy Holdings may deem that a lessee has a high probability of defaulting on the lease obligation and would consider the need to record an impairment of its investment. In the event the lease is ultimately rejected by the lessee in a Bankruptcy Court proceeding, the fair value of the underlying asset and the associated debt would be recorded on the Consolidated Balance Sheets instead of the net equity investment in the lease. CRITICAL ACCOUNTING ESTIMATES Under GAAP, many accounting standards require the use of estimates, variable inputs and assumptions (collectively referred to as estimates) that are subjective in nature. Because of this, differences between the actual measure realized versus the estimate can have a material impact on results of operations, financial position and cash flows. We have determined that the following estimates are considered critical to the application of rules that relate to the respective businesses. Accounting for Pensions and OPEB PSEG sponsors qualified and nonqualified pension plans and OPEB plans covering PSEG’s and its participating affiliates’ current and former employees who meet certain eligibility criteria. In late June 2019, PSEG approved a plan amendment to its qualified pension plan, effective July 1, 2019. The amendment involved the spin-off of predominantly active participants from the existing qualified pension plan (Pension Plan) into a new qualified pension plan (Pension Plan II). See Item 8. Note 14. Pension, Other Postretirement Benefits (OPEB) and Savings Plans for additional information. The market-related value of plan assets held for the qualified pension and OPEB plans is equal to the fair value of these assets as of year-end. The plan assets are comprised of investments in both debt and equity securities which are valued using quoted market prices, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. Plan assets also include investments in unlisted real estate which is valued via third-party appraisals. We calculate pension and OPEB costs using various economic and demographic assumptions. Assumptions and Approach Used: Economic assumptions include the discount rate and the long-term rate of return on trust assets. Demographic pension and OPEB assumptions include projections of future mortality rates, pay increases and retirement patterns, as well as projected health care costs for OPEB. The discount rate used to calculate pension and OPEB obligations is determined as of December 31 each year, our measurement date. The discount rate is determined by developing a spot rate curve based on the yield to maturity of a universe of high quality corporate bonds with similar maturities to the plan obligations. The spot rates are used to discount the estimated plan distributions. The discount rate is the single equivalent rate that produces the same result as the full spot rate curve. Our expected rate of return on plan assets reflects current asset allocations, historical long-term investment performance and an estimate of future long-term returns by asset class, long-term inflation assumptions and a premium for active management. We utilize a corridor approach that reduces the volatility of reported costs/credits. The corridor requires differences between actuarial assumptions and plan results be deferred and amortized as part of the costs/credits. This occurs only when the accumulated differences exceed 10% of the greater of the benefit obligation or the fair value of plan assets as of each year-end. For the Pension Plan, the excess would be amortized over the average remaining expected life of inactive participants, which is approximately twenty years. For Pension Plan II, the excess would be amortized over the average remaining service period of active employees, which is approximately fourteen years. Effect if Different Assumptions Used: As part of the business planning process, we have modeled future costs assuming a 7.70% expected rate of return and a 3.30% discount rate for 2020 pension costs/credits and a 3.20% discount rate for 2020 OPEB costs/credits. Based upon these assumptions, we have estimated a net periodic pension credit in 2020 of approximately $28 million, or $84 million, net of amounts capitalized, and a net periodic OPEB credit in 2020 of approximately $77 million, or $81 million, net of amounts capitalized. Actual future pension costs/credits and funding levels will depend on future investment performance, changes in discount rates, market conditions, funding levels relative to our projected benefit obligation and accumulated benefit obligation and various other factors related to the populations participating in the pension plans. Actual future OPEB costs/credits will depend on future investment performance, changes in discount rates, market conditions, and various other factors. The following chart reflects the sensitivities associated with a change in certain assumptions. The effects of the assumption changes shown below solely reflect the impact of that specific assumption. See

<s>[INST] PSEG’s business consists of two reportable segments, our principal direct wholly owned subsidiaries, which are: PSE&Gwhich is a public utility engaged principally in the transmission of electricity and distribution of electricity and natural gas in certain areas of New Jersey. PSE&G is subject to regulation by the New Jersey Board of Public Utilities (BPU) and the Federal Energy Regulatory Commission (FERC). PSE&G also invests in regulated solar generation projects and energy efficiency and related programs in New Jersey, which are regulated by the BPU, and PSEG Powerwhich is a multiregional energy supply company that integrates the operations of its merchant nuclear and fossil generating assets with its power marketing businesses and fuel supply functions through competitive energy sales in welldeveloped energy markets primarily in the Northeast and MidAtlantic United States through its principal direct wholly owned subsidiaries. In addition, PSEG Power owns and operates solar generation in various states. PSEG Power’s subsidiaries are subject to regulation by FERC, the Nuclear Regulatory Commission, the Environmental Protection Agency (EPA) and the states in which they operate. PSEG’s other direct wholly owned subsidiaries are: PSEG Long Island LLC (PSEG LI), which operates the Long Island Power Authority’s (LIPA) transmission and distribution (T&D) system under an Operations Services Agreement; PSEG Energy Holdings L.L.C. (Energy Holdings), which primarily has investments in leveraged leases; and PSEG Services Corporation (Services), which provides certain management, administrative and general services to PSEG and its subsidiaries at cost. Our business discussion in Item 1. Business provides a review of the regions and markets where we operate and compete, as well as our strategy for conducting our businesses within these markets, focusing on operational excellence, financial strength and making disciplined investments. Our risk factor discussion in Item 1A. Risk Factors provides information about factors that could have a material adverse impact on our businesses. The following discussion provides an overview of the significant events and business developments that have occurred during 2019 and key factors that we expect may drive our future performance. This discussion refers to the Consolidated Financial Statements (Statements) and the related Notes to the Consolidated Financial Statements (Notes). This discussion should be read in conjunction with such Statements and Notes. For a discussion of 2017 items and yearoveryear comparisons of changes in our financial condition and results of operations as of and for the years ended December 31, 2018 and December 31, 2017, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10K for the year ended December 31, 2018 (2018 Annual Report) as filed with the Securities and Exchange Commission on February 27, 2019. EXECUTIVE OVERVIEW OF 2019 AND FUTURE OUTLOOK Our business plan is designed to achieve growth while managing the risks associated with regulatory changes, fluctuating commodity prices and changes in customer demand. Over the past few years, our investments have altered our business mix to reflect a higher percentage of earnings contribution by PSE&G. PSE&G At PSE&G, our focus is on enhancing reliability and resiliency of our T&D system, meeting customer expectations and supporting public policy objectives by investing capital in T&D infrastructure and clean energy programs. For the fiveyear period ending December 31, 2024, PSE&G expects to invest between $11.5 billion to $15 billion, resulting in an expected compound annual rate base growth of 6.5% to 8%. These ranges are driven by certain unapproved investment programs, including the Clean Energy Future (CEF) and incremental reliability and resiliency investments anticipated in the 2024 timeframe that we intend to seek approval for under the third phase of existing infrastructure programs. See below for a description of the CEF program. In 2019, we commenced our BPUapproved Gas System Modernization Program II (GSMP II), an expanded [/INST] Negative. </s>

KROGER CO

2015-03-31

2015-01-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I, the “Risk Factors” section set forth in Item 1A of Part I and “Outlook” below. OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. Kroger is one of the nation’s largest retailers, as measured by revenue, operating 2,625 supermarket and multi-department stores under two dozen banners including Kroger, City Market, Dillons, Food 4 Less, Fred Meyer, Fry’s, Harris Teeter, Jay C, King Soopers, QFC, Ralphs and Smith’s. Of these stores, 1,330 have fuel centers. We also operate 782 convenience stores, either directly or through franchisees, 326 fine jewelry stores and an online retailer. We operate 37 manufacturing plants, primarily bakeries and dairies, which supply approximately 40% of the corporate brand units sold in our supermarkets. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 99% of our consolidated sales and EBITDA, is our only reportable segment. On January 28, 2014, we closed our merger with Harris Teeter by purchasing 100% of the Harris Teeter outstanding common stock for approximately $2.4 billion. The merger allows us to expand into the fast-growing southeastern and mid-Atlantic markets and into Washington, D.C. Harris Teeter is included in our ending Consolidated Balance Sheets for 2013 and 2014 and in our Consolidated Statements of Operations for 2014. Due to the timing of the merger closing late in fiscal year 2013, its results of operations were not material to our consolidated results of operations for 2013. Year-over-year comparisons will be affected as a result. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Harris Teeter. On August 18, 2014, we closed our merger with Vitacost.com by purchasing 100% of the Vitacost.com outstanding common stock for $8.00 per share or $287 million. Vitacost.com is a leading online retailer in health and wellness products, which are sold directly to consumers through the website vitacost.com. The merger affords us access to Vitacost.com’s extensive e-commerce platform, which can be combined with our customer insights and loyal customer base, to create new levels of personalization and convenience for our customers. Vitacost.com is included in our ending Consolidated Balance Sheets and Consolidated Statements of Operations for 2014. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Vitacost.com. OUR 2014 PERFORMANCE We achieved outstanding results in 2014. Our business strategy continues to resonate with a full range of customers and our results reflect the balance we seek to achieve across our business including positive identical sales growth, increases in loyal household count, and good cost control, as well as growth in net earnings and net earnings per diluted share. Our 2014 net earnings were $1.7 billion or $3.44 per diluted share, compared to $1.5 billion, or $2.90 per diluted share for the same period of 2013. Our net earnings for 2014 include a net $39 million after-tax charge for an $87 million ($56 million after-tax) charge to operating, general and administrative (“OG&A”) expenses due to the commitments and withdrawal liabilities arising from restructuring of certain pension plan agreements to help stabilize associates’ future pension benefits, offset partially by the benefits from certain tax items ($17 million) (“2014 Adjusted Items”). In addition, our net earnings for 2014 included unusually high fuel margins, partially offset by a last-in, first-out (“LIFO”) charge that was significantly higher than 2013 and $140 million in contributions charged to OG&A expenses for the United Food and Commercial Workers International Union (“UFCW”) Consolidated Pension Plan ($55 million) and our charitable foundation ($85 million) (“2014 Contributions”). Fuel margin per gallon was $0.19 per gallon in 2014, compared to $0.14 per gallon in 2013. The $55 million contribution to the UFCW Consolidated Pension Plan was to further fund the plan. The $85 million contribution to Kroger’s charitable foundation will enable it to continue to support causes such as hunger relief, breast cancer awareness, the military and their families and local community organizations. Our net earnings for 2013 include a net benefit of $23 million, which includes benefits from certain tax items of $40 million, offset partially by costs of $11 million in interest and $16 million in OG&A expenses ($17 million after-tax) related to our merger with Harris Teeter (“2013 Adjusted Items”). Excluding the 2014 Adjusted Items, net earnings for 2014 totaled $1.8 billion, or $3.52 per diluted share, compared to net earnings in 2013 of $1.5 billion, or $2.85 per diluted share, excluding the 2013 Adjusted Items. We believe adjusted net earnings and adjusted net earnings per diluted share present a more accurate year-over-year comparison of our financial results because the Adjusted Items were not the result of our normal operations. Our adjusted net earnings per diluted share for 2014 represent a 24% increase, compared to 2013. Please refer to the “Net Earnings” section of MD&A for more information. Our identical supermarket sales increased 5.2%, excluding fuel, in 2014, compared to 2013. We have achieved 45 consecutive quarters of positive identical supermarket sales growth, excluding fuel. As we continue to outpace many of our competitors on identical supermarket sales growth, we continue to gain market share. We focus on identical supermarket sales growth, excluding fuel, as it is a key performance target for our long-term growth strategy. Increasing market share is an important part of our long-term strategy as it best reflects how our products and services resonate with customers. Market share growth allows us to spread the fixed costs in our business over a wider revenue base. Our fundamental operating philosophy is to maintain and increase market share by offering customers good prices and superior products and service. Based on Nielsen POS+ data, our overall market share of the products we sell in markets in which we operate increased by approximately 60 basis points in 2014. This data also indicates that our market share increased in 18 markets and declined slightly in two. Wal-Mart is one of our top two competitors in 15 of the 20 markets outlined in the Nielson report. Our market share increased in all 15 of these markets. These market share results reflect our long-term strategy of market share growth. RESULTS OF OPERATIONS The following discussion summarizes our operating results for 2014 compared to 2013 and for 2013 compared to 2012. Comparability is affected by income and expense items that fluctuated significantly between and among the periods, our merger with Harris Teeter in late 2013 and an extra week in 2012. Net Earnings Net earnings totaled $1.7 billion in 2014 and $1.5 billion in 2013 and 2012. Net earnings improved in 2014, compared to net earnings in 2013, due to an increase in operating profit, partially offset by increases in interest and tax expense. Operating profit increased in 2014, compared to 2013, primarily due to an increase in first-in, first-out (“FIFO”) non-fuel gross profit, excluding Harris Teeter, the effect of our merger with Harris Teeter and an increase in fuel operating profit, partially offset by continued investments in lower prices for our customers, the 2014 Contributions, an $87 million ($56 million after-tax) charge due to the restructuring of certain pension plan agreements and a higher LIFO charge which was $147 million (pre-tax), compared to a LIFO charge of $52 million (pre-tax) in 2013. Net earnings improved in 2013, compared to net earnings of 2012, due to a decrease in tax and interest expense, partially offset by a decrease in operating profit. Operating profit decreased in 2013, compared to 2012, primarily due to a 53rd week in fiscal year 2012 (the “Extra Week”), continued investments in lower prices for our customers, the 2012 settlement with Visa and MasterCard and the reduction in our obligation to fund the UFCW Consolidated Pension Plan created in 2012, partially offset by an increase in FIFO non-fuel gross profit. The net earnings for 2014 include a net charge of $39 million, after tax, related to the 2014 Adjusted Items. The net earnings for 2013 include a net benefit of $23 million, after tax, related to the 2013 Adjusted Items. The net earnings for 2012 include a benefit from net earnings of approximately $58 million, after-tax, due to the Extra Week and a net $115 million ($74 million after-tax) benefit in OG&A expenses for the settlement with Visa and MasterCard and a reduction in our obligation to fund the UFCW Consolidated Pension Plan created in January 2012 (“2012 Adjusted Items”). Excluding these benefits and charges for Adjusted Items for 2014, 2013 and 2012, adjusted net earnings were $1.8 billion in 2014, $1.5 billion in 2013 and $1.4 billion in 2012. 2014 adjusted net earnings improved, compared to adjusted net earnings in 2013, due to an increase in FIFO non-fuel operating profit, excluding Harris Teeter, the effect of our merger with Harris Teeter and an increase in fuel operating profit, partially offset by continued investments in lower prices for our customers, increases in interest and tax expense and a higher LIFO charge which was $147 million (pre-tax), compared to a LIFO charge of $52 million (pre-tax) in 2013. 2013 adjusted net earnings improved, compared to adjusted net earnings in 2012, due to an increase in FIFO non-fuel operating profit and decreased interest, partially offset by continued investments in lower prices for our customers and increased tax expense. Net earnings per diluted share totaled $3.44 in 2014, $2.90 in 2013 and $2.77 in 2012. Net earnings per diluted share in 2014, compared to 2013, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in net earnings. Net earnings per diluted share in 2013, compared to 2012, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in net earnings. Excluding the 2014, 2013 and 2012 Adjusted Items, adjusted net earnings per diluted share totaled $3.52 in 2014, $2.85 in 2013 and $2.52 in 2012. Adjusted net earnings per diluted share in 2014, compared to adjusted net earnings per diluted share in 2013, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in adjusted net earnings. Adjusted net earnings per diluted share in 2013, compared to adjusted net earnings per diluted share in 2012, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in adjusted net earnings. Management believes adjusted net earnings (and adjusted net earnings per diluted share) are useful metrics to investors and analysts because they more accurately reflect our day-to-day business operations than do the generally accepted accounting principle (“GAAP”) measures of net earnings and net earnings per diluted share. Adjusted net earnings (and adjusted net earnings per diluted share) are non-generally accepted accounting principle (“non-GAAP”) financial measures and should not be considered alternatives to net earnings (and net earnings per diluted share) or any other GAAP measure of performance. Adjusted net earnings (and adjusted net earnings per diluted share) should not be viewed in isolation or considered substitutes for our financial results as reported in accordance with GAAP. Management uses adjusted net earnings (and adjusted net earnings per diluted share) in evaluating our results of operations as it believes these measures are more meaningful indicators of operating performance since, as adjusted, those earnings relate more directly to our day-to-day operations. Management also uses adjusted net earnings (and adjusted net earnings per diluted share) as a performance metric for management incentive programs, and to measure our progress against internal budgets and targets. The following table provides a reconciliation of net earnings attributable to The Kroger Co. to net earnings attributable to The Kroger Co. excluding the Adjusted Items for 2014, 2013 and 2012 and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to the net earnings attributable to The Kroger Co. per diluted common share excluding the Adjusted Items for 2014, 2013 and 2012: Net Earnings per Diluted Share excluding the Adjusted Items (in millions, except per share amounts) (1) The amounts presented represent the net earnings per diluted common share effect of each adjusted item. Sales Total Sales (in millions) (1) Other sales primarily relate to sales at convenience stores, excluding fuel; jewelry stores; manufacturing plants to outside customers; variable interest entities; a specialty pharmacy; in-store health clinics; and online sales by Vitacost.com. (2) This column represents the sales percentage increases in 2014, compared to 2013. (3) This column represents the sales percentage increases in 2013, compared to 2012 Adjusted. (4) The 2012 Adjusted column represents the items presented in the 2012 column as adjusted to remove the Extra Week. Total sales increased in 2014, compared to 2013, by 10.3%. This increase in 2014 total sales, compared to 2013, was primarily due to our merger with Harris Teeter, which closed on January 28, 2014, and an increase in identical supermarket sales, excluding fuel, of 5.2%. Identical supermarket sales, excluding fuel for 2014, compared to 2013, increased primarily due to an increase in the number of households shopping with us, an increase in visits per household and product cost inflation. Total fuel sales decreased in 2014, compared to 2013, primarily due to a 6.8% decrease in the average retail fuel price, partially offset by an increase in fuel gallons sold of 6.6%. Total sales increased in 2013, compared to 2012, by 1.82%. The increase in 2013 total sales, compared to 2012, was primarily due to our identical supermarket sales increase, excluding fuel, of 3.6%, partially offset by the Extra Week in fiscal 2012. Total sales increased in 2013, compared to 2012 adjusted total sales, by 3.9%. The increase in 2013 total sales, compared to 2012 adjusted total sales, was primarily due to our identical supermarket sales increase, excluding fuel, of 3.6%. Identical supermarket sales, excluding fuel, increased in 2013, compared to 2012, primarily due to an increase in number of households shopping with us, an increase in visits per household and product cost inflation. Total fuel sales increased in 2013, compared to 2012 adjusted total sales, primarily due to an increase in fuel gallons sold of 5.2% partially offset by a decrease in the average retail fuel price of 2.9%. We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Although identical supermarket sales is a relatively standard term, numerous methods exist for calculating identical supermarket sales growth. As a result, the method used by our management to calculate identical supermarket sales may differ from methods other companies use to calculate identical supermarket sales. We urge you to understand the methods used by other companies to calculate identical supermarket sales before comparing our identical supermarket sales to those of other such companies. Fuel discounts received at our fuel centers and earned based on in-store purchases are included in all of the supermarket identical sales results calculations illustrated below and reduce our identical supermarket sales results. Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Identical supermarket sales include sales from all departments at identical Fred Meyer multi-department stores and include Harris Teeter sales for stores that are identical as if they were part of the Company in our prior year. We calculate annualized identical supermarket sales by adding together four quarters of identical supermarket sales. Our identical supermarket sales results are summarized in the table below. Identical Supermarket Sales (dollars in millions) (1) Identical supermarket sales for 2013 were calculated on a 52 week basis by excluding week 1 of fiscal 2012 in our 2012 identical supermarket sales base. Gross Margin and FIFO Gross Margin We calculate gross margin as sales less merchandise costs, including advertising, warehousing, and transportation expenses. Merchandise costs exclude depreciation and rent expenses. Our gross margin rates, as a percentage of sales, were 21.16% in 2014, 20.57% in 2013 and 20.59% in 2012. The increase in 2014, compared to 2013, resulted primarily from the effect of our merger with Harris Teeter, an increase in fuel gross margin rate and a reduction in warehouse and transportation costs, as a percentage of sales, partially offset by continued investments in lower prices for our customers and an increase in our LIFO charge, as a percentage of sales. The merger with Harris Teeter, which closed late in fiscal year 2013, had a positive effect on our gross margin rate in 2014 since Harris Teeter has a higher gross margin rate as compared to total Company without Harris Teeter. The increase in fuel gross margin rate for 2014, compared to 2013, resulted primarily from an increase in fuel margin per gallon sold of $0.19 in 2014, compared to $0.14 in 2013. The decrease in 2013, compared to 2012, resulted primarily from continued investments in lower prices for our customers and increased shrink and advertising costs, as a percentage of sales, offset partially by a growth rate in retail fuel sales that was lower than the total Company sales growth rate. Our retail fuel operations lower our gross margin rate, as a percentage of sales, due to the very low gross margin on retail fuel sales as compared to non-fuel sales. A lower growth rate in retail fuel sales, as compared to the growth rate for the total Company, increases the gross margin rates, as a percentage of sales, when compared to the prior year. We calculate FIFO gross margin as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the LIFO charge. Merchandise costs exclude depreciation and rent expenses. Our LIFO charge was $147 million in 2014, $52 million in 2013 and $55 million in 2012. FIFO gross margin is a non-GAAP financial measure and should not be considered as an alternative to gross margin or any other GAAP measure of performance. FIFO gross margin should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness. Management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness. Our FIFO gross margin rates, as a percentage of sales, were 21.30% in 2014, 20.62% in 2013 and 20.65% in 2012. Our retail fuel operations lower our FIFO gross margin rate, as a percentage of sales, due to the very low FIFO gross margin rate on retail fuel as compared to non-fuel sales. Excluding the effect of retail fuel, our FIFO gross margin rate decreased three basis points in 2014, as a percentage of sales, compared to 2013. The decrease in FIFO gross margin rates, excluding retail fuel, in 2014, compared to 2013, resulted primarily from continued investments in lower prices for our customers, offset partially by the effect of our merger with Harris Teeter and a reduction of warehouse and transportation costs, as a percentage of sales. Excluding the effect of retail fuel operations, our FIFO gross margin rate decreased 14 basis points in 2013, as a percentage of sales, compared to 2012. The decrease in FIFO gross margin rates, excluding retail fuel, in 2013, compared to 2012, resulted primarily from continued investments in lower prices for our customers and increased shrink and advertising costs, as a percentage of sales. LIFO Charge The LIFO charge was $147 million in 2014, $52 million in 2013 and $55 million in 2012. In 2014, we experienced higher levels of product cost inflation, compared to 2013. In 2014, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, grocery, deli, meat and seafood. We experienced relatively consistent levels of product cost inflation in 2013, compared to 2012. In 2013, our LIFO charge resulted primarily from an annualized product cost inflation related to meat, seafood and pharmacy. In 2012, our LIFO charge resulted primarily from an annualized product cost inflation related to grocery, natural foods, meat, deli and bakery, general merchandise and grocery, partially offset by deflation in seafood and manufactured product. Operating, General and Administrative Expenses OG&A expenses consist primarily of employee-related costs such as wages, health care benefits and retirement plan costs, utilities and credit card fees. Rent expense, depreciation and amortization expense and interest expense are not included in OG&A. OG&A expenses, as a percentage of sales, were 15.82% in 2014, 15.45% in 2013 and 15.37% in 2012. The increase in OG&A expenses, as a percentage of sales, in 2014, compared to 2013, resulted primarily from the 2014 Contributions, expenses related to commitments and withdrawal liabilities arising from restructuring of certain pension plan agreements to help stabilize associates future pension benefits, the effect of fuel, the effect of our merger with Harris Teeter and increases in credit card fees and incentive plan costs, as a percentage of sales, partially offset by increased supermarket sales growth, productivity improvements and effective cost controls at the store level. Retail fuel sales lower our OG&A rate due to the very low OG&A rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our OG&A rate, as a percentage of sales, since Harris Teeter has a higher OG&A rate as compared to the total Company without Harris Teeter. The increase in OG&A rate in 2013, compared to 2012, resulted primarily from the 2012 settlement with Visa and MasterCard and a reduction in our obligation to fund the UFCW Consolidated Pension Plan created in January 2012, the effect of fuel and increased incentive plan costs, as a percentage of sales, offset partially by increased identical supermarket sales growth, productivity improvements and effective cost controls at the store level. Our retail fuel operations reduce our overall OG&A rate, as a percentage of sales, due to the very low OG&A rate on retail fuel sales as compared to non-fuel sales. OG&A expenses, as a percentage of sales excluding fuel, the 2014 Contributions and the 2014 Adjusted Items, decreased 19 basis points in 2014, compared to 2013, adjusted for the 2013 Adjusted Items. The decrease in our adjusted OG&A rate in 2014, compared to 2013, resulted primarily from increased supermarket sales growth, productivity improvements and effective cost controls at the store level, offset partially by the effect of our merger with Harris Teeter and increases in credit card fees and incentive plan costs, as a percentage of sales. OG&A expenses, as a percentage of sales excluding fuel and the 2013 Adjusted Items, decreased 17 basis points in 2013, compared to 2012, adjusted for the 2012 Adjusted Items. The decrease in our adjusted OG&A rate in 2013, compared to 2012, resulted primarily from increased identical supermarket sales growth, productivity improvements and effective cost controls at the store level, offset partially by increased incentive plan costs, as a percentage of sales. Rent Expense Rent expense was $707 million in 2014, compared to $613 million in 2013 and $628 million in 2012. Rent expense, as a percentage of sales, was 0.65% in 2014, compared to 0.62% in 2013 and 0.65% in 2012. The increase in rent expense, as a percentage of sales, in 2014, compared to 2013, is due to the effect of our merger with Harris Teeter, partially offset by our continued emphasis to own rather than lease, whenever possible, and the benefit of increased sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased rent expense, as a percentage of sales, since Harris Teeter has a higher rent expense rate compared to the total Company without Harris Teeter. The decrease in rent expense, as a percentage of sales, in 2013, compared to 2012, is due to our continued emphasis to own rather than lease, whenever possible, and the benefit of increased sales. Depreciation and Amortization Expense Depreciation and amortization expense was $1.9 billion, compared to $1.7 billion in 2013 and 2012. Depreciation and amortization expense, as a percentage of sales, was 1.80% in 2014, 1.73% in 2013 and 1.71% in 2012. The increase in depreciation and amortization expense for 2014, compared to 2013, in total dollars, was due to the effect of our merger with Harris Teeter and our increased spending in capital investments, including acquisitions and lease buyouts, of $3.1 billion in 2014. The increase in depreciation and amortization expense, as a percentage of sales, from 2014, compared to 2013, is primarily due to the effect of our merger with Harris Teeter and our increased spending in capital investments, partially offset by increased supermarket sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our depreciation and amortization expense, as a percentage of sales, since Harris Teeter has a higher depreciation expense rate as compared to the total Company without Harris Teeter. The increase in depreciation and amortization expense, as a percentage of sales, from 2013, compared to 2012, is primarily the result of increased spending in capital investments, partially offset by increases in supermarket sales and the Extra Week. Operating Profit and Adjusted FIFO Operating Profit Operating profit was $3.1 billion in 2014, $2.7 billion in 2013 and $2.8 billion in 2012. Operating profit, as a percentage of sales, was 2.89% in 2014, 2.77% in 2013 and 2.86% in 2012. Operating profit, as a percentage of sales, increased 12 basis points in 2014, compared to 2013, primarily from the effect of our merger with Harris Teeter, an increase in fuel gross margin rate and a reduction in warehouse and transportation costs, rent and depreciation and amortization expenses, as a percentage of sales, partially offset by continued investments in lower prices for our customers and an increase in the LIFO charge, as a percentage of sales. Operating profit, as a percentage of sales, decreased 9 basis points in 2013, compared to 2012, primarily from continued investments in lower prices for our customers, the 2012 settlement with Visa and MasterCard and the reduction in our obligation to fund the UFCW Consolidated Pension Plan created in January 2012 and increased shrink and advertising costs, as a percentage of sales, partially offset by productivity improvements, effective cost controls at store level and a reduction in rent expense, as a percentage of sales. We calculate FIFO operating profit as operating profit excluding the LIFO charge. FIFO operating profit is a non-GAAP financial measure and should not be considered as an alternative to operating profit or any other GAAP measure of performance. FIFO operating profit should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. FIFO operating profit is an important measure used by management to evaluate operational effectiveness. Management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness. Since fuel discounts are earned based on in-store purchases, fuel operating profit does not include fuel discounts, which are allocated to our in-store supermarket location departments. We also derive OG&A, rent and depreciation and amortization expenses through the use of estimated allocations in the calculation of fuel operating profit. FIFO operating profit was $3.3 billion in 2014 and $2.8 billion in 2013 and 2012. Excluding the Extra Week in 2012, FIFO operating profit was $2.7 billion. FIFO operating profit, as a percentage of sales, was 3.03% in 2014, 2.82% in 2013 and 2.92% in 2012. FIFO operating profit, as a percentage of sales excluding the Extra Week in 2012, was 2.87%. FIFO operating profit, excluding the 2014, 2013 and 2012 Adjusted Items and the 2014 Contributions, was $3.5 billion in 2014, $2.8 billion in 2013 and $2.6 billion in 2012. FIFO operating profit, as a percentage of sales excluding the 2014, 2013 and 2012 Adjusted Items and the 2014 Contributions, was 3.24% in 2014, 2.84% in 2013 and 2.75% in 2012. Retail fuel sales lower our overall FIFO operating profit rate due to the very low FIFO operating profit rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. FIFO operating profit, as a percentage of sales excluding fuel, the 2014 Contributions and the 2014 Adjusted Items, increased 10 basis points in 2014, compared to 2013, adjusted for the 2013 Adjusted Items. The increase in our adjusted FIFO operating profit rate in 2014, compared to 2013, was primarily due to the effect of our merger with Harris Teeter and a reduction in warehouse and transportation costs, improvements in OG&A, rent and depreciation and amortization expense, as a percentage of sales, partially offset by continued investments in lower prices for our customers. FIFO operating profit, as a percentage of sales excluding fuel and the 2013 Adjusted Items, increased 11 basis points in 2013, compared to 2012, adjusted for the 2012 Adjusted Items. The increase in our adjusted FIFO operating profit rate in 2013, compared to 2012, was primarily due to improvements in OG&A and rent expenses, as a percentage of sales, offset partially by continued investments in lower prices for our customers and increased shrink and advertising costs, as a percentage of sales. Interest Expense Interest expense totaled $488 million in 2014, $443 million in 2013 and $462 million in 2012. The increase in interest expense in 2014, compared to 2013, resulted primarily from an increase in net total debt, primarily due to financing the merger with Harris Teeter and repurchases of our outstanding common shares. The decrease in interest expense in 2013, compared to 2012, resulted primarily from a lower weighted average interest rate, offset partially by a decrease in the net benefit from interest rate swaps and the Extra Week. Income Taxes Our effective income tax rate was 34.1% in 2014, 32.9% in 2013 and 34.5% in 2012. The 2014 and 2013 tax rates differed from the federal statutory rate primarily as a result of the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes. The 2013 benefit from the Domestic Manufacturing deduction was greater than 2014 and 2012 due to the amendment of prior years’ tax returns to claim additional benefit available in years still under review by the Internal Revenue Service. The 2012 tax rate differed from the federal statutory rate primarily as a result of the utilization of tax credits, the favorable resolution of certain tax issues and other changes, partially offset by the effect of state income taxes. COMMON SHARE REPURCHASE PROGRAMS We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time. We made open market purchases of our common shares totaling $1.1 billion in 2014, $338 million in 2013 and $1.2 billion in 2012 under these repurchase programs. In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises. We repurchased approximately $155 million in 2014, $271 million in 2013 and $96 million in 2012 of our common shares under the stock option program. The shares repurchased in 2014 were acquired under three separate share repurchase programs. The first is a $500 million repurchase program that was authorized by our Board of Directors on October 16, 2012. The second is a $1 billion repurchase program that was authorized by our Board of Directors on March 13, 2014, that replaced the first referenced program. The third is a program that uses the cash proceeds from the exercises of stock options by participants in our stock option and long-term incentive plans as well as the associated tax benefits. On June 26, 2014, we announced a new $500 million share repurchase program that was authorized by our Board of Directors, replacing the $1 billion repurchase program that was authorized by our Board of Directors on March 13, 2014. As of January 31, 2015, we have not repurchased any shares utilizing the June 26, 2014 repurchase program. CAPITAL INVESTMENTS Capital investments, including changes in construction-in-progress payables and excluding acquisitions and the purchase of leased facilities, totaled $2.8 billion in 2014, $2.3 billion in 2013 and $2.0 billion in 2012. Capital investments for acquisitions totaled $252 million in 2014, $2.3 billion in 2013 and $122 million in 2012. Payments for acquisitions of $2.3 billion in 2013 relate to our merger with Harris Teeter. Refer to Note 2 to the Consolidated Financial Statements for more information on the merger with Harris Teeter. Capital investments for the purchase of leased facilities totaled $135 million in 2014, $108 million in 2013 and $73 million in 2012. The table below shows our supermarket storing activity and our total food store square footage: Supermarket Storing Activity RETURN ON INVESTED CAPITAL We calculate return on invested capital (“ROIC”) by dividing adjusted operating profit for the prior four quarters by the average invested capital. Adjusted operating profit is calculated by excluding certain items included in operating profit, and adding our LIFO charge, depreciation and amortization and rent. Average invested capital is calculated as the sum of (i) the average of our total assets, (ii) the average LIFO reserve, (iii) the average accumulated depreciation and amortization and (iv) a rent factor equal to total rent for the last four quarters multiplied by a factor of eight; minus (i) the average taxes receivable, (ii) the average trade accounts payable, (iii) the average accrued salaries and wages and (iv) the average other current liabilities. Averages are calculated for return on invested capital by adding the beginning balance of the first quarter and the ending balance of the fourth quarter, of the last four quarters, and dividing by two. We use a factor of eight for our total rent as we believe this is a common factor used by our investors and analysts. ROIC is a non-GAAP financial measure of performance. ROIC should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital. Management believes ROIC is a useful metric to investors and analysts because it measures how effectively we are deploying our assets. All items included in the calculation of ROIC are GAAP measures, excluding certain adjustments to operating profit. Although ROIC is a relatively standard financial term, numerous methods exist for calculating a company’s ROIC. As a result, the method used by our management to calculate ROIC may differ from methods other companies use to calculate their ROIC. We urge you to understand the methods used by other companies to calculate their ROIC before comparing our ROIC to that of such other companies. The following table provides a calculation of ROIC for 2014 and 2013. The calculation of the numerator in the table below only includes Harris Teeter in 2014. The calculation of the denominator excludes the assets and liabilities recorded as of February 1, 2014 for Harris Teeter due to the merger being completed at the end of 2013 ($ in millions): (1) Taxes receivable were $20 as of January 31, 2015, $18 as of February 1, 2014 and $2 as of February 2, 2013. (2) Other current liabilities included accrued income taxes of $5 as of January 31, 2015, $92 as of February 1, 2014 and $128 as of February 2, 2013. Accrued income taxes are removed from other current liabilities in the calculation of average invested capital. (3) Harris Teeter’s invested capital has been excluded from the calculation for 2013 due to the merger being completed at the end of 2013. CRITICAL ACCOUNTING POLICIES We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Our significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. We believe that the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain. Self-Insurance Costs We primarily are self-insured for costs related to workers’ compensation and general liability claims. The liabilities represent our best estimate, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred but not reported for all claims incurred through January 31, 2015. We establish case reserves for reported claims using case-basis evaluation of the underlying claim data and we update as information becomes known. For both workers’ compensation and general liability claims, we have purchased stop-loss coverage to limit our exposure to any significant exposure on a per claim basis. We are insured for covered costs in excess of these per claim limits. We account for the liabilities for workers’ compensation claims on a present value basis utilizing a risk-adjusted discount rate. A 25 basis point decrease in our discount rate would increase our liability by approximately $2 million. General liability claims are not discounted. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can affect ultimate costs. Our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, and any changes could have a considerable effect on future claim costs and currently recorded liabilities. Impairments of Long-Lived Assets We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value. Fair value is determined based on market values or discounted future cash flows. We record impairment when the carrying value exceeds fair market value. With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal. We recorded asset impairments in the normal course of business totaling $37 million in 2014, $39 million in 2013 and $18 million in 2012. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as “Operating, general and administrative” expense. The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different level, could produce significantly different results. Goodwill Our goodwill totaled $2.3 billion as of January 31, 2015. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our operating divisions and variable interest entities (collectively, “reporting units”) that have goodwill balances. Fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment. We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future. If we identify potential for impairment, we measure the fair value of a reporting unit against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the reporting unit’s goodwill. We recognize goodwill impairment for any excess of the carrying value of the reporting unit’s goodwill over the implied fair value. In 2014, goodwill increased $160 million due to our merger with Vitacost.com which closed on August 18, 2014. In addition, goodwill increased $9 million in 2014 and $901 million in 2013 due to our merger with Harris Teeter which closed on January 28, 2014. For additional information related to the allocation of the purchase price for Vitacost.com and Harris Teeter, refer to Note 2 to the Consolidated Financial Statements. The annual evaluation of goodwill performed for our other reporting units during the fourth quarter of 2014, 2013 and 2012 did not result in impairment. Based on current and future expected cash flows, we believe goodwill impairments are not reasonably likely. A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance. For additional information relating to our results of the goodwill impairment reviews performed during 2014, 2013 and 2012 see Note 3 to the Consolidated Financial Statements. The impairment review requires the extensive use of management judgment and financial estimates. Application of alternative estimates and assumptions, such as reviewing goodwill for impairment at a different level, could produce significantly different results. The cash flow projections embedded in our goodwill impairment reviews can be affected by several factors such as inflation, business valuations in the market, the economy and market competition. Store Closing Costs We provide for closed store liabilities on the basis of the present value of the estimated remaining non-cancellable lease payments after the closing date, net of estimated subtenant income. We estimate the net lease liabilities using a discount rate to calculate the present value of the remaining net rent payments on closed stores. We usually pay closed store lease liabilities over the lease terms associated with the closed stores, which generally have remaining terms ranging from one to 20 years. Adjustments to closed store liabilities primarily relate to changes in subtenant income and actual exit costs differing from original estimates. We make adjustments for changes in estimates in the period in which the change becomes known. We review store closing liabilities quarterly to ensure that any accrued amount that is not a sufficient estimate of future costs is adjusted to earnings in the proper period. We estimate subtenant income, future cash flows and asset recovery values based on our experience and knowledge of the market in which the closed store is located, our previous efforts to dispose of similar assets and current economic conditions. The ultimate cost of the disposition of the leases and the related assets is affected by current real estate markets, inflation rates and general economic conditions. We reduce owned stores held for disposal to their estimated net realizable value. We account for costs to reduce the carrying values of property, equipment and leasehold improvements in accordance with our policy on impairment of long-lived assets. We classify inventory write-downs in connection with store closings, if any, in “Merchandise costs.” We expense costs to transfer inventory and equipment from closed stores as they are incurred. Post-Retirement Benefit Plans We account for our defined benefit pension plans using the recognition and disclosure provisions of GAAP, which require the recognition of the funded status of retirement plans on the Consolidated Balance Sheet. We record, as a component of Accumulated Other Comprehensive Income (“AOCI”), actuarial gains or losses, prior service costs or credits and transition obligations that have not yet been recognized. The determination of our obligation and expense for Company-sponsored pension plans and other post-retirement benefits is dependent upon our selection of assumptions used by actuaries in calculating those amounts. Those assumptions are described in Note 15 to the Consolidated Financial Statements and include, among others, the discount rate, the expected long-term rate of return on plan assets, mortality and the rate of increases in compensation and health care costs. Actual results that differ from our assumptions are accumulated and amortized over future periods and, therefore, generally affect our recognized expense and recorded obligation in future periods. While we believe that our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions, including the discount rate used and the expected return on plan assets, may materially affect our pension and other post-retirement obligations and our future expense. Note 15 to the Consolidated Financial Statements discusses the effect of a 1% change in the assumed health care cost trend rate on other post-retirement benefit costs and the related liability. The objective of our discount rate assumptions was intended to reflect the rates at which the pension benefits could be effectively settled. In making this determination, we take into account the timing and amount of benefits that would be available under the plans. Our methodology for selecting the discount rates was to match the plan’s cash flows to that of a hypothetical bond portfolio whose cash flow from coupons and maturities match the plan’s projected benefit cash flows. The discount rates are the single rates that produce the same present value of cash flows. The selection of the 3.87% and 3.74% discount rates as of year-end 2014 for pension and other benefits, respectively, represents the hypothetical bond portfolio using bonds with an AA or better rating constructed with the assistance of an outside consultant. We utilized a discount rate of 4.99% and 4.68% as of year-end 2013 for pension and other benefits, respectively. A 100 basis point increase in the discount rate would decrease the projected pension benefit obligation as of January 31, 2015, by approximately $500 million. To determine the expected rate of return on pension plan assets held by Kroger for 2014, we considered current and forecasted plan asset allocations as well as historical and forecasted rates of return on various asset categories. In 2014, we decreased our assumed pension plan investment return rate to 7.44%, compared to 8.50% in 2013 and 2012. Our pension plan’s average rate of return was 7.58% for the 10 calendar years ended December 31, 2014, net of all investment management fees and expenses. The value of all investments in our Company-sponsored defined benefit pension plans during the calendar year ending December 31, 2014, net of investment management fees and expenses, increased 5.65%. For the past 20 years, our average annual rate of return has been 9.58%. Based on the above information and forward looking assumptions for investments made in a manner consistent with our target allocations, we believe a 7.44% rate of return assumption is reasonable for 2014. See Note 15 to the Consolidated Financial Statements for more information on the asset allocations of pension plan assets. On January 31, 2015, we adopted new mortality tables based on mortality experience and assumptions for generational mortality improvement in calculating our 2014 year end pension obligation. The tables assume an improvement in life expectancy and increase our benefit obligation and future expenses. We used the RP-2000 projected 2021 mortality table in calculating our 2013 year end pension obligation and 2014, 2013 and 2012 pension expense. Sensitivity to changes in the major assumptions used in the calculation of Kroger’s pension plan liabilities is illustrated below (in millions). In 2014, we did not contribute to our Company-sponsored defined benefit plans and do not expect to make any contributions to this plan in 2015. We contributed $100 million in 2013 and $71 million in 2012 to our Company-sponsored defined benefit pension plans. Among other things, investment performance of plan assets, the interest rates required to be used to calculate the pension obligations, and future changes in legislation, will determine the amounts of contributions. We contributed and expensed $177 million in 2014, $148 million in 2013 and $140 million in 2012 to employee 401(k) retirement savings accounts. The increase in 2014 is due to the effect of our merger with Harris Teeter. The 401(k) retirement savings account plans provide to eligible employees both matching contributions and automatic contributions from the Company based on participant contributions, plan compensation, and length of service. Multi-Employer Pension Plans We contribute to various multi-employer pension plans, including the UFCW Consolidated Pension Plan, based on obligations arising from collective bargaining agreements. We are designated as the named fiduciary of the UFCW Consolidated Pension Plan and have sole investment authority over these assets. These multi-employer pension plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans. In the first quarter of 2014, we incurred a charge of $56 million (after-tax) related to commitments and withdrawal liabilities associated with the restructuring of pension plan agreements, of which $15 million was contributed to the UFCW Consolidated Pension Plan in 2014. We are required to contribute an additional $75 million over the next four years related to the restructuring of these pension plan agreements. We recognize expense in connection with these plans as contributions are funded or, in the case of the UFCW Consolidated Pension Plan, when commitments are made, in accordance with GAAP. We made cash contributions to these plans of $297 million in 2014, $228 million in 2013 and $492 million in 2012. The cash contributions for 2012 include our $258 million contribution to the UFCW Consolidated Pension Plan in the fourth quarter of 2012. Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2014. Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding. Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer except as noted above. As of December 31, 2014, we estimate that our share of the underfunding of multi-employer plans to which we contribute was $1.8 billion, pre-tax, or $1.2 billion, after-tax. This represents an increase in the estimated amount of underfunding of approximately $200 million, pre-tax, or $130 million, after-tax, as of December 31, 2014, compared to December 31, 2013. The increase in the amount of underfunding is attributable to lower than expected returns on the assets held in the multi-employer plans during 2014. Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable. We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours. Rather, we believe the underfunding is likely to have important consequences. In 2015, we expect to contribute approximately $250 million to multi-employer pension plans, subject to collective bargaining and capital market conditions. We expect increases in expense as a result of increases in multi-employer pension plan contributions over the next few years. Finally, underfunding means that, in the event we were to exit certain markets or otherwise cease making contributions to these funds, we could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated, in accordance with GAAP. The amount of underfunding described above is an estimate and could change based on contract negotiations, returns on the assets held in the multi-employer plans and benefit payments. The amount could decline, and our future expense would be favorably affected, if the values of the assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, our share of the underfunding could increase and our future expense could be adversely affected if the asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation. We continue to evaluate our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of ours, any commitments to fund certain multi-employer plans will be expensed when our commitment is probable and an estimate can be made. See Note 16 to the Consolidated Financial Statements for more information relating to our participation in these multi-employer pension plans. Uncertain Tax Positions We review the tax positions taken or expected to be taken on tax returns to determine whether and to what extent a benefit can be recognized in our Consolidated Financial Statements. Refer to Note 5 to the Consolidated Financial Statements for the amount of unrecognized tax benefits and other disclosures related to uncertain tax positions. Various taxing authorities periodically audit our income tax returns. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing positions, including state and local taxes, we record allowances for probable exposures. A number of years may elapse before a particular matter, for which an allowance has been established, is audited and fully resolved. As of January 31, 2015, the Internal Revenue Service had concluded its examination of our 2008 and 2009 federal tax returns. Tax years 2010 through 2013 remain under examination. The assessment of our tax position relies on the judgment of management to estimate the exposures associated with our various filing positions. Share-Based Compensation Expense We account for stock options under the fair value recognition provisions of GAAP. Under this method, we recognize compensation expense for all share-based payments granted. We recognize share-based compensation expense, net of an estimated forfeiture rate, over the requisite service period of the award. In addition, we record expense for restricted stock awards in an amount equal to the fair market value of the underlying stock on the grant date of the award, over the period the award restrictions lapse. Inventories Inventories are stated at the lower of cost (principally on a LIFO basis) or market. In total, approximately 95% of inventories in 2014 and 2013 were valued using the LIFO method. Cost for the balance of the inventories, including substantially all fuel inventories, was determined using the FIFO method. Replacement cost was higher than the carrying amount by $1.2 billion at January 31, 2015 and February 1, 2014. We follow the Link-Chain, Dollar-Value LIFO method for purposes of calculating our LIFO charge or credit. We follow the item-cost method of accounting to determine inventory cost before the LIFO adjustment for substantially all store inventories at our supermarket divisions. This method involves counting each item in inventory, assigning costs to each of these items based on the actual purchase costs (net of vendor allowances and cash discounts) of each item and recording the cost of items sold. The item-cost method of accounting allows for more accurate reporting of periodic inventory balances and enables management to more precisely manage inventory. In addition, substantially all of our inventory consists of finished goods and is recorded at actual purchase costs (net of vendor allowances and cash discounts). We evaluate inventory shortages throughout the year based on actual physical counts in our facilities. We record allowances for inventory shortages based on the results of recent physical counts to provide for estimated shortages from the last physical count to the financial statement date. Vendor Allowances We recognize all vendor allowances as a reduction in merchandise costs when the related product is sold. In most cases, vendor allowances are applied to the related product cost by item, and therefore reduce the carrying value of inventory by item. When it is not practicable to allocate vendor allowances to the product by item, we recognize vendor allowances as a reduction in merchandise costs based on inventory turns and as the product is sold. We recognized approximately $6.9 billion in 2014 and $6.2 billion in 2013 and 2012 of vendor allowances as a reduction in merchandise costs. We recognized approximately 93% of all vendor allowances in the item cost with the remainder being based on inventory turns. RECENTLY ADOPTED ACCOUNTING STANDARDS In February 2013, the Financial Accounting Standards Board (“FASB”) amended its standards on comprehensive income by requiring disclosure of information about amounts reclassified out of AOCI by component. Specifically, the amendment requires disclosure of the effect of significant reclassifications out of AOCI on the respective line items in net income in which the item was reclassified if the amount being reclassified is required to be reclassified to net income in its entirety in the same reporting period. It requires cross reference to other disclosures that provide additional detail for amounts that are not required to be reclassified in their entirety in the same reporting period. This new disclosure became effective for us beginning February 3, 2013, and was adopted prospectively in accordance with the standard. See Note 9 to the Consolidated Financial Statements for our disclosures related to this amended standard. In July 2013, the FASB amended Accounting Standards Codification 740, “Income Taxes.” The amendment provides guidance on the financial statement presentation of an unrecognized tax benefit, as either a reduction of a deferred tax asset or as a liability, when a net operating loss carryforward, similar tax loss, or a tax credit carryforward exists. This amendment became effective for us beginning February 2, 2014, and was adopted prospectively in accordance with the standard. The adoption of this amendment did not have an effect on net income and did not have a significant effect on the Consolidated Balance Sheets. RECENTLY ISSUED ACCOUNTING STANDARDS In May 2014, FASB issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers”, which provides guidance for revenue recognition. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. This guidance will be effective for us in the first quarter of its fiscal year ending January 27, 2018. Early adoption is not permitted. We are currently in the process of evaluating the effect of adoption of this ASU on the Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES Cash Flow Information Net cash provided by operating activities We generated $4.2 billion of cash from operations in 2014, compared to $3.6 billion in 2013 and $3.0 billion in 2012. The cash provided by operating activities came from net earnings including non-controlling interests adjusted primarily for non-cash expenses of depreciation and amortization, the LIFO charge and changes in working capital. The increase in net cash provided by operating activities in 2014, compared to 2013, resulted primarily due to an increase in net earnings including non-controlling interests, which include the results of Harris Teeter, an increase in non-cash items, a reduction in contributions to Company-sponsored pension plans and changes in working capital. The increase in non-cash items in 2014, as compared to 2013, was primarily due to increases in depreciation and amortization expense and the LIFO charge. Cash provided (used) by operating activities for changes in working capital was ($49) million in 2014, compared to $63 million in 2013 and ($211) million in 2012. The increase in cash used by operating activities for changes in working capital in 2014, compared to 2013, was primarily due to an increase in cash used for receivables and a decrease in cash provided by trade accounts payables, partially offset by an increase in cash provided by accrued expenses. The increase in net cash provided by operating activities in 2013, compared to 2012, resulted primarily due to changes in working capital and long-term liabilities. The increase in cash provided by operating activities for changes in working capital in 2013, compared to 2012, was primarily due to a decrease in cash used for deposits in-transit, prepaid expenses and receivables. The use of cash for the payment of long-term liabilities decreased in 2013, as compared to 2012, primarily due to our funding of the remaining unfunded actuarial accrued liability for the UFCW Consolidated Pension Plan in 2012. The amount of cash paid for income taxes increased in 2014, compared to 2013, primarily due to an increase in net earnings including non-controlling interests. The amount of cash paid for income taxes increased in 2013, compared to 2012, primarily due to additional deductions taken in 2012 related to the funding of our pension contributions and union health benefits. Net cash used by investing activities Cash used by investing activities was $3.1 billion in 2014, compared to $4.8 billion in 2013 and $2.2 billion in 2012. The amount of cash used by investing activities decreased in 2014, compared to 2013, due to decreased payments for acquisitions, offset primarily by increased payments for capital investments. The amount of cash used by investing activities increased in 2013, compared to 2012, due to increased payments for capital investments and acquisitions. Capital investments, including payments for lease buyouts and excluding acquisitions, were $2.8 billion in 2014, $2.3 billion in 2013 and $2.1 billion in 2012. Acquisitions were $252 million in 2014, $2.3 billion in 2013 and $122 million in 2012. The decrease in payments for acquisitions in 2014, compared to 2013, and the increase in payments for acquisitions in 2013, compared to 2012, was primarily due to our merger with Harris Teeter in 2013. Refer to the “Capital Investments” section for an overview of our supermarket storing activity during the last three years. Net cash provided (used) by financing activities Financing activities provided (used) cash of ($1.2) billion in 2014, $1.4 billion in 2013 and ($721) million in 2012. The increase in the amount of cash used for financing activities in 2014, compared to 2013, was primarily related to decreased proceeds from the issuance of long-term debt and increased treasury stock purchases, offset partially by decreased payments on long-term debt. The increase in cash provided by financing activities in 2013, compared to 2012, was primarily related to increased proceeds from the issuance of long-term debt, primarily to finance our merger with Harris Teeter, and a reduction in payments on long-term debt and treasury stock purchases, offset partially by net payments on our commercial paper program. Proceeds from the issuance of long-term debt were $576 million in 2014, $3.5 billion in 2013 and $863 million in 2012. Net borrowings (payments) provided from our commercial paper program were $25 million in 2014, ($395) million in 2013 and $1.3 billion in 2012. Please refer to the “Debt Management” section of MD&A for additional information. We repurchased $1.3 billion of Kroger common shares in 2014, compared to $609 million in 2013 and $1.3 billion in 2012. We paid dividends totaling $338 million in 2014, $319 million in 2013 and $267 million in 2012. Debt Management Total debt, including both the current and long-term portions of capital lease and lease-financing obligations increased $346 million to $11.7 billion as of year-end 2014, compared to 2013. The increase in 2014, compared to 2013, resulted primarily from the issuance of (i) $500 million of senior notes bearing an interest rate of 2.95% and (ii) an increase in commercial paper of $25 million, partially offset by payments at maturity of $300 million of senior notes bearing an interest rate of 4.95%. The increase in financing obligations was due to partially funding our outstanding common share repurchases. Total debt, including both the current and long-term portions of capital lease and lease-financing obligations increased $2.4 billion to $11.3 billion as of year-end 2013, compared to 2012. The increase in 2013, compared to 2012, resulted from the issuance of (i) $600 million of senior notes bearing an interest rate of 3.85%, (ii) $400 million of senior notes bearing an interest rate of 5.15%, (iii) $500 million of senior notes bearing an interest rate of 3-month London Inter-Bank Offering Rate (“LIBOR”) plus 53 basis points, (iv) $300 million of senior notes bearing an interest rate of 1.2%, (v) $500 million of senior notes bearing an interest rate of 2.3%, (vi) $700 million of senior notes bearing an interest rate of 3.3%, and (vii) $500 million of senior notes bearing an interest rate of 4.0%, offset partially by a reduction in commercial paper of $395 million and payments at maturity of $400 million of senior notes bearing an interest rate of 5.0% and $600 million of senior notes bearing an interest rate of 7.5%. This increase in financing obligations was due to partially funding our merger with Harris Teeter, refinancing our debt maturities in 2013 and replacing the senior notes that matured in the fourth quarter of 2012, offset partially by the payment at maturity of our $400 million of senior notes bearing an interest rate of 5.0%, $600 million of senior notes bearing an interest rate of 7.5% and a reduction in commercial paper of $395 million. Liquidity Needs We estimate our liquidity needs over the next twelve-month period to be approximately $5.2 billion, which includes anticipated requirements for working capital, capital expenditures, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2014. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months. We have approximately $1.3 billion of commercial paper and $500 million of senior notes maturing in the next twelve months, which is included in the $5.2 billion in estimated liquidity needs. We expect to refinance this debt, in 2015, by issuing additional senior notes or commercial paper on favorable terms based on our past experience. We also currently plan to continue repurchases of common shares under the Company’s share repurchase programs. We believe we have adequate coverage of our debt covenants to continue to maintain our current debt ratings and to respond effectively to competitive conditions. Factors Affecting Liquidity We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper (“CP”) program. At January 31, 2015, we had $1.3 billion of CP borrowings outstanding. CP borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility. If our short-term credit ratings fall, the ability to borrow under our current CP program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our CP program. This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity. However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our CP program would be any lower than $500 million on a daily basis. Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost on borrowings under the credit facility could be affected by an increase in our Leverage Ratio. As of March 27, 2015, we had $1.0 billion of CP borrowings outstanding. The decrease as of March 27, 2015, compared to year-end 2014, was due to applying cash from operations against our year-end CP outstanding borrowings. Our credit facility requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our “financial covenants”). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants and ratios are described below: · Our Leverage Ratio (the ratio of Net Debt to Consolidated EBITDA, as defined in the credit facility) was 2.06 to 1 as of January 31, 2015. If this ratio were to exceed 3.50 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. In addition, our Applicable Margin on borrowings is determined by our Leverage Ratio. · Our Fixed Charge Coverage Ratio (the ratio of Consolidated EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facility) was 4.99 to 1 as of January 31, 2015. If this ratio fell below 1.70 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. Our credit agreement is more fully described in Note 6 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2014. The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of January 31, 2015 (in millions of dollars): (1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $25 million in 2014. This table also excludes contributions under various multi-employer pension plans, which totaled $297 million in 2014. (2) The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined. (3) As of January 31, 2015, we had $1.3 billion of borrowings of commercial paper and no borrowings under our credit agreement. (4) Amounts include contractual interest payments using the interest rate as of January 31, 2015, and stated fixed and swapped interest rates, if applicable, for all other debt instruments. (5) The amounts included in the contractual obligations table for self-insurance liability related to workers’ compensation claims have been stated on a present value basis. (6) Amounts include funds owed to third parties for projects currently under construction. These amounts are reflected in other current liabilities in our Consolidated Balance Sheets. (7) Amounts include commitments, many of which are short-term in nature, to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our manufacturing plants and several contracts to purchase energy to be used in our stores and manufacturing facilities. Our obligations also include management fees for facilities operated by third parties and outside service contracts. Any upfront vendor allowances or incentives associated with outstanding purchase commitments are recorded as either current or long-term liabilities in our Consolidated Balance Sheets. As of January 31, 2015, we maintained a $2.75 billion (with the ability to increase by $750 million), unsecured revolving credit facility that, unless extended, terminates on June 30, 2019. Outstanding borrowings under the credit agreement and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit agreement. As of January 31, 2015, we had $1.3 billion of borrowings of commercial paper and no borrowings under our credit agreement. The outstanding letters of credit that reduce funds available under our credit agreement totaled $10 million as of January 31, 2015. In addition to the available credit mentioned above, as of January 31, 2015, we had authorized for issuance $2 billion of securities under a shelf registration statement filed with the SEC and effective on December 13, 2013. We also maintain surety bonds related primarily to our self-insured workers’ compensation claims. These bonds are required by most states in which we are self-insured for workers’ compensation and are placed with predominately third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of ours, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility. We also are contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. We could be required to satisfy obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of our assignments among third parties, and various other remedies available to us, we believe the likelihood that we will be required to assume a material amount of these obligations is remote. We have agreed to indemnify certain third-party logistics operators for certain expenses, including pension trust fund contribution obligations and withdrawal liabilities. In addition to the above, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third party claims arising out of agreements to provide services to us; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability. OUTLOOK This discussion and analysis contains certain forward-looking statements about our future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available to it. Such statements are indicated by words such as “comfortable,” “committed,” “will,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” “plan,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially. Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially. · We expect net earnings per diluted share in the range of $3.80-$3.90 for fiscal year 2015, which is consistent with our long-term net earnings per diluted share growth rate of 8 - 11%, growing off of 2014 adjusted net earnings of $3.52 per diluted share. · We expect identical supermarket sales growth, excluding fuel sales, of 3.0%-4.0% in fiscal year 2015. · We expect full-year FIFO non-fuel operating margin for 2015 to expand slightly compared to 2014, excluding the 2014 Adjusted Items. · For 2015, we expect our annualized LIFO charge to be approximately $75 million. · For 2015, we expect interest expense to be approximately $480 million. · We plan to use cash flow primarily to maintain our current investment grade debt rating, fund capital investments, fund our cash dividend and repurchase shares of common stock. · We expect to obtain sales growth from new square footage, as well as from increased productivity from existing locations. · We expect capital investments, excluding mergers, acquisitions and purchases of leased facilities, to be $3.0 - $3.3 billion. We expect total food store square footage for 2015 to grow approximately 2.0% - 2.5% before mergers, acquisitions and operational closings. · For 2015, we expect our effective tax rate to be approximately 35.0%, excluding the resolution of certain tax items and potential changes to tax legislation. · We do not anticipate goodwill impairments in 2015. · For 2015, we expect to contribute approximately $250 million to multi-employer pension funds. We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of Kroger, any new agreements that would commit us to fund certain multi-employer plans will be expensed when our commitment is probable and an estimate can be made. · In 2015, we will negotiate agreements with the UFCW for store associates in Columbus, Denver, Las Vegas, Louisville, Memphis and Portland, and agreements with the Teamsters covering several distribution and manufacturing facilities. Negotiations this year will be challenging as we must have competitive cost structures in each market while meeting our associates’ needs for solid wages and good quality, affordable health care and retirement benefits. Various uncertainties and other factors could cause actual results to differ materially from those contained in the forward-looking statements. These include: · The extent to which our sources of liquidity are sufficient to meet our requirements may be affected by the state of the financial markets and the effect that such condition has on our ability to issue commercial paper at acceptable rates. Our ability to borrow under our committed lines of credit, including our bank credit facilities, could be impaired if one or more of our lenders under those lines is unwilling or unable to honor its contractual obligation to lend to us, or in the event that natural disasters or weather conditions interfere with the ability of our lenders to lend to us. Our ability to refinance maturing debt may be affected by the state of the financial markets. · Our ability to use cash flow to continue to maintain our investment grade debt rating and repurchase shares, fund dividends and increase capital investments, could be affected by unanticipated increases in net total debt, our inability to generate cash flow at the levels anticipated, and our failure to generate expected earnings. · Our ability to achieve sales, earnings and cash flow goals may be affected by: labor negotiations or disputes; changes in the types and numbers of businesses that compete with us; pricing and promotional activities of existing and new competitors, including non-traditional competitors, and the aggressiveness of that competition; our response to these actions; the state of the economy, including interest rates, the inflationary and deflationary trends in certain commodities, and the unemployment rate; the effect that fuel costs have on consumer spending; volatility of fuel margins; changes in government-funded benefit programs; manufacturing commodity costs; diesel fuel costs related to our logistics operations; trends in consumer spending; the extent to which our customers exercise caution in their purchasing in response to economic conditions; the inconsistent pace of the economic recovery; changes in inflation or deflation in product and operating costs; stock repurchases; our ability to retain pharmacy sales from third party payors; consolidation in the health care industry, including pharmacy benefit managers; our ability to negotiate modifications to multi-employer pension plans; natural disasters or adverse weather conditions; the potential costs and risks associated with potential cyber-attacks or data security breaches; the success of our future growth plans; and the successful integration of Harris Teeter. Our ability to achieve sales and earnings goals may also be affected by our ability to manage the factors identified above. · Our capital investments could differ from our estimate if we are unsuccessful in acquiring suitable sites for new stores, if development costs vary from those budgeted, if our logistics and technology or store projects are not completed on budget or within the time frame projected, or if economic conditions fail to improve, or worsen. · During the first three quarters of each fiscal year, our LIFO charge and the recognition of LIFO expense is affected primarily by estimated year-end changes in product costs. Our fiscal year LIFO charge is affected primarily by changes in product costs at year-end. · If actual results differ significantly from anticipated future results for certain reporting units including variable interest entities, an impairment loss for any excess of the carrying value of the reporting units’ goodwill over the implied fair value would have to be recognized. · Our effective tax rate may differ from the expected rate due to changes in laws, the status of pending items with various taxing authorities, and the deductibility of certain expenses. · Changes in our product mix may negatively affect certain financial indicators. For example, we continue to add supermarket fuel centers to our store base. Since gasoline generates low profit margins, we expect to see our FIFO gross profit margins decline as gasoline sales increase. We cannot fully foresee the effects of changes in economic conditions on Kroger’s business. We have assumed economic and competitive situations will not change significantly in 2015. Other factors and assumptions not identified above could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in, contemplated or implied by forward-looking statements made by us or our representatives. We undertake no obligation to update the forward-looking information contained in this filing.

<s>[INST] OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. Kroger is one of the nation’s largest retailers, as measured by revenue, operating 2,625 supermarket and multidepartment stores under two dozen banners including Kroger, City Market, Dillons, Food 4 Less, Fred Meyer, Fry’s, Harris Teeter, Jay C, King Soopers, QFC, Ralphs and Smith’s. Of these stores, 1,330 have fuel centers. We also operate 782 convenience stores, either directly or through franchisees, 326 fine jewelry stores and an online retailer. We operate 37 manufacturing plants, primarily bakeries and dairies, which supply approximately 40% of the corporate brand units sold in our supermarkets. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 99% of our consolidated sales and EBITDA, is our only reportable segment. On January 28, 2014, we closed our merger with Harris Teeter by purchasing 100% of the Harris Teeter outstanding common stock for approximately $2.4 billion. The merger allows us to expand into the fastgrowing southeastern and midAtlantic markets and into Washington, D.C. Harris Teeter is included in our ending Consolidated Balance Sheets for 2013 and 2014 and in our Consolidated Statements of Operations for 2014. Due to the timing of the merger closing late in fiscal year 2013, its results of operations were not material to our consolidated results of operations for 2013. Yearoveryear comparisons will be affected as a result. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Harris Teeter. On August 18, 2014, we closed our merger with Vitacost.com by purchasing 100% of the Vitacost.com outstanding common stock for $8.00 per share or $287 million. Vitacost.com is a leading online retailer in health and wellness products, which are sold directly to consumers through the website vitacost.com. The merger affords us access to Vitacost.com’s extensive ecommerce platform, which can be combined with our customer insights and loyal customer base, to create new levels of personalization and convenience for our customers. Vitacost.com is included in our ending Consolidated Balance Sheets and Consolidated Statements of Operations for 2014. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Vitacost.com. OUR 2014 PERFORMANCE We achieved outstanding results in 2014. Our business strategy continues to resonate with a full range of customers and our results reflect the balance we seek to achieve across our business including positive identical sales growth, increases in loyal household count, and good cost control, as well as growth in net earnings and net earnings per diluted share. Our 2014 net earnings were $1.7 billion or $3.44 per diluted share, compared to $1.5 billion, or $2.90 per diluted share for the same period of 2013. Our net earnings for 2014 include a net $39 million aftertax charge for an $87 million ($56 million aftertax) charge to operating, general and administrative (“OG&A”) expenses due to the commitments and withdrawal liabilities arising from restructuring of certain pension plan agreements to help stabilize associates’ future pension benefits, offset partially by the benefits from certain tax items ($17 million) (“2014 Adjusted Items”). In addition, our net earnings for 2014 included unusually high fuel margins, partially offset by a lastin, firstout (“ [/INST] Positive. </s>

KROGER CO

2016-03-29

2016-01-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I, the “Risk Factors” section set forth in Item 1A of Part I and the “Outlook” section below. OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. Kroger is one of the nation’s largest retailers, as measured by revenue, operating 2,778 supermarket and multi-department stores under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 1,387 have fuel centers. We also operate 784 convenience stores, either directly or through franchisees, 323 fine jewelry stores and an online retailer. We operate 38 food production plants, primarily bakeries and dairies, which supply approximately 40% of the corporate brand units sold in our supermarkets. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 99% of our consolidated sales and EBITDA, is our only reportable segment. On December 18, 2015, we closed our merger with Roundy’s by purchasing 100% of the Roundy’s outstanding common stock for $3.60 per share and assuming Roundy’s outstanding debt, for a purchase price of $866 million. Roundy’s is included in our ending Consolidated Balance Sheets for 2015 and in our Consolidated Statements of Operations for the last six weeks of 2015. Certain year-over-year comparisons will be affected as a result. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Roundy’s. On August 18, 2014, we closed our merger with Vitacost.com by purchasing 100% of the Vitacost.com outstanding common stock for $8.00 per share or $287 million. Vitacost.com is included in our ending Consolidated Balance Sheets and Consolidated Statements of Operations for 2014 and 2015. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Vitacost.com. On January 28, 2014, we closed our merger with Harris Teeter by purchasing 100% of the Harris Teeter outstanding common stock for approximately $2.4 billion. Harris Teeter is included in our ending Consolidated Balance Sheets for 2014 and 2015 and in our Consolidated Statements of Operations for 2014 and 2015. Due to the timing of the merger closing late in fiscal year 2013, its results of operations were not material to our consolidated results of operations for 2013. Certain year-over-year comparisons will be affected as a result. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Harris Teeter. OUR 2015 PERFORMANCE We achieved outstanding results in 2015. Our business strategy continues to resonate with a full range of customers and our results reflect the balance we seek to achieve across our business including positive identical supermarket sales growth, increases in loyal household count, and good cost control, as well as growth in net earnings and net earnings per diluted share. Our 2015 net earnings were $2.0 billion or $2.06 per diluted share, compared to $1.7 billion, or $1.72 per diluted share for 2014. All share and per share amounts presented are reflective of the two-for-one stock split that began trading at the split adjusted price on July 14, 2015. Our net earnings for 2015 include a $110 million expense to operating, general, and administrative (“OG&A”) for certain contributions to the United Food and Commercial Workers International Union (“UFCW”) Consolidated Pension Plan (“2015 UFCW Contributions”) made during the third and fourth quarters of 2015. In addition, our net earnings for 2015 include a lower last-in, first-out (“LIFO”) charge compared to 2014. Net earnings for 2014 include a net $39 million after-tax charge for an $87 million ($56 million after-tax) charge to OG&A due to the commitments and withdrawal liabilities arising from restructuring of certain multi-employer obligations (“2014 Multi-Employer Pension Plan Obligation”) to help stabilize associates’ future pension benefits, offset partially by the benefits from certain tax items of $17 million (“2014 Adjusted Items”). In addition, our net earnings for 2014 include unusually high fuel margins, partially offset by a LIFO charge that was significantly higher than 2013 and $140 million in contributions charged to OG&A expenses for the UFCW Consolidated Pension Plan ($55 million) and The Kroger Co. Foundation ($85 million) (“2014 Contributions”). The 2015 and 2014 contributions to the UFCW Consolidated Pension Plan was to further fund the plan. The $85 million contribution, in 2014, to The Kroger Co. Foundation will enable it to continue to support causes such as hunger relief, breast cancer awareness, the military and their families and local community organizations. Fuel margin per gallon was $0.19 in 2014, compared to $0.14 in 2013. Our net earnings for 2013 include a net benefit of $23 million, which includes benefits from certain tax items of $40 million, offset partially by costs of $11 million in interest and $16 million in OG&A expenses ($17 million after-tax) related to our merger with Harris Teeter (“2013 Adjusted Items”). Our 2015 net earnings were $2.0 billion or $2.06 per diluted share, compared to $1.7 billion, or $1.72 per diluted share for 2014. Net earnings for 2015 totaled $2.0 billion, or $2.06 per diluted share, compared to net earnings in 2014 of $1.8 billion, or $1.76 per diluted share, excluding the 2014 Adjusted Items. We believe adjusted net earnings and adjusted net earnings per diluted share present a more accurate year-over-year comparison of our financial results because the 2014 Adjusted Items were not the result of our normal operations. Our net earnings per diluted share for 2015 represent a 17% increase, compared to 2014 adjusted net earnings per diluted share. Please refer to the “Net Earnings” section of MD&A for more information. Our identical supermarket sales increased 5.0%, excluding fuel, in 2015, compared to 2014. We have achieved 49 consecutive quarters of positive identical supermarket sales growth, excluding fuel. As we continue to outpace many of our competitors on identical supermarket sales growth, we continue to gain market share. We focus on identical supermarket sales growth, excluding fuel, as it is a key performance target for our long-term growth strategy. Increasing market share is an important part of our long-term strategy as it best reflects how our products and services resonate with customers. Market share growth allows us to spread the fixed costs in our business over a wider revenue base. Our fundamental operating philosophy is to maintain and increase market share by offering customers good prices and superior products and service. Based on Nielsen POS+ data, our overall market share of the products we sell in markets in which we operate increased by approximately 40 basis points in 2015. This data also indicates that our market share increased in 17 markets and declined in one. These market share results reflect our long-term strategy of market share growth. RESULTS OF OPERATIONS The following discussion summarizes our operating results for 2015 compared to 2014 and for 2014 compared to 2013. Comparability is affected by income and expense items that fluctuated significantly between and among the periods, our merger with Roundy’s in late 2015 and our merger with Harris Teeter in late 2013. All share and per share amounts presented below are reflective of the two-for-one stock split that began trading at the split adjusted price on July 14, 2015. Management believes adjusted net earnings (and adjusted net earnings per diluted share) are useful metrics to investors and analysts because they more accurately reflect our day-to-day business operations than do the generally accepted accounting principle (“GAAP”) measures of net earnings and net earnings per diluted share. Adjusted net earnings (and adjusted net earnings per diluted share) are non-generally accepted accounting principle (“non-GAAP”) financial measures and should not be considered alternatives to net earnings (and net earnings per diluted share) or any other GAAP measure of performance. Adjusted net earnings (and adjusted net earnings per diluted share) should not be viewed in isolation or considered substitutes for our financial results as reported in accordance with GAAP. Management uses adjusted net earnings (and adjusted net earnings per diluted share) in evaluating our results of operations as it believes these measures are more meaningful indicators of operating performance since, as adjusted, those earnings relate more directly to our day-to-day operations. Management also uses adjusted net earnings (and adjusted net earnings per diluted share) as a performance metric for management incentive programs, and to measure our progress against internal budgets and targets. Net Earnings Net earnings totaled $2.0 billion in 2015, $1.7 billion in 2014 and $1.5 billion in 2013. Net earnings improved in 2015, compared to net earnings in 2014, due to an increase in operating profit, partially offset by an increase in income tax expense. Operating profit increased in 2015, compared to 2014, primarily due to an increase in first-in, first-out (“FIFO”) non-fuel operating profit, lower charges for total contributions to The Kroger Co. Foundation, UFCW Consolidated Pension Plan, the charge related to the 2014 Multi-Employer Pension Plan Obligation and a lower LIFO charge which was $28 million (pre-tax), compared to a LIFO charge of $147 million (pre-tax) in 2014, partially offset by a decrease in fuel operating profit and continued investments in lower prices for our customers. The decrease in fuel operating profit was primarily due to a decrease in fuel margin per gallon to $0.17 in 2015, compared to $0.19 in 2014, partially offset by an increase in fuel gallons sold. Continued investments in lower prices for our customers includes our pharmacy department, which experienced high levels of inflation that were not fully passed on to the customer in 2015. Net earnings improved in 2014, compared to net earnings in 2013, due to an increase in operating profit, partially offset by increases in interest and income tax expense. Operating profit increased in 2014, compared to 2013, primarily due to an increase in FIFO non-fuel operating profit, excluding Harris Teeter, the effect of our merger with Harris Teeter and an increase in fuel operating profit, partially offset by continued investments in lower prices for our customers, the 2014 Contributions, the charge related to the 2014 Multi-Employer Pension Plan Obligation and a higher LIFO charge which was $147 million (pre-tax), compared to a LIFO charge of $52 million (pre-tax) in 2013. The net earnings for 2015 do not include any non-GAAP adjustments. The net earnings for 2014 include a net charge of $39 million, after tax, related to the 2014 Adjusted Items. The net earnings for 2013 include a net benefit of $23 million, after tax, related to the 2013 Adjusted Items. Excluding these benefits and charges for Adjusted Items for 2014 and 2013, adjusted net earnings were $2.0 billion in 2015, $1.8 billion in 2014 and $1.5 billion in 2013. 2015 net earnings improved, compared to adjusted net earnings in 2014, due to an increase in FIFO non-fuel operating profit, lower charges for total contributions to The Kroger Co. Foundation and UFCW Consolidated Pension Plan and a lower LIFO charge which was $28 million (pre-tax), compared to a LIFO charge of $147 million (pre-tax) in 2014, partially offset by continued investments in lower prices for our customers, a decrease in fuel operating profit and an increase in income tax expense. Continued investments in lower prices for our customers includes our pharmacy department, which experienced high levels of inflation that were not fully passed on to the customer in 2015. 2014 adjusted net earnings improved, compared to adjusted net earnings in 2013, due to an increase in FIFO non-fuel operating profit, excluding Harris Teeter, the effect of our merger with Harris Teeter and an increase in fuel operating profit, partially offset by continued investments in lower prices for our customers, the 2014 Contributions, increases in interest and income tax expense and a higher LIFO charge which was $147 million (pre-tax), compared to a LIFO charge of $52 million (pre-tax) in 2013. Net earnings per diluted share totaled $2.06 in 2015, $1.72 in 2014 and $1.45 in 2013. Net earnings per diluted share in 2015, compared to 2014, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in net earnings. Net earnings per diluted share in 2014, compared to 2013, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in net earnings. There were no adjustment items in 2015, but excluding the 2014 and 2013 Adjusted Items, adjusted net earnings per diluted share totaled $1.76 in 2014 and $1.43 in 2013. Net earnings per diluted share in 2015, compared to adjusted net earnings per diluted share in 2014, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in adjusted net earnings. Adjusted net earnings per diluted share in 2014, compared to adjusted net earnings per diluted share in 2013, increased primarily due to fewer shares outstanding as a result of the repurchase of Kroger common shares and an increase in adjusted net earnings. The following table provides a reconciliation of net earnings attributable to The Kroger Co. to net earnings attributable to The Kroger Co. excluding Adjusted Items for 2014 and 2013 and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to the net earnings attributable to The Kroger Co. per diluted common share excluding Adjusted Items for 2014 and 2013. In 2015, we did not have any adjustment items that affect net earnings or net earnings per diluted share. Net Earnings per Diluted Share excluding the Adjusted Items (in millions, except per share amounts) (1) The amounts presented represent the net earnings per diluted common share effect of each adjusted item. Sales Total Sales (in millions) (1) Other sales primarily relate to sales at convenience stores, excluding fuel; jewelry stores; food production plants to outside customers; variable interest entities; a specialty pharmacy; in-store health clinics; sales on digital coupon services; and online sales by Vitacost.com. (2) This column represents the sales percentage increases in 2015, compared to 2014. (3) This column represents the sales percentage increases in 2014, compared to 2013. Total sales increased in 2015, compared to 2014, by 1.3%. This increase in 2015 total sales, compared to 2014, was primarily due to an increase in identical supermarket sales, excluding fuel, of 5.0%. Total sales also increased due to the inclusion of Roundy’s sales, due to our merger, for the period of December 18, 2015 to January 30, 2016. Identical supermarket sales, excluding fuel, for 2015, compared to 2014, increased primarily due to an increase in the number of households shopping with us, an increase in visits per household, changes in product mix and product cost inflation. Total fuel sales decreased in 2015, compared to 2014, primarily due to a 26.7% decrease in the average retail fuel price, partially offset by an increase in fuel gallons sold of 7.1%. Total sales increased in 2014, compared to 2013, by 10.3%. This increase in 2014 total sales, compared to 2013, was primarily due to our merger with Harris Teeter, which closed on January 28, 2014, and an increase in identical supermarket sales, excluding fuel, of 5.2%. Identical supermarket sales, excluding fuel for 2014, compared to 2013, increased primarily due to an increase in the number of households shopping with us, an increase in visits per household and product cost inflation. Total fuel sales decreased in 2014, compared to 2013, primarily due to a 6.8% decrease in the average retail fuel price, partially offset by an increase in fuel gallons sold of 6.6%. We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Although identical supermarket sales is a relatively standard term, numerous methods exist for calculating identical supermarket sales growth. As a result, the method used by our management to calculate identical supermarket sales may differ from methods other companies use to calculate identical supermarket sales. We urge you to understand the methods used by other companies to calculate identical supermarket sales before comparing our identical supermarket sales to those of other such companies. Fuel discounts received at our fuel centers and earned based on in-store purchases are included in all of the supermarket identical sales results calculations illustrated below and reduce our identical supermarket sales results. Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Identical supermarket sales include sales from all departments at identical Fred Meyer multi-department stores and include Roundy’s sales for the last six weeks of fiscal 2015 for stores that are identical as if they were part of the Company in the prior year. We calculate annualized identical supermarket sales by adding together four quarters of identical supermarket sales. Our identical supermarket sales results are summarized in the table below. Identical Supermarket Sales (dollars in millions) Gross Margin and FIFO Gross Margin We calculate gross margin as sales less merchandise costs, including advertising, warehousing, and transportation expenses. Merchandise costs exclude depreciation and rent expenses. Our gross margin rates, as a percentage of sales, were 22.16% in 2015, 21.16% in 2014 and 20.57% in 2013. The increase in 2015, compared to 2014, resulted primarily from a decrease in retail fuel sales and reductions in transportation costs and a decrease in our LIFO charge, as a percentage of sales, partially offset by continued investments in lower prices for our customers and increased shrink costs, as a percentage of sales. The increase in 2014, compared to 2013, resulted primarily from the effect of our merger with Harris Teeter, an increase in fuel gross margin rate and a reduction in warehouse and transportation costs, as a percentage of sales, partially offset by continued investments in lower prices for our customers and an increase in our LIFO charge, as a percentage of sales. The merger with Harris Teeter, which closed late in fiscal year 2013, had a positive effect on our gross margin rate in 2014 since Harris Teeter has a higher gross margin rate as compared to total Company without Harris Teeter. The increase in fuel gross margin rate for 2014, compared to 2013, resulted primarily from an increase in fuel margin per gallon sold of $0.19 in 2014, compared to $0.14 in 2013. Our retail fuel operations lower our gross margin rate, as a percentage of sales, due to the very low gross margin on retail fuel sales as compared to non-fuel sales. A lower growth rate in retail fuel sales, as compared to the growth rate for the total Company, increases the gross margin rates, as a percentage of sales, when compared to the prior year. We calculate FIFO gross margin as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the LIFO charge. Merchandise costs exclude depreciation and rent expenses. Our LIFO charge was $28 million in 2015, $147 million in 2014 and $52 million in 2013. FIFO gross margin is a non-GAAP financial measure and should not be considered as an alternative to gross margin or any other GAAP measure of performance. FIFO gross margin should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness. Management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness. Our FIFO gross margin rates, as a percentage of sales, were 22.18% in 2015, 21.30% in 2014 and 20.62% in 2013. Our retail fuel operations lower our FIFO gross margin rate, as a percentage of sales, due to the very low FIFO gross margin rate on retail fuel as compared to non-fuel sales. Excluding the effect of retail fuel operations, our FIFO gross margin rate decreased four basis points in 2015, as a percentage of sales, compared to 2014. The decrease in FIFO gross margin rates, excluding retail fuel, in 2015, compared to 2014, resulted primarily from continued investments in lower prices for our customers and increased shrink costs, partially offset by a reduction in transportation costs, as a percentage of sales. Excluding the effect of retail fuel, our FIFO gross margin rate decreased three basis points in 2014, as a percentage of sales, compared to 2013. The decrease in FIFO gross margin rates, excluding retail fuel, in 2014, compared to 2013, resulted primarily from continued investments in lower prices for our customers, offset partially by the effect of our merger with Harris Teeter and a reduction of warehouse and transportation costs, as a percentage of sales. LIFO Charge The LIFO charge was $28 million in 2015, $147 million in 2014 and $52 million in 2013. In 2015, we experienced lower product cost inflation, compared to 2014, which resulted in a lower LIFO charge. In 2015, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation related to meat and dairy. In 2014, we experienced higher product cost inflation, compared to 2013, which resulted in a higher LIFO charge. In 2014, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, grocery, deli, meat and seafood. In 2013, our LIFO charge resulted primarily from an annualized product cost inflation related to meat, seafood and pharmacy. Operating, General and Administrative Expenses OG&A expenses consist primarily of employee-related costs such as wages, health care benefits and retirement plan costs, utilities and credit card fees. Rent expense, depreciation and amortization expense and interest expense are not included in OG&A. OG&A expenses, as a percentage of sales, were 16.34% in 2015, 15.82% in 2014 and 15.45% in 2013. The increase in OG&A expenses, as a percentage of sales, in 2015, compared to 2014, resulted primarily from a decrease in retail fuel sales, increases in EMV chargebacks, company sponsored pension, healthcare and incentive plan costs, as a percentage of sales, partially offset by increased supermarket sales, the 2014 Multi-Employer Pension Plan Obligation, lower charges for total contributions to The Kroger Foundation and UFCW Consolidated Pension Plan, productivity improvements and effective cost controls at the store level. The increase in OG&A expenses, as a percentage of sales, in 2014, compared to 2013, resulted primarily from the 2014 Contributions, the 2014 Multi-Employer Pension Plan Obligation, the effect of fuel, the effect of our merger with Harris Teeter and increases in credit card fees and incentive plan costs, as a percentage of sales, partially offset by increased supermarket sales growth, productivity improvements and effective cost controls at the store level. Retail fuel sales lower our OG&A rate due to the very low OG&A rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our OG&A rate, as a percentage of sales, since Harris Teeter has a higher OG&A rate as compared to the total Company without Harris Teeter. Our retail fuel operations reduce our overall OG&A rate, as a percentage of sales, due to the very low OG&A rate on retail fuel sales as compared to non-fuel sales. OG&A expenses, as a percentage of sales excluding fuel, the 2015 UFCW Contributions, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, decreased 9 basis points, compared to 2014. The decrease in our adjusted OG&A rate in 2015, compared to 2014, resulted primarily from increased supermarket sales, productivity improvements and effective cost controls at the store level, partially offset by increases in EMV chargebacks , company sponsored pension, healthcare and incentive plan costs, as a percentage of sales. OG&A expenses, as a percentage of sales excluding fuel, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, decreased 19 basis points in 2014, compared to 2013, adjusted for the 2013 Adjusted Items. The decrease in our adjusted OG&A rate in 2014, compared to 2013, resulted primarily from increased supermarket sales growth, productivity improvements and effective cost controls at the store level, offset partially by the effect of our merger with Harris Teeter and increases in credit card fees and incentive plan costs, as a percentage of sales. Rent Expense Rent expense was $723 million in 2015, compared to $707 million in 2014 and $613 million in 2013. Rent expense, as a percentage of sales, was 0.66% in 2015, compared to 0.65% in 2014 and 0.62% in 2013. Rent expense increased in 2015, compared to 2014, due to the effect of our merger with Roundy’s, partially offset by our continued emphasis on owning rather than leasing, whenever possible. Rent expense, as a percentage of sales, in 2015 was consistent with 2014 due to the effect of our merger with Roundy’s, partially offset by our continued emphasis to own rather than lease, whenever possible, and the benefit of increased sales. The increase in rent expense, as a percentage of sales, in 2014, compared to 2013, is due to the effect of our merger with Harris Teeter, partially offset by our continued emphasis to own rather than lease, whenever possible, and the benefit of increased sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased rent expense, as a percentage of sales, since Harris Teeter has a higher rent expense rate compared to the total Company without Harris Teeter. Depreciation and Amortization Expense Depreciation and amortization expense was $2.1 billion, compared to $1.9 billion in 2014 and $1.7 billion in 2013. Depreciation and amortization expense, as a percentage of sales, was 1.90% in 2015, 1.80% in 2014 and 1.73% in 2013. The increase in depreciation and amortization expense for 2015, compared to 2014, was the result of additional depreciation due to our merger with Roundy’s and on capital investments, including mergers and lease buyouts, of $3.4 billion, excluding Roundy’s. The increase in depreciation and amortization expense, as a percentage of sales, from 2015, compared to 2014, is primarily due to the additional depreciation resulting from our increased capital investments, including mergers and lease buyouts in 2015, compared to 2014. The increase in depreciation and amortization expense for 2014, compared to 2013, in total dollars, was due to the effect of our merger with Harris Teeter and our increased spending in capital investments, including mergers and lease buyouts, of $3.1 billion in 2014. The increase in depreciation and amortization expense, as a percentage of sales, from 2014, compared to 2013, is primarily due to the effect of our merger with Harris Teeter and our increased spending in capital investments, partially offset by increased supermarket sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our depreciation and amortization expense, as a percentage of sales, since Harris Teeter has a higher depreciation expense rate as compared to the total Company without Harris Teeter. Operating Profit and Adjusted FIFO Operating Profit Operating profit was $3.6 billion in 2015, $3.1 billion in 2014 and $2.7 billion in 2013. Operating profit, as a percentage of sales, was 3.26% in 2015, 2.89% in 2014 and 2.77% in 2013. Operating profit, as a percentage of sales, increased 37 basis points in 2015, compared to 2014, primarily from increased supermarket sales, a LIFO charge that was significantly lower in 2015, lower charges for total contributions to The Kroger Co. Foundation and UFCW Consolidated Pension Plan, the 2014 Multi-Employer Pension Obligation, productivity improvements, effective cost controls at the store level, and reductions in transportation costs, as a percentage of sales, partially offset by the effect of our merger with Roundy’s, continued investments in lower prices for our customers, a decrease in operating profit from our fuel operations, an increase in depreciation and amortization expense and increases in EMV chargebacks, company sponsored pension, healthcare, incentive plan and shrink costs, as a percentage of sales. The decrease in operating profit from our fuel operations for 2015, compared to 2014, resulted primarily from a decrease in the average margin per gallon of fuel sold, partially offset by an increase in fuel gallons sold. Operating profit, as a percentage of sales, increased 12 basis points in 2014, compared to 2013, primarily from the effect of our merger with Harris Teeter, an increase in fuel gross margin rate and a reduction in warehouse and transportation costs, rent and depreciation and amortization expenses, as a percentage of sales, partially offset by continued investments in lower prices for our customers and an increase in the LIFO charge, as a percentage of sales. We calculate FIFO operating profit as operating profit excluding the LIFO charge. FIFO operating profit is a non-GAAP financial measure and should not be considered as an alternative to operating profit or any other GAAP measure of performance. FIFO operating profit should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. FIFO operating profit is an important measure used by management to evaluate operational effectiveness. Management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness. Since fuel discounts are earned based on in-store purchases, fuel operating profit does not include fuel discounts, which are allocated to our in-store supermarket location departments. We also derive OG&A, rent and depreciation and amortization expenses through the use of estimated allocations in the calculation of fuel operating profit. FIFO operating profit was $3.6 billion in 2015, $3.3 billion in 2014 and $2.8 billion in 2013. FIFO operating profit, as a percentage of sales, was 3.28% in 2015, 3.03% in 2014 and 2.82% in 2013. FIFO operating profit, excluding the 2015 UFCW Contributions, the 2014 Contributions, the 2014 Multi-Employer Pension Plan Obligation and 2013 Adjusted Items, was $3.7 billion in 2015, $3.5 billion in 2014 and $2.8 billion in 2013. FIFO operating profit, as a percentage of sales excluding the 2015 UFCW Contributions, the 2014 Contributions, the 2014 Multi-Employer Pension Plan Obligation and 2013 Adjusted Items, was 3.38% in 2015, 3.24% in 2014 and 2.84% in 2013. Retail fuel sales lower our overall FIFO operating profit rate due to the very low FIFO operating profit rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. FIFO operating profit, as a percentage of sales excluding fuel, the 2015 UFCW Contributions, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, increased 5 basis points in 2015, compared to 2014. The increase in our adjusted FIFO operating profit rate in 2015, compared to 2014, was primarily due to increased supermarket sales, productivity improvements, effective cost controls at the store level and reductions in transportation costs, as a percentage of sales, partially offset by continued investments in lower prices for our customers, the effect of our merger with Roundy’s, an increase in depreciation and amortization expense and increases in EMV chargebacks, company sponsored pension, healthcare, incentive plan and shrink costs, as a percentage of sales. Excluding the effects of our merger with Roundy’s, FIFO operating profit increased 8 basis points in 2015, compared to 2014. FIFO operating profit, as a percentage of sales, excluding fuel, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, increased 10 basis points in 2014, compared to 2013, adjusted for the 2013 Adjusted Items. The increase in our adjusted FIFO operating profit rate in 2014, compared to 2013, was primarily due to the effect of our merger with Harris Teeter and a reduction in warehouse and transportation costs, improvements in OG&A, rent and depreciation and amortization expense, as a percentage of sales, partially offset by continued investments in lower prices for our customers. Interest Expense Interest expense totaled $482 million in 2015, $488 million in 2014 and $443 million in 2013. The decrease in interest expense in 2015, compared to 2014, resulted primarily due to the timing of debt principal payments and debt issuances, partially offset by an increase in interest expense associated with our commercial paper program. The increase in interest expense in 2014, compared to 2013, resulted primarily from an increase in net total debt, primarily due to financing the merger with Harris Teeter and repurchases of our outstanding common shares. Income Taxes Our effective income tax rate was 33.8% in 2015, 34.1% in 2014 and 32.9% in 2013. The 2015, 2014 and 2013 tax rate differed from the federal statutory rate primarily as a result of the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes. COMMON SHARE REPURCHASE PROGRAMS We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time. We made open market purchases of our common shares totaling $500 million in 2015, $1.1 billion in 2014 and $338 million in 2013 under these repurchase programs. In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises. We repurchased approximately $203 million in 2015, $155 million in 2014 and $271 million in 2013 of our common shares under the stock option program. The shares repurchased in 2015 were acquired under two separate share repurchase programs. The first is a $500 million repurchase program that was authorized by our Board of Directors on June 26, 2014. The second is a program that uses the cash proceeds from the exercises of stock options by participants in our stock option and long-term incentive plans as well as the associated tax benefits. On June 25, 2015, our Board of Directors approved a new $500 million share repurchase program to replace our prior authorization, which had been exhausted. As of January 30, 2016, we have not repurchased any shares utilizing the June 25, 2015 repurchase program. On March 10, 2016, our Board of Directors approved a new $500 million share repurchase program to supplement the 2015 Repurchase Program, which is expected to be exhausted by the end of the second quarter of 2016. CAPITAL INVESTMENTS Capital investments, including changes in construction-in-progress payables and excluding mergers and the purchase of leased facilities, totaled $3.3 billion in 2015, $2.8 billion in 2014 and $2.3 billion in 2013. Capital investments for mergers totaled $168 million in 2015, $252 million in 2014 and $2.3 billion in 2013. Payments for mergers of $168 million in 2015, $252 million in 2014 and $2.3 billion in 2013 relate to our mergers with Roundy’s, Vitacost.com and Harris Teeter, respectively. Refer to Note 2 to the Consolidated Financial Statements for more information on the mergers with Roundy’s, Vitacost.com and Harris Teeter. Capital investments for the purchase of leased facilities totaled $35 million in 2015, $135 million in 2014 and $108 million in 2013. The table below shows our supermarket storing activity and our total food store square footage: Supermarket Storing Activity RETURN ON INVESTED CAPITAL We calculate return on invested capital (“ROIC”) by dividing adjusted operating profit for the prior four quarters by the average invested capital. Adjusted operating profit is calculated by excluding certain items included in operating profit, and adding back our LIFO charge, depreciation and amortization and rent to our U.S. GAAP operating profit of the prior four quarters. Average invested capital is calculated as the sum of (i) the average of our total assets, (ii) the average LIFO reserve, (iii) the average accumulated depreciation and amortization and (iv) a rent factor equal to total rent for the last four quarters multiplied by a factor of eight; minus (i) the average taxes receivable, (ii) the average trade accounts payable, (iii) the average accrued salaries and wages and (iv) the average other current liabilities, excluding accrued income taxes. Averages are calculated for ROIC by adding the beginning balance of the first quarter and the ending balance of the fourth quarter, of the last four quarters, and dividing by two. We use a factor of eight for our total rent as we believe this is a common factor used by our investors, analysts and rating agencies. ROIC is a non-GAAP financial measure of performance. ROIC should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital. Management believes ROIC is a useful metric to investors and analysts because it measures how effectively we are deploying our assets. Although ROIC is a relatively standard financial term, numerous methods exist for calculating a company’s ROIC. As a result, the method used by our management to calculate ROIC may differ from methods other companies use to calculate their ROIC. We urge you to understand the methods used by other companies to calculate their ROIC before comparing our ROIC to that of such other companies. The following table provides a calculation of ROIC for 2015 and 2014. The 2015 calculation of ROIC excludes the financial position, results and merger costs for the Roundy’s transaction: (1) Taxes receivable were $392 as of January 30, 2016, $20 as of January 31, 2015 and $18 as of February 1, 2014. The increase in taxes receivable as of January 30, 2016, compared to as of January 31, 2015, is due to recently issued tangible property regulations. Refer to Note 5 of the Consolidated Financial Statements for further detail. (2) Other current liabilities included accrued income taxes of $5 as of January 31, 2015 and $92 as of February 1, 2014. We did not have any accrued income taxes as of January 30, 2016. Accrued income taxes are removed from other current liabilities in the calculation of average invested capital. CRITICAL ACCOUNTING POLICIES We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Our significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. We believe that the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain. Self-Insurance Costs We primarily are self-insured for costs related to workers’ compensation and general liability claims. The liabilities represent our best estimate, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred but not reported for all claims incurred through January 30, 2016. We establish case reserves for reported claims using case-basis evaluation of the underlying claim data and we update as information becomes known. For both workers’ compensation and general liability claims, we have purchased stop-loss coverage to limit our exposure to any significant exposure on a per claim basis. We are insured for covered costs in excess of these per claim limits. We account for the liabilities for workers’ compensation claims on a present value basis utilizing a risk-adjusted discount rate. A 25 basis point decrease in our discount rate would increase our liability by approximately $2 million. General liability claims are not discounted. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can affect ultimate costs. Our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, and any changes could have a considerable effect on future claim costs and currently recorded liabilities. Impairments of Long-Lived Assets We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value. Fair value is determined based on market values or discounted future cash flows. We record impairment when the carrying value exceeds fair market value. With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal. We recorded asset impairments in the normal course of business totaling $46 million in 2015, $37 million in 2014 and $39 million in 2013. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as “Operating, general and administrative” expense. The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different level, could produce significantly different results. Goodwill Our goodwill totaled $2.7 billion as of January 30, 2016. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our operating divisions and variable interest entities (collectively, “reporting units”) that have goodwill balances. Fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment. We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future. If we identify potential for impairment, we measure the fair value of a reporting unit against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the reporting unit’s goodwill. We recognize goodwill impairment for any excess of the carrying value of the reporting unit’s goodwill over the implied fair value. In 2015, goodwill increased $420 million primarily due to our merger with Roundy’s. In 2014, goodwill increased $169 million primarily due to our merger with Vitacost.com. For additional information related to the allocation of the purchase price for Roundy’s and Vitacost.com, refer to Note 2 to the Consolidated Financial Statements. The annual evaluation of goodwill performed for our other reporting units during the fourth quarter of 2015, 2014 and 2013 did not result in impairment. Based on current and future expected cash flows, we believe goodwill impairments are not reasonably likely. A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance. For additional information relating to our results of the goodwill impairment reviews performed during 2015, 2014 and 2013 see Note 3 to the Consolidated Financial Statements. The impairment review requires the extensive use of management judgment and financial estimates. Application of alternative estimates and assumptions, such as reviewing goodwill for impairment at a different level, could produce significantly different results. The cash flow projections embedded in our goodwill impairment reviews can be affected by several factors such as inflation, business valuations in the market, the economy and market competition. Store Closing Costs We provide for closed store liabilities on the basis of the present value of the estimated remaining non-cancellable lease payments after the closing date, net of estimated subtenant income. We estimate the net lease liabilities using a discount rate to calculate the present value of the remaining net rent payments on closed stores. We usually pay closed store lease liabilities over the lease terms associated with the closed stores, which generally have remaining terms ranging from one to 20 years. Adjustments to closed store liabilities primarily relate to changes in subtenant income and actual exit costs differing from original estimates. We make adjustments for changes in estimates in the period in which the change becomes known. We review store closing liabilities quarterly to ensure that any accrued amount that is not a sufficient estimate of future costs is adjusted to earnings in the proper period. We estimate subtenant income, future cash flows and asset recovery values based on our experience and knowledge of the market in which the closed store is located, our previous efforts to dispose of similar assets and current economic conditions. The ultimate cost of the disposition of the leases and the related assets is affected by current real estate markets, inflation rates and general economic conditions. We reduce owned stores held for disposal to their estimated net realizable value. We account for costs to reduce the carrying values of property, equipment and leasehold improvements in accordance with our policy on impairment of long-lived assets. We classify inventory write-downs in connection with store closings, if any, in “Merchandise costs.” We expense costs to transfer inventory and equipment from closed stores as they are incurred. Post-Retirement Benefit Plans We account for our defined benefit pension plans using the recognition and disclosure provisions of GAAP, which require the recognition of the funded status of retirement plans on the Consolidated Balance Sheet. We record, as a component of Accumulated Other Comprehensive Income (“AOCI”), actuarial gains or losses, prior service costs or credits and transition obligations that have not yet been recognized. The determination of our obligation and expense for Company-sponsored pension plans and other post-retirement benefits is dependent upon our selection of assumptions used by actuaries in calculating those amounts. Those assumptions are described in Note 15 to the Consolidated Financial Statements and include, among others, the discount rate, the expected long-term rate of return on plan assets, mortality and the rate of increases in compensation and health care costs. Actual results that differ from our assumptions are accumulated and amortized over future periods and, therefore, generally affect our recognized expense and recorded obligation in future periods. While we believe that our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions, including the discount rate used and the expected return on plan assets, may materially affect our pension and other post-retirement obligations and our future expense. Note 15 to the Consolidated Financial Statements discusses the effect of a 1% change in the assumed health care cost trend rate on other post-retirement benefit costs and the related liability. The objective of our discount rate assumptions was intended to reflect the rates at which the pension benefits could be effectively settled. In making this determination, we take into account the timing and amount of benefits that would be available under the plans. Our methodology for selecting the discount rates was to match the plan’s cash flows to that of a hypothetical bond portfolio whose cash flow from coupons and maturities match the plan’s projected benefit cash flows. The discount rates are the single rates that produce the same present value of cash flows. The selection of the 4.62% and 4.44% discount rates as of year-end 2015 for pension and other benefits, respectively, represents the hypothetical bond portfolio using bonds with an AA or better rating constructed with the assistance of an outside consultant. We utilized a discount rate of 3.87% and 3.74% as of year-end 2014 for pension and other benefits, respectively. A 100 basis point increase in the discount rate would decrease the projected pension benefit obligation as of January 30, 2016, by approximately $438 million. To determine the expected rate of return on pension plan assets held by Kroger for 2015, we considered current and forecasted plan asset allocations as well as historical and forecasted rates of return on various asset categories. In 2015, our assumed pension plan investment return rate was 7.44%, compared to 7.44% in 2014 and 8.50 in 2013. Our pension plans’ average rate of return was 6.47% for the 10 calendar years ended December 31, 2015, net of all investment management fees and expenses. The value of all investments in our Company-sponsored defined benefit pension plans during the calendar year ending December 31, 2015, net of investment management fees and expenses, decreased 0.80%. For the past 20 years, our average annual rate of return has been 7.99%. Based on the above information and forward looking assumptions for investments made in a manner consistent with our target allocations, we believe a 7.44% rate of return assumption is reasonable for 2015. See Note 15 to the Consolidated Financial Statements for more information on the asset allocations of pension plan assets. On January 31, 2015, we adopted new mortality tables, including industry-based tables for annuitants, reflecting more current mortality experience and assumptions for future generational mortality improvement in calculating our projected benefit obligations as of January 30, 2016 and January 31, 2015 and our 2015 pension expense. The tables assume an improvement in life expectancy and increased our benefit obligation and future expenses. We used the RP-2000 projected to 2021 mortality table in calculating our 2013 year end pension obligation and 2014 and 2013 pension expense. Sensitivity to changes in the major assumptions used in the calculation of Kroger’s pension plan liabilities is illustrated below (in millions). In 2015, we contributed $5 million to our Company-sponsored defined benefit plans and do not expect to make any contributions to these plans in 2016. In 2014, we did not contribute to our Company-sponsored defined benefit plans and do not expect to make any contributions to this plan in 2015. We did not make a contribution in 2014 and contributed $100 million in 2013 to our Company-sponsored defined benefit pension plans. Among other things, investment performance of plan assets, the interest rates required to be used to calculate the pension obligations, and future changes in legislation, will determine the amounts of contributions. We contributed and expensed $196 million in 2015, $177 million in 2014 and $148 million in 2013 to employee 401(k) retirement savings accounts. The increase in 2015, compared to 2014, is due to a higher employee savings rate. The increase in 2014, compared to 2013, is due to the effect of our merger with Harris Teeter. The 401(k) retirement savings account plans provide to eligible employees both matching contributions and automatic contributions from the Company based on participant contributions, plan compensation, and length of service. Multi-Employer Pension Plans We contribute to various multi-employer pension plans, including the UFCW Consolidated Pension Plan, based on obligations arising from collective bargaining agreements. We are designated as the named fiduciary of the UFCW Consolidated Pension Plan and have sole investment authority over these assets. These multi-employer pension plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans. In 2015, we contributed $190 million to the UFCW Consolidated Pension Plan. We had previously accrued $60 million of the total contributions at January 31, 2015 and recorded expense for the remaining $130 million at the time of payment in 2015. In 2014, we incurred a charge of $56 million (after-tax) related to commitments and withdrawal liabilities associated with the restructuring of pension plan agreements, of which $15 million was contributed to the UFCW Consolidated Pension Plan in 2014. As of January 30, 2016, we are not required to contribute to the UFCW Consolidated Pension Plan in 2016. We recognize expense in connection with these plans as contributions are funded or when commitments are made, in accordance with GAAP. We made cash contributions to these plans of $426 million in 2015, $297 million in 2014 and $228 million in 2013. Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2015. Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding. Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer. As of December 31, 2015, we estimate that our share of the underfunding of multi-employer plans to which we contribute was approximately $2.9 billion, pre-tax, or $1.8 billion, after-tax, which includes Roundy’s share of underfunding of its multi-employer plans. This represents an increase in the estimated amount of underfunding of approximately $1.1 billion, pre-tax, or approximately $680 million, after-tax, as of December 31, 2015, compared to December 31, 2014. The increase in the amount of underfunding is attributable to lower than expected returns on the assets held in the multi-employer plans during 2015, changes in mortality rate assumptions and the merger of Roundy’s. Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable. We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours. Rather, we believe the underfunding is likely to have important consequences. In 2016, we expect to contribute approximately $260 million to multi-employer pension plans, subject to collective bargaining and capital market conditions. We expect increases in expense as a result of increases in multi-employer pension plan contributions over the next few years. Finally, underfunding means that, in the event we were to exit certain markets or otherwise cease making contributions to these funds, we could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated, in accordance with GAAP. The amount of underfunding described above is an estimate and could change based on contract negotiations, returns on the assets held in the multi-employer plans and benefit payments. The amount could decline, and our future expense would be favorably affected, if the values of the assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, our share of the underfunding could increase and our future expense could be adversely affected if the asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation. We continue to evaluate our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of ours, any commitments to fund certain multi-employer plans will be expensed when our commitment is probable and an estimate can be made. See Note 16 to the Consolidated Financial Statements for more information relating to our participation in these multi-employer pension plans. Uncertain Tax Positions We review the tax positions taken or expected to be taken on tax returns to determine whether and to what extent a benefit can be recognized in our Consolidated Financial Statements. Refer to Note 5 to the Consolidated Financial Statements for the amount of unrecognized tax benefits and other disclosures related to uncertain tax positions. Various taxing authorities periodically audit our income tax returns. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing positions, including state and local taxes, we record allowances for probable exposures. A number of years may elapse before a particular matter, for which an allowance has been established, is audited and fully resolved. As of January 30, 2016, the Internal Revenue Service had concluded its examination of our 2010 and 2011 federal tax returns. Tax years 2012 and 2013 remain under examination. The assessment of our tax position relies on the judgment of management to estimate the exposures associated with our various filing positions. Share-Based Compensation Expense We account for stock options under the fair value recognition provisions of GAAP. Under this method, we recognize compensation expense for all share-based payments granted. We recognize share-based compensation expense, net of an estimated forfeiture rate, over the requisite service period of the award. In addition, we record expense for restricted stock awards in an amount equal to the fair market value of the underlying stock on the grant date of the award, over the period the award restrictions lapse. Inventories Inventories are stated at the lower of cost (principally on a LIFO basis) or market. In total, approximately 95% of inventories in 2015 and 2014 were valued using the LIFO method. Cost for the balance of the inventories, including substantially all fuel inventories, was determined using the FIFO method. Replacement cost was higher than the carrying amount by $1.3 billion at January 30, 2016 and January 31, 2015. We follow the Link-Chain, Dollar-Value LIFO method for purposes of calculating our LIFO charge or credit. We follow the item-cost method of accounting to determine inventory cost before the LIFO adjustment for substantially all store inventories at our supermarket divisions. This method involves counting each item in inventory, assigning costs to each of these items based on the actual purchase costs (net of vendor allowances and cash discounts) of each item and recording the cost of items sold. The item-cost method of accounting allows for more accurate reporting of periodic inventory balances and enables management to more precisely manage inventory. In addition, substantially all of our inventory consists of finished goods and is recorded at actual purchase costs (net of vendor allowances and cash discounts). We evaluate inventory shortages throughout the year based on actual physical counts in our facilities. We record allowances for inventory shortages based on the results of recent physical counts to provide for estimated shortages from the last physical count to the financial statement date. Vendor Allowances We recognize all vendor allowances as a reduction in merchandise costs when the related product is sold. In most cases, vendor allowances are applied to the related product cost by item, and therefore reduce the carrying value of inventory by item. When it is not practicable to allocate vendor allowances to the product by item, we recognize vendor allowances as a reduction in merchandise costs based on inventory turns and as the product is sold. We recognized approximately $7.3 billion in 2015, $6.9 billion in 2014 and $6.2 billion in 2013 of vendor allowances as a reduction in merchandise costs. We recognized approximately 91% of all vendor allowances in the item cost with the remainder being based on inventory turns. RECENTLY ADOPTED ACCOUNTING STANDARDS In 2015, the Financial Accounting Standards Board (“FASB”) amended Accounting Standards Codification 835, “Interest-Imputation of Interest.” The amendment simplifies the presentation of debt issuance costs related to a recognized debt liability by requiring it be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This amendment became effective beginning February 1, 2015, and was adopted retrospectively in accordance with the standard. The adoption of this amendment resulted in amounts previously reported in other assets to now be reported within long-term debt including obligations under capital leases and financing obligations in the Consolidated Balance Sheets. These amounts were not material to the prior year. The adoption of this amendment did not have an effect on our Consolidated Statements of Operations. RECENTLY ISSUED ACCOUNTING STANDARDS In May 2014, the FASB issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers,” which provides guidance for revenue recognition. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. Per ASU 2015-14, “Deferral of Effective Date,” this guidance will be effective for us in the first quarter of our fiscal year ending February 2, 2019. Early adoption is permitted as of the first quarter of our fiscal year ending February 3, 2018. We are currently in the process of evaluating the effect of adoption of this ASU on our Consolidated Financial Statements. In April 2015, the FASB issued ASU 2015-04, “Retirement Benefits (Topic 715): Practical Expedient for the Measurement Date of an Employer’s Defined Benefit Obligation and Plan Assets.” This amendment permits an entity to measure defined benefit plan assets and obligations using the month end that is closest to the entity’s fiscal year end for all plans. This guidance will be effective for us in the fiscal year ending January 28, 2017. The implementation of this amendment will not have an effect on our Consolidated Statements of Operations, and will not have a significant effect on our Consolidated Balance Sheets. In April 2015, the FASB issued ASU 2015-07, “Fair Value Measurement (Topic 820): Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent).” This amendment removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share. This guidance will be effective for us in the fiscal year ending January 28, 2017. The implementation of this amendment will have an effect on our Notes to the Consolidated Financial Statements and will not have an effect on our Consolidated Statements of Operations or Consolidated Balance Sheets. In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments.” This amendment eliminates the requirement to retrospectively account for adjustments made to provisional amounts recognized in a business combination. This guidance will be effective for us in the fiscal year ending January 28, 2017. The implementation of this amendment is not expected to have a significant effect on our Consolidated Financial Statements. In November 2015, the FASB issued ASU 2015-17, “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes.” This amendment requires deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. This guidance will be effective for our fiscal year ending January 28, 2017. Early adoption is permitted. The implementation of this amendment will not have an effect on our Consolidated Statements of Operations and will not have a significant effect on our Consolidated Balance Sheets. In February 2016, the FASB issued ASU 2016-02, “Leases”, which provides guidance for the recognition of lease agreements. The standard’s core principle is that a company will now recognize most leases on its balance sheet as lease liabilities with corresponding right-of-use assets. This guidance will be effective for us in the first quarter of fiscal year ending February 1, 2020. Early adoption is permitted. The adoption of this ASU will result in a significant increase to our Consolidated Balance Sheets for lease liabilities and right-of-use assets, and we are currently evaluating the other effects of adoption of this ASU on our Consolidated Financial Statements. We believe our current off-balance sheet leasing commitments are reflected in our investment grade debt rating. LIQUIDITY AND CAPITAL RESOURCES Cash Flow Information Net cash provided by operating activities We generated $4.8 billion of cash from operations in 2015, compared to $4.2 billion in 2014 and $3.6 billion in 2013. The cash provided by operating activities came from net earnings including non-controlling interests adjusted primarily for non-cash expenses of depreciation and amortization, stock compensation, expense for Company-sponsored pension plans, the LIFO charge and changes in working capital. The increase in net cash provided by operating activities in 2015, compared to 2014, resulted primarily due to an increase in net earnings including non-controlling interests, an increase in non-cash items and changes in working capital. The increase in non-cash items in 2015, as compared to 2014, was primarily due to increases in depreciation and amortization expense and expense for Company-sponsored pension plans, partially offset by a lower LIFO charge. The increase in net cash provided by operating activities in 2014, compared to 2013, resulted primarily due to an increase in net earnings including non-controlling interests, which include the results of Harris Teeter, an increase in non-cash items, a reduction in contributions to Company-sponsored pension plans and changes in working capital. The increase in non-cash items in 2014, as compared to 2013, was primarily due to increases in depreciation and amortization expense and the LIFO charge. The amount of cash paid for income taxes increased in 2014, compared to 2013, primarily due to an increase in net earnings including non-controlling interests. Cash provided (used) by operating activities for changes in working capital was $96 million in 2015, compared to ($49) million in 2014 and $63 million in 2013. The increase in cash provided by operating activities for changes in working capital in 2015, compared to 2014, was primarily due to an increase in cash provided by trade accounts payables and store deposits in transit, partially offset by a decrease in cash provided by income taxes receivable and payable. The increase in cash used by operating activities for changes in working capital in 2014, compared to 2013, was primarily due to an increase in cash used for receivables and a decrease in cash provided by trade accounts payables, partially offset by an increase in cash provided by accrued expenses. Net cash used by investing activities Cash used by investing activities was $3.6 billion in 2015, compared to $3.1 billion in 2014 and $4.8 billion in 2013. The amount of cash used by investing activities increased in 2015, compared to 2014, due to increased payments for capital investments, partially offset by lower payments for mergers. The amount of cash used by investing activities decreased in 2014, compared to 2013, due to decreased payments for mergers, offset primarily by increased payments for capital investments. Capital investments, including payments for lease buyouts, but excluding mergers, were $3.3 billion in 2015, $2.8 billion in 2014 and $2.3 billion in 2013. Merger payments were $168 million in 2015, $252 million in 2014 and $2.3 billion in 2013. Merger payments decreased in 2014, compared to 2013, primarily due to our merger with Harris Teeter in 2013. Refer to the “Capital Investments” section for an overview of our supermarket storing activity during the last three years. Net cash provided (used) by financing activities Financing activities (used) provided cash of ($1.3) billion in 2015, ($1.2) billion in 2014 and $1.4 billion in 2013. The increase in the amount of cash used for financing activities in 2015, compared to 2014, was primarily related to increased payments on long-term debt and commercial paper, partially offset by higher proceeds from issuances of long-term debt and decreased treasury stock purchases. The increase in the amount of cash used for financing activities in 2014, compared to 2013, was primarily related to decreased proceeds from the issuance of long-term debt and increased treasury stock purchases, offset partially by decreased payments on long-term debt. Proceeds from the issuance of long-term debt were $1.2 billion in 2015, $576 million in 2014 and $3.5 billion in 2013. Net (payments) borrowings provided from our commercial paper program were ($285) million in 2015, $25 million in 2014 and ($395) million in 2013. Please refer to the “Debt Management” section of MD&A for additional information. We repurchased $703 million of Kroger common shares in 2015, compared to $1.3 billion in 2014 and $609 million in 2013. We paid dividends totaling $385 million in 2015, $338 million in 2014 and $319 million in 2013. Debt Management Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $481 million to $12.1 billion as of year-end 2015, compared to 2014. The increase in 2015, compared to 2014, resulted primarily from the issuance of (i) $300 million of senior notes bearing an interest rate of 2.00%, (ii) $300 million of senior notes bearing an interest rate of 2.60%, (iii) $500 million of senior notes bearing an interest rate of 3.50% and (iv) an increase in capital lease obligations due to our merger with Roundy’s and various leased locations, partially offset by payments of $678 million on long-term debt obligations assumed as part of our merger with Roundy’s and $500 million of payments at maturity of senior notes bearing an interest rate of 3.90%. The increase in financing obligations was due to partially funding our merger with Roundy’s. Total debt, including both the current and long-term portions of capital lease and lease-financing obligations increased $346 million to $11.7 billion as of year-end 2014, compared to 2013. The increase in 2014, compared to 2013, resulted primarily from (i) the issuance of $500 million of senior notes bearing an interest rate of 2.95% and (ii) an increase in commercial paper of $25 million, partially offset by payments at maturity of $300 million of senior notes bearing an interest rate of 4.95%. The increase in financing obligations was due to partially funding our outstanding common share repurchases. Liquidity Needs We estimate our liquidity needs over the next twelve-month period to range from $6.6 to $6.9 billion, which includes anticipated requirements for working capital, capital investments, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2015. We generally operate with a working capital deficit due to our efficient use of cash in funding operations and because we have consistent access to the capital markets. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months. We have approximately $990 million of commercial paper and $1.3 billion of senior notes maturing in the next twelve months, which is included in the range of $6.6 to $6.9 billion in estimated liquidity needs. We expect to refinance this debt, in 2016, by issuing additional senior notes or commercial paper on favorable terms based on our past experience. We also currently plan to continue repurchases of common shares under the Company’s share repurchase programs. We believe we have adequate coverage of our debt covenants to continue to maintain our current debt ratings and to respond effectively to competitive conditions. Factors Affecting Liquidity We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper (“CP”) program. At January 30, 2016, we had $990 million of CP borrowings outstanding. CP borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility. If our short-term credit ratings fall, the ability to borrow under our current CP program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our CP program. This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity. However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our CP program would be any lower than $500 million on a daily basis. Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost on borrowings under the credit facility could be affected by an increase in our Leverage Ratio. As of March 23, 2016, we had $1.1 billion of CP borrowings outstanding. The increase as of March 23, 2016, compared to year-end 2015, was due to partially funding our outstanding common share repurchases. Our credit facility requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our “financial covenants”). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants and ratios are described below: · Our Leverage Ratio (the ratio of Net Debt to Consolidated EBITDA, as defined in the credit facility) was 1.97 to 1 as of January 30, 2016. If this ratio were to exceed 3.50 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. In addition, our Applicable Margin on borrowings is determined by our Leverage Ratio. · Our Fixed Charge Coverage Ratio (the ratio of Consolidated EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facility) was 5.30 to 1 as of January 30, 2016. If this ratio fell below 1.70 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. Our credit agreement is more fully described in Note 6 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2015. The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of January 30, 2016 (in millions of dollars): (1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $30 million in 2015. This table also excludes contributions under various multi-employer pension plans, which totaled $426 million in 2015. (2) The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined. (3) As of January 30, 2016, we had $990 million of borrowings of commercial paper and no borrowings under our credit agreement. (4) Amounts include contractual interest payments using the interest rate as of January 30, 2016, and stated fixed and swapped interest rates, if applicable, for all other debt instruments. (5) The amounts included in the contractual obligations table for self-insurance liability related to workers’ compensation claims have been stated on a present value basis. (6) Amounts include funds owed to third parties for projects currently under construction. These amounts are reflected in other current liabilities in our Consolidated Balance Sheets. (7) Amounts include commitments, many of which are short-term in nature, to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our food production plants and several contracts to purchase energy to be used in our stores and food production plants. Our obligations also include management fees for facilities operated by third parties and outside service contracts. Any upfront vendor allowances or incentives associated with outstanding purchase commitments are recorded as either current or long-term liabilities in our Consolidated Balance Sheets. As of January 30, 2016, we maintained a $2.75 billion (with the ability to increase by $750 million), unsecured revolving credit facility that, unless extended, terminates on June 30, 2019. Outstanding borrowings under the credit agreement and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit agreement. As of January 30, 2016, we had $990 million of borrowings of commercial paper and no borrowings under our credit agreement. The outstanding letters of credit that reduce funds available under our credit agreement totaled $13 million as of January 30, 2016. In addition to the available credit mentioned above, as of January 30, 2016, we had authorized for issuance $900 million of securities under a shelf registration statement filed with the SEC and effective on December 13, 2013. We also maintain surety bonds related primarily to our self-insured workers’ compensation claims. These bonds are required by most states in which we are self-insured for workers’ compensation and are placed with predominately third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of ours, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility. We also are contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. We could be required to satisfy obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of our assignments among third parties, and various other remedies available to us, we believe the likelihood that we will be required to assume a material amount of these obligations is remote. We have agreed to indemnify certain third-party logistics operators for certain expenses, including pension trust fund contribution obligations and withdrawal liabilities. In addition to the above, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third party claims arising out of agreements to provide services to us; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability. OUTLOOK This discussion and analysis contains certain forward-looking statements about our future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available to it. Such statements are indicated by words such as “comfortable,” “committed,” “will,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” “plan,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially. Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially. The guidance below includes our expectations for Roundy’s. · We expect net earnings to be $2.19 to $2.28 per diluted share, which is essentially in line with our long-term net earnings per diluted share growth rate of 8% - 11%. Where we fall within the range will be primarily driven by actual fuel margins, which we expect to be at or slightly below the five-year average, with continued volatility. We expect our core business in 2016 to grow in line with our long-term net earnings per diluted share growth rate of 8% - 11%. · We expect identical supermarket sales growth, excluding fuel sales, of 2.5%-3.5% in 2016, reflecting the lower inflationary environment. · We expect full-year FIFO operating margin in 2016, excluding fuel, to expand slightly compared to 2015 results. · We expect capital investments, excluding mergers, acquisitions and purchases of leased facilities, to be $4.1 to $4.4 billion. These capital investments include approximately 100 major projects covering new stores, expansions and relocations, including 10 Ruler locations; 200 to 220 major remodels; and other investments including minor remodels and technology and infrastructure to support our Customer 1st business strategy. · We expect total supermarket square footage for 2016 to grow approximately 3.0% - 3.5% before mergers, acquisitions and operational closings. · We expect 2016 year-end ROIC to increase slightly compared to the 2015 result. · We expect the 2016 effective tax rate to be approximately 35%, excluding the resolution of certain tax items. · In 2016, we anticipate annualized product cost inflation of 1.0% to 2.0%, excluding fuel, and an annualized LIFO charge of approximately $50 million. We expect inflation to be lower during the earlier portion of 2016 and to gradually rise during the later portion of 2016. · We expect 2016 Company-sponsored pension plans expense to be approximately $80 million. We do not expect to make a cash contribution in 2016. · In 2016, we expect to contribute approximately $260 million to multi-employer pension funds. We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of Kroger, any new agreements that would commit us to fund certain multi-employer plans will be expensed when our commitment is probable and an estimate can be made. · In 2016, we will negotiate agreements with UFCW for store associates in Houston, Indianapolis, Little Rock, Nashville, Portland, Southern California and Fry’s in Arizona. Negotiations this year will be challenging as we must have competitive cost structures in each market while meeting our associates’ needs for solid wages and good quality, affordable health care and retirement benefits. Various uncertainties and other factors could cause actual results to differ materially from those contained in the forward-looking statements. These include: · The extent to which our sources of liquidity are sufficient to meet our requirements may be affected by the state of the financial markets and the effect that such condition has on our ability to issue commercial paper at acceptable rates. Our ability to borrow under our committed lines of credit, including our bank credit facilities, could be impaired if one or more of our lenders under those lines is unwilling or unable to honor its contractual obligation to lend to us, or in the event that natural disasters or weather conditions interfere with the ability of our lenders to lend to us. Our ability to refinance maturing debt may be affected by the state of the financial markets. · Our ability to achieve sales, earnings and cash flow goals may be affected by: labor negotiations or disputes; changes in the types and numbers of businesses that compete with us; pricing and promotional activities of existing and new competitors, including non-traditional competitors, and the aggressiveness of that competition; our response to these actions; the state of the economy, including interest rates, the inflationary and deflationary trends in certain commodities, and the unemployment rate; the effect that fuel costs have on consumer spending; volatility of fuel margins; changes in government-funded benefit programs; manufacturing commodity costs; diesel fuel costs related to our logistics operations; trends in consumer spending; the extent to which our customers exercise caution in their purchasing in response to economic conditions; the inconsistent pace of the economic recovery; changes in inflation or deflation in product and operating costs; stock repurchases; our ability to retain pharmacy sales from third party payors; consolidation in the healthcare industry, including pharmacy benefit managers; our ability to negotiate modifications to multi-employer pension plans; natural disasters or adverse weather conditions; the potential costs and risks associated with potential cyber-attacks or data security breaches; the success of our future growth plans; and the successful integration of Harris Teeter and Roundy’s. Our ability to achieve sales and earnings goals may also be affected by our ability to manage the factors identified above. Our ability to execute our financial strategy may be affected by our ability to generate cash flow. · During the first three quarters of each fiscal year, our LIFO charge and the recognition of LIFO expense is affected primarily by estimated year-end changes in product costs. Our fiscal year LIFO charge is affected primarily by changes in product costs at year-end. · If actual results differ significantly from anticipated future results for certain reporting units including variable interest entities, an impairment loss for any excess of the carrying value of the reporting units’ goodwill over the implied fair value would have to be recognized. · Our effective tax rate may differ from the expected rate due to changes in laws, the status of pending items with various taxing authorities, and the deductibility of certain expenses. · Changes in our product mix may negatively affect certain financial indicators. For example, we continue to add supermarket fuel centers to our store base. Since fuel generates lower profit margins than our supermarket sales, we expect to see our FIFO gross margins decline as fuel sales increase. We cannot fully foresee the effects of changes in economic conditions on Kroger’s business. We have assumed economic and competitive situations will not change significantly in 2016. Other factors and assumptions not identified above could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in, contemplated or implied by forward-looking statements made by us or our representatives. We undertake no obligation to update the forward-looking information contained in this filing.

<s>[INST] OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. Kroger is one of the nation’s largest retailers, as measured by revenue, operating 2,778 supermarket and multidepartment stores under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 1,387 have fuel centers. We also operate 784 convenience stores, either directly or through franchisees, 323 fine jewelry stores and an online retailer. We operate 38 food production plants, primarily bakeries and dairies, which supply approximately 40% of the corporate brand units sold in our supermarkets. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 99% of our consolidated sales and EBITDA, is our only reportable segment. On December 18, 2015, we closed our merger with Roundy’s by purchasing 100% of the Roundy’s outstanding common stock for $3.60 per share and assuming Roundy’s outstanding debt, for a purchase price of $866 million. Roundy’s is included in our ending Consolidated Balance Sheets for 2015 and in our Consolidated Statements of Operations for the last six weeks of 2015. Certain yearoveryear comparisons will be affected as a result. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Roundy’s. On August 18, 2014, we closed our merger with Vitacost.com by purchasing 100% of the Vitacost.com outstanding common stock for $8.00 per share or $287 million. Vitacost.com is included in our ending Consolidated Balance Sheets and Consolidated Statements of Operations for 2014 and 2015. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Vitacost.com. On January 28, 2014, we closed our merger with Harris Teeter by purchasing 100% of the Harris Teeter outstanding common stock for approximately $2.4 billion. Harris Teeter is included in our ending Consolidated Balance Sheets for 2014 and 2015 and in our Consolidated Statements of Operations for 2014 and 2015. Due to the timing of the merger closing late in fiscal year 2013, its results of operations were not material to our consolidated results of operations for 2013. Certain yearoveryear comparisons will be affected as a result. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Harris Teeter. OUR 2015 PERFORMANCE We achieved outstanding results in 2015. Our business strategy continues to resonate with a full range of customers and our results reflect the balance we seek to achieve across our business including positive identical supermarket sales growth, increases in loyal household count, and good cost control, as well as growth in net earnings and net earnings per diluted share. Our 2015 net earnings were $2.0 billion or $2.06 per diluted share, compared to $1.7 billion, or $1.72 per diluted share for 2014. All share and per share amounts presented are reflective of the twoforone stock split that began trading at the split adjusted price on July 14, 2015. Our net earnings for 2015 include a $110 million expense to operating, general, and administrative (“OG&A”) for certain contributions to the United Food and Commercial Workers International Union (“UFCW”) Consolidated Pension Plan (“2015 UFCW Contributions”) made during the third and [/INST] Negative. </s>

KROGER CO

2017-03-28

2017-01-28

ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I, the “Risk Factors” section set forth in Item 1A of Part I and the “Outlook” section below. OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,796 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,255 have pharmacies and 1,445 have fuel centers. We also offer ClickList™ and Harris Teeter ExpressLane - personalized, order online, pick up at the store services - at 637 of our supermarkets, and operate 784 convenience stores, either directly or through franchisees, 319 fine jewelry stores and an online retailer. We operate 38 food production plants, primarily bakeries and dairies, which supply approximately 35% of the corporate brand units sold in our supermarkets; the remaining corporate brand items are produced to our strict specifications by outside manufacturers. This percentage has declined recently due to an expanded portfolio of non-grocery corporate brand units produced by outside manufacturers. Our food production plants produced 45% of our grocery category corporate brand units sold in our supermarkets, which is consistent with our historical trend. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 98% of our consolidated sales and EBITDA, is our only reportable segment. On September 2, 2016, we closed our merger with Modern HC Holdings, Inc. (“ModernHEALTH”) by purchasing 100% of the outstanding shares of ModernHEALTH for $407 million. ModernHEALTH is included in our ending Consolidated Balance Sheet for 2016 and in our Consolidated Statements of Operations from September 2, 2016 through January 28, 2017. On December 18, 2015, we closed our merger with Roundy’s, Inc. (“Roundy’s”) by purchasing 100% of Roundy’s® outstanding common stock for $3.60 per share and assuming Roundy’s outstanding debt, for a purchase price of $866 million. Roundy’s is included in our ending Consolidated Balance Sheets for 2015 and 2016 and in our Consolidated Statements of Operations for the last six weeks of 2015 and all periods in 2016. On August 18, 2014, we closed our merger with Vitacost.com® by purchasing 100% of the Vitacost.com outstanding common stock for $8.00 per share or $287 million. Vitacost.com is included in our ending Consolidated Balance Sheets for 2015 and 2016 and in our Consolidated Statements of Operations for all periods succeeding the merger. See Note 2 to the Consolidated Financial Statements for more information related to our mergers with ModernHEALTH, Roundy’s and Vitacost.com. USE OF NON-GAAP FINANCIAL MEASURES The accompanying Consolidated Financial Statements, including the related notes, set forth in Part II, Item 8 of this Form 10-K are presented in accordance with generally accepted accounting principles (“GAAP”). We provide non-GAAP measures, including First-In, First-Out (“FIFO”) gross margin, FIFO operating profit, adjusted net earnings and adjusted net earnings per diluted share because management believes these metrics are useful to investors and analysts. These non-GAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings and net earnings per diluted share or any other GAAP measure of performance. These measures should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. Our calculation and reasons these are useful metrics to investors and analysts are explained below. We calculate FIFO gross margin as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the Last-In, First-Out (“LIFO”) charge. Merchandise costs exclude depreciation and rent expenses. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness. Management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness. We calculate FIFO operating profit as operating profit excluding the LIFO charge. FIFO operating profit is an important measure used by management to evaluate operational effectiveness. Management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day operational effectiveness. We believe the adjusted net earnings per diluted share metric presents more accurate year-over-year comparisons for our net earnings per diluted share because adjusted items are not the result of our normal operations. OVERVIEW Notable items for 2016 are:  Net earnings per diluted share of $2.05.  Net earnings for 2016 includes $111 million ($71 million after-tax) of charges to operating, general and administrative expenses related to the restructuring of certain pension obligations to help stabilize associates’ future benefits (“2016 Adjusted Items”).  Adjusted net earnings per diluted share of $2.12.  Identical supermarket sales, excluding fuel, increased 1.0%.  Increased market share, total unit growth, added 420 Clicklist™ locations and achieved record high unit share for Corporate Brands.  Results include unfavorable pricing and cost effects and the loss of sales leverage due to a challenging, deflationary operating environment.  During 2016, we returned $2.2 billion to shareholders from share repurchases and dividend payments and invested $407 million in the ModernHEALTH merger. The following table provides a reconciliation of net earnings attributable to The Kroger Co. to adjusted net earnings attributable to The Kroger Co. and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to adjusted net earnings attributable to The Kroger Co. per diluted common share, excluding the 2016 and 2014 Adjusted Items. In 2015, we did not have any adjustment items that affect net earnings or net earnings per diluted share. Net Earnings per Diluted Share excluding the Adjusted Items ($ in millions, except per share amounts) (1) The amounts presented represent the after-tax effect of the 2016 and 2014 Adjusted Items. The “2014 Adjusted Items” are an $87 million ($56 million after-tax) charge to OG&A due to the commitments and withdrawal liabilities arising from restructuring of certain multi-employer obligations (“2014 Multi-Employer Pension Plan Obligation”) to help stabilize associates’ future pension benefits, offset partially by the benefits from certain tax items of $17 million. (2) The pre-tax adjustments for the 2016 and 2014 Adjusted Items were $111 million and $87 million, respectively. (3) The amounts presented represent the net earnings per diluted common share effect of the 2016 and 2014 Adjusted Items. RESULTS OF OPERATIONS Sales Total Sales ($ in millions) (1) Other sales primarily relate to sales at convenience stores, excluding fuel; jewelry stores; food production plants to outside customers; data analytic services; variable interest entities; specialty pharmacy; in-store health clinics; digital coupon services; and online sales by Vitacost.com. (2) This column represents the sales percentage increases in 2016, compared to 2015. (3) This column represents the sales percentage increases in 2015, compared to 2014. Total sales increased in 2016, compared to 2015, by 5.0%. This increase was primarily due to our increase in total supermarket sales, without fuel, and our merger with ModernHEALTH, partially offset by a decrease in fuel sales due to a 9.4% decrease in the average retail fuel price. The increase in total supermarket sales without fuel for 2016, compared to 2015, was primarily due to our merger with Roundy’s, an increase in supermarket square footage and our identical supermarket sales increase, excluding fuel, of 1.0%. Identical supermarket sales, excluding fuel, for 2016, compared to 2015, increased primarily due to an increase in the number of households shopping with us, partially offset by product cost deflation of 0.8%. Excluding mergers, acquisitions and operational closings, total supermarket square footage at the end of 2016 increased 3.4% over 2015. Total fuel sales decreased 5.6% in 2016, compared to 2015, primarily due to a decrease in the average retail fuel price of 9.4%, partially offset by an increase in fuel gallons sold of 4.2%. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel. Total sales increased in 2015, compared to 2014, by 1.3%. This increase in 2015 total sales, compared to 2014, was primarily due to an increase in identical supermarket sales, excluding fuel, of 5.0%. Total sales also increased due to the inclusion of Roundy’s sales, due to our merger, for the period of December 18, 2015 to January 30, 2016. Identical supermarket sales, excluding fuel, for 2015, compared to 2014, increased primarily due to an increase in the number of households shopping with us, an increase in visits per household, changes in product mix and product cost inflation. Total fuel sales decreased in 2015, compared to 2014, primarily due to a 26.7% decrease in the average retail fuel price, partially offset by an increase in fuel gallons sold of 7.1%. We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Although identical supermarket sales is a relatively standard term, numerous methods exist for calculating identical supermarket sales growth. As a result, the method used by our management to calculate identical supermarket sales may differ from methods other companies use to calculate identical supermarket sales. We urge you to understand the methods used by other companies to calculate identical supermarket sales before comparing our identical supermarket sales to those of other such companies. Fuel discounts received at our fuel centers and earned based on in-store purchases are included in all of the identical supermarket sales results calculations as illustrated in the following table and reduce our identical supermarket sales results. Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Identical supermarket sales include sales from all departments at identical multi-department stores and Roundy’s stores that are identical as if they were part of the Company in the prior year. Our identical supermarket sales results are summarized in the following table. We used the identical supermarket dollar figures presented below to calculate percentage changes for 2016 and 2015. Identical Supermarket Sales (dollars in millions) Gross Margin, LIFO and FIFO Gross Margin Our gross margin rates, as a percentage of sales, were 22.40% in 2016, 22.16% in 2015 and 21.16% in 2014. The increase in 2016, compared to 2015, resulted primarily from lower fuel sales, a lower LIFO charge and our merger with Roundy’s due to its historically higher gross margin rate, partially offset by continued investments in lower prices for our customers, unfavorable pricing and cost effects due to transitioning to a deflationary operating environment, our merger with ModernHEALTH due to its historically lower gross margin rate and increased warehousing and shrink costs, as a percentage of sales. The increase in 2015, compared to 2014, resulted primarily from lower fuel sales, reductions in transportation costs and a lower LIFO charge, partially offset by continued investments in lower prices for our customers and increased shrink costs, as a percentage of sales. Lower fuel sales increase our gross margin rate, as a percentage of sales, due to the very low gross margin rate, as a percentage of sales, on fuel sales compared to non-fuel sales. Our LIFO charge was $19 million in 2016, $28 million in 2015 and $147 million in 2014. In 2016, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation in other departments. In 2015, we experienced lower product cost inflation, compared to 2014, which resulted in a lower LIFO charge. In 2015, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation related to meat and dairy. In 2014, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, grocery, deli, meat and seafood. Our FIFO gross margin rates, as a percentage of sales, were 22.42% in 2016, 22.18% in 2015 and 21.30% in 2014. Excluding the effect of fuel and our mergers with Roundy’s and ModernHEALTH (“recent mergers”), our FIFO gross margin rate decreased seven basis points in 2016, compared to 2015. This decrease resulted primarily from continued investments in lower prices for our customers, unfavorable pricing and cost effects due to transitioning to a deflationary operating environment and increased warehousing and shrink costs, as a percentage of sales. Excluding the effect of fuel, our FIFO gross margin rate decreased four basis points in 2015, compared to 2014. This decrease resulted primarily from continued investments in lower prices for our customers and increased shrink costs, partially offset by a reduction in transportation costs, as a percentage of sales. Operating, General and Administrative Expenses OG&A expenses consist primarily of employee-related costs such as wages, health care benefits and retirement plan costs, utility and credit card fees. Rent expense, depreciation and amortization expense and interest expense are not included in OG&A. OG&A expenses, as a percentage of sales, were 16.63% in 2016, 16.34% in 2015 and 15.82% in 2014. OG&A expenses, as a percentage of sales, increased 29 basis points to 16.63% in 2016 from 16.34% in 2015. This increase resulted primarily from a decrease in fuel sales, the loss of sales leverage due to transitioning to a deflationary operating environment, the 2016 Adjusted Items, our recent mergers due to their historically higher OG&A rate, compared to our other divisions, and increases in healthcare benefit and credit card costs, partially offset by increased supermarket sales, productivity improvements, effective cost controls, $110 million United Food and Commercial Workers International Union (“UFCW”) contributions made during 2015 (“2015 UFCW Contributions”) and decreases in incentive plans, company-sponsored pension plans and utility costs, as a percentage of sales. Our fuel sales lower our OG&A rate, as a percentage of sales, due to the very low OG&A rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel, the 2016 Adjusted Items, recent mergers and the 2015 UFCW Contributions, our OG&A rate decreased five basis points in 2016, compared to 2015. This decrease resulted primarily from increased supermarket sales, productivity improvements, effective cost controls and decreases in incentive plans, company-sponsored pension plans and utility costs, partially offset by the loss of sales leverage due to transitioning to a deflationary operating environment and increases in healthcare benefit and credit card costs, as a percentage of sales. OG&A expenses, as a percentage of sales, increased 52 basis points to 16.34% in 2015 from 15.82% in 2014. This increase resulted primarily from a decrease in fuel sales, increases in EMV chargebacks, company-sponsored pension, healthcare and incentive plan costs, partially offset by increased supermarket sales, the 2014 Multi-Employer Pension Plan Obligation, lower charges for total contributions to The Kroger Foundation and UFCW Consolidated Pension Plan (“2014 Contributions”), compared to the 2015 UFCW Contributions, productivity improvements and effective cost controls at the store level. Excluding fuel, the 2015 UFCW Contributions, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, our OG&A rate decreased nine basis points, compared to 2014. The decrease resulted primarily from increased supermarket sales, productivity improvements and effective cost controls at the store level, partially offset by increases in EMV chargebacks , company-sponsored pension, healthcare and incentive plan costs, as a percentage of sales. Rent Expense Rent expense increased on a total dollars and percentage of sales basis in 2016, compared to 2015, due to: · Our merger with Roundy’s, due to its higher volume of leased versus owned supermarkets, and · Lower fuel sales, which increases our rent expense rate, as a percentage of sales. Rent expense increased in 2015, compared to 2014, due to our merger with Roundy’s, partially offset by our continued emphasis to own rather than lease, whenever possible. Rent expense, as a percentage of sales, in 2015 was consistent with 2014, due to the effect of our merger with Roundy’s being offset by our continued emphasis to own rather than lease, whenever possible, and the benefit of increased sales. Depreciation and Amortization Expense Depreciation and amortization expense increased on a total dollars and percentage of sales basis in 2016, compared to 2015, due to: · Additional depreciation on capital investments, excluding mergers and lease buyouts, of $3.6 billion, during 2016, · Unfavorable sales leveraging from transitioning to a deflationary operating environment, and · Our merger with Roundy’s. Depreciation and amortization expense increased on a total dollars and percentage of sales basis in 2015, compared to 2014, due to: · Additional depreciation on capital investments, excluding mergers and lease buyouts of $3.3 billion, during 2015, and · Our merger with Roundy’s. Operating Profit and FIFO Operating Profit Operating profit was $3.4 billion in 2016, $3.6 billion in 2015 and $3.1 billion in 2014. Operating profit, as a percentage of sales, decreased 28 basis points in 2016, compared to 2015, due to increased OG&A, depreciation and amortization and rent expenses, partially offset by higher gross margin and a lower LIFO charge, as a percentage of sales. Operating profit, as a percentage of sales, increased 37 basis points in 2015, compared to 2014, due to higher gross margin and a lower LIFO charge, partially offset by increased OG&A, depreciation and amortization and rent expenses, as a percentage of sales. Specific factors of these operating trends are discussed earlier in this section. FIFO operating profit was $3.5 billion in 2016, $3.6 billion in 2015 and $3.3 billion in 2014. FIFO operating profit, as a percentage of sales, was 3.00% in 2016, 3.28% in 2015 and 3.03% in 2014. Fuel sales lower our operating profit rate due to the very low operating profit rate, as a percentage of sales, of fuel sales compared to non-fuel sales. FIFO operating profit, as a percentage of sales excluding fuel, the 2016 Adjusted Items, the effects of our recent mergers and the 2015 UFCW Contributions, decreased 14 basis points in 2016, compared to 2015. This decrease was due to lower gross margin, higher depreciation and amortization, partially offset by decreased OG&A and rent expenses, as a percentage of sales. FIFO operating profit, as a percentage of sales excluding fuel, the effects of our Roundy’s merger, the 2015 UFCW Contributions, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, increased 8 basis points in 2015, compared to 2014. This increase was primarily due to decreased OG&A and rent, partially offset by lower gross margin and increased depreciation and amortization, as a percentage of sales. Specific factors of these operating trends are discussed earlier in this section. Interest Expense Interest expense totaled $522 million in 2016, $482 million in 2015 and $488 million in 2014. The increase in interest expense in 2016, compared to 2015, resulted primarily from additional borrowings used for share repurchases, mergers and a higher weighted average interest rate. The decrease in interest expense in 2015, compared to 2014, resulted primarily from the timing of debt principal payments and debt issuances, partially offset by an increase in interest expense associated with our commercial paper program. Income Taxes Our effective income tax rate was 32.8% in 2016, 33.8% in 2015 and 34.1% in 2014. The 2016 tax rate differed from the federal statutory rate primarily as a result of the recognition of excess tax benefits related to share-based payments after the adoption of ASU 2016-09, the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes. The 2015 and 2014 tax rate differed from the federal statutory rate primarily as a result of the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes. Net Earnings and Net Earnings Per Diluted Share Our net earnings are based on the factors discussed in the Results of Operations section. Net earnings of $2.05 per diluted share in 2016 represented a decrease of 0.5% from net earnings of $2.06 per diluted share in 2015. Excluding the 2016 Adjusted Items, net earnings of $2.12 per diluted share in 2016 represented an increase of 2.9% from net earnings of $2.06 per diluted share in 2015. The net earnings of 2015 do not include any adjusted items. The 2.9% increase resulted primarily from a lower LIFO charge, lower income tax expense and lower weighted average common shares outstanding due to common share repurchases, partially offset by lower non-fuel FIFO operating profit and lower fuel earnings. Net earnings of $2.06 per diluted share in 2015 represented a increase of 19.8% from net earnings of $1.72 per diluted share in 2014. Excluding the 2014 Adjusted Items, net earnings of $2.06 per diluted share in 2015 represented an increase of 17.0% from net earnings of $1.76 per diluted share in 2014. The net earnings of 2015 do not include any adjusted items. The 17.0% increase resulted primarily from higher non-fuel FIFO operating profit, a lower LIFO charge and lower weighted average common shares outstanding due to common share repurchases, partially offset by lower fuel earnings and higher income tax expense. COMMON SHARE REPURCHASE PROGRAMS We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time. We made open market purchases of our common shares totaling $1.7 billion in 2016, $500 million in 2015 and $1.1 billion in 2014 under these repurchase programs. In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises. We repurchased approximately $105 million in 2016, $203 million in 2015 and $155 million in 2014 of our common shares under the stock option program. The following Board of Director authorizations created repurchase programs to reacquire shares via open market purchases: · A $500 million share repurchase program authorized by our Board of Directors and announced on June 25, 2015. On March 10, 2016, our Board of Directors approved an additional $500 million share repurchase authority to supplement the June 2015 program. These programs were exhausted during the first quarter of 2016. · On June 22, 2016, our Board of Directors approved a $500 million share repurchase program. On September 15, 2016, our Board of Directors approved an additional $500 million share repurchase authority to supplement the June 2016 program. The June 2016 program was exhausted during the fourth quarter of 2016. · On March 9, 2017, our Board of Directors approved an additional $500 million share repurchase authority to supplement the September 2016 program. During the first quarter through March 28, 2017, the Company used an additional $341 million of cash to repurchase 11 million common shares at an average price of $31.09 per share. As of March 28, 2017, we have exhausted the September 2016 program and have $498 million remaining under the March 2017 program. CAPITAL INVESTMENTS Capital investments, including changes in construction-in-progress payables and excluding mergers and the purchase of leased facilities, totaled $3.7 billion in 2016, $3.3 billion in 2015 and $2.7 billion in 2014. Capital investments for mergers totaled $401 million in 2016, $168 million in 2015 and $252 million in 2014. We merged with ModernHEALTH in 2016, Roundy’s in 2015 and Vitacost.com in 2014. Refer to Note 2 to the Consolidated Financial Statements for more information on these mergers. Capital investments for the purchase of leased facilities totaled $5 million in 2016, $35 million in 2015 and $135 million in 2014. The table below shows our supermarket storing activity and our total supermarket square footage: Supermarket Storing Activity RETURN ON INVESTED CAPITAL We calculate return on invested capital (“ROIC”) by dividing adjusted operating profit for the prior four quarters by the average invested capital. Adjusted operating profit is calculated by excluding certain items included in operating profit, and adding back our LIFO charge, depreciation and amortization and rent to our U.S. GAAP operating profit of the prior four quarters. Average invested capital is calculated as the sum of (i) the average of our total assets, (ii) the average LIFO reserve, (iii) the average accumulated depreciation and amortization and (iv) a rent factor equal to total rent for the last four quarters multiplied by a factor of eight; minus (i) the average taxes receivable, (ii) the average trade accounts payable, (iii) the average accrued salaries and wages and (iv) the average other current liabilities, excluding accrued income taxes. Averages are calculated for ROIC by adding the beginning balance of the first quarter and the ending balance of the fourth quarter, of the last four quarters, and dividing by two. We use a factor of eight for our total rent as we believe this is a common factor used by our investors, analysts and rating agencies. ROIC is a non-GAAP financial measure of performance. ROIC should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital. Management believes ROIC is a useful metric to investors and analysts because it measures how effectively we are deploying our assets. Although ROIC is a relatively standard financial term, numerous methods exist for calculating a company’s ROIC. As a result, the method used by our management to calculate ROIC may differ from methods other companies use to calculate their ROIC. We urge you to understand the methods used by other companies to calculate their ROIC before comparing our ROIC to that of such other companies. The following table provides a calculation of ROIC for 2016 and 2015. The January 30, 2016 calculation of ROIC excludes the financial position and results for the Roundy's merger. (1) Taxes receivable were $132 as of January 28, 2017, $392 as of January 30, 2016 and $20 as of January 31, 2015. The January 30, 2016 balance is higher than the other comparative balances due to changes to tangible property regulations in 2015. Refer to Note 5 of the Consolidated Financial Statements for further detail. (2) Other current liabilities included accrued income taxes of $1 as of January 28, 2017 and $5 as of January 31, 2015. We did not have any accrued income taxes as of January 30, 2016. Accrued income taxes are removed from other current liabilities in the calculation of average invested capital. CRITICAL ACCOUNTING POLICIES We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Our significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. We believe that the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain. Self-Insurance Costs We primarily are self-insured for costs related to workers’ compensation and general liability claims. The liabilities represent our best estimate, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred but not reported for all claims incurred through January 28, 2017. We establish case reserves for reported claims using case-basis evaluation of the underlying claim data and we update as information becomes known. For both workers’ compensation and general liability claims, we have purchased stop-loss coverage to limit our exposure to any significant exposure on a per claim basis. We are insured for covered costs in excess of these per claim limits. We account for the liabilities for workers’ compensation claims on a present value basis utilizing a risk-adjusted discount rate. A 25 basis point decrease in our discount rate would increase our liability by approximately $2 million. General liability claims are not discounted. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can affect ultimate costs. Our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, and any changes could have a considerable effect on future claim costs and currently recorded liabilities. Impairments of Long-Lived Assets We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value. Fair value is determined based on market values or discounted future cash flows. We record impairment when the carrying value exceeds fair market value. With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal. We recorded asset impairments in the normal course of business totaling $26 million in 2016, $46 million in 2015 and $37 million in 2014. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as “Operating, general and administrative” expense. The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different level, could produce significantly different results. Goodwill Our goodwill totaled $3.0 billion as of January 28, 2017. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our operating divisions and variable interest entities (collectively, “reporting units”) that have goodwill balances. Fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment. We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future. If we identify potential for impairment, we measure the fair value of a reporting unit against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the reporting unit’s goodwill. We recognize goodwill impairment for any excess of the carrying value of the reporting unit’s goodwill over the implied fair value. The annual evaluation of goodwill performed for our reporting units during the fourth quarter of 2016, 2015 and 2014 did not result in impairment. Based on current and future expected cash flows, we believe goodwill impairments are not reasonably likely. A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance. For additional information relating to our results of the goodwill impairment reviews performed during 2016, 2015 and 2014 see Note 3 to the Consolidated Financial Statements. The impairment review requires the extensive use of management judgment and financial estimates. Application of alternative estimates and assumptions, such as reviewing goodwill for impairment at a different level, could produce significantly different results. The cash flow projections embedded in our goodwill impairment reviews can be affected by several factors such as inflation, business valuations in the market, the economy, market competition and our ability to successfully integrate recently acquired businesses. Store Closing Costs We provide for closed store liabilities on the basis of the present value of the estimated remaining non-cancellable lease payments after the closing date, net of estimated subtenant income. We estimate the net lease liabilities using a discount rate to calculate the present value of the remaining net rent payments on closed stores. We usually pay closed store lease liabilities over the lease terms associated with the closed stores, which generally have remaining terms ranging from one to 20 years. Adjustments to closed store liabilities primarily relate to changes in subtenant income and actual exit costs differing from original estimates. We make adjustments for changes in estimates in the period in which the change becomes known. We review store closing liabilities quarterly to ensure that any accrued amount that is not a sufficient estimate of future costs is adjusted to earnings in the proper period. We estimate subtenant income, future cash flows and asset recovery values based on our experience and knowledge of the market in which the closed store is located, our previous efforts to dispose of similar assets and current economic conditions. The ultimate cost of the disposition of the leases and the related assets is affected by current real estate markets, inflation rates and general economic conditions. We reduce owned stores held for disposal to their estimated net realizable value. We account for costs to reduce the carrying values of property, equipment and leasehold improvements in accordance with our policy on impairment of long-lived assets. We classify inventory write-downs in connection with store closings, if any, in “Merchandise costs.” We expense costs to transfer inventory and equipment from closed stores as they are incurred. Post-Retirement Benefit Plans We account for our defined benefit pension plans using the recognition and disclosure provisions of GAAP, which require the recognition of the funded status of retirement plans on the Consolidated Balance Sheet. We record, as a component of Accumulated Other Comprehensive Income (“AOCI”), actuarial gains or losses, prior service costs or credits and transition obligations that have not yet been recognized. The determination of our obligation and expense for Company-sponsored pension plans and other post-retirement benefits is dependent upon our selection of assumptions used by actuaries in calculating those amounts. Those assumptions are described in Note 15 to the Consolidated Financial Statements and include, among others, the discount rate, the expected long-term rate of return on plan assets, mortality and the rate of increases in compensation and health care costs. Actual results that differ from our assumptions are accumulated and amortized over future periods and, therefore, generally affect our recognized expense and recorded obligation in future periods. While we believe that our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions, including the discount rate used and the expected return on plan assets, may materially affect our pension and other post-retirement obligations and our future expense. Note 15 to the Consolidated Financial Statements also discusses the effect of a 1% change in the assumed health care cost trend rate on other post-retirement benefit costs and the related liability. The objective of our discount rate assumptions was intended to reflect the rates at which the pension benefits could be effectively settled. In making this determination, we take into account the timing and amount of benefits that would be available under the plans. Our methodology for selecting the discount rates was to match the plan’s cash flows to that of a hypothetical bond portfolio whose cash flow from coupons and maturities match the plan’s projected benefit cash flows. The discount rates are the single rates that produce the same present value of cash flows. The selection of the 4.25% and 4.18% discount rates as of year-end 2016 for pension and other benefits, respectively, represents the hypothetical bond portfolio using bonds with an AA or better rating constructed with the assistance of an outside consultant. We utilized a discount rate of 4.62% and 4.44% as of year-end 2015 for pension and other benefits, respectively. A 100 basis point increase in the discount rate would decrease the projected pension benefit obligation as of January 28, 2017, by approximately $510 million. To determine the expected rate of return on pension plan assets held by Kroger for 2016, we considered current and forecasted plan asset allocations as well as historical and forecasted rates of return on various asset categories. In 2016, our assumed pension plan investment return rate was 7.40% compared to 7.44% in 2015 and 2014. During 2016, Kroger began managing the assets for the Harris Teeter and Roundy’s pension plans, and our expected rate of return reflects implementing a similar investment management strategy for the Harris Teeter and Roundy’s plans’ assets. Historically, the Kroger pension plans’ average rate of return was 5.81% for the 10 calendar years ended December 31, 2016, net of all investment management fees and expenses. The value of all investments in our Company-sponsored defined benefit pension plans during the calendar year ending December 31, 2016, net of investment management fees and expenses, increased 6.90%. For the past 20 years, the Kroger pension plans’ average annual rate of return has been 7.77%. Based on the above information and forward looking assumptions for investments made in a manner consistent with our target allocations, we believe a 7.40% rate of return assumption is reasonable for 2016. See Note 15 to the Consolidated Financial Statements for more information on the asset allocations of pension plan assets. On January 31, 2015, we adopted new industry specific mortality tables based on mortality experience and assumptions for generational mortality improvement in determining our benefit obligations. On January 28, 2017, we adopted an updated assumption for generational mortality improvement, based on additional years of published mortality experience. Sensitivity to changes in the major assumptions used in the calculation of Kroger’s pension plan liabilities is illustrated below (in millions). In 2016, we contributed $3 million to our Company-sponsored defined benefit plans and are not required to make any contributions to these plans in 2017. We contributed $5 million to our Company-sponsored defined benefit plans in 2015 and did not make contributions in 2014. Among other things, investment performance of plan assets, the interest rates required to be used to calculate the pension obligations, and future changes in legislation, will determine the amounts of contributions. We contributed and expensed $215 million in 2016, $196 million in 2015 and $177 million in 2014 to employee 401(k) retirement savings accounts. The increase in 2016, compared to 2015, is primarily due to our recent mergers. The increase in 2015, compared to 2014, is due to a higher employee savings rate. The 401(k) retirement savings account plans provide to eligible employees both matching contributions and automatic contributions from the Company based on participant contributions, plan compensation and length of service. Multi-Employer Pension Plans We contribute to various multi-employer pension plans based on obligations arising from collective bargaining agreements. These multi-employer pension plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans. We recognize expense in connection with these plans as contributions are funded or when commitments are probable and reasonably estimable, in accordance with GAAP. We made cash contributions to these plans of $289 million in 2016, $426 million in 2015 and $297 million in 2014. We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans as it relates to our associates who are beneficiaries of these plans. These under-fundings are not our liability. When an opportunity arises that is economically feasible and beneficial to us and our associates, we may negotiate the restructuring of under-funded multi-employer pension plan obligations to help stabilize associates’ future benefits and become the fiduciary of the restructured multi-employer pension plan. The commitments from these restructurings do not change our debt profile as it relates to our credit rating. We are currently designated as the named fiduciary of the UFCW Consolidated Pension Plan and have sole investment authority over these assets. Significant effects of these restructuring agreements recorded in our Consolidated Financial Statements are: · In 2016, we incurred a charge of $111 million, $71 million, after tax, due to commitments and withdrawal liabilities arising from the restructuring of certain multi-employer pension plan obligations, of which $28 million was contributed to the UFCW Consolidated Pension Plan in 2016. · In 2015, we contributed $190 million to the UFCW Consolidated Pension Plan. We had previously accrued $60 million of the total contributions at January 31, 2015 and recorded expense for the remaining $130 million at the time of payment in 2015. · In 2014, we incurred a charge of $56 million. after-tax, related to commitments and withdrawal liabilities associated with the restructuring of pension plan agreements, of which $15 million was contributed to the UFCW Consolidated Pension Plan in 2014. As we continue to work to find solutions to under-funded multi-employer pension plans, it is possible we could incur withdrawal liabilities for certain funds. Two locations have initiated a withdrawal process, in the first quarter of 2017, resulting in an estimated withdrawal liability of less than $100 million, after-tax. Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2016. Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding. Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer. As of December 31, 2016, we estimate that our share of the underfunding of multi-employer pension plans to which we contribute, or as it relates to certain funds, an estimated withdrawal liability, was approximately $3.0 billion, pre-tax, or $1.8 billion, after-tax. This represents an increase in the estimated amount of underfunding of approximately $100 million, pre-tax, or approximately $40 million, after-tax, as of December 31, 2016, compared to December 31, 2015. The increase in the amount of underfunding is attributable to lower than expected returns on the assets held in the multi-employer pension plans during 2016 and changes in mortality rate assumptions. Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable. We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours. Rather, we believe the underfunding is likely to have important consequences. In 2017, we expect to contribute approximately $360 million to multi-employer pension plans, which excludes any additional multi-employer pension plan restructurings that could occur. Of this amount, $35 million has been accrued for as of January 28, 2017. We expect increases in expense as a result of increases in multi-employer pension plan contributions over the next few years. Finally, underfunding means that, in the event we were to exit certain markets or otherwise cease making contributions to these plans, we could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated, in accordance with GAAP. The amount of underfunding described above is an estimate and could change based on contract negotiations, returns on the assets held in the multi-employer pension plans, benefit payments or future restructuring agreements. The amount could decline, and our future expense would be favorably affected, if the values of the assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, our share of the underfunding could increase and our future expense could be adversely affected if the asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation. We continue to evaluate our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of ours, any commitments to fund certain multi-employer pension plans will be expensed when our commitment is probable and an estimate can be made. See Note 16 to the Consolidated Financial Statements for more information relating to our participation in these multi-employer pension plans. Uncertain Tax Positions We review the tax positions taken or expected to be taken on tax returns to determine whether and to what extent a benefit can be recognized in our Consolidated Financial Statements. Refer to Note 5 to the Consolidated Financial Statements for the amount of unrecognized tax benefits and other disclosures related to uncertain tax positions. Various taxing authorities periodically audit our income tax returns. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing positions, including state and local taxes, we record allowances for probable exposures. A number of years may elapse before a particular matter, for which an allowance has been established, is audited and fully resolved. As of January 28, 2017, the Internal Revenue Service had concluded its examination of our 2012 and 2013 federal tax returns. The assessment of our tax position relies on the judgment of management to estimate the exposures associated with our various filing positions. Share-Based Compensation Expense We account for stock options under the fair value recognition provisions of GAAP. Under this method, we recognize compensation expense for all share-based payments granted. We recognize share-based compensation expense, net of an estimated forfeiture rate, over the requisite service period of the award. In addition, we record expense for restricted stock awards in an amount equal to the fair market value of the underlying stock on the grant date of the award, over the period the award restrictions lapse. As described in Note 17 to the Consolidated Financial Statements, we adopted a new share-based compensation standard during 2016, which requires recognition of excess tax benefits related to share-based payments in our provision for income taxes. Excess tax benefits were historically recorded in additional paid-in capital. Inventories Inventories are stated at the lower of cost (principally on a LIFO basis) or market. In total, approximately 89% and 95% of inventories were valued using the LIFO method in 2016 and 2015, respectively. Cost for the balance of the inventories, including substantially all fuel inventories, was determined using the FIFO method. Replacement cost was higher than the carrying amount by $1.3 billion at January 28, 2017 and January 31, 2016. We follow the Link-Chain, Dollar-Value LIFO method for purposes of calculating our LIFO charge or credit. We follow the item-cost method of accounting to determine inventory cost before the LIFO adjustment for substantially all store inventories at our supermarket divisions. This method involves counting each item in inventory, assigning costs to each of these items based on the actual purchase costs (net of vendor allowances and cash discounts) of each item and recording the cost of items sold. The item-cost method of accounting allows for more accurate reporting of periodic inventory balances and enables management to more precisely manage inventory. In addition, substantially all of our inventory consists of finished goods and is recorded at actual purchase costs (net of vendor allowances and cash discounts). We evaluate inventory shortages throughout the year based on actual physical counts in our facilities. We record allowances for inventory shortages based on the results of recent physical counts to provide for estimated shortages from the last physical count to the financial statement date. Vendor Allowances We recognize all vendor allowances as a reduction in merchandise costs when the related product is sold. In most cases, vendor allowances are applied to the related product cost by item, and therefore reduce the carrying value of inventory by item. When it is not practicable to allocate vendor allowances to the product by item, we recognize vendor allowances as a reduction in merchandise costs based on inventory turns and as the product is sold. We recognized approximately $7.8 billion in 2016, $7.3 billion in 2015 and $6.9 billion in 2014 of vendor allowances as a reduction in merchandise costs. We recognized approximately 92% of all vendor allowances in the item cost with the remainder being based on inventory turns. RECENTLY ADOPTED ACCOUNTING STANDARDS In September 2015, the FASB issued Accounting Standards Update (“ASU”) 2015-16, “Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments.” This amendment eliminates the requirement to retrospectively account for adjustments made to provisional amounts recognized in a business combination. This amendment became effective for us beginning January 31, 2016, and was adopted prospectively in accordance with the standard. The adoption of this amendment did not have an effect on our Consolidated Balance Sheets or Consolidated Statements of Operations. During the second quarter of 2016, we adopted ASU 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” This amendment addresses several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. As a result of the adoption, we recognized $49 million of excess tax benefits related to share-based payments in our provision for income taxes in 2016. These items were historically recorded in additional paid-in capital. In addition, for 2016, cash flows related to excess tax benefits are classified as an operating activity. Cash paid on employees’ behalf related to shares withheld for tax purposes is classified as a financing activity. Retrospective application of the cash flow presentation requirements resulted in increases to both “Net cash provided by operating activities” and “Net cash used by financing activities” of $59 million for 2016, $84 million for 2015 and $52 for 2014. Our stock compensation expense continues to reflect estimated forfeitures. During 2016, we adopted ASU 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (Topic 205)”. This standard requires us to evaluate, for each annual and interim reporting period, whether there are conditions and events, considered in the aggregate, that raise substantial doubt about our ability to continue as a going concern within one year after the date the Consolidated Financial Statements are issued or are available to be issued. If substantial doubt is raised, additional disclosures around our plan to alleviate these doubts are required. The adoption of this standard did not affect our Consolidated Financial Statements. During 2016, we adopted ASU 2015-07, “Fair Value Measurement - Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or Its Equivalent) (Topic 820)”. This standard requires us to disclose which assets we value using net asset value as a practical expedient, and ends the requirement to classify these assets within the GAAP fair value hierarchy. See Note 15 of our Consolidated Financial Statements for disclosures of assets we value using net asset value as a practical expedient. RECENTLY ISSUED ACCOUNTING STANDARDS In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers,” as amended by several subsequent ASUs, which provides guidance for revenue recognition. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. Per ASU 2015-14, “Deferral of Effective Date,” this guidance will be effective for us in the first quarter of our fiscal year ending February 2, 2019. Early adoption is permitted as of the first quarter of our fiscal year ending February 3, 2018. We are currently in the process of evaluating the effect of adoption of this ASU on our Consolidated Financial Statements. In November 2015, the FASB issued ASU 2015-17, “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes.” This amendment requires deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. This guidance will be effective for our fiscal year ending February 3, 2018. Early adoption is permitted. The implementation of this amendment will not have an effect on our Consolidated Statements of Operations and will not have a significant effect on our Consolidated Balance Sheets. In February 2016, the FASB issued ASU 2016-02, “Leases”, which provides guidance for the recognition of lease agreements. The standard’s core principle is that a company will now recognize most leases on its balance sheet as lease liabilities with corresponding right-of-use assets. This guidance will be effective for us in the first quarter of fiscal year ending February 1, 2020. Early adoption is permitted. The adoption of this ASU will result in a significant increase to our Consolidated Balance Sheets for lease liabilities and right-of-use assets, and we are currently evaluating the other effects of adoption of this ASU on our Consolidated Financial Statements. We believe our current off-balance sheet leasing commitments are reflected in our investment grade debt rating. LIQUIDITY AND CAPITAL RESOURCES Cash Flow Information Net cash provided by operating activities We generated $4.3 billion of cash from operations in 2016, compared to $4.9 billion in 2015 and $4.2 billion in 2014. The cash provided by operating activities came from net earnings including non-controlling interests adjusted primarily for non-cash expenses of depreciation and amortization, stock compensation, expense for Company-sponsored pension plans and the LIFO charge. Changes in working capital created a net cash outflow in 2016, and net cash inflows for 2015 and 2014. The decrease in net cash provided by operating activities in 2016, compared to 2015, resulted primarily due to a decrease in net earnings including noncontrolling interests and changes in working capital, partially offset by an increase in non-cash expenses, deferred taxes and lower payments on long-term liabilities. The increase in net cash provided by operating activities in 2015, compared to 2014, resulted primarily due to an increase in net earnings including non-controlling interests, an increase in non-cash items and changes in working capital. The increase in non-cash items in 2015, as compared to 2014, was primarily due to increases in depreciation and amortization expense and expense for Company-sponsored pension plans, partially offset by a lower LIFO charge. Cash provided (used) by operating activities for changes in working capital was ($492) million in 2016, compared to $180 million in 2015 and $3 million in 2014. The decrease in cash provided by operating activities for changes in working capital in 2016, compared to 2015, was primarily due to the net effect of the following: · Higher receivables due to increasing vendor allowance activity and pharmacy sales requiring third party payments, · Increased inventory purchases due to store growth and new distribution centers, · Higher prepayment of benefit costs, · Lower accrued expenses due to reduced incentive plan payout accruals, and · Lower tax payments due to a 2015 tax deduction associated with tangible property regulations. The increase in cash provided by operating activities for changes in working capital in 2015, compared to 2014, was primarily due to an increase in cash provided by trade accounts payables and store deposits in transit, partially offset by a decrease in cash provided by income taxes receivable and payable. Net cash used by investing activities Cash used by investing activities was $3.9 billion in 2016, compared to $3.6 billion in 2015 and $3.1 billion in 2014. The amount of cash used by investing activities increased in 2016, compared to 2015, primarily due to increased cash payments for capital investments and our merger with ModernHEALTH. The amount of cash used by investing activities increased in 2015, compared to 2014, due to increased payments for capital investments, partially offset by lower payments for mergers. Net cash provided (used) by financing activities Financing activities used cash of $352 million in 2016, $1.3 billion in 2015 and $1.2 billion in 2014. The decrease in the amount of cash used for financing activities in 2016, compared to 2015, was primarily due to higher treasury stock purchases, partially offset by higher long-term and commercial paper borrowings. The increase in the amount of cash used for financing activities in 2015, compared to 2014, was primarily related to increased payments on long-term debt and commercial paper, partially offset by higher proceeds from issuances of long-term debt and decreased treasury stock purchases. Debt Management Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $2.0 billion to $14.1 billion as of year-end 2016, compared to 2015. The increase in 2016, compared to 2015, resulted from the issuance of (i) $1.0 billion of senior notes bearing an interest rate of 4.45%, (ii) 750 million of senior notes bearing an interest rate of 2.65%, (iii) $500 million of senior notes bearing an interest rate of 3.875%, (iv) $500 million of senior notes bearing an interest rate of 1.5%, (v) increases in commercial paper borrowings and (vi) increases in capital lease obligations due to additional leased locations, partially offset by payments of $1.4 billion on maturing long-term debt obligations. Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $481 million to $12.1 billion as of year-end 2015, compared to 2014. The increase in 2015, compared to 2014, resulted primarily from the issuance of (i) $300 million of senior notes bearing an interest rate of 2.00%, (ii) $300 million of senior notes bearing an interest rate of 2.60%, (iii) $500 million of senior notes bearing an interest rate of 3.50% and (iv) an increase in capital lease obligations due to our merger with Roundy’s and various leased locations, partially offset by payments of $678 million on long-term debt obligations assumed as part of our merger with Roundy’s and $500 million of payments at maturity of senior notes bearing an interest rate of 3.90%. The increase in financing obligations was due to partially funding our merger with Roundy’s. Liquidity Needs We estimate our liquidity needs over the next twelve-month period to range from $5.9 to $6.4 billion, which includes anticipated requirements for working capital, capital investments, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2016. We generally operate with a working capital deficit due to our efficient use of cash in funding operations and because we have consistent access to the capital markets. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months. We have approximately $1.4 billion of commercial paper and $600 million of senior notes maturing in the next twelve months, which is included in the range of $5.9 to $6.4 billion in estimated liquidity needs. We expect to refinance this debt, in 2017, by issuing additional senior notes or commercial paper on favorable terms based on our past experience. We also currently plan to continue repurchases of common shares under the Company’s share repurchase programs and a growing dividend. We believe we have adequate coverage of our debt covenants to continue to maintain our current debt ratings and to respond effectively to competitive conditions. Factors Affecting Liquidity We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper program. At January 28, 2017, we had $1.4 billion of commercial paper borrowings outstanding. Commercial paper borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility. If our short-term credit ratings fall, the ability to borrow under our current commercial paper program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our commercial paper program. This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity. However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our commercial paper program would be any lower than $500 million on a daily basis. Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost on borrowings under the credit facility could be affected by an increase in our Leverage Ratio. As of March 22, 2017, we had $956 million of commercial paper borrowings outstanding. Our credit facility requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our “financial covenants”). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants are described below: · Our Leverage Ratio (the ratio of Net Debt to Consolidated EBITDA, as defined in the credit facility) was 2.27 to 1 as of January 28, 2017. If this ratio were to exceed 3.50 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. In addition, our applicable margin on borrowings is determined by our Leverage Ratio. · Our Fixed Charge Coverage Ratio (the ratio of Consolidated EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facility) was 4.75 to 1 as of January 28, 2017. If this ratio fell below 1.70 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. Our credit facility is more fully described in Note 6 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2016. The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of January 28, 2017 (in millions of dollars): (1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $33 million in 2016. This table also excludes contributions under various multi-employer pension plans, which totaled $289 million in 2016. (2) The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined. (3) As of January 28, 2017 we had $1.4 billion of commercial paper and no borrowings under our credit facility. (4) Amounts include contractual interest payments using the interest rate as of January 28, 2017, and stated fixed and swapped interest rates, if applicable, for all other debt instruments. (5) The amounts included in the contractual obligations table for self-insurance liability related to workers’ compensation claims have been stated on a present value basis. (6) Amounts include funds owed to third parties for projects currently under construction. These amounts are reflected in other current liabilities in our Consolidated Balance Sheets. (7) Amounts include commitments, many of which are short-term in nature, to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our food production plants and several contracts to purchase energy to be used in our stores and food production plants. Our obligations also include management fees for facilities operated by third parties and outside service contracts. Any upfront vendor allowances or incentives associated with outstanding purchase commitments are recorded as either current or long-term liabilities in our Consolidated Balance Sheets. As of January 28, 2017, we maintained a $2.75 billion (with the ability to increase by $750 million), unsecured revolving credit facility that, unless extended, terminates on June 30, 2019. Outstanding borrowings under the credit facility and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit facility. As of January 28, 2017, we had $1.4 billion of borrowings of commercial paper and no borrowings under our credit facility. The outstanding letters of credit that reduce funds available under our credit facility totaled $13 million as of January 28, 2017. In addition to the available credit mentioned above, as of January 28, 2017, we had authorized for issuance $4 billion of securities under a shelf registration statement filed with the SEC and effective on December 14, 2016. We also maintain surety bonds related primarily to our self-insured workers’ compensation claims. These bonds are required by most states in which we are self-insured for workers’ compensation and are placed with predominately third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of ours, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility. We also are contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. We could be required to satisfy obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of our assignments among third parties, and various other remedies available to us, we believe the likelihood that we will be required to assume a material amount of these obligations is remote. We have agreed to indemnify certain third-party logistics operators for certain expenses, including multi-employer pension plan obligations and withdrawal liabilities. In addition to the above, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third party claims arising out of agreements to provide services to us; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability. OUTLOOK This discussion and analysis contains certain forward-looking statements about our future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available to it. Such statements are indicated by words such as “comfortable,” “committed,” “will,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” “plan,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially. Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially. · For 2017, we expect net earnings to be $2.21 to $2.25 per diluted share, including an estimated $0.09 for the 53rd week. We expect the first quarter to be in the $0.55 to $0.59 range, the second quarter to be up slightly compared to last year, the third quarter to be up strongly compared to last year, and the fourth quarter to be up high single-digits compared to last year, without the benefit of the 53rd week. · We expect identical supermarket sales growth, excluding fuel sales, in 2017 to range from flat to 1.0% growth. · We expect full-year FIFO operating margin in 2017, excluding fuel, to decline approximately 10 basis points compared to 2016 results. · We expect capital investments, excluding mergers, acquisitions and purchases of leased facilities, to be $3.2 to $3.5 billion. These capital investments include approximately 55 major projects covering new stores, expansions and relocations; 175 major remodels; and other investments including digital, technology, minor remodels, and upgrades to logistics, merchandising systems and infrastructure to support our Customer 1st business strategy. · We expect total supermarket square footage for 2017 to grow approximately 1.8% before mergers, acquisitions and operational closings. · We expect the 2017 effective tax rate to be approximately 35%, excluding the resolution of certain tax items. · In 2017, we anticipate annualized product cost inflation, excluding fuel, and an annualized LIFO charge of approximately $25 million. · We expect 2017 Company-sponsored pension plans expense to be approximately $110 million. We are not required to make a cash contribution in 2017. · In 2017, we expect to contribute approximately $360 million to multi-employer pension funds. Of this amount, $35 million has been accrued for as of year-end. This excludes any additional multi-employer pension plan restructuring that could occur. We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of Kroger, any new agreements that would commit us to fund certain multi-employer plans will be expensed when our commitment is probable and an estimate can be made. · We are currently negotiating an agreement with UFCW for store associates in Atlanta. In 2017, we will also negotiate agreements with UFCW for store associates in Dallas and Food 4 Less® Warehouse Stores. Negotiations this year will be challenging as we must have competitive cost structures in each market while meeting our associates’ needs for solid wages and good quality, affordable health care and retirement benefits. Various uncertainties and other factors could cause actual results to differ materially from those contained in the forward-looking statements. These include: · The extent to which our sources of liquidity are sufficient to meet our requirements may be affected by the state of the financial markets and the effect that such condition has on our ability to issue commercial paper at acceptable rates. Our ability to borrow under our committed lines of credit, including our bank credit facilities, could be impaired if one or more of our lenders under those lines is unwilling or unable to honor its contractual obligation to lend to us, or in the event that natural disasters or weather conditions interfere with the ability of our lenders to lend to us. Our ability to refinance maturing debt may be affected by the state of the financial markets.  · Our ability to achieve sales, earnings and cash flow goals may be affected by: labor negotiations or disputes; changes in the types and numbers of businesses that compete with us; pricing and promotional activities of existing and new competitors, including non-traditional competitors, and the aggressiveness of that competition; our response to these actions; the state of the economy, including interest rates, the inflationary and deflationary trends in certain commodities, and the unemployment rate; the effect that fuel costs have on consumer spending; volatility of fuel margins; changes in government-funded benefit programs; manufacturing commodity costs; diesel fuel costs related to our logistics operations; trends in consumer spending; the extent to which our customers exercise caution in their purchasing in response to economic conditions; the inconsistent pace of the economic recovery; changes in inflation or deflation in product and operating costs; stock repurchases; our ability to retain pharmacy sales from third party payors; consolidation in the healthcare industry, including pharmacy benefit managers; our ability to negotiate modifications to multi-employer pension plans; natural disasters or adverse weather conditions; the potential costs and risks associated with potential cyber-attacks or data security breaches; the success of our future growth plans; and the successful integration of Harris Teeter and Roundy’s. Our ability to achieve sales and earnings goals may also be affected by our ability to manage the factors identified above. Our ability to execute our financial strategy may be affected by our ability to generate cash flow. · During the first three quarters of each fiscal year, our LIFO charge and the recognition of LIFO expense is affected primarily by estimated year-end changes in product costs. Our fiscal year LIFO charge is affected primarily by changes in product costs at year-end. · If actual results differ significantly from anticipated future results for certain reporting units, including variable interest entities, an impairment loss for any excess of the carrying value of the reporting units’ goodwill over the implied fair value would have to be recognized.  · Our effective tax rate may differ from the expected rate due to changes in laws, the status of pending items with various taxing authorities, and the deductibility of certain expenses.  · Changes in our product mix may negatively affect certain financial indicators. For example, we continue to add supermarket fuel centers to our store base. Since fuel generates lower profit margins than our supermarket sales, we expect to see our FIFO gross margins decline as fuel sales increase. We cannot fully foresee the effects of changes in economic conditions on our business. We have assumed economic and competitive situations will not change significantly in 2017. Other factors and assumptions not identified above could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in, contemplated or implied by forward-looking statements made by us or our representatives. We undertake no obligation to update the forward-looking information contained in this filing.

<s>[INST] OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,796 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,255 have pharmacies and 1,445 have fuel centers. We also offer ClickList™ and Harris Teeter ExpressLane personalized, order online, pick up at the store services at 637 of our supermarkets, and operate 784 convenience stores, either directly or through franchisees, 319 fine jewelry stores and an online retailer. We operate 38 food production plants, primarily bakeries and dairies, which supply approximately 35% of the corporate brand units sold in our supermarkets; the remaining corporate brand items are produced to our strict specifications by outside manufacturers. This percentage has declined recently due to an expanded portfolio of nongrocery corporate brand units produced by outside manufacturers. Our food production plants produced 45% of our grocery category corporate brand units sold in our supermarkets, which is consistent with our historical trend. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 98% of our consolidated sales and EBITDA, is our only reportable segment. On September 2, 2016, we closed our merger with Modern HC Holdings, Inc. (“ModernHEALTH”) by purchasing 100% of the outstanding shares of ModernHEALTH for $407 million. ModernHEALTH is included in our ending Consolidated Balance Sheet for 2016 and in our Consolidated Statements of Operations from September 2, 2016 through January 28, 2017. On December 18, 2015, we closed our merger with Roundy’s, Inc. (“Roundy’s”) by purchasing 100% of Roundy’s® outstanding common stock for $3.60 per share and assuming Roundy’s outstanding debt, for a purchase price of $866 million. Roundy’s is included in our ending Consolidated Balance Sheets for 2015 and 2016 and in our Consolidated Statements of Operations for the last six weeks of 2015 and all periods in 2016. On August 18, 2014, we closed our merger with Vitacost.com® by purchasing 100% of the Vitacost.com outstanding common stock for $8.00 per share or $287 million. Vitacost.com is included in our ending Consolidated Balance Sheets for 2015 and 2016 and in our Consolidated Statements of Operations for all periods succeeding the merger. See Note 2 to the Consolidated Financial Statements for more information related to our mergers with ModernHEALTH, Roundy’s and Vitacost.com. USE OF NONGAAP FINANCIAL MEASURES The accompanying Consolidated Financial Statements, including the related notes, set forth in Part II, Item 8 of this Form 10K are presented in accordance with generally accepted accounting principles (“GAAP”). We provide nonGAAP measures, including FirstIn, FirstOut (“FIFO”) gross margin, FIFO operating profit, adjusted net earnings and adjusted net earnings per diluted share because management believes these metrics are useful to investors and analysts. These nonGAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings and net earnings per diluted share or any other GAAP measure of performance. These measures should not be reviewed in isolation or considered as a substitute for our [/INST] Positive. </s>

KROGER CO

2018-04-03

2018-02-03

ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I, the “Risk Factors” section set forth in Item 1A of Part I and the “Outlook” section below. OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. As of February 3, 2018, Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,782 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,268 have pharmacies and 1,489 have fuel centers. We offer ClickList™ and Harris Teeter ExpressLane - personalized, order online, pick up at the store services - at 1,056 of our supermarkets and continue to increase our home delivery service available to customers. In addition, we operate 782 convenience stores, either directly or through franchisees, 274 fine jewelry stores and an online retailer. We operate 37 food production plants, primarily bakeries and dairies, which supply approximately 33% of Our Brands units and 44% of the grocery category Our Brands units sold in our supermarkets; the remaining Our Brands items are produced to our strict specifications by outside manufacturers. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 97% of our consolidated sales, is our only reportable segment. On September 2, 2016, we closed our merger with Modern HC Holdings, Inc. (“ModernHEALTH”) by purchasing 100% of the outstanding shares of ModernHEALTH for $407 million. ModernHEALTH is included in our ending Consolidated Balance Sheet for 2016 and 2017 and in our Consolidated Statements of Operations from September 2, 2016 through January 28, 2017 and all periods in 2017. On December 18, 2015, we closed our merger with Roundy’s, Inc. (“Roundy’s”) by purchasing 100% of Roundy’s® outstanding common stock for $3.60 per share and assuming Roundy’s outstanding debt, for a purchase price of $866 million. Roundy’s is included in our ending Consolidated Balance Sheets for 2015, 2016 and 2017, and in our Consolidated Statements of Operations for the last six weeks of 2015 and all periods in 2016 and 2017. See Note 2 to the Consolidated Financial Statements for more information related to our mergers with ModernHEALTH and Roundy’s. USE OF NON-GAAP FINANCIAL MEASURES The accompanying Consolidated Financial Statements, including the related notes, are presented in accordance with generally accepted accounting principles (“GAAP”). We provide non-GAAP measures, including First-In, First-Out (“FIFO”) gross margin, FIFO operating profit, adjusted net earnings, adjusted net earnings per diluted share and free cash flow because management believes these metrics are useful to investors and analysts. These non-GAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings, net earnings per diluted share and net cash provided or used by operating or investing activities or any other GAAP measure of performance. These measures should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. Our calculation and reasons these are useful metrics to investors and analysts are explained below. We calculate FIFO gross margin as FIFO gross profit divided by sales. FIFO gross profit is calculated as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the Last-In, First-Out (“LIFO”) credit or charge. Merchandise costs exclude depreciation and rent expenses. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness. Management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness. We calculate FIFO operating profit as operating profit excluding the LIFO credit or charge. FIFO operating profit is an important measure used by management to evaluate operational effectiveness. Management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day operational effectiveness. The adjusted net earnings per diluted share metric is an important measure used by management to compare the performance of core operating results between periods. We believe adjusted net earnings per diluted share is a useful metric to investors and analysts because it presents more accurate year-over-year comparisons for our net earnings per diluted share because adjusted items are not the result of our normal operations. Net earnings for 2017 include the following, which we define as the “2017 Adjusted Items”: · Charges to operating, general and administrative expenses (“OG&A”) of $550 million, $360 million net of tax, for obligations related to withdrawing from and settlements of withdrawal liabilities for certain multi-employer pension funds; $184 million, $117 million net of tax, related to the voluntary retirement offering (“VRO”); $110 million, $74 million net of tax, related to the Kroger Specialty Pharmacy goodwill impairment; and $502 million, $335 million net of tax, related to a company-sponsored pension plan termination (the “2017 OG&A Adjusted Items”). · A reduction to depreciation and amortization expenses of $19 million, $13 million net of tax, related to held for sale assets (the “2017 Depreciation Adjusted Item”). · A reduction to income tax expense of $922 million primarily due to the re-measurement of deferred tax liabilities and the reduction of the statutory rate for the last five weeks of the fiscal year from the Tax Cuts and Jobs Act ("Tax Act") (the “2017 Tax Expense Adjusted Item”). In addition, net earnings include $119 million, $79 million net of tax, due to a 53rd week in fiscal year 2017 (the “Extra Week”). Net earnings for 2016 include $111 million, $71 million net of tax, of charges to OG&A related to the restructuring of certain pension obligations to help stabilize associates’ future benefits (the “2016 Adjusted Items”). There were no adjusted items in 2015. We calculate free cash flow as net cash provided by operating activities minus net cash used by investing activities. Free cash flow is an important measure used by management to evaluate available funding for share repurchases, dividends, other strategic investments and managing debt levels. Management believes free cash flow is a useful metric to investors and analysts because it demonstrates our ability to make share repurchases and other strategic investments, pay dividends and manage debt levels. OVERVIEW Notable items for 2017 are: · Net earnings per diluted share of $2.09. · Adjusted net earnings per diluted share of $2.04. · The Extra Week in 2017 contributed $0.09 to our net earnings per diluted share result for 2017. · Identical supermarket sales, excluding fuel, increased 0.7% in 2017. · Digital revenue up 90% in 2017, driven by ClickList. Digital revenue primarily includes revenue from all curbside pickup locations and online sales by Vitacost.com. · On February 5, 2018, we announced a definitive agreement for the sale of our convenience store business unit to EG Group for $2.15 billion. · Gross margin for 2017 decreased, as a percentage of sales, as compared to 2016. See Gross Margin, LIFO and FIFO Gross Margin section for additional details. · OG&A expenses for 2017 increased, as a percentage of sales, as compared to 2016. See Operating, General and Administrative Expenses section for additional details on these fluctuations. · During 2017, we returned $2.1 billion to shareholders from share repurchases and dividend payments. · We contributed $1.2 billion to company-sponsored and company-managed pension plans, which significantly addressed the underfunded position of these plans, and paid $467 million to satisfy withdrawal obligations to the Central States Pension Fund. These contributions were deductible for tax purposes, resulting in a tax benefit of approximately $613 million. Included in the contribution is an incremental $111 million to the United Food and Commercial Workers International Union (“UFCW”) Consolidated Pension Plan (the “2017 UFCW Contribution”), which was contributed in the third quarter of 2017. · Net cash provided by operating activities was $3.4 billion in 2017 compared to $4.3 billion in 2016. Net cash used by investing activities was $2.7 billion in 2017 compared to $3.9 billion in 2016. · Free cash flow was $706 million in 2017 compared to $397 million during 2016. · Announced Restock Kroger during 2017. Restock Kroger has four main drivers: Redefine the Food and Grocery Customer Experience, Expand Partnerships to Create Customer Value, Develop Talent, and Live Kroger’s Purpose. Over the next three years, Restock Kroger will be fueled by cost savings that we will invest in associates, customers and infrastructure. Our goal is to continue generating shareholder value even as we make strategic investments to grow our business. The following table provides a reconciliation of net earnings attributable to The Kroger Co. to adjusted net earnings attributable to The Kroger Co. and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to adjusted net earnings attributable to The Kroger Co. per diluted common share, excluding the 2017 and 2016 Adjusted Items. In 2015, we did not have any adjustment items that affected net earnings or net earnings per diluted share. Net Earnings per Diluted Share excluding the Adjusted Items ($ in millions, except per share amounts) (1) The amounts presented represent the after-tax effect of each adjustment. (2) The pre-tax adjustments for the pension plan agreements were $550 and $111 in 2017 and 2016, respectively. (3) The pre-tax adjustment for the voluntary retirement offering was $184. (4) The pre-tax adjustment for Kroger Specialty Pharmacy goodwill impairment was $110. (5) The pre-tax adjustment for the company-sponsored pension plan termination was $502. (6) The pre-tax adjustment for depreciation related to held for sale assets was ($19). (7) Due to the re-measurement of deferred tax liabilities and the reduction of the statutory income tax rate for the last few weeks of the fiscal year. (8) The pretax Extra Week adjustment was ($119). (9) The amount presented represents the net earnings per diluted common share effect of each adjustment. RESULTS OF OPERATIONS Sales Total Sales ($ in millions) (1) Other sales primarily relate to sales at convenience stores, excluding fuel; jewelry stores; food production plants to outside customers; data analytic services; variable interest entities; Kroger Specialty Pharmacy; in-store health clinics; digital coupon services; and online sales by Vitacost.com. (2) The 2017 Adjusted column represents the items presented in the 2017 column adjusted to remove the Extra Week. (3) This column represents the percentage change in 2017 adjusted sales, compared to 2016. (4) This column represents the percentage change in 2016, compared to 2015. The increase in total sales in 2017, compared to 2016, is due to the increase in adjusted sales and the Extra Week. Total adjusted sales increased in 2017, compared to 2016, by 4.4%. This increase was primarily due to our increases in total supermarket sales without fuel, fuel sales and our merger with Modern HC Holdings, Inc. (“ModernHEALTH”). The increase in total supermarket sales without fuel for 2017, adjusted for the Extra Week, compared to 2016, was primarily due to our identical supermarket sales increase, excluding fuel, of 0.7%, and an increase in supermarket square footage. Identical supermarket sales, excluding fuel, for 2017, compared to 2016, increased primarily due to an increase in the number of households shopping with us, changes in product mix and product cost inflation of 0.7%, partially offset by our continued investments in lower prices for our customers. Excluding mergers, acquisitions and operational closings, total supermarket square footage at the end of 2017 increased 1.9% over the end of 2016. Total adjusted fuel sales increased 13.9% in 2017, compared to 2016, primarily due to an increase in the average retail fuel price of 12.3% and an increase in fuel gallons sold of 1.4%. The increase in the average retail fuel price was caused by an increase in the product cost of fuel. Total sales increased in 2016, compared to 2015, by 5.0%. This increase was primarily due to our increase in total supermarket sales, without fuel, and our merger with ModernHEALTH, partially offset by a decrease in fuel sales due to a 9.4% decrease in the average retail fuel price. The increase in total supermarket sales without fuel for 2016, compared to 2015, was primarily due to our merger with Roundy’s, an increase in supermarket square footage and our identical supermarket sales increase, excluding fuel, of 1.0%. Identical supermarket sales, excluding fuel, for 2016, compared to 2015, increased primarily due to an increase in the number of households shopping with us, partially offset by product cost deflation of 0.8%. Excluding mergers, acquisitions and operational closings, total supermarket square footage at the end of 2016 increased 3.4% over 2015. Total fuel sales decreased 5.6% in 2016, compared to 2015, primarily due to a decrease in the average retail fuel price of 9.4%, partially offset by an increase in fuel gallons sold of 4.2%. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel. We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Although identical supermarket sales is a relatively standard term, numerous methods exist for calculating identical supermarket sales growth. As a result, the method used by our management to calculate identical supermarket sales may differ from methods other companies use to calculate identical supermarket sales. We urge you to understand the methods used by other companies to calculate identical supermarket sales before comparing our identical supermarket sales to those of other such companies. Fuel discounts received at our fuel centers and earned based on in-store purchases are included in all of the identical supermarket sales results calculations illustrated below and reduce our identical supermarket sales results. Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Identical supermarket sales include sales from all departments at identical multi-department stores. Our identical supermarket sales results are summarized in the following table. We used the identical supermarket dollar figures presented below to calculate percentage changes for 2017 and 2016. Identical Supermarket Sales ($ in millions) (1) Identical supermarket sales for 2016 were adjusted to a comparable 53 week basis by including week 1 of fiscal 2017 in our 2016 identical supermarket sales base. However, for purposes of determining the percentage change in identical supermarket sales from 2015 to 2016, 2016 identical supermarket sales were not adjusted to include the sales from week 1 of 2017. Gross Margin, LIFO and FIFO Gross Margin We define gross margin as sales minus merchandise costs, including advertising, warehousing, and transportation. Rent expense, depreciation and amortization expense, and interest expense are not included in gross margin. Our gross margin rates, as a percentage of sales, were 22.01% in 2017, 22.40% in 2016 and 22.16% in 2015. The decrease in 2017, compared to 2016, resulted primarily from continued investments in lower prices for our customers and our merger with ModernHEALTH due to its lower gross margin rate, and increased warehousing, transportation and shrink costs, as a percentage of sales, partially offset by improved merchandise costs, a lower LIFO charge, a change in our product sales mix, including higher gross margin perishable departments growing their percentage share of sales to total sales, growth in Our Brands products which have a higher gross margin compared to national brand products, decreased advertising costs, as a percentage of sales, and a higher gross margin rate on fuel sales. The increase in 2016, compared to 2015, resulted primarily from lower fuel sales, a lower LIFO charge and our merger with Roundy’s due to its historically higher gross margin rate, partially offset by continued investments in lower prices for our customers, unfavorable pricing and cost effects due to transitioning to a deflationary operating environment, our merger with ModernHEALTH due to its historically lower gross margin rate and increased warehousing and shrink costs, as a percentage of sales. Our LIFO credit for 2017 was $8 million, compared to a LIFO charge of $19 million in 2016 and $28 million in 2015. Our LIFO credit in 2017 was primarily due to a reduction of pharmacy inventory in 2017 compared to 2016. In 2016, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation in other departments. In 2015, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation related to meat and dairy. Our FIFO gross margin rates, which exclude the LIFO credit and charge, were 22.01% in 2017, 22.42% in 2016 and 22.18% in 2015. Excluding the effect of fuel, the Extra Week and ModernHEALTH, our FIFO gross margin rate decreased 19 basis points in 2017, compared to 2016. This decrease resulted primarily from continued investments in lower prices for our customers, increased warehousing, transportation and shrink costs, as a percentage of sales, partially offset by improved merchandise costs, a change in our product sales mix, including higher gross margin perishable departments growing their percentage share of sales to total sales, growth in Our Brands products which have a higher gross margin compared to national brand products and decreased advertising costs, as a percentage of sales. Excluding the effect of fuel and our mergers with Roundy’s and ModernHEALTH, our FIFO gross margin rate decreased seven basis points in 2016, compared to 2015. This decrease resulted primarily from continued investments in lower prices for our customers, unfavorable pricing and cost effects due to transitioning to a deflationary operating environment and increased warehousing and shrink costs, as a percentage of sales. Operating, General and Administrative Expenses OG&A expenses consist primarily of employee-related costs such as wages, healthcare benefit costs and retirement plan costs; and utility and credit card fees. Rent expense, depreciation and amortization expense, and interest expense are not included in OG&A. OG&A expenses, as a percentage of sales, were 17.58% in 2017, 16.63% in 2016 and 16.34% in 2015. The increase in 2017, compared to 2016, resulted primarily from the 2017 OG&A Adjusted Items, investing in our digital strategy, increases in store wages attributed to investing in incremental labor hours and higher wages to improve retention, employee engagement and customer experience, the 2017 UFCW Contribution, increases in incentive plan and healthcare costs, partially offset by savings from the VRO, effective cost controls, higher fuel sales, the 2016 Adjusted Items and our merger with ModernHEALTH due to its lower OG&A rate, as a percentage of sales. Our fuel sales lower our OG&A rate, as a percentage of sales, due to the very low OG&A rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel, the Extra Week, the 2017 UFCW Contribution, the 2017 OG&A and 2016 Adjusted Items and ModernHEALTH, our OG&A rate increased 22 basis points in 2017, compared to 2016. This increase resulted primarily from investing in our digital strategy, increases in store wages attributed to investing in incremental labor hours and higher wages to improve retention, employee engagement and customer experience, increases in incentive plan and healthcare costs, partially offset by savings from the VRO and effective cost controls. The increase in 2016, compared to 2015, resulted primarily from a decrease in fuel sales, the loss of sales leverage due to transitioning to a deflationary operating environment, the 2016 Adjusted Items, our mergers with Roundy’s and ModernHEALTH due to their historically higher OG&A rate, compared to our other divisions, and increases in healthcare benefit and credit card costs, partially offset by increased supermarket sales, productivity improvements, effective cost controls, $110 million UFCW contributions made during 2015 (“2015 UFCW Contributions”) and decreases in incentive plans, company-sponsored pension plans and utility costs, as a percentage of sales. Excluding the effect of fuel, the 2016 Adjusted Items, recent mergers and the 2015 UFCW Contributions, our OG&A rate decreased five basis points in 2016, compared to 2015. This decrease resulted primarily from increased supermarket sales, productivity improvements, effective cost controls and decreases in incentive plans, company-sponsored pension plans and utility costs, partially offset by the loss of sales leverage due to transitioning to a deflationary operating environment and increases in healthcare benefit and credit card costs, as a percentage of sales. Rent Expense Rent expense decreased as a percentage of sales in 2017, compared to 2016, due to our continued emphasis on owning rather than leasing, whenever possible, and higher fuel sales, which decreases our rent expense, as a percentage of sales, partially offset by increased closed store liabilities. Rent expense increased as a percentage of sales in 2016, compared to 2015, due to our merger with Roundy’s, due to its higher volume of leased versus owned supermarkets, and lower fuel sales, which increases our rent expense rate, as a percentage of sales. Depreciation and Amortization Expense Depreciation and amortization expense decreased as a percentage of sales in 2017, compared to 2016, due to higher fuel sales, which decreases our depreciation expense as a percentage of sales, the Extra Week and the 2017 Depreciation Adjusted Item, partially offset by additional depreciation on capital investments, excluding mergers and lease buyouts, of $3.0 billion, during 2017. Depreciation and amortization expense increased as a percentage of sales 2016, compared to 2015, due to additional depreciation on capital investments, excluding mergers and lease buyouts, of $3.6 billion, during 2016, unfavorable sales leveraging from transitioning to a deflationary operating environment, and our merger with Roundy’s. Operating Profit and FIFO Operating Profit Operating profit was $2.1 billion in 2017, $3.4 billion in 2016 and $3.6 billion in 2015. Operating profit, as a percentage of sales, was 1.70% in 2017, 2.98% in 2016 and 3.26% in 2015. Operating profit, as a percentage of sales, decreased 128 basis points in 2017, compared to 2016, due to a lower gross margin and increased OG&A, partially offset by lower depreciation and amortization expenses and a lower LIFO charge, as a percentage of sales. Operating profit, as a percentage of sales, decreased 28 basis points in 2016, compared to 2015, due to increased OG&A, depreciation and amortization and rent expenses, partially offset by higher gross margin and a lower LIFO charge, as a percentage of sales. FIFO operating profit was $2.1 billion in 2017, $3.5 billion in 2016 and $3.6 billion in 2015. FIFO operating profit, as a percentage of sales, was 1.69% in 2017, 3.00% in 2016 and 3.28% in 2015. Fuel sales lower our operating profit rate due to the very low operating profit rate, as a percentage of sales, of fuel sales compared to non-fuel sales. FIFO operating profit, as a percentage of sales excluding fuel, the Extra Week, the 2017 UFCW Contribution, the 2017 and 2016 Adjusted Items and ModernHEALTH, decreased 46 basis points in 2017, compared to 2016, due to a lower gross margin and increased OG&A and depreciation and amortization expenses, as a percentage of sales. FIFO operating profit, as a percentage of sales excluding fuel, the 2016 Adjusted Items, the effects of our recent mergers and the 2015 UFCW Contributions, decreased 14 basis points in 2016, compared to 2015. This decrease was due to lower gross margin, higher depreciation and amortization, partially offset by decreased OG&A and rent expenses, as a percentage of sales. Specific factors of the above operating trends under operating profit and FIFO operating profit are discussed earlier in this section. Interest Expense Interest expense totaled $601 million in 2017, $522 million in 2016 and $482 million in 2015. The increase in interest expense in 2017, compared to 2016, resulted primarily from additional borrowings used for share repurchases, the Extra Week, the $1.2 billion we contributed to company-sponsored and company-managed pension plans in 2017, a $467 million pre-tax payment to satisfy withdrawal obligations to the Central States Pension Fund, partially offset by a lower weighted average interest rate. The increase in interest expense in 2016, compared to 2015, resulted primarily from additional borrowings used for share repurchases, mergers and a higher weighted average interest rate. Income Taxes Our effective income tax rate was (27.3)% in 2017, 32.8% in 2016 and 33.8% in 2015. The 2017 tax rate differed from the federal statutory rate primarily as a result of remeasuring deferred taxes due to the Tax Act, the Domestic Manufacturing Deduction and other changes, partially offset by non-deductible goodwill impairment charges and the effect of state income taxes. The 2016 tax rate differed from the federal statutory rate primarily as a result of the recognition of excess tax benefits related to share-based payments after the adoption of ASU 2016-09, the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes. The 2015 tax rate differed from the federal statutory rate primarily as a result of the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes. Net Earnings and Net Earnings Per Diluted Share Our net earnings are based on the factors discussed in the Results of Operations section. Net earnings of $2.09 per diluted share in 2017 represented an increase of 2.0% from net earnings of $2.05 per diluted share in 2016. Excluding the 2017 and 2016 Adjusted Items and the Extra Week, adjusted net earnings of $1.95 per diluted share in 2017 represented a decrease of 8.0% from adjusted net earnings of $2.12 per diluted share in 2016. The 8.0% decrease in adjusted net earnings per diluted share resulted primarily from lower non-fuel FIFO operating profit and increased interest expense, partially offset by higher fuel earnings, a lower LIFO charge, decreased income tax expense and lower weighted average common shares outstanding due to common share repurchases. Net earnings of $2.05 per diluted share in 2016 represented a decrease of 0.5% from net earnings of $2.06 per diluted share in 2015. Excluding the 2016 Adjusted Items, net earnings of $2.12 per diluted share in 2016 represented an increase of 2.9% from net earnings of $2.06 per diluted share in 2015. The net earnings of 2015 do not include any adjusted items. The 2.9% increase resulted primarily from a lower LIFO charge, lower income tax expense and lower weighted average common shares outstanding due to common share repurchases, partially offset by lower non-fuel FIFO operating profit and lower fuel earnings. COMMON SHARE REPURCHASE PROGRAMS We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time. The share repurchase programs do not have an expiration date but may be suspended or terminated by our Board of Directors at any time. We made open market purchases of our common shares totaling $1.6 billion in 2017, $1.7 billion in 2016 and $500 million in 2015 under these repurchase programs. In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises. We repurchased approximately $66 million in 2017, $105 million in 2016 and $203 million in 2015 of our common shares under the stock option program. The shares repurchased in 2017 were reacquired under the following repurchase programs authorized by the Board of Directors to reacquire shares via open market purchases: · On September 15, 2016, our Board of Directors approved a $500 million share repurchase program (the “September 2016 Repurchase Program”). This program was exhausted during the first quarter of 2017. · On March 9, 2017, our Board of Directors approved an additional $500 million share repurchase program to supplement the September 2016 Repurchase Program. This program was exhausted during the second quarter of 2017. · On June 22, 2017, our Board of Directors approved a $1.0 billion share repurchase program. As of February 3, 2018, there was $272 million remaining under this share repurchase program. On March 15, 2018, our Board of Directors approved a $1.0 billion share repurchase program, to supplement the June 2017 Repurchase Program, to reacquire shares via open market purchase or privately negotiated transactions, including accelerated stock repurchase transactions, block trades, or pursuant to trades intending to comply with rule 10b5-1 of the Securities Exchange Act of 1934 (the “March 2018 Repurchase Program”). During the first quarter through March 29, 2018, we used an additional $388 million of cash to repurchase 16 million common shares at an average price of $25.05 per share. As of March 29, 2018, we have exhausted the June 2017 Repurchase Program and have $885 million remaining under the March 2018 Repurchase Program. CAPITAL INVESTMENTS Capital investments, including changes in construction-in-progress payables and excluding mergers and the purchase of leased facilities, totaled $3.0 billion in 2017, $3.7 billion in 2016 and $3.3 billion in 2015. Capital investments for mergers totaled $16 million in 2017, $401 million in 2016 and $168 million in 2015. We merged with ModernHEALTH in 2016 and Roundy’s in 2015. Refer to Note 2 to the Consolidated Financial Statements for more information on these mergers. Capital investments for the purchase of leased facilities totaled $13 million in 2017, $5 million in 2016 and $35 million in 2015. The table below shows our supermarket storing activity and our total supermarket square footage: Supermarket Storing Activity RETURN ON INVESTED CAPITAL We calculate return on invested capital (“ROIC”) by dividing adjusted operating profit for the prior four quarters by the average invested capital. Adjusted operating profit is calculated by excluding certain items included in operating profit, and adding back our LIFO charge, depreciation and amortization and rent to our U.S. GAAP operating profit of the prior four quarters. Average invested capital is calculated as the sum of (i) the average of our total assets, (ii) the average LIFO reserve, (iii) the average accumulated depreciation and amortization and (iv) a rent factor equal to total rent for the last four quarters multiplied by a factor of eight; minus (i) the average taxes receivable, (ii) the average trade accounts payable, (iii) the average accrued salaries and wages, (iv) the average other current liabilities, excluding accrued income taxes and (v) the average liabilities held for sale. Averages are calculated for ROIC by adding the beginning balance of the first quarter and the ending balance of the fourth quarter, of the last four quarters, and dividing by two. We use a factor of eight for our total rent as we believe this is a common factor used by our investors, analysts and rating agencies. ROIC is a non-GAAP financial measure of performance. ROIC should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital. Management believes ROIC is a useful metric to investors and analysts because it measures how effectively we are deploying our assets. Although ROIC is a relatively standard financial term, numerous methods exist for calculating a company’s ROIC. As a result, the method used by our management to calculate ROIC may differ from methods other companies use to calculate their ROIC. We urge you to understand the methods used by other companies to calculate their ROIC before comparing our ROIC to that of such other companies. The following table provides a calculation of ROIC for 2017 and 2016 on a 52 week basis ($ in millions). (1) Taxes receivable were $229 as of February 3, 2018, $132 as of January 28, 2017 and $392 as of January 30, 2016. The January 30, 2016 balance is higher than the other comparative balances due to changes to tangible property regulations in 2015. Refer to Note 5 of the Consolidated Financial Statements for further detail. (2) Other current liabilities included accrued income taxes of $1 as of January 28, 2017. We did not have any accrued income taxes as of February 3, 2018 or January 30, 2016. Accrued income taxes are removed from other current liabilities in the calculation of average invested capital. CRITICAL ACCOUNTING POLICIES We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Our significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. We believe that the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain. Self-Insurance Costs We primarily are self-insured for costs related to workers’ compensation and general liability claims. The liabilities represent our best estimate, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred but not reported for all claims incurred through February 3, 2018. We establish case reserves for reported claims using case-basis evaluation of the underlying claim data and we update as information becomes known. For both workers’ compensation and general liability claims, we have purchased stop-loss coverage to limit our exposure to any significant exposure on a per claim basis. We are insured for covered costs in excess of these per claim limits. We account for the liabilities for workers’ compensation claims on a present value basis utilizing a risk-adjusted discount rate. A 25 basis point decrease in our discount rate would increase our liability by approximately $3 million. General liability claims are not discounted. The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can affect ultimate costs. Our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, and any changes could have a considerable effect on future claim costs and currently recorded liabilities. Impairments of Long-Lived Assets We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value. Fair value is determined based on market values or discounted future cash flows. We record impairment when the carrying value exceeds fair market value. With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal. We recorded asset impairments in the normal course of business totaling $71 million in 2017, $26 million in 2016 and $46 million in 2015. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as “Operating, general and administrative” expense. The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different level, could produce significantly different results. Goodwill Our goodwill totaled $2.9 billion as of February 3, 2018. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our operating divisions and variable interest entities (collectively, “reporting units”) that have goodwill balances. Generally, fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment. We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future. We recognize goodwill impairment for any excess of a reporting unit's carrying value over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. Our annual evaluation of goodwill is performed for our reporting units during the fourth quarter. In 2017, we recorded goodwill impairment for our Kroger Specialty Pharmacy reporting unit totaling $110 million, $74 million net of tax. The annual evaluation of goodwill performed in 2016 and 2015 did not result in impairment. Based on current and future expected cash flows, we believe additional goodwill impairments are not reasonably likely. A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance. For additional information relating to our results of the goodwill impairment reviews performed during 2017, 2016 and 2015 see Note 3 to the Consolidated Financial Statements. The impairment review requires the extensive use of management judgment and financial estimates. Application of alternative estimates and assumptions, such as reviewing goodwill for impairment at a different level, could produce significantly different results. The cash flow projections embedded in our goodwill impairment reviews can be affected by several factors such as inflation, business valuations in the market, the economy, market competition and our ability to successfully integrate recently acquired businesses. Post-Retirement Benefit Plans We account for our defined benefit pension plans using the recognition and disclosure provisions of GAAP, which require the recognition of the funded status of retirement plans on the Consolidated Balance Sheet. We record, as a component of Accumulated Other Comprehensive Income (“AOCI”), actuarial gains or losses, prior service costs or credits and transition obligations that have not yet been recognized. The determination of our obligation and expense for company-sponsored pension plans and other post-retirement benefits is dependent upon our selection of assumptions used by actuaries in calculating those amounts. Those assumptions are described in Note 15 to the Consolidated Financial Statements and include, among others, the discount rate, the expected long-term rate of return on plan assets, mortality and the rate of increases in compensation and health care costs. Actual results that differ from our assumptions are accumulated and amortized over future periods and, therefore, generally affect our recognized expense and recorded obligation in future periods. While we believe that our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions, including the discount rate used and the expected return on plan assets, may materially affect our pension and other post-retirement obligations and our future expense. Note 15 to the Consolidated Financial Statements also discusses the effect of a 1% change in the assumed health care cost trend rate on other post-retirement benefit costs and the related liability. The objective of our discount rate assumptions was intended to reflect the rates at which the pension benefits could be effectively settled. In making this determination, we take into account the timing and amount of benefits that would be available under the plans. Our methodology for selecting the discount rates was to match the plan’s cash flows to that of a hypothetical bond portfolio whose cash flow from coupons and maturities match the plan’s projected benefit cash flows. The discount rates are the single rates that produce the same present value of cash flows. The selection of the 4.00% and 3.93% discount rates as of year-end 2017 for pension and other benefits, respectively, represents the hypothetical bond portfolio using bonds with an AA or better rating constructed with the assistance of an outside consultant. We utilized a discount rate of 4.25% and 4.18% as of year-end 2016 for pension and other benefits, respectively. A 100 basis point increase in the discount rate would decrease the projected pension benefit obligation as of February 3, 2018, by approximately $426 million. Our 2017 assumed pension plan investment return rate was 7.50% compared to 7.40% in 2016 and 7.44% in 2015. The value of all investments in our company-sponsored defined benefit pension plans during the calendar year ending December 31, 2017, net of investment management fees and expenses, increased 8.7%. Historically, the Kroger pension plans’ average rate of return was 5.7% for the 10 calendar years ended December 31, 2017, net of all investment management fees and expenses. For the past 20 years, the Kroger pension plans’ average annual rate of return has been 7.10%. At the beginning of 2017, to determine the expected rate of return on pension plan assets held by Kroger for 2017, we considered current and forecasted plan asset allocations as well as historical and forecasted rates of return on various asset categories. Based on this information and forward looking assumptions for investments made in a manner consistent with our target allocations, which contemplates our transition to a liability driven investment strategy, we believed a 7.50% rate of return assumption was reasonable for 2017. In 2016, Kroger began managing the assets for the Harris Teeter and Roundy’s pension plans, and our expected rate of return for 2016 reflects implementing a similar investment management strategy for the Harris Teeter and Roundy’s plans’ assets. See Note 15 to the Consolidated Financial Statements for more information on the asset allocations of pension plan assets. On January 31, 2015, we adopted new industry specific mortality tables based on mortality experience and assumptions for generational mortality improvement in determining our benefit obligations. On January 28, 2017, we adopted an updated assumption for generational mortality improvement, based on additional years of published mortality experience. Sensitivity to changes in the major assumptions used in the calculation of Kroger’s pension plan liabilities is illustrated below (in millions). In 2017, we contributed $1.0 billion to our company-sponsored defined benefit plans and we are not required to make any contributions to these plans in 2018. We contributed $3 million to our company-sponsored defined benefit plans in 2016 and $5 million in 2015. Among other things, investment performance of plan assets, the interest rates required to be used to calculate the pension obligations, and future changes in legislation, will determine the amounts of contributions. In 2017, we settled certain company-sponsored pension plan obligations using existing assets of the plan and the $1.0 billion contribution. We recognized a settlement charge of approximately $502 million, $335 million net of tax, associated with the settlement of our obligations for the eligible participants’ pension balances that were distributed out of the plan via a transfer to other qualified retirement plan options, a lump sum payout, or the purchase of an annuity contract, based on each participant’s election. We contributed and expensed $219 million in 2017, $215 million in 2016 and $196 million in 2015 to employee 401(k) retirement savings accounts. The increase in 2016, compared to 2015, is primarily due to our recent mergers. The 401(k) retirement savings account plans provide to eligible employees both matching contributions and automatic contributions from the Company based on participant contributions, plan compensation and length of service. Multi-Employer Pension Plans We contribute to various multi-employer pension plans based on obligations arising from collective bargaining agreements. These multi-employer pension plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans. We recognize expense in connection with these plans as contributions are funded or when commitments are probable and reasonably estimable, in accordance with GAAP. We made cash contributions to these plans of $954 million in 2017, $289 million in 2016 and $426 million in 2015. The increase in 2017, compared to 2016, is due to the $467 million pre-tax payment to satisfy withdrawal obligations to the Central States Pension Fund and the 2017 UFCW Contribution. We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans as it relates to our associates who are beneficiaries of these plans. These under-fundings are not our liability. When an opportunity arises that is economically feasible and beneficial to us and our associates, we may negotiate the restructuring of under-funded multi-employer pension plan obligations to help stabilize associates’ future benefits and become the fiduciary of the restructured multi-employer pension plan. The commitments from these restructurings do not change our debt profile as it relates to our credit rating since these off balance sheet commitments are typically considered in our investment grade debt rating. We are currently designated as the named fiduciary of the UFCW Consolidated Pension Plan and the International Brotherhood of Teamsters (“IBT”) Consolidated Pension Fund and have sole investment authority over these assets. As such, we include contributions to these plans when we disclose contributions to company-sponsored and company-managed pension plans. We became the fiduciary of the IBT Consolidated Pension Fund in 2017 due to the ratification of a new labor contract with the IBT that provided our withdrawal from the Central States Pension Fund. Significant effects of these restructuring agreements recorded in our Consolidated Financial Statements are: · In 2017, we incurred a $550 million charge, $360 million net of tax, for obligations related to withdrawing from and settlements for withdrawal liabilities for certain multi-employer pension plan obligations, of which $467 million was contributed to the Central States Pension Fund in 2017. · In 2017, we contributed an incremental $111 million, $71 million net of tax, to the UFCW Consolidated Pension Plan. · In 2016, we incurred a charge of $111 million, $71 million net of tax, due to commitments and withdrawal liabilities arising from the restructuring of certain multi-employer pension plan obligations, of which $28 million was contributed to the UFCW Consolidated Pension Plan in 2016. · In 2015, we contributed $190 million to the UFCW Consolidated Pension Plan. We had previously accrued $60 million of the total contributions at January 31, 2015 and recorded expense for the remaining $130 million at the time of payment in 2015. As we continue to work to find solutions to under-funded multi-employer pension plans, it is possible we could incur withdrawal liabilities for certain funds. Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2017. Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding. Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer. As of December 31, 2017, we estimate our share of the underfunding of multi-employer pension plans to which we contribute, or as it relates to certain funds, an estimated withdrawal liability, was approximately $2.3 billion, $1.8 billion net of tax. This represents a decrease in the estimated amount of underfunding of approximately $700 million, $446 million net of tax, as of December 31, 2017, compared to December 31, 2016. The decrease in the amount of underfunding is primarily attributable to withdrawing from and settlements for withdrawal liabilities for certain multi-employer pension plan obligations, the 2017 UFCW Contribution and returns on assets in the funds. Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable. We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours. Rather, we believe the underfunding is likely to have important consequences. In the event we were to exit certain markets or otherwise cease making contributions to these plans, we could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated, in accordance with GAAP. The amount of underfunding described above is an estimate and could change based on contract negotiations, returns on the assets held in the multi-employer pension plans, benefit payments or future restructuring agreements. The amount could decline, and our future expense would be favorably affected, if the values of the assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, our share of the underfunding could increase and our future expense could be adversely affected if the asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation. We continue to evaluate our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of ours, any commitments to fund certain multi-employer pension plans will be expensed when our commitment is probable and an estimate can be made. See Note 16 to the Consolidated Financial Statements for more information relating to our participation in these multi-employer pension plans. Inventories Inventories are stated at the lower of cost (principally on a LIFO basis) or market. In total, approximately 93% and 89% of inventories were valued using the LIFO method in 2017 and 2016, respectively. The remaining inventories, including substantially all fuel inventories, are stated at the lower of cost (on a FIFO basis) or net realizable value. Replacement cost was higher than the carrying amount by $1.2 billion at February 3, 2018 and $1.3 billion at January 28, 2017. We follow the Link-Chain, Dollar-Value LIFO method for purposes of calculating our LIFO charge or credit. We follow the item-cost method of accounting to determine inventory cost before the LIFO adjustment for substantially all store inventories at our supermarket divisions. This method involves counting each item in inventory, assigning costs to each of these items based on the actual purchase costs (net of vendor allowances and cash discounts) of each item and recording the cost of items sold. The item-cost method of accounting allows for more accurate reporting of periodic inventory balances and enables management to more precisely manage inventory. In addition, substantially all of our inventory consists of finished goods and is recorded at actual purchase costs (net of vendor allowances and cash discounts). We evaluate inventory shortages throughout the year based on actual physical counts in our facilities. We record allowances for inventory shortages based on the results of recent physical counts to provide for estimated shortages from the last physical count to the financial statement date. Vendor Allowances We recognize all vendor allowances as a reduction in merchandise costs when the related product is sold. In most cases, vendor allowances are applied to the related product cost by item, and therefore reduce the carrying value of inventory by item. When it is not practicable to allocate vendor allowances to the product by item, we recognize vendor allowances as a reduction in merchandise costs based on inventory turns and as the product is sold. We recognized approximately $8.5 billion in 2017, $7.8 billion in 2016 and $7.3 billion in 2015 of vendor allowances as a reduction in merchandise costs. We recognized approximately 93% of all vendor allowances in the item cost with the remainder being based on inventory turns. RECENTLY ADOPTED ACCOUNTING STANDARDS In September 2015, the FASB issued Accounting Standards Update (“ASU”) 2015-16, “Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments.” This amendment eliminates the requirement to retrospectively account for adjustments made to provisional amounts recognized in a business combination. This amendment became effective for us beginning January 31, 2016, and was adopted prospectively in accordance with the standard. The adoption of this amendment did not have a material effect on our Consolidated Balance Sheets or Consolidated Statements of Operations. During the second quarter of 2016, we adopted ASU 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.” This amendment addresses several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. As a result of the adoption, we recognized $49 million of excess tax benefits related to share-based payments in our provision for income taxes in 2016. These items were historically recorded in additional paid-in capital. In addition, for 2016, cash flows related to excess tax benefits are classified as an operating activity. Cash paid on employees’ behalf related to shares withheld for tax purposes is classified as a financing activity. Retrospective application of the cash flow presentation requirements resulted in increases to both “Net cash provided by operating activities” and “Net cash used by financing activities” of $59 million for 2016 and $84 million for 2015. Our stock compensation expense continues to reflect estimated forfeitures. During 2016, we adopted ASU 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (Topic 205)”. This standard requires us to evaluate, for each annual and interim reporting period, whether there are conditions and events, considered in the aggregate, that raise substantial doubt about our ability to continue as a going concern within one year after the date the Consolidated Financial Statements are issued or are available to be issued. If substantial doubt is raised, additional disclosures around our plan to alleviate these doubts are required. The adoption of this standard did not affect our Consolidated Financial Statements. During 2016, we adopted ASU 2015-07, “Fair Value Measurement - Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or Its Equivalent) (Topic 820)”. This standard requires us to disclose which assets we value using net asset value as a practical expedient, and ends the requirement to classify these assets within the GAAP fair value hierarchy. See Note 15 of our Consolidated Financial Statements for disclosures of assets we value using net asset value as a practical expedient. In November 2015, the FASB issued ASU 2015-17, “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes.” This amendment requires deferred tax liabilities and assets to be classified as noncurrent in a classified statement of financial position. This amendment became effective for us beginning January 29, 2017, and was adopted prospectively in accordance with the standard. The implementation of this amendment resulted in the reclassification of current deferred tax liabilities as non-current and had no effect on our Consolidated Statements of Operations. During the fourth quarter of 2017, we adopted ASU 2017-04 "Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating the second step from the goodwill impairment test. ASU 2017-04 requires applying a one-step quantitative test and recording the amount of goodwill impairment as the excess of the reporting unit's carrying value over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. ASU 2017-04 does not amend the optional qualitative assessment of goodwill impairment. We performed our annual evaluation of goodwill in accordance with this standard, which resulted in a goodwill impairment charge of $110 million, $74 million net of tax, related to our Kroger Specialty Pharmacy reporting unit. RECENTLY ISSUED ACCOUNTING STANDARDS In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers”, as amended by several subsequent ASUs, which provides guidance for revenue recognition. The standard’s overarching principle is that revenue must be recognized when goods and services are transferred to the customer in an amount that is proportionate to what has been delivered at that point and that reflects the consideration to which the company expects to be entitled for those goods or services. Per ASU 2015-14, “Deferral of Effective Date,” this guidance will be effective for us in the first quarter of fiscal year ending February 2, 2019. We formed a project team to assess and document our accounting policies related to the new revenue guidance. As of the end of 2017, we have completed this assessment and documentation. Based on this project, we do not expect that the implementation of the new standard will have a material effect on our Consolidated Statements of Operations, Consolidated Balance Sheets or Consolidated Statements of Cash Flows. We intend to adopt the new standard on a modified retrospective basis and will be addressing new disclosures regarding revenue recognition policies as required by the new standard at adoption. During our assessment, we identified and will be implementing changes, at the beginning of the first quarter of 2018, to our accounting policies and practices, business processes, systems and controls to support the new revenue recognition and disclosure requirements. In February 2016, the FASB issued ASU 2016-02, “Leases,” which provides guidance for the recognition of lease agreements. The standard’s core principle is that a company will now recognize most leases on its balance sheet as lease liabilities with corresponding right-of-use assets. This guidance will be effective for us in the first quarter of fiscal year ending February 1, 2020. Early adoption is permitted. The adoption of this ASU will result in a significant increase to our Consolidated Balance Sheets for lease liabilities and right-of-use assets, and we are currently evaluating the other effects of adoption of this ASU on our Consolidated Financial Statements. This evaluation process includes reviewing all forms of leases, performing a completeness assessment over the lease population, analyzing the practical expedients and assessing opportunities to make certain changes to our lease accounting information technology system in order to determine the best implementation strategy. We believe our current off-balance sheet leasing commitments are reflected in our investment grade debt rating. In March 2017, the FASB issued ASU 2017-07 "Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.” ASU 2017-07 requires an employer to report the service cost component of retiree benefits in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented separately from the service cost component and outside a subtotal of income from operations. ASU 2017-07 is effective for years, and interim periods within those years, beginning after December 15, 2017, and requires retrospective application to all periods presented. This ASU will impact our Operating Profit subtotal as reported in our Consolidated Statement of Operations by excluding interest expense, investment returns, settlements and other non-service cost components of retiree benefit expenses. Information about interest expense, investment returns and other components of retiree benefit expenses can be found in Note 15 of our Consolidated Financial Statements. In February 2018, the FASB issued ASU 2018-02, “Reclassification of Certain Tax Effects From Accumulated Other Comprehensive Income.” ASU 2018-02 amends ASC 220, “Income Statement - Reporting Comprehensive Income,” to allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Act. In addition, under the ASU 2018-02, we may be required to provide certain disclosures regarding stranded tax effects. ASU 2018-02 is effective for years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. We are currently evaluating the effect of the standard on our Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES Cash Flow Information Net cash provided by operating activities We generated $3.4 billion of cash from operations in 2017, compared to $4.3 billion in 2016 and $4.9 billion in 2015. The cash provided by operating activities came from net earnings including non-controlling interests adjusted primarily for non-cash expenses of depreciation and amortization, LIFO (credit) charge, stock compensation, expense for company-sponsored pension plans, goodwill impairment charge and deferred income taxes. Changes in working capital created a net cash outflow in 2017 and 2016, and a net cash inflow for 2015. The decrease in net cash provided by operating activities in 2017, compared to 2016, resulted primarily from a decrease in net earnings including noncontrolling interests, the $1.0 billion contribution to the company-sponsored defined benefit plans and deferred taxes, partially offset by an increase in non-cash expenses and changes in working capital. Deferred taxes changed in 2017, compared to 2016, as a result of remeasuring deferred taxes due to the Tax Act. The decrease in net cash provided by operating activities in 2016, compared to 2015, resulted primarily due to a decrease in net earnings including noncontrolling interests and changes in working capital, partially offset by an increase in non-cash expenses, deferred taxes and lower payments on long-term liabilities. Cash provided (used) by operating activities for changes in working capital was ($164) in 2017 compared to ($492) million in 2016 and $180 million in 2015. The decrease in cash used by operating activities for changes in working capital in 2017, compared to 2016, was primarily due to the following: · A lower amount of cash used for inventory purchases due to decreased capital investments related to store growth, · Increased cash collections due to our emphasis on better receivables management, and · A lower increase, over the prior year, of prepaid benefit costs in 2017, compared to 2016; partially offset by · An overpayment of our fourth quarter 2017 estimated income taxes, and · An increase in store deposits in-transit due to increased sales in the last few days of the year. The decrease in cash provided by operating activities for changes in working capital in 2016, compared to 2015, was primarily due to the net effect of the following: · Higher receivables due to increasing vendor allowance activity and pharmacy sales requiring third party payments, · Increased inventory purchases due to store growth and new distribution centers, · Higher prepayment of benefit costs, · Lower accrued expenses due to reduced incentive plan payout accruals, and · Lower tax payments due to a 2015 tax deduction associated with tangible property regulations. Net cash used by investing activities Cash used by investing activities was $2.7 billion in 2017, compared to $3.9 billion in 2016 and $3.6 billion in 2015. The amount of cash used by investing activities decreased in 2017 compared to 2016 primarily due to reduced cash payments for capital investments and lower payments for mergers. The amount of cash used by investing activities increased in 2016, compared to 2015, primarily due to increased cash payments for capital investments and our merger with ModernHEALTH. Net cash used by financing activities Cash used by financing activities was $681 million in 2017, $352 million in 2016 and $1.3 billion in 2015. The increase in the amount of cash used for financing activities in 2017 compared to 2016 was primarily due to lower net long-term borrowings, partially offset by lower treasury stock purchases and higher net commercial paper borrowings. The decrease in the amount of cash used for financing activities in 2016, compared to 2015, was primarily due to higher treasury stock purchases, partially offset by higher long-term and commercial paper borrowings. Debt Management Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $1.5 billion to $15.6 billion as of year-end 2017 compared to 2016. The increase in 2017, compared to 2016, resulted from the issuance of (i) $400 million of senior notes bearing an interest rate of 2.80%, (ii) $600 million of senior notes bearing an interest rate of 3.70%, (iii) $500 million of senior notes bearing an interest rate of 4.65% and (iv) increases in commercial paper borrowings, partially offset by payments of $700 million on maturing long-term debt obligations. Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $2.0 billion to $14.1 billion as of year-end 2016, compared to 2015. The increase in 2016, compared to 2015, resulted from the issuance of (i) $1.0 billion of senior notes bearing an interest rate of 4.45%, (ii) $750 million of senior notes bearing an interest rate of 2.65%, (iii) $500 million of senior notes bearing an interest rate of 3.875%, (iv) $500 million of senior notes bearing an interest rate of 1.5%, (v) increases in commercial paper borrowings and (vi) increases in capital lease obligations due to additional leased locations, partially offset by payments of $1.4 billion on maturing long-term debt obligations. Liquidity Needs We estimate our liquidity needs over the next twelve-month period to approximate $6.9 billion, which includes anticipated requirements for working capital, capital investments, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2017. We generally operate with a working capital deficit due to our efficient use of cash in funding operations and because we have consistent access to the capital markets. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months. We have approximately $2.1 billion of commercial paper and $1.3 billion of senior notes maturing in the next twelve months, which is included in the $6.9 billion of estimated liquidity needs. We expect to refinance this debt, in 2018, by issuing additional senior notes, a term loan or commercial paper on favorable terms based on our past experience. We currently plan to continue repurchases of common shares under the Company’s share repurchase programs and have a growing dividend, subject to Board approval. We believe we have adequate coverage of our debt covenants to continue to maintain our current debt ratings and to respond effectively to competitive conditions. Factors Affecting Liquidity We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper program. At February 3, 2018, we had $2.1 billion of commercial paper borrowings outstanding. Commercial paper borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility. If our short-term credit ratings fall, the ability to borrow under our current commercial paper program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our commercial paper program. This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity. However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our commercial paper program would be any lower than $500 million on a daily basis. Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost and applicable margin on borrowings under the credit facility could be affected by a downgrade in our Public Debt Rating. As of March 29, 2018, we had $1.1 billion of commercial paper borrowings outstanding. Our credit facility requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our “financial covenants”). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants are described below: · Our Leverage Ratio (the ratio of Net Debt to Adjusted EBITDA, as defined in the credit facility) was 2.45 to 1 as of February 3, 2018. If this ratio were to exceed 3.50 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. · Our Fixed Charge Coverage Ratio (the ratio of Adjusted EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facility) was 4.49 to 1 as of February 3, 2018. If this ratio fell below 1.70 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. Our credit facility is more fully described in Note 6 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2017. The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of February 3, 2018 (in millions of dollars): (1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $1.0 billion in 2017. This table also excludes contributions under various multi-employer pension plans, which totaled $954 million in 2017. (2) The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined. (3) As of February 3, 2018, we had $2.1 billion of commercial paper and no borrowings under our credit facility. (4) Amounts include contractual interest payments using the interest rate as of February 3, 2018, and stated fixed and swapped interest rates, if applicable, for all other debt instruments. (5) The amounts included in the contractual obligations table for self-insurance liability related to workers’ compensation claims have been stated on a present value basis. (6) Amounts include funds owed to third parties for projects currently under construction. These amounts are reflected in other current liabilities in our Consolidated Balance Sheets. (7) Amounts include commitments, many of which are short-term in nature, to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our food production plants and several contracts to purchase energy to be used in our stores and food production plants. Our obligations also include management fees for facilities operated by third parties and outside service contracts. Any upfront vendor allowances or incentives associated with outstanding purchase commitments are recorded as either current or long-term liabilities in our Consolidated Balance Sheets. As of February 3, 2018, we maintained a $2.75 billion (with the ability to increase by $1 billion), unsecured revolving credit facility that, unless extended, terminates on August 29, 2022. Outstanding borrowings under the credit facility, the commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit facility. As of February 3, 2018, we had $2.1 billion of outstanding commercial paper and no borrowings under our credit facility. The outstanding letters of credit that reduce funds available under our credit facility totaled $6 million as of February 3, 2018. In addition to the available credit mentioned above, as of February 3, 2018, we had authorized for issuance $2.5 billion of securities remaining under a shelf registration statement filed with the SEC and effective on December 14, 2016. We also maintain surety bonds related primarily to our self-insured workers’ compensation claims. These bonds are required by most states in which we are self-insured for workers’ compensation and are placed with predominately third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of ours, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility. We also are contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. We could be required to satisfy obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of our assignments among third parties, and various other remedies available to us, we believe the likelihood that we will be required to assume a material amount of these obligations is remote. We have agreed to indemnify certain third-party logistics operators for certain expenses, including multi-employer pension plan obligations and withdrawal liabilities. In addition to the above, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third party claims arising out of agreements to provide services to us; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability. OUTLOOK This discussion and analysis contains certain forward-looking statements about our future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available to it. Such statements are indicated by words such as “will,” “would,” “could,” “continue,” “targeting,” “range,” “guidance,” “assume,” “possible,” “estimate,” “may,” “expect,” “goal,” “should,” “intend,” “believe,” “anticipate,” “plan,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially. Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially. · We are targeting identical supermarket sales growth, excluding fuel, to range from 1.5% to 2.0% in 2018. · We expect net earnings to range from $1.95 to $2.15 per diluted share for 2018. · We expect capital investments, excluding mergers, acquisitions, and purchases of leased facilities, to be approximately $3.0 billion in 2018. · We expect our 2018 tax rate to be approximately 22%. Various uncertainties and other factors could cause actual results to differ materially from those contained in the forward-looking statements. These include: · The extent to which our sources of liquidity are sufficient to meet our requirements may be affected by the state of the financial markets and the effect that such condition has on our ability to issue commercial paper at acceptable rates. Our ability to borrow under our committed lines of credit, including our bank credit facilities, could be impaired if one or more of our lenders under those lines is unwilling or unable to honor its contractual obligation to lend to us, or in the event that natural disasters or weather conditions interfere with the ability of our lenders to lend to us. Our ability to refinance maturing debt may be affected by the state of the financial markets.  · Our ability to achieve sales, earnings and cash flow goals may be affected by: labor negotiations or disputes; changes in the types and numbers of businesses that compete with us; pricing and promotional activities of existing and new competitors, including non-traditional competitors, and the aggressiveness of that competition; our response to these actions; the state of the economy, including interest rates, the inflationary and deflationary trends in certain commodities, and the unemployment rate; the effect that fuel costs have on consumer spending; volatility of fuel margins; changes in government-funded benefit programs; manufacturing commodity costs; diesel fuel costs related to our logistics operations; trends in consumer spending; the extent to which our customers exercise caution in their purchasing in response to economic conditions; the inconsistent pace of the economic recovery; changes in inflation or deflation in product and operating costs; stock repurchases; our ability to retain pharmacy sales from third party payors; consolidation in the healthcare industry, including pharmacy benefit managers; our ability to negotiate modifications to multi-employer pension plans; natural disasters or adverse weather conditions; the potential costs and risks associated with potential cyber-attacks or data security breaches; the success of our future growth plans; the successful integration of our acquired companies; and the successful completion of the sale of our convenience stores business. Our ability to achieve sales and earnings goals may also be affected by our ability to manage the factors identified above. Our ability to execute our financial strategy may be affected by our ability to generate cash flow.  · Our effective tax rate may differ from the expected rate due to changes in laws, the status of pending items with various taxing authorities, and the deductibility of certain expenses. We cannot fully foresee the effects of changes in economic conditions on our business. We have assumed economic and competitive situations will not change significantly in 2018. Other factors and assumptions not identified above, including those discussed in Item 1A of this Report, could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in, contemplated or implied by forward-looking statements made by us or our representatives. We undertake no obligation to update the forward-looking information contained in this filing.

<s>[INST] OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. As of February 3, 2018, Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,782 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,268 have pharmacies and 1,489 have fuel centers. We offer ClickList™ and Harris Teeter ExpressLane personalized, order online, pick up at the store services at 1,056 of our supermarkets and continue to increase our home delivery service available to customers. In addition, we operate 782 convenience stores, either directly or through franchisees, 274 fine jewelry stores and an online retailer. We operate 37 food production plants, primarily bakeries and dairies, which supply approximately 33% of Our Brands units and 44% of the grocery category Our Brands units sold in our supermarkets; the remaining Our Brands items are produced to our strict specifications by outside manufacturers. Our revenues are earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent over 97% of our consolidated sales, is our only reportable segment. On September 2, 2016, we closed our merger with Modern HC Holdings, Inc. (“ModernHEALTH”) by purchasing 100% of the outstanding shares of ModernHEALTH for $407 million. ModernHEALTH is included in our ending Consolidated Balance Sheet for 2016 and 2017 and in our Consolidated Statements of Operations from September 2, 2016 through January 28, 2017 and all periods in 2017. On December 18, 2015, we closed our merger with Roundy’s, Inc. (“Roundy’s”) by purchasing 100% of Roundy’s® outstanding common stock for $3.60 per share and assuming Roundy’s outstanding debt, for a purchase price of $866 million. Roundy’s is included in our ending Consolidated Balance Sheets for 2015, 2016 and 2017, and in our Consolidated Statements of Operations for the last six weeks of 2015 and all periods in 2016 and 2017. See Note 2 to the Consolidated Financial Statements for more information related to our mergers with ModernHEALTH and Roundy’s. USE OF NONGAAP FINANCIAL MEASURES The accompanying Consolidated Financial Statements, including the related notes, are presented in accordance with generally accepted accounting principles (“GAAP”). We provide nonGAAP measures, including FirstIn, FirstOut (“FIFO”) gross margin, FIFO operating profit, adjusted net earnings, adjusted net earnings per diluted share and free cash flow because management believes these metrics are useful to investors and analysts. These nonGAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings, net earnings per diluted share and net cash provided or used by operating or investing activities or any other GAAP measure of performance. These measures should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. Our calculation and reasons these are useful metrics to investors and analysts are explained below. We calculate FIFO gross margin as FIFO gross profit divided by sales. FIFO gross profit is calculated as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the LastIn, FirstOut (“LIFO”) credit or charge. Merchandise costs exclude depreciation and rent expenses [/INST] Positive. </s>

KROGER CO

2019-04-02

2019-02-02

ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I, the “Risk Factors” section set forth in Item 1A of Part I and the “Outlook” section below. OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. As of February 2, 2019, Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,764 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,270 have pharmacies and 1,537 have fuel centers. We offer Pickup (also referred to as ClickList®) and Harris Teeter ExpressLane™ - personalized, order online, pick up at the store services - at 1,581 of our supermarkets and provide home delivery service to 91% of Kroger households. We also operate an online retailer. We operate 37 food production plants, primarily bakeries and dairies, which supply approximately 32% of Our Brands units and 43% of the grocery category Our Brands units sold in our supermarkets; the remaining Our Brands items are produced to our strict specifications by outside manufacturers. Our revenues are predominately earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent 97% of our consolidated sales, is our only reportable segment. On June 22, 2018, we closed our merger with Home Chef by purchasing 100% of the ownership interest in Home Chef, for $197 million net of cash and cash equivalents of $30 million, in addition to future earnout payments of up to $500 million over five years that are contingent on achieving certain milestones. Home Chef is included in our ending Consolidated Balance Sheet for 2018 and in our Consolidated Statements of Operations from June 22, 2018 through February 2, 2019. On April 20, 2018, we completed the sale of our convenience store business unit for $2.2 billion. The convenience store business is included in our ending Consolidated Balance Sheet for 2017 and in our Consolidated Statements of Operations in all periods in 2016 and 2017 and through April 19, 2018. On September 2, 2016, we closed our merger with Modern HC Holdings, Inc. (“ModernHEALTH”) by purchasing 100% of the outstanding shares of ModernHEALTH for $407 million. ModernHEALTH is included in our ending Consolidated Balance Sheet for 2016, 2017 and 2018 and in our Consolidated Statements of Operations from September 2, 2016 through January 28, 2017 and all periods in 2017 and 2018. See Note 2 to the Consolidated Financial Statements for more information related to our mergers with Home Chef and ModernHEALTH. USE OF NON-GAAP FINANCIAL MEASURES The accompanying Consolidated Financial Statements, including the related notes, are presented in accordance with generally accepted accounting principles (“GAAP”). We provide non-GAAP measures, including First-In, First-Out (“FIFO”) gross margin, FIFO operating profit, adjusted operating net earnings, adjusted operating net earnings per diluted share and Restock cash flow because management believes these metrics are useful to investors and analysts. These non-GAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings, net earnings per diluted share and net cash provided or used by operating or investing activities or any other GAAP measure of performance. These measures should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. We calculate FIFO gross margin as FIFO gross profit divided by sales. FIFO gross profit is calculated as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the Last-In, First-Out (“LIFO”) charge. Merchandise costs exclude depreciation and rent expenses. FIFO gross margin is an important measure used by management as management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness. We calculate FIFO operating profit as operating profit excluding the LIFO charge. FIFO operating profit is an important measure used by management as management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day operational effectiveness. The adjusted operating net earnings and adjusted operating net earnings per diluted share metrics are important measures used by management to compare the performance of core operating results between periods. We believe adjusted operating net earnings and adjusted operating net earnings per diluted share are useful metrics to investors and analysts because they present more accurate year-over-year comparisons for our net earnings and net earnings per diluted share because adjusted items are not the result of our normal operations. Net earnings for 2018 include the following, which we define as the “2018 Adjusted Items:” · Charges to operating, general and administrative expenses (“OG&A”) of $155 million, $121 million net of tax, for obligations related to withdrawal liabilities for certain local unions of the Central States multi-employer pension fund; $33 million, $26 million net of tax, for the revaluation of contingent consideration; and $42 million, $33 million net of tax, for an impairment of financial instrument (the “2018 OG&A Adjusted Items”). We had initially received the financial instrument in 2016 with no cash outlay as part of the consideration for entering into agreements with a third party. · A reduction to depreciation and amortization expenses of $14 million, $11 million net of tax, related to held for sale assets (the “2018 Depreciation Adjusted Item”). · Gains in other income (expense) of $1.8 billion, $1.4 billion net of tax, related to the sale of our convenience store business unit and $228 million, $174 million net of tax, for the mark to market gain on Ocado Group plc (“Ocado”) securities. Net earnings for 2017 include the following, which we define as the “2017 Adjusted Items:” · Charges to OG&A of $550 million, $360 million net of tax, for obligations related to withdrawing from and settlements of withdrawal liabilities for certain multi-employer pension funds; $184 million, $117 million net of tax, related to the voluntary retirement offering (“VRO”); and $110 million, $74 million net of tax, related to the Kroger Specialty Pharmacy goodwill impairment (the “2017 OG&A Adjusted Items”). · A reduction to depreciation and amortization expenses of $19 million, $13 million net of tax, related to held for sale assets (the “2017 Depreciation Adjusted Item”). · A reduction to income tax expense of $922 million primarily due to the re-measurement of deferred tax liabilities and the reduction of the statutory rate for the last five weeks of the fiscal year from the Tax Cuts and Jobs Act ("Tax Act") (the “2017 Tax Expense Adjusted Item”). · A charge in other income (expense) of $502 million, $335 million net of tax, related to a company-sponsored pension plan termination. In addition, net earnings for 2017 include $119 million, $79 million net of tax, due to a 53rd week in fiscal year 2017 (the “Extra Week”). Net earnings for 2016 include $111 million, $71 million net of tax, of charges to OG&A related to the restructuring of certain pension obligations to help stabilize associates’ future benefits (the “2016 Adjusted Items”). OVERVIEW Notable items for 2018 are: · Net earnings per diluted share of $3.76. · Adjusted operating net earnings per diluted share of $2.11. · Identical sales, excluding fuel, increased 1.8% in 2018. · Digital revenue grew over 58% in 2018, driven by Pickup. Digital revenue primarily includes revenue from all curbside pickup locations and online sales delivered to customer locations. · Alternative profit increased in 2018, including third party media and our Kroger Personal Finance business, which had combined operating profit growth of approximately 20% in 2018. · Sold our convenience store business unit for $2.2 billion. · Announced Ocado partnership and completed our merger with Home Chef. · Announced we had entered into a definitive agreement to sell our You Technology business to Inmar. On March 13, 2019, we completed the sale of our You Technology business for $565 million, which includes a long-term service agreement for Inmar to provide us digital coupon services. · During 2018, we announced we had decided to explore strategic alternatives for our Turkey Hill Dairy business, including a potential sale. On March 19, 2019, we announced a definitive agreement for the sale of our Turkey Hill Dairy business to an affiliate of Peak Rock Capital. · During 2018, we returned $2.4 billion to shareholders from share repurchases and dividend payments, which includes $1.2 billion repurchased under a $1.2 billion accelerated stock repurchase (“ASR”) program using after tax proceeds from the sale of our convenience store business unit. · Net cash provided by operating activities was $4.2 billion in 2018 compared to $3.4 billion in 2017. · Restock cash flow was $1.9 billion in 2018 and $735 million in 2017. The following table provides a reconciliation of net earnings attributable to The Kroger Co. to adjusted operating net earnings attributable to The Kroger Co. and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to adjusted operating net earnings attributable to The Kroger Co. per diluted common share, excluding the 2018, 2017 and 2016 Adjusted Items. Net Earnings per Diluted Share excluding the Adjusted Items ($ in millions, except per share amounts) Net Earnings per Diluted Share excluding the Adjusted Items (continued) ($ in millions, except per share amounts) (1) The amounts presented represent the after-tax effect of each adjustment. (2) The pre-tax adjustments for the pension plan agreements were $155 in 2018, $550 in 2017, and $111 in 2016. (3) The pre-tax adjustment for the voluntary retirement offering was $184. (4) The pre-tax adjustment for Kroger Specialty Pharmacy goodwill impairment was $110. (5) The pre-tax adjustment for the company-sponsored pension plan termination was $502. (6) The pre-tax adjustment for gain on sale of convenience store business was ($1,782). (7) The pre-tax adjustment for mark to market gain on Ocado securities was ($228). (8) The pre-tax adjustment for depreciation related to held for sale assets was ($14) in 2018 and ($19) in 2017. (9) The pre-tax adjustment for contingent consideration was $33. (10) The pre-tax adjustment for impairment of financial instrument was $42. (11) Due to the re-measurement of deferred tax liabilities and the reduction of the statutory income tax rate for the last few weeks of the fiscal year. (12) The pre-tax Extra Week adjustment was ($119). (13) The amount presented represents the net earnings per diluted common share effect of each adjustment. RESULTS OF OPERATIONS Sales Total Sales ($ in millions) (1) This column represents the percentage change in 2018 compared to 2017 adjusted sales, which removes the Extra Week. (2) The 2017 Adjusted column represents the items presented in the 2017 column adjusted to remove the Extra Week. (3) This column represents the percentage change in 2017 adjusted sales compared to 2016. (4) Digital sales, primarily including Pickup, Delivery and pharmacy e-commerce sales, grew approximately 58% in 2018, 90% in 2017 and 49% in 2016, adjusted to remove the Extra Week. These sales are included in the “total sales to retail customers without fuel” line above. (5) We completed the sale of our convenience store business during the first quarter of 2018. (6) Other sales primarily relate to external sales at food production plants, data analytic services, third party media revenue and digital coupon services. Total sales decreased in 2018, compared to 2017, by 1.2%. The decrease in total sales in 2018, compared to 2017, is due to the Extra Week in 2017, partially offset by the increase in 2018 sales, compared to 2017 adjusted sales. Total sales increased in 2018, compared to 2017 adjusted sales, by 0.6%. This increase was primarily due to our increases in total sales to retail customers without fuel and supermarket fuel sales, partially offset by a reduction in convenience store sales due to the sale of our convenience store business unit. The increase in total sales to retail customers without fuel for 2018, compared to 2017 adjusted sales to retail customers without fuel, was primarily due to our merger with Home Chef and our identical sales increase, excluding fuel, of 1.8%. Identical sales, excluding fuel, for 2018, compared to 2017, increased primarily due to changes in product mix, including higher quality products at a higher price point, and Kroger Specialty Pharmacy sales growth, partially offset by our continued investments in lower prices for our customers. Total supermarket fuel sales increased 15.5% in 2018, compared to 2017 adjusted supermarket fuel sales, primarily due to an increase in the average retail fuel price of 13.6% and an increase in fuel gallons sold of 1.5%. The increase in the average retail fuel price was caused by an increase in the product cost of fuel. Total sales increased in 2017, compared to 2016, by 6.4%. The increase in total sales in 2017, compared to 2016, is due to the increase in adjusted sales and the Extra Week. Total adjusted sales increased in 2017, compared to 2016, by 4.4%. This increase was primarily due to our increases in total sales to retail customers without fuel and supermarket fuel sales. The increase in total sales to retail customers without fuel for 2017, adjusted for the Extra Week, compared to 2016, was primarily due to our merger with ModernHEALTH, identical sales increase, excluding fuel, of 0.9%, and an increase in supermarket square footage. Identical sales, excluding fuel, for 2017, compared to 2016, increased primarily due to an increase in the number of households shopping with us, changes in product mix, Kroger Specialty Pharmacy sales growth and product cost inflation of 0.7%, partially offset by our continued investments in lower prices for our customers. Excluding mergers, acquisitions and operational closings, total supermarket square footage at the end of 2017 increased 1.9% over the end of 2016. Total adjusted supermarket fuel sales increased 14.4% in 2017, compared to 2016, primarily due to an increase in the average retail fuel price of 12.3% and an increase in fuel gallons sold of 1.9%. The increase in the average retail fuel price was caused by an increase in the product cost of fuel. We calculate identical sales, excluding fuel, as sales to retail customers, including sales from all departments at identical supermarket locations, Kroger Specialty Pharmacy businesses and ship-to-home solutions. We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Additionally, sales from all acquired businesses are treated as identical as if they were part of the Company in the prior year. Although identical sales is a relatively standard term, numerous methods exist for calculating identical sales growth. As a result, the method used by our management to calculate identical sales may differ from methods other companies use to calculate identical sales. We urge you to understand the methods used by other companies to calculate identical sales before comparing our identical sales to those of other such companies. Certain pharmacy fees recorded as a reduction of sales have been comparatively reflected in the identical sales calculation. Our identical sales results are summarized in the following table. We used the identical sales dollar figures presented below to calculate percentage changes for 2018. Identical Sales ($ in millions) (1) Identical sales for 2018 were calculated on a 52 week basis by excluding week 1 of fiscal 2017 in our 2017 identical sales base. (2) Identical sales for 2017 were calculated on a 53 week basis by including week 1 of fiscal 2017 in our 2016 identical sales base. Gross Margin, LIFO and FIFO Gross Margin We define gross margin as sales minus merchandise costs, including advertising, warehousing, and transportation. Rent expense, depreciation and amortization expense, and interest expense are not included in gross margin. Our gross margin rates, as a percentage of sales, were 21.68% in 2018, 22.01% in 2017 and 22.40% in 2016. The decrease in 2018, compared to 2017, resulted primarily from continued investments in lower prices for our customers, a higher LIFO charge, a change in product sales mix and increased transportation and advertising costs, as a percentage of sales, partially offset by growth in Our Brands products which have a higher gross margin compared to national brand products, improved merchandise costs, decreased shrink, as a percentage of sales, and a higher gross margin rate on fuel sales. The decrease in 2017, compared to 2016, resulted primarily from continued investments in lower prices for our customers and our merger with ModernHEALTH due to its lower gross margin rate, and increased warehousing, transportation and shrink costs, as a percentage of sales, partially offset by improved merchandise costs, a lower LIFO charge, a change in our product sales mix, including higher gross margin perishable departments growing their percentage share of sales to total sales, growth in Our Brands products which have a higher gross margin compared to national brand products, decreased advertising costs, as a percentage of sales, and a higher gross margin rate on fuel sales. Our LIFO charge for 2018 was $29 million, compared to a LIFO credit of $8 million in 2017 and a LIFO charge of $19 million in 2016. In 2018, our LIFO charge primarily resulted from annualized product cost inflation, primarily related to pharmacy. Our LIFO credit in 2017 was primarily due to a reduction of pharmacy inventory in 2017 compared to 2016. In 2016, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation in other departments. Our FIFO gross margin rates, which exclude the LIFO charges and credit, were 21.70% in 2018, 22.01% in 2017 and 22.42% in 2016. Our fuel sales lower our FIFO gross margin rate due to the very low FIFO gross margin rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel and the Extra Week, our FIFO gross margin rate decreased 55 basis points in 2018, compared to 2017. This decrease resulted primarily from our lower gross margin rate, excluding the effect of the LIFO charge and fuel, which has been described above. Excluding the effect of fuel, the Extra Week and ModernHEALTH, our FIFO gross margin rate decreased 19 basis points in 2017, compared to 2016. This decrease resulted primarily from our lower gross margin rate, excluding the effect of the LIFO credit and charge, fuel and ModernHEALTH which has been described above. Operating, General and Administrative Expenses OG&A expenses consist primarily of employee-related costs such as wages, healthcare benefit costs and retirement plan costs; and utility and credit card fees. Certain other income items are classified as a reduction of OG&A expenses. These items include gift card and lottery commissions, coupon processing and vending machine fees, check cashing, money order and wire transfer fees, and baled salvage credits. Rent expense, depreciation and amortization expense, and interest expense are not included in OG&A. OG&A expenses, as a percentage of sales, were 16.76% in 2018, 17.15% in 2017 and 16.61% in 2016. The decrease in 2018, compared to 2017 resulted primarily from effective cost controls due to process changes, decreased utilities, the 2017 OG&A Adjusted Items, and our incremental contribution of $111 million, $69 million net of tax, to the United Food and Commercial Workers (“UFCW”) Consolidated Pension Plan in 2017 (“2017 UFCW Contribution”), partially offset by the 2018 OG&A Adjusted Items, investments in our digital strategy and increased incentive plan costs. Our fuel sales lower our OG&A rate, as a percentage of sales, due to the very low OG&A rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel, the Extra Week, the 2018 OG&A Adjusted Items, the 2017 OG&A Adjusted Items, and the 2017 UFCW Contribution, our OG&A rate increased 14 basis points in 2018, compared to 2017. This increase resulted primarily from investments in our digital strategy and increased incentive plan costs, partially offset by effective cost controls due to process changes and decreased utilities. The increase in 2017, compared to 2016, resulted primarily from the 2017 OG&A Adjusted Items, investing in our digital strategy, increases in store wages attributed to investing in incremental labor hours and higher wages to improve retention, employee engagement and customer experience, the 2017 UFCW Contribution, increases in incentive plan and healthcare costs, partially offset by savings from the VRO, effective cost controls, higher fuel sales, the 2016 Adjusted Items and our merger with ModernHEALTH due to its lower OG&A rate, as a percentage of sales. Excluding the effect of fuel, the Extra Week, the 2017 UFCW Contribution, the 2017 OG&A and 2016 Adjusted Items and ModernHEALTH, our OG&A rate increased 21 basis points in 2017, compared to 2016. This increase resulted primarily from investing in our digital strategy, increases in store wages attributed to investing in incremental labor hours and higher wages to improve retention, employee engagement and customer experience, increases in incentive plan and healthcare costs, partially offset by savings from the VRO and effective cost controls. Rent Expense Rent expense decreased, as a percentage of sales, in 2018 compared to 2017, due to decreased closed store liabilities. Rent expense decreased as a percentage of sales in 2017, compared to 2016, due to our continued emphasis on owning rather than leasing, whenever possible, and higher fuel sales, which decreases our rent expense, as a percentage of sales, partially offset by increased closed store liabilities. Depreciation and Amortization Expense Depreciation and amortization expense increased as a percentage of sales in 2018, compared to 2017, due to the Extra Week and additional depreciation on capital investments, excluding mergers and lease buyouts, of $3.0 billion, during 2018, partially offset by higher fuel sales, which decreases our depreciation expense as a percentage of sales. Depreciation and amortization expense decreased as a percentage of sales in 2017, compared to 2016, due to higher fuel sales, which decreases our depreciation expense as a percentage of sales, the Extra Week and the 2017 Depreciation Adjusted Item, partially offset by additional depreciation on capital investments, excluding mergers and lease buyouts, of $3.0 billion, during 2017. Operating Profit and FIFO Operating Profit Operating profit was $2.6 billion in 2018, $2.6 billion in 2017 and $3.5 billion in 2016. Operating profit, as a percentage of sales, was 2.16% in 2018, 2.13% in 2017 and 2.99% in 2016. Operating profit, as a percentage of sales, increased 3 basis points in 2018, compared to 2017, due to decreased OG&A and rent expenses, as a percentage of sales, partially offset by a lower gross margin rate, increased depreciation and amortization expenses and a higher LIFO charge, as a percentage of sales. Operating profit, as a percentage of sales, decreased 86 basis points in 2017, compared to 2016, due to a lower gross margin and increased OG&A expense, as a percentage of sales, partially offset by lower depreciation and amortization and rent expenses and a lower LIFO charge, as a percentage of sales. FIFO operating profit was $2.6 billion in 2018, $2.6 billion in 2017 and $3.5 billion in 2016. FIFO operating profit, as a percentage of sales, was 2.18% in 2018, 2.12% in 2017 and 3.01% in 2016. Fuel sales lower our operating profit rate due to the very low operating profit rate, as a percentage of sales, of fuel sales compared to non-fuel sales. FIFO operating profit, as a percentage of sales excluding fuel, the Extra Week, the 2017 UFCW Contribution and the 2018 and 2017 Adjusted Items, decreased 68 basis points in 2018, compared to 2017, due to a lower gross margin and increased OG&A and depreciation and amortization expenses, as a percentage of sales, partially offset by lower rent expense, as a percentage of sales. FIFO operating profit, as a percentage of sales excluding fuel, the Extra Week, the 2017 UFCW Contribution, the 2017 and 2016 Adjusted Items and ModernHEALTH, decreased 45 basis points in 2017, compared to 2016, due to a lower gross margin and increased OG&A and depreciation and amortization expenses, as a percentage of sales. Specific factors of the above operating trends under operating profit and FIFO operating profit are discussed earlier in this section. Interest Expense Interest expense totaled $620 million in 2018, $601 million in 2017 and $522 million in 2016. The increase in interest expense in 2018, compared to 2017, resulted primarily from a higher weighted average interest rate. The increase in interest expense in 2017, compared to 2016, resulted primarily from additional borrowings used for share repurchases, the Extra Week, the $1.2 billion we contributed to company-sponsored and company-managed pension plans in 2017, a $467 million pre-tax payment to satisfy withdrawal obligations for certain local unions of the Central States Pension Fund, partially offset by a lower weighted average interest rate. Income Taxes Our effective income tax rate was 22.6% in 2018, (27.3)% in 2017 and 32.8% in 2016. The 2018 tax rate differed from the federal statutory rate primarily due to the effect of state income taxes and an IRS audit that resulted in a reduction of prior year tax deductions at pre-Tax Act rates and an increase in future tax deductions at post-Tax Act rates. These 2018 items were partially offset by the utilization of tax credits and deductions, the remeasurement of uncertain tax positions and adjustments to provisional amounts that increased prior year deductions at pre-Tax Act rates and decreased future deductions at post-Tax Act rates. The 2017 tax rate differed from the federal statutory rate primarily as a result of remeasuring deferred taxes due to the Tax Act, the Domestic Manufacturing Deduction and other changes, partially offset by non-deducible goodwill impairment charges and the effect of state income taxes. The 2016 tax rate differed from the federal statutory rate primarily as a result of the recognition of excess tax benefits related to share-based payments after the adoption of Accounting Standards Update (“ASU”) 2016-09, the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes. Net Earnings and Net Earnings Per Diluted Share Our net earnings are based on the factors discussed in the Results of Operations section. Net earnings of $3.76 per diluted share in 2018 represented an increase of 79.9% from net earnings of $2.09 per diluted share in 2017. Adjusted operating net earnings of $2.11 per diluted share in 2018 represented an increase of 8.2% from adjusted operating net earnings of $1.95 per diluted share in 2017. The 8.2% increase in adjusted operating net earnings per diluted share resulted primarily from lower income tax expense, higher fuel earnings and lower weighted average common shares outstanding due to common share repurchases, partially offset by lower non-fuel FIFO operating profit, a higher LIFO charge and increased interest expense. Net earnings of $2.09 per diluted share in 2017 represented an increase of 2.0% from net earnings of $2.05 per diluted share in 2016. Adjusted operating net earnings of $1.95 per diluted share in 2017 represented a decrease of 8.0% from adjusted operating net earnings of $2.12 per diluted share in 2016. The 8.0% decrease in adjusted operating net earnings per diluted share resulted primarily from lower non-fuel FIFO operating profit and increased interest expense, partially offset by higher fuel earnings, a lower LIFO charge, decreased income tax expense and lower weighted average common shares outstanding due to common share repurchases. COMMON SHARE REPURCHASE PROGRAMS We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time. The share repurchase programs do not have an expiration date but may be suspended or terminated by our Board of Directors at any time. We made open market purchases of our common shares totaling $727 million in 2018, $1.6 billion in 2017 and $1.7 billion in 2016. On April 20, 2018, we entered and funded a $1.2 billion ASR program to reacquire shares in privately negotiated transactions. In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises. We repurchased approximately $83 million in 2018, $66 million in 2017 and $105 million in 2016 of our common shares under the stock option program. The shares repurchased in 2018 were reacquired under two separate share repurchase programs. The first is a series of Board of Director authorizations: · On June 22, 2017, our Board of Directors approved a $1.0 billion share repurchase program (the “June 2017 Repurchase Program”). This program was exhausted during the first quarter of 2018. · On March 15, 2018, our Board of Directors approved a $1.0 billion share repurchase program, to supplement the June 2017 Repurchase Program, to reacquire shares via open market purchase or privately negotiated transactions, including accelerated stock repurchase transactions, block trades, or pursuant to trades intending to comply with rule 10b5-1 of the Securities Exchange Act of 1934 (the “March 2018 Repurchase Program”). · On April 19, 2018, our Board of Directors approved a $1.2 billion ASR program to reacquire shares in privately negotiated transactions. This program was exhausted during the second quarter of 2018. As of February 2, 2019, there was $546 million remaining under the March 2018 Repurchase Program. The second share repurchase program is a program that uses the cash proceeds from the exercises of stock options by participants in Kroger’s stock option, long-term incentive plans and the associated tax benefits. During the first quarter through March 28, 2019, we repurchased an additional $9 million of our common shares under the stock option program and no additional shares under the March 2018 Repurchase Program. As of March 28, 2019, we have $546 million remaining under the March 2018 Repurchase Program. CAPITAL INVESTMENTS Capital investments, including changes in construction-in-progress payables and excluding mergers and the purchase of leased facilities, totaled $3.0 billion in 2018, $3.0 billion in 2017 and $3.7 billion in 2016. Capital investments for mergers totaled $197 million in 2018, $16 million in 2017 and $401 million in 2016. We merged with Home Chef in 2018 and ModernHEALTH in 2016. Refer to Note 2 to the Consolidated Financial Statements for more information on these mergers. Capital investments for the purchase of leased facilities totaled $5 million in 2018, $13 million in 2017 and $5 million in 2016. The table below shows our supermarket storing activity and our total supermarket square footage: Supermarket Storing Activity RETURN ON INVESTED CAPITAL We calculate return on invested capital (“ROIC”) by dividing adjusted operating profit for the prior four quarters by the average invested capital. Adjusted operating profit is calculated by excluding certain items included in operating profit, and adding back our LIFO charge, depreciation and amortization and rent to our U.S. GAAP operating profit of the prior four quarters. Average invested capital is calculated as the sum of (i) the average of our total assets, (ii) the average LIFO reserve, (iii) the average accumulated depreciation and amortization and (iv) a rent factor equal to total rent for the last four quarters multiplied by a factor of eight; minus (i) the average taxes receivable, (ii) the average trade accounts payable, (iii) the average accrued salaries and wages, (iv) the average other current liabilities, excluding accrued income taxes and (v) the average liabilities held for sale. Averages are calculated for ROIC by adding the beginning balance of the first quarter and the ending balance of the fourth quarter, of the last four quarters, and dividing by two. We use a factor of eight for our total rent as we believe this is a common factor used by our investors, analysts and rating agencies. ROIC is a non-GAAP financial measure of performance. ROIC should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital. Management believes ROIC is a useful metric to investors and analysts because it measures how effectively we are deploying our assets. Although ROIC is a relatively standard financial term, numerous methods exist for calculating a company’s ROIC. As a result, the method used by our management to calculate ROIC may differ from methods other companies use to calculate their ROIC. We urge you to understand the methods used by other companies to calculate their ROIC before comparing our ROIC to that of such other companies. The following table provides a calculation of ROIC for 2018 and 2017 on a 52 week basis ($ in millions). The 2018 calculation of ROIC excludes the financial position and results of operations of Home Chef, due to the merger in 2018, and the convenience store business, due to the sale in 2018. (1) Taxes receivable were $229 as of February 3, 2018 and $132 as of January 28, 2017. We did not have any taxes receivable as of February 2, 2019. (2) Other current liabilities included accrued income taxes of $60 as of February 2, 2019 and $1 as of January 28, 2017. We did not have any accrued income taxes as of February 3, 2018. Accrued income taxes are removed from other current liabilities in the calculation of average invested capital. RESTOCK CASH FLOW Restock cash flow is an adjusted free cash flow measure calculated as net cash provided by operating activities minus net cash used by investing activities plus or minus adjustments for certain items. We updated our definition of Restock cash flow during 2018 to more closely align with the performance metrics under our Restock Kroger plan. Restock cash flow is an important measure used by management to evaluate available funding for dividends, managing debt levels, share repurchases and other strategic investments. Management believes Restock cash flow is a useful metric to investors and analysts to demonstrate our available funding for dividends, managing debt levels, share repurchases and other strategic investments. The following table provides a calculation of Restock cash flow for 2018 and 2017 ($ in millions). CRITICAL ACCOUNTING POLICIES We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Our significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements. The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates. We believe the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain. Impairments of Long-Lived Assets We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value. Fair value is determined based on market values or discounted future cash flows. We record impairment when the carrying value exceeds fair market value. With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal. We recorded asset impairments in the normal course of business totaling $56 million in 2018, $71 million in 2017 and $26 million in 2016. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as “Operating, general and administrative” expense. The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different level, could produce significantly different results. Business Combinations We account for business combinations using the acquisition method of accounting. All the assets acquired, liabilities assumed and amounts attributable to noncontrolling interests are recorded at their respective fair values at the date of acquisition once we obtain control of an entity. The determination of fair values of identifiable assets and liabilities involves estimates and the use of valuation techniques when market value is not readily available. We use various techniques to determine fair value in such instances, primarily including the income approach. Significant estimates used in determining fair value include, but are not limited to, the amount and timing of future cash flows, growth rates, discount rates and useful lives. The excess of the purchase price over fair values of identifiable assets and liabilities is recorded as goodwill. See Note 3 for further information about goodwill. Goodwill Our goodwill totaled $3.1 billion as of February 2, 2019. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our operating divisions and other consolidated entities (collectively, “reporting units”) that have goodwill balances. Generally, fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment. We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future. We recognize goodwill impairment for any excess of a reporting unit's carrying value over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. Our annual evaluation of goodwill is performed for our reporting units during the fourth quarter. In 2017, we recorded goodwill impairment for our Kroger Specialty Pharmacy (“KSP”) reporting unit totaling $110 million, $74 million net of tax, resulting in a remaining goodwill balance of $243 million. The 2018 fair value of our KSP reporting unit was estimated primarily based on a discounted cash flow model resulting in a percentage of excess fair value over carrying value of approximately 3%. The annual evaluation of goodwill performed in 2018 and 2016 did not result in impairment for any of our reporting units. Based on current and future expected cash flows, we believe additional goodwill impairments are not reasonably likely. A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance except for our KSP reporting unit. For additional information relating to our results of the goodwill impairment reviews performed during 2018, 2017 and 2016, see Note 3 to the Consolidated Financial Statements. The impairment review requires the extensive use of management judgment and financial estimates. Application of alternative estimates and assumptions could produce significantly different results. The cash flow projections embedded in our goodwill impairment reviews can be affected by several factors such as inflation, business valuations in the market, the economy, market competition and our ability to successfully integrate recently acquired businesses. Multi-Employer Pension Plans We contribute to various multi-employer pension plans based on obligations arising from collective bargaining agreements. These multi-employer pension plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans. We recognize expense in connection with these plans as contributions are funded or when commitments are probable and reasonably estimable, in accordance with GAAP. We made cash contributions to these plans of $358 million in 2018, $954 million in 2017 and $289 million in 2016. The increase in 2017, compared to 2018 and 2016 is due to the $467 million pre-tax payment we made in 2017 to satisfy withdrawal obligations for certain local unions of the Central States Pension Fund and the 2017 UFCW Contribution. We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans as it relates to our associates who are beneficiaries of these plans. These under-fundings are not our liability. When an opportunity arises that is economically feasible and beneficial to us and our associates, we may negotiate the restructuring of under-funded multi-employer pension plan obligations to help stabilize associates’ future benefits and become the fiduciary of the restructured multi-employer pension plan. The commitments from these restructurings do not change our debt profile as it relates to our credit rating since these off-balance sheet commitments are typically considered in our investment grade debt rating. We are currently designated as the named fiduciary of the UFCW Consolidated Pension Plan and the International Brotherhood of Teamsters (“IBT”) Consolidated Pension Fund and have sole investment authority over these assets. We became the fiduciary of the IBT Consolidated Pension Fund in 2017 due to the ratification of a new labor contract with the IBT that provided for the withdrawal of certain local unions from the Central States Pension Fund. Significant effects of these restructuring agreements recorded in our Consolidated Financial Statements are: · In 2018, we incurred a $155 million charge, $121 million net of tax, for obligations related to withdrawal liabilities for certain local unions of the Central States multi-employer pension fund. · In 2017, we incurred a $550 million charge, $360 million net of tax, for obligations related to withdrawing from and settlements for withdrawal liabilities for certain multi-employer pension plan obligations, of which $467 million was contributed to the Central States Pension Fund in 2017. · In 2017, we contributed an incremental $111 million, $71 million net of tax, to the UFCW Consolidated Pension Plan. · In 2016, we incurred a charge of $111 million, $71 million net of tax, due to commitments and withdrawal liabilities arising from the restructuring of certain multi-employer pension plan obligations, of which $28 million was contributed to the UFCW Consolidated Pension Plan in 2016. As we continue to work to find solutions to under-funded multi-employer pension plans, it is possible we could incur withdrawal liabilities for certain funds. Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2018. Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding. Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer. As of December 31, 2018, we estimate our share of the underfunding of multi-employer pension plans to which we contribute, or as it relates to certain funds, an estimated withdrawal liability, was approximately $3.1 billion, $2.4 billion net of tax. This represents an increase in the estimated amount of underfunding of approximately $800 million, $600 million net of tax, as of December 31, 2018, compared to December 31, 2017. The increase in the amount of underfunding is primarily attributable to lower expected returns on assets in the funds. Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable. We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours. Rather, we believe the underfunding is likely to have important consequences. In the event we were to exit certain markets or otherwise cease making contributions to these plans, we could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated, in accordance with GAAP. The amount of underfunding described above is an estimate and could change based on contract negotiations, returns on the assets held in the multi-employer pension plans, benefit payments or future restructuring agreements. The amount could decline, and our future expense would be favorably affected, if the values of the assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, our share of the underfunding could increase and our future expense could be adversely affected if the asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation. We continue to evaluate our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of ours, any commitments to fund certain multi-employer pension plans will be expensed when our commitment is probable and an estimate can be made. See Note 16 to the Consolidated Financial Statements for more information relating to our participation in these multi-employer pension plans. RECENTLY ADOPTED ACCOUNTING STANDARDS During the fourth quarter of 2017, we adopted ASU 2017-04 "Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 simplifies the subsequent measurement of goodwill by eliminating the second step from the goodwill impairment test. ASU 2017-04 requires applying a one-step quantitative test and recording the amount of goodwill impairment as the excess of the reporting unit's carrying value over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. ASU 2017-04 does not amend the optional qualitative assessment of goodwill impairment. We performed our annual evaluation of goodwill in accordance with this standard, which resulted in a goodwill impairment charge in 2017 of $110 million, $74 million net of tax, related to our Kroger Specialty Pharmacy reporting unit. On February 4, 2018, we adopted ASU 2014-09, “Revenue from Contracts with Customers (Topic 606)” which superseded previous revenue recognition guidance. Topic 606 is a comprehensive new revenue recognition model that requires a company to recognize revenue when goods and services are transferred to the customer in an amount that is proportionate to what has been delivered at that point and that reflects the consideration to which the company expects to be entitled for those goods or services. We adopted the standard using a modified retrospective approach with the adoption primarily involving the evaluation of whether we act as principal or agent in certain vendor arrangements where the purchase and sale of inventory are virtually simultaneous. We will continue to record revenue and related costs on a gross basis for the arrangements. The adoption of the standard did not have a material effect on our Consolidated Statements of Operations, Consolidated Balance Sheets or Consolidated Statements of Cash Flows. In March 2017, the Financial Accounting Standard’s Board (“FASB”) issued ASU "Compensation - Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost (ASU 2017-07).” ASU 2017-07 requires an employer to report the service cost component of retiree benefits in the same line item or items as other compensation costs arising from services rendered by the pertinent employees during the period. The other components of net benefit cost are required to be presented separately from the service cost component and outside a subtotal of income from operations. We adopted ASU 2017-07 on February 4, 2018 and retrospectively applied it to all periods presented. As a result, retiree benefit plan interest expense, investment returns, settlements and other non-service cost components of retiree benefit expenses are excluded from our operating profit subtotal as reported in our Consolidated Statements of Operations, but remain included in net earnings before income tax expense. Due to the adoption, we reclassified $527 million for 2017 and $16 million for 2016, of non-service company-sponsored pension plan costs from operating profit to other income (expense) on our Consolidated Statements of Operations. Information about retiree benefit plans' interest expense, investment returns and other components of retiree benefit expenses can be found in Note 15 to our Consolidated Financial Statements. In January 2016, the FASB issued “Financial Instruments-Overall (Topic 825),” which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments (ASU 2016-01). We adopted this ASU on February 4, 2018. As a result of the adoption, we recorded a mark to market gain on Ocado securities, for those securities we owned as of the end of 2018, within the Consolidated Statements of Operations as opposed to a component of Other Comprehensive Income on our Consolidated Statements of Comprehensive Income. RECENTLY ISSUED ACCOUNTING STANDARDS In February 2016, the FASB issued ASU 2016-02, “Leases,” which provides guidance for the recognition of lease agreements. The standard’s core principle is that a company will now recognize most leases on its balance sheet as lease liabilities with corresponding right-of-use assets. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. This guidance will be effective for us in the first quarter of our fiscal year ending February 1, 2020. We will apply the transition package of practical expedients permitted within the standard, which allows us to carryforward our historical lease classification, and will apply the transition option which does not require application of the guidance to comparative periods in the year of adoption. We estimate adoption of the standard will result in recognition of right of use assets and lease liabilities of approximately $6.7 billion as of February 3, 2019. When combined with our existing capital leases, our total lease assets will be approximately $7.4 billion and our total lease liabilities will be approximately $7.6 billion as of February 3, 2019. We do not expect adoption to have a material impact on our consolidated net earnings or cash flows. We believe our current off-balance sheet leasing commitments are reflected in our investment grade debt rating. In February 2018, the FASB issued ASU 2018-02, “Reclassification of Certain Tax Effects From Accumulated Other Comprehensive Income.” ASU 2018-02 amends ASC 220, “Income Statement - Reporting Comprehensive Income,” to allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. In addition, under ASU 2018-02, we may be required to provide certain disclosures regarding stranded tax effects. ASU 2018-02 is effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption is permitted. We are currently evaluating the effect of this standard on our Consolidated Financial Statements. LIQUIDITY AND CAPITAL RESOURCES Cash Flow Information Net cash provided by operating activities We generated $4.2 billion of cash from operations in 2018, compared to $3.4 billion in 2017 and $4.3 billion in 2016. The increase in net cash provided by operating activities in 2018, compared to 2017, resulted primarily from an increase in net earnings including noncontrolling interests, a decrease in the non-cash adjustment for deferred income taxes, positive changes in working capital and reduced contributions to the company sponsored pension plans, partially offset by non-cash adjustments for the expense for company-sponsored pension plans, the gain on sale of our convenience store business unit and the mark to market gain on Ocado securities. The decrease in net cash provided by operating activities in 2017, compared to 2016, resulted primarily from a decrease in net earnings including noncontrolling interests, the $1.0 billion contribution to the company-sponsored defined benefit plans and deferred taxes, partially offset by an increase in non-cash expenses and changes in working capital. Deferred taxes changed in 2017, compared to 2016, as a result of remeasuring deferred taxes due to the Tax Act. Cash provided (used) by operating activities for changes in working capital was $580 million in 2018, ($164) million in 2017 and ($492) million in 2016. The increase in cash provided by operating activities for changes in working capital in 2018, compared to 2017, was primarily due to the following: · A lower increase, over the prior year, of store deposits in-transit in 2018, compared to 2017; · A decrease in prepaid medical benefit costs at the end of 2018, compared to 2017; · Increases in accrued incentive plan costs; and · Positive working capital related to income taxes receivable and payable as a result of an overpayment of our fourth quarter 2017 estimated taxes and our estimated taxes on the gain on sale of our convenience store business unit; partially offset by · Higher third-party payor receivables due to increasing pharmacy sales and the timing of third-party payments; and · Increased inventory purchases due to change in inventory mix and new distribution centers. The decrease in cash used by operating activities for changes in working capital in 2017, compared to 2016, was primarily due to the following: · A lower amount of cash used for inventory purchases due to decreased capital investments related to store growth, · Increased cash collections due to our emphasis on better receivables management, and · A lower increase, over the prior year, of prepaid benefit costs in 2017, compared to 2016; partially offset by · An overpayment of our fourth quarter 2017 estimated income taxes, and · An increase in store deposits in-transit due to increased sales in the last few days of 2017. Cash paid for taxes increased in 2018, compared to 2017, primarily due to the payment of estimated taxes on the gain on sale of our convenience store business unit and lower estimated tax payments in 2017 due to the $1 billion, $650 million net of tax, pension contribution made in 2017. Net cash used by investing activities Cash used by investing activities was $1.2 billion in 2018, $2.7 billion in 2017 and $3.9 billion in 2016. The amount of cash used by investing activities decreased in 2018 compared to 2017 primarily due to the net proceeds from the sale of our convenience store business unit, partially offset by the payment for our merger with Home Chef and the purchases of Ocado securities. The amount of cash used by investing activities decreased in 2017 compared to 2016 primarily due to reduced cash payments for capital investments and lower payments for mergers. Net cash used by financing activities Cash used by financing activities was $2.9 billion in 2018, $681 million in 2017 and $352 million in 2016. The increase in the amount of cash used for financing activities in 2018 compared to 2017 was primarily due to increased payments on long-term debt and commercial paper and increased share repurchases, partially offset by an increase in proceeds from issuance of long-term debt. We used a portion of the proceeds from the sale of our convenience store business unit to pay down outstanding commercial paper borrowings and fund a $1.2 billion ASR program, which was completed in the second quarter of 2018. The increase in the amount of cash used for financing activities in 2017 compared to 2016 was primarily due to lower net long-term borrowings, partially offset by lower treasury stock purchases and higher net commercial paper borrowings. Debt Management Total debt, including both the current and long-term portions of capital leases and lease-financing obligations, decreased $360 million to $15.2 billion as of year-end 2018 compared to 2017. The decrease in 2018, compared to 2017, resulted primarily from net payments on commercial paper borrowings of $1.3 billion and payments of $1.3 billion on maturing long-term debt obligations, partially offset by the issuance of (i) $600 million of senior notes bearing an interest rate of 4.50%, (ii) $600 million of senior notes bearing an interest rate of 5.40% and (iii) our $1.0 billion term loan that has a variable interest rate. The variable interest rate on the term loan was 3.37% as of February 2, 2019. The combined $1.2 billion senior notes issuance has a higher weighted average interest rate than the $1.3 billion maturing long-term debt obligations it replaced. As a result, we expect a higher weighted average interest rate in 2019 which may contribute to increased interest expense. The sale of our convenience store business unit allowed us to pay down debt and fund our ASR program. Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $1.5 billion to $15.6 billion as of year-end 2017 compared to 2016. The increase in 2017, compared to 2016, resulted from the issuance of (i) $400 million of senior notes bearing an interest rate of 2.80%, (ii) $600 million of senior notes bearing an interest rate of 3.70%, (iii) $500 million of senior notes bearing an interest rate of 4.65% and (iv) increases in commercial paper borrowings, partially offset by payments of $700 million on maturing long-term debt obligations. Liquidity Needs We estimate our liquidity needs over the next twelve-month period to approximate $6.4 billion, which includes anticipated requirements for working capital, capital investments, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2018. We generally operate with a working capital deficit due to our efficient use of cash in funding operations and because we have consistent access to the capital markets. Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months. We have approximately $1.3 billion of senior notes, $800 million of commercial paper and the $1.0 billion term loan maturing in the next twelve months, which are included in the $6.4 billion of estimated liquidity needs. We expect to satisfy these obligations using cash generated from operations, proceeds from the sale of our You Technology and Turkey Hill Dairy businesses and through issuing additional senior notes, a term loan or commercial paper. On March 15, 2019, we repaid our $1.0 billion term loan through increased commercial paper borrowings, which have a lower interest rate. We believe we have adequate coverage of our debt covenants to continue to maintain our current investment grade debt ratings and to respond effectively to competitive conditions. Factors Affecting Liquidity We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper program. At February 2, 2019, we had $800 million of commercial paper borrowings outstanding. Commercial paper borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility. If our short-term credit ratings fall, the ability to borrow under our current commercial paper program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our commercial paper program. This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity. However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our commercial paper program would be any lower than $500 million on a daily basis. Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost and applicable margin on borrowings under the credit facility could be affected by a downgrade in our Public Debt Rating. “Public Debt Rating” means, as of any date, the rating that has been most recently announced by either S&P or Moody’s, as the case may be, for any class of non-credit enhanced long-term senior unsecured debt issued by the Company. As of March 28, 2019, we had $810 million of commercial paper borrowings outstanding. Our credit facility requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our “financial covenants”). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants are described below: · Our Leverage Ratio (the ratio of Net Debt to Adjusted EBITDA, as defined in the credit facility) was 2.64 to 1 as of February 2, 2019. If this ratio were to exceed 3.50 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. · Our Fixed Charge Coverage Ratio (the ratio of Adjusted EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facility) was 4.17 to 1 as of February 2, 2019. If this ratio fell below 1.70 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired. Our credit facility is more fully described in Note 6 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2018. The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of February 2, 2019 (in millions of dollars): (1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $218 million in 2018. This table also excludes contributions under various multi-employer pension plans, which totaled $358 million in 2018. (2) The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined. (3) As of February 2, 2019, we had $800 million of commercial paper and no borrowings under our credit facility. (4) Amounts include contractual interest payments using the interest rate as of February 2, 2019, and stated fixed and swapped interest rates, if applicable, for all other debt instruments. (5) The amounts included in the contractual obligations table for self-insurance liability related to workers’ compensation claims have been stated on a present value basis. (6) Amounts include funds owed to third parties for projects currently under construction. These amounts are reflected in other current liabilities in our Consolidated Balance Sheets. (7) Amounts include commitments, many of which are short-term in nature, to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our food production plants and several contracts to purchase energy to be used in our stores and food production plants. Our obligations also include management fees for facilities operated by third parties and outside service contracts. Any upfront vendor allowances or incentives associated with outstanding purchase commitments are recorded as either current or long-term liabilities in our Consolidated Balance Sheets. As of February 2, 2019, we maintained a $2.75 billion (with the ability to increase by $1 billion), unsecured revolving credit facility that, unless extended, terminates on August 29, 2022. Outstanding borrowings under the credit facility, the commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit facility. As of February 2, 2019, we had $800 million of outstanding commercial paper and no borrowings under our revolving credit facility. The outstanding letters of credit that reduce funds available under our credit facility totaled $3 million as of February 2, 2019. In addition to the available credit mentioned above, as of February 2, 2019, we had authorized for issuance $1.3 billion of securities remaining under a shelf registration statement filed with the SEC and effective on December 14, 2016. We also maintain surety bonds related primarily to our self-insured workers’ compensation claims. These bonds are required by most states in which we are self-insured for workers’ compensation and are placed with predominately third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of ours, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility. We also are contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. We could be required to satisfy obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of our assignments among third parties, and various other remedies available to us, we believe the likelihood that we will be required to assume a material amount of these obligations is remote. We have agreed to indemnify certain third-party logistics operators for certain expenses, including multi-employer pension plan obligations and withdrawal liabilities. In addition to the above, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third party claims arising out of agreements to provide services to us; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability. OUTLOOK This discussion and analysis contains certain forward-looking statements about our future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available to it. Such statements are indicated by words such as “achieve,” “affect,” “believe,” “committed,” “continue,” “could,” “effect,” “estimate,” “expects,” “future,” “growth,” “intends,” “likely,” “may,” “plan,” “range,” “result,” “strategy,” “strong,” “trend,” “vision,” “will, and “would,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially. Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially. · We are targeting identical sales growth, excluding fuel, to range from 2.0% to 2.25% in 2019. · We expect net earnings to range from $2.15 to $2.25 per diluted share for 2019. · We expect FIFO operating profit to range from $2.9 billion to $3.0 billion for 2019. · We expect capital investments, excluding mergers, acquisitions, and purchases of leased facilities, to range between $3.0 and $3.2 billion in 2019. · We expect our 2019 tax rate to be approximately 22%. · We expect a higher weighted average interest rate in 2019 which may contribute to increased interest expense. Various uncertainties and other factors could cause actual results to differ materially from those contained in the forward-looking statements. These include: · The extent to which our sources of liquidity are sufficient to meet our requirements may be affected by the state of the financial markets and the effect that such condition has on our ability to issue commercial paper at acceptable rates. Our ability to borrow under our committed lines of credit, including our bank credit facilities, could be impaired if one or more of our lenders under those lines is unwilling or unable to honor its contractual obligation to lend to us, or in the event that natural disasters or weather conditions interfere with the ability of our lenders to lend to us. Our ability to refinance maturing debt may be affected by the state of the financial markets.  · Our ability to achieve sales, earnings, incremental FIFO operating profit, and free cash flow goals may be affected by: labor negotiations or disputes; changes in the types and numbers of businesses that compete with us; pricing and promotional activities of existing and new competitors, including non-traditional competitors, and the aggressiveness of that competition; Our response to these actions; the state of the economy, including interest rates, the inflationary and deflationary trends in certain commodities, changes in tariffs, and the unemployment rate; the effect that fuel costs have on consumer spending; volatility of fuel margins; changes in government-funded benefit programs; manufacturing commodity costs; diesel fuel costs related to our logistics operations; trends in consumer spending; the extent to which our customers exercise caution in their purchasing in response to economic conditions; the uncertain pace of economic growth; changes in inflation or deflation in product and operating costs; stock repurchases; our ability to retain pharmacy sales from third party payors; consolidation in the healthcare industry, including pharmacy benefit managers; our ability to negotiate modifications to multi-employer pension plans; natural disasters or adverse weather conditions; the potential costs and risks associated with potential cyber-attacks or data security breaches; the success of our future growth plans; the ability to execute on Restock Kroger; and the successful integration of merged companies and new partnerships. · Our ability to achieve these goals may also be affected by our ability to manage the factors identified above. Our ability to execute our financial strategy may be affected by our ability to generate cash flow.  · Our effective tax rate may differ from the expected rate due to changes in laws, the status of pending items with various taxing authorities, and the deductibility of certain expenses. We cannot fully foresee the effects of changes in economic conditions on our business. We have assumed economic and competitive situations will not change significantly in 2019. Other factors and assumptions not identified above, including those discussed in Item 1A of this Report, could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in, contemplated or implied by forward-looking statements made by us or our representatives. We undertake no obligation to update the forward-looking information contained in this filing.

<s>[INST] OUR BUSINESS The Kroger Co. was founded in 1883 and incorporated in 1902. As of February 2, 2019, Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,764 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,270 have pharmacies and 1,537 have fuel centers. We offer Pickup (also referred to as ClickList®) and Harris Teeter ExpressLane™ personalized, order online, pick up at the store services at 1,581 of our supermarkets and provide home delivery service to 91% of Kroger households. We also operate an online retailer. We operate 37 food production plants, primarily bakeries and dairies, which supply approximately 32% of Our Brands units and 43% of the grocery category Our Brands units sold in our supermarkets; the remaining Our Brands items are produced to our strict specifications by outside manufacturers. Our revenues are predominately earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent 97% of our consolidated sales, is our only reportable segment. On June 22, 2018, we closed our merger with Home Chef by purchasing 100% of the ownership interest in Home Chef, for $197 million net of cash and cash equivalents of $30 million, in addition to future earnout payments of up to $500 million over five years that are contingent on achieving certain milestones. Home Chef is included in our ending Consolidated Balance Sheet for 2018 and in our Consolidated Statements of Operations from June 22, 2018 through February 2, 2019. On April 20, 2018, we completed the sale of our convenience store business unit for $2.2 billion. The convenience store business is included in our ending Consolidated Balance Sheet for 2017 and in our Consolidated Statements of Operations in all periods in 2016 and 2017 and through April 19, 2018. On September 2, 2016, we closed our merger with Modern HC Holdings, Inc. (“ModernHEALTH”) by purchasing 100% of the outstanding shares of ModernHEALTH for $407 million. ModernHEALTH is included in our ending Consolidated Balance Sheet for 2016, 2017 and 2018 and in our Consolidated Statements of Operations from September 2, 2016 through January 28, 2017 and all periods in 2017 and 2018. See Note 2 to the Consolidated Financial Statements for more information related to our mergers with Home Chef and ModernHEALTH. USE OF NONGAAP FINANCIAL MEASURES The accompanying Consolidated Financial Statements, including the related notes, are presented in accordance with generally accepted accounting principles (“GAAP”). We provide nonGAAP measures, including FirstIn, FirstOut (“FIFO”) gross margin, FIFO operating profit, adjusted operating net earnings, adjusted operating net earnings per diluted share and Restock cash flow because management believes these metrics are useful to investors and analysts. These nonGAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings, net earnings per diluted share and net cash provided or used by operating or investing activities or any other GAAP measure of performance. These measures should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. We calculate FIFO gross margin as FIFO gross profit divided by sales [/INST] Negative. </s>

HCP, INC.

2015-02-10

2014-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: · 2014 Transaction Overview · Dividends · Results of Operations · Liquidity and Capital Resources · Non-GAAP Financial Measures-FFO and FAD · Off-Balance Sheet Arrangements · Contractual Obligations · Inflation · Critical Accounting Policies · Recent Accounting Pronouncements 2014 Transaction Overview Investment Transactions In 2014 we completed $2.1 billion of investment transactions, including $777 million (£483 million) in debt and real estate in the United Kingdom (“U.K.”) and $588 million for our 49% interest in the industry’s largest CCRC joint venture, which transactions are further described below: Brookdale Lease Amendments and Terminations and the Formation of Two RIDEA Joint Ventures (“Brookdale Transaction”) On August 29, 2014, HCP and Brookdale, through a Master Contribution and Transactions Agreement, closed a multiple-element transaction that has three major components: · formed new unconsolidated joint ventures that collectively own 14 campuses of continuing care retirement communities (the “CCRC JV”). At closing, Brookdale contributed eight of its owned campuses; we contributed two campuses previously leased to Brookdale and cash used to acquire four additional campuses from third parties. HCP and Brookdale own 49% and 51%, respectively, of the CCRC JV, and Brookdale manages these communities; · amended existing lease agreements on 153 HCP-owned senior housing communities, including the termination of embedded tenant purchase options relating to 30 properties and future rent reductions; and · terminated existing lease agreements on 49 HCP-owned senior housing properties, including the termination of embedded tenant purchase options relating to 19 properties. At closing, we contributed 48 of these properties to a newly formed RIDEA partnerships (the “RIDEA Subsidiaries”); the 49th property was contributed on January 1, 2015. Brookdale owns a 20% noncontrolling equity interest in the RIDEA Subsidiaries and manages the facilities on behalf of the partnership. £395 Million Debt Investment in U.K. Care Home Portfolio In November 2014, we were the lead investor in the financing for Formation Capital and Safanad’s acquisition of NHP, a company that, at closing, owned 273 nursing and residential care homes representing over 12,500 beds in the U.K. principally operated by HC-One. We provided a loan facility totaling $630 million (£395 million), secured by substantially all of NHP’s assets, with £363 million drawn at closing. Other Investment Transactions During the year ended December 31, 2014, we completed $634 million of additional investments and commitments in 34 properties across our senior housing, life science and medical office segments, including $147 million (£88 million) for 23 care homes in the U.K. Additionally, we funded $287 million for construction and other capital projects, primarily in our life science, medical office and senior housing segments. Financing Activities We raised $2.1 billion of debt in 2014 and through January 2015, including the following transactions: · On January 21, 2015, we issued $600 million of 3.4% senior unsecured notes due 2025. The notes were priced at 99.185% of the principal amount with a yield-to-maturity of 3.497%. · On January 12, 2015, we completed a $333 million (£220 million) four-year unsecured term loan that accrues interest at a rate of GBP LIBOR plus 0.975%, subject to adjustments based on our credit ratings. Concurrently, we entered into a three-year interest rate swap agreement that effectively fixes the rate of the term loan at 1.79%. · On August 14, 2014, we issued $800 million of 3.875% senior unsecured notes due 2024. The notes were priced at 99.63% of the principal amount with an effective yield-to-maturity of 3.92%. · On February 12, 2014, we issued $350 million of 4.2% senior unsecured notes due 2024. The notes were priced at 99.537% of the principal amount with an effective yield-to-maturity of 4.257%. On March 31, 2014, we amended our unsecured revolving credit facility and increased it by $500 million to $2 billion. The amended facility reduces our funded interest cost by 17.5 basis points and extends the maturity date to March 31, 2018. Based on our current credit ratings, the amended facility bears interest annually at LIBOR plus 92.5 basis points and has a facility fee of 15.0 basis points. Other terms of the amended facility were substantially unchanged, including a one-year extension option at our discretion, and the ability to increase the commitments by an aggregate amount of up to $500 million, subject to customary conditions. During the year ended December 31, 2014, we repaid $911 million of aggregate senior unsecured notes and mortgage debt with a weighted average interest rate of 4.33%. Dividends Quarterly dividends paid during 2014 aggregated $2.18 per share, which represents a 3.8% increase from 2013. On January 29, 2015, our Board of Directors declared a quarterly cash dividend of $0.565 per common share. The annualized distribution rate per share for 2015 increased 3.7% to $2.26, compared to $2.18 for 2014. The dividend will be paid on February 24, 2015 to stockholders of record as of the close of business on February 9, 2015. Results of Operations We evaluate our business and allocate resources among our five business segments: (i) senior housing, (ii) post-acute/skilled nursing, (iii) life science, (iv) medical office and (v) hospital. Under the medical office segment, we invest through the acquisition and development of MOBs, which generally require a greater level of property management. Otherwise, we primarily invest, through the acquisition and development of real estate, in single tenants and operators occupied properties and debt issued by tenants and operators in these sectors. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 2 to the Consolidated Financial Statements). Non-GAAP Financial Measures Same Property Portfolio Our evaluation of results of operations by each business segment includes an analysis of NOI and adjusted NOI of our Same Property Portfolio (“SPP”) and our total property portfolio. We believe NOI provides relevant and useful information because it reflects only income and operating expense items that are incurred at the property level and presents them on an unleveraged basis. We use NOI and adjusted NOI to make decisions about resource allocations and to assess and compare property level performance. SPP NOI and adjusted NOI information allows us to evaluate the performance of our property portfolio under a consistent population by eliminating changes in the composition of our portfolio of properties. We identify our SPP as stabilized properties that remained in operations and were consistently reported as leased properties or RIDEA properties for the duration of the year-over-year comparison periods presented. Accordingly, it takes a stabilized property a minimum of 12 months in operations under a consistent reporting structure to be included in our SPP. Newly acquired operating assets are generally considered stabilized at the earlier of lease-up (typically when the tenant(s) controls the physical use of at least 80% of the space) or 12 months from the acquisition date. Newly completed developments and redevelopments, are considered stabilized at the earlier of lease-up or 24 months from the date the property is placed in service. SPP NOI excludes certain non-property specific operating expenses that are allocated to each operating segment on a consolidated basis. A property is removed from our SPP when it is sold or placed into redevelopment. NOI and adjusted NOI are non-GAAP supplemental financial measures; for a reconciliation of net income to NOI and adjusted NOI and other relevant disclosure, refer to Note 14 to the Consolidated Financial Statements. Operating expenses generally relate to leased medical office and life science properties and senior housing RIDEA properties. We generally recover all or a portion of our leased medical office and life science property expenses through tenant recoveries. We present expenses as operating or general and administrative based on the underlying nature of the expense. Periodically, we review the classification of expenses between categories and make revisions based on changes in the underlying nature of the expenses. Funds From Operations We believe FFO applicable to common shares, diluted FFO applicable to common shares, and diluted FFO per common share are important supplemental non-GAAP measures of operating performance for a REIT. Because the historical cost accounting convention used for real estate assets utilizes straight-line depreciation (except on land), such accounting presentation implies that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen and fallen with market conditions, presentations of operating results for a REIT that use historical cost accounting for depreciation could be less informative. The term FFO was designed by the REIT industry to address this issue. FFO as defined by the National Association of Real Estate Investment Trusts (“NAREIT”) is net income applicable to common shares (computed in accordance with GAAP), excluding gains or losses from sales of property, impairments of, or related to, depreciable real estate, plus real estate and DFL depreciation and amortization, and after adjustments for joint ventures. Adjustments for joint ventures are calculated to reflect FFO on the same basis. FFO does not represent cash generated from operating activities in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income. We compute FFO in accordance with the current NAREIT definition; however, other REITs may report FFO differently or have a different interpretation of the current NAREIT definition from ours. In addition, we present FFO before the impact of severance-related charges, litigation settlement charges, preferred stock redemption charges, impairments (recoveries) of non-depreciable assets and transaction-related items (defined below) (“FFO as adjusted”). Transaction-related items include acquisition and pursuit costs (e.g., due diligence and closing) and gains/charges incurred as a result of mergers and acquisitions and lease amendment or termination activities. Management believes that FFO as adjusted provides a meaningful supplemental measurement of our FFO run-rate. This measure is a modification of the NAREIT definition of FFO and should not be used as an alternative to net income (determined in accordance with GAAP) or NAREIT FFO. Funds Available for Distribution FAD is defined as FFO as adjusted after excluding the impact of the following: (i) amortization of acquired market lease intangibles, net; (ii) amortization of deferred compensation expense; (iii) amortization of deferred financing costs, net; (iv) straight-line rents; (v) accretion and depreciation related to DFLs; and (vi) deferred revenues, effective 2014, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents. Also, FAD is: (i) computed after deducting recurring capital expenditures, including leasing costs and second generation tenant and capital improvements; and (ii) includes lease restructure payments and adjustments to compute our share of FAD from our unconsolidated joint ventures and those related to CCRC non-refundable entrance fees. Other REITs or real estate companies may use different methodologies for calculating FAD, and accordingly, our FAD may not be comparable to those reported by other REITs. Although our FAD computation may not be comparable to that of other REITs, management believes FAD provides a meaningful supplemental measure of our ability to fund our ongoing dividend payments. In addition, management believes that in order to further understand and analyze our liquidity, FAD should not be compared with net cash flows from operating activities as determined in accordance with GAAP and presented in our consolidated financial statements. FAD does not represent cash generated from operating activities determined in accordance with GAAP, and FAD should not be considered as an alternative to net income (determined in accordance with GAAP) as an indication of our performance, as an alternative to net cash flows from operating activities (determined in accordance with GAAP), or as a measure of our liquidity. Net Operating Income (“NOI”) NOI and adjusted NOI are non-GAAP supplemental financial measures used to evaluate the operating performance of real estate. NOI is defined as rental and related revenues, including tenant recoveries, resident fees and services, and income from DFLs, less property level operating expense; NOI excludes all other financial statement amounts included in net income as presented in Note14 to the Consolidated Financial Statements. Management believes NOI provides relevant and useful information because it reflects only income and operating expense items that are incurred at the property level and presents them on an unleveraged basis. Adjusted NOI is calculated as NOI after eliminating the effects of straight-line rents, DFL accretion, amortization of market lease intangibles and lease termination fees. Adjusted NOI is oftentimes referred to as “cash NOI.” We use NOI and adjusted NOI to make decisions about resource allocations and to assess and compare property level performance. We believe that net income is the most directly comparable GAAP measure to NOI. NOI should not be viewed as an alternative measure of operating performance to net income as defined by GAAP because it does not reflect various excluded items. Further, our definition of NOI may not be comparable to the definition used by other REITs or real estate companies, as those companies may use different methodologies for calculating NOI. Comparison of the Year Ended December 31, 2014 to the Year Ended December 31, 2013 Overview(1) Results are for the years ended December 31, 2014 and 2013 (dollars in thousands except per share data): (1) For the reconciliation, see “Non-GAAP Financial Measures-FFO and FAD” section beginning on page 56. FFO increased $0.05 per share primarily as a result of: (i) net gains from the Brookdale Transaction, (ii) increased NOI from our SPP and our 2013 and 2014 acquisitions, and (iii) a general and administrative charge in 2013 resulting from the termination of our former chief executive officer. The aforementioned were partially offset by: (i) an impairment charge in 2014 for our equity ownership investment in HCRMC and (ii) favorable one-time items including interest income in 2013 from the par payoff of our Barchester debt investments and sale of marketable equity securities. FFO as adjusted and FAD increased $0.02 and $0.03 per share, respectively, primarily as a result of increased NOI from our SPP and 2013 and 2014 acquisitions, which were partially offset by favorable one-time items including interest income in 2013 from the par payoff of our Barchester debt investments and sale of marketable equity securities. Earnings per share ("EPS") decreased $0.13 per share primarily as a result of: (i) decreased gain on sales of real estate and (ii) increased depreciation expense, partially offset by the net result of the aforementioned events impacting FFO. Segment NOI and Adjusted NOI The tables below provide selected operating information for our SPP and total property portfolio for each of our five business segments. Our consolidated SPP consists of 1,011 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2013 and that remained in operations under a consistent reporting structure through December 31, 2014. Our consolidated total property portfolio represents 1,108 and 1,079 properties at December 31, 2014 and 2013, respectively, and excludes properties classified as discontinued operations. Senior Housing As part of the previously described Brookdale Transaction, we contributed 49 properties (one property was contributed on January 1, 2015) that were triple-net leased into a RIDEA structure, with Brookdale managing the communities and acquiring a 20% equity interest in the RIDEA partnerships. For the 49 properties in the RIDEA partnerships, we report the resident-level revenues and corresponding operating expenses in our consolidated financial statements rather than the pre-transaction triple-net rents. In future periods, we expect increases in resident fee and service revenue and operating expenses and a decrease in rental and related revenues. Additionally, we created the CCRC JV, which is managed by Brookdale. In future periods, we expect to record our share of income from unconsolidated joint ventures; also, as a result of deconsolidating three senior housing properties that were contributed to the CCRC JV, we expect a decrease in rental and related revenues and depreciation expense. See information regarding the Brookdale Transaction in Note 3 to the Consolidated Financial Statements. Results are as of and for the years ended December 31, 2014 and 2013 (dollars in thousands except per unit data): (1) From our 2013 presentation of SPP, we removed one senior housing property that was sold and 51 senior housing properties that were contributed to partnerships under a RIDEA structure as part of the Brookdale Transaction and no longer meet our criteria for SPP upon contribution. (2) Represents rental and related revenues and income from DFLs. (3) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. (4) Average annual rent per unit for operating properties under a RIDEA structure is based on NOI. SPP NOI and Adjusted NOI. SPP NOI increased primarily from improved performance from RIDEA properties; SPP adjusted NOI improved as a result of annual rent increases and improved performance from RIDEA properties. Total Portfolio NOI and Adjusted NOI. In addition to the impact of our SPP, our total portfolio NOI increased as a result of recognizing net fees of $38 million from the Brookdale Transaction (see Note 3 to the Consolidated Financial Statements). Our total portfolio NOI and adjusted NOI also increased as a result of our senior housing acquisitions in 2014 and 2013. Post-Acute/Skilled Nursing Results are as of and for the years ended December 31, 2014 and 2013 (dollars in thousands, except per bed data): (1) From our 2013 presentation of SPP, we removed a post-acute/skilled nursing property that was sold. (2) Represents rental and related revenues and income from DFLs. (3) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. NOI and Adjusted NOI. SPP and total portfolio NOI and adjusted NOI increased primarily as a result of annual rent escalations from our HCRMC DFL investments. HCRMC equity method and DFL investments. On December 19, 2014, we concluded that our 9.4% equity ownership interest in HCRMC was other-than-temporarily impaired, and we recorded an impairment charge of $36 million, or $0.08 per diluted share, in the fourth quarter of 2014; the impairment charge reduced the carrying amount of our equity investment in HCRMC to $39 million. We made this conclusion principally based on the receipt and review of HCRMC’s preliminary base financial forecast for 2015, together with HCRMC’s year-to-date operating results through November 2014. HCRMC’s preliminary base financial forecast and operating results primarily reflected a continued shift in patient payor sources from Medicare to Medicare Advantage, which negatively impacts reimbursement rates and length of stay for HCRMC’s skilled nursing segment. HCRMC has indicated that its 2015 preliminary base financial forecast does not include the effect of any dispositions, acquisitions or other initiatives HCRMC may undertake to improve financial performance in 2015. We believe that HCRMC’s trailing Twelve-month Fixed Charge Coverage (“TFCC”) ratio may continue to deteriorate over the next several quarters. HCRMC’s 2015 preliminary base financial forecast implies that the TFCC ratio is projected to decline to 1.07x at the end of 2015, compared to the TFCC ratio of 1.08x at the end of 2014, before the impact of $24 million of certain general and professional liability charges that HCRMC incurred in the second quarter of 2014. As noted above, the TFCC ratio is calculated using HCRMC’s 2015 preliminary base financial forecast that does not include the effects of any dispositions, acquisitions or other initiatives HCRMC may undertake to improve financial performance in 2015. Notwithstanding these developments, HCRMC’s 2015 preliminary base financial forecast also indicates that HCRMC will continue to meet its contractual obligations to us under a master lease (the “Master Lease”). Therefore, we continue to believe that the collection and timing of all amounts owed by HCRMC under our Master Lease are reasonably assured. HCRMC believes that it is favorably positioned to grow as part of the ongoing changes in the healthcare environment. Based on discussions with the management of HCRMC and our evaluation of other industry data, we note the following factors that influenced our evaluation of HCRMC: (i) Medicare rate increases of 1.7% and 1.4% took effect on October 1, 2014 for the skilled nursing and hospice businesses, respectively; (ii) additional cost cutting measures were implemented in the fourth quarter of 2014; (iii) new facility developments and expansions will be operational in 2015; (iv) assisted living and hospice operations demonstrated continued growth; (v) HCP and HCR ManorCare have jointly agreed to market for sale certain non-strategic assets that are under the master lease; the purpose of the dispositions is to increase EBITDAR, reduce rent and improve HCRMC’s TFCC; however, no assurances can be given that the facilities will be sold or as to the timing of the sales; and (vi) hospital admissions are forecasted to improve in 2015. While we remain confident in HCRMC’s ongoing adjustments to their business model, HCRMC has not been able to reverse the decline in their financial performance. Failure of HCRMC to reverse the decline in its financial performance may lead us to conclude that the collection and timing of contractual obligations, or a portion thereof, under the Master Lease may not be reasonably assured; in which case, we would place the HCRMC DFL, or a portion thereof, on nonaccrual status. If we further determine that it is probable that we will not be able to collect all amounts due under the terms of the Master Lease, we may incur an impairment on our HCRMC DFL, or a portion thereof. Life Science Results are as of and for the years ended December 31, 2014 and 2013 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) From our 2013 presentation of SPP, we removed three life science facilities that were placed into land held for development and a life science facility that was placed into redevelopment in 2014, which no longer meet our criteria for SPP as of the date placed into development. SPP NOI and Adjusted NOI. SPP NOI and adjusted NOI increased as a result of increased average occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI. In addition to the impact of our SPP, our total portfolio NOI and adjusted NOI increased primarily as a result of the impact of our life science development projects placed in service during 2014 and 2013. During the year ended December 31, 2014, 1.5 million square feet of new and renewal leases commenced at an average annual base rent of $30.40 per square foot compared to 1.1 million square feet of expiring leases with an average annual base rent of $30.83 per square foot. During the year ended December 31, 2014, we acquired a fully-occupied 83,000 square foot building with an average annual base rent of $33.87 per square foot. Medical Office Results are as of and for the years ended December 31, 2014 and 2013 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) From our 2013 presentation of SPP, we removed a MOB that was sold. SPP NOI and Adjusted NOI. SPP NOI and adjusted NOI increased primarily as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI. In addition to the impact of our SPP, our total portfolio NOI and adjusted NOI increased primarily as a result of our medical office acquisitions in 2014. During the year ended December 31, 2014, 2.6 million square feet of new and renewal leases commenced at an average annual base rent of $23.15 per square foot compared to 2.6 million square feet of expiring and terminated leases with an average annual base rent of $25.06 per square foot. During the year ended December 31, 2014, we acquired six MOBs with 953,000 occupied square feet that have average annual base rent of $25.00 per square foot. Hospital Results are as of and for the years ended December 31, 2014 and 2013 (dollars in thousands, except per bed data): (1) Represents rental and related revenues and income from DFLs. (2) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. Certain operators in our hospital portfolio are not required under their respective leases to provide operational data. NOI and Adjusted NOI. SPP and total portfolio NOI increased primarily due to a net $12 million correction in 2013 that reduced previously recognized non-cash revenues including straight-line rents and accelerated amortization of below market lease intangibles related to our Medical City Dallas hospital. SPP and total portfolio adjusted NOI increased primarily as a result of annual rent escalations. Other Income and Expense Items Interest income. Interest income decreased $12 million to $74 million for the year ended December 31, 2014. The decrease was primarily the result of the repayment of our Barchester loan in September 2013, partially offset by interest earned from the June 2013 funding under the Tandem Health Care mezzanine loan facility and the November 2014 U.K. debt investment (see Note 7 to the Consolidated Financial Statements). Interest expense. For the year ended December 31, 2014, interest expense increased $4 million to $440 million. The increase was primarily the result of net increase in indebtedness as presented below. The table below sets forth information with respect to our debt, excluding premiums and discounts (dollars in thousands): (1) At December 31, 2014, excludes $97 million of other debt that represents non-interest bearing life care bonds and occupancy fee deposits at certain of our senior housing facilities and demand notes that have no scheduled maturities. At December 31, 2013, excludes $75 million of other debt that represents non-interest bearing life care bonds and occupancy fee deposits at certain of our senior housing facilities. At December 31, 2014 and 2013, $71 million and $72 million of variable-rate mortgages, respectively, and a £137 million ($214 million and $227 million, respectively) term loan are presented as fixed-rate debt as the interest payments were swapped from variable to fixed. Our exposure to expense fluctuations related to our variable rate indebtedness is mitigated by our interest rate swap contracts. For a more detailed discussion of our interest rate risk, see

<s>[INST] · 2014 Transaction Overview · Dividends · Results of Operations · Liquidity and Capital Resources · NonGAAP Financial MeasuresFFO and FAD · OffBalance Sheet Arrangements · Contractual Obligations · Inflation · Critical Accounting Policies · Recent Accounting Pronouncements 2014 Transaction Overview Investment Transactions In 2014 we completed $2.1 billion of investment transactions, including $777 million (£483 million) in debt and real estate in the United Kingdom (“U.K.”) and $588 million for our 49% interest in the industry’s largest CCRC joint venture, which transactions are further described below: Brookdale Lease Amendments and Terminations and the Formation of Two RIDEA Joint Ventures (“Brookdale Transaction”) On August 29, 2014, HCP and Brookdale, through a Master Contribution and Transactions Agreement, closed a multipleelement transaction that has three major components: · formed new unconsolidated joint ventures that collectively own 14 campuses of continuing care retirement communities (the “CCRC JV”). At closing, Brookdale contributed eight of its owned campuses; we contributed two campuses previously leased to Brookdale and cash used to acquire four additional campuses from third parties. HCP and Brookdale own 49% and 51%, respectively, of the CCRC JV, and Brookdale manages these communities; · amended existing lease agreements on 153 HCPowned senior housing communities, including the termination of embedded tenant purchase options relating to 30 properties and future rent reductions; and · terminated existing lease agreements on 49 HCPowned senior housing properties, including the termination of embedded tenant purchase options relating to 19 properties. At closing, we contributed 48 of these properties to a newly formed RIDEA partnerships (the “RIDEA Subsidiaries”); the 49th property was contributed on January 1, 2015. Brookdale owns a 20% noncontrolling equity interest in the RIDEA Subsidiaries and manages the facilities on behalf of the partnership. £395 Million Debt Investment in U.K. Care Home Portfolio In November 2014, we were the lead investor in the financing for Formation Capital and Safanad’s acquisition of NHP, a company that, at closing, owned 273 nursing and residential care homes representing over 12,500 beds in the U.K. principally operated by HCOne. We provided a loan facility totaling $630 million (£395 million), secured by substantially all of NHP’s assets, with £363 million drawn at closing. Other Investment Transactions During the year ended December 31, 2014, we completed $634 million of additional investments and commitments in 34 properties across our senior housing, life science and medical office segments, including $147 million (£88 million) for 23 care homes in the U.K. Additionally, we funded $287 million for construction and other capital projects, primarily in our life science, medical office and senior housing segments. Financing Activities We raised $2.1 billion of debt in 2014 and through January 2015, including the following transactions: · On January 21, 2015, we issued $600 million of 3.4% senior unsecured notes due 2025. The notes were priced at 99.185% of the principal amount with a yieldtomaturity of 3.497%. · On January 12, 2015, we completed a $333 million (£220 million) fouryear unsecured term loan that accrues interest at a rate of GBP LIBOR plus 0.975%, subject to adjustments based on our credit ratings. Concurrently, we entered into a threeyear interest rate swap agreement that effectively fixes the rate of the term loan at 1.79 [/INST] Negative. </s>

HCP, INC.

2016-02-09

2015-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: · 2015 Transaction Overview · Dividends · Results of Operations · Liquidity and Capital Resources · Contractual Obligations · Off-Balance Sheet Arrangements · Inflation · Non-GAAP Financial Measures Reconciliations · Critical Accounting Policies · Recent Accounting Pronouncements 2015 Transaction Overview HCR ManorCare, Inc. HCRMC Fourth Quarter 2015 The post-acute/skilled nursing (“SNF”) industry and HCRMC continued to experience a challenging operating environment in 2015, due to the ongoing change in reimbursement models which reduces rates and lowers census, the result of shorter lengths of stay. HCRMC’s normalized fixed charge coverage for the 12-month period ended December 31, 2015 was 1.07x. For the fourth quarter 2015, HCRMC reported normalized EBITDAR of $110 million, which decreased $36 million on a year-over-year basis compared to the fourth quarter 2014, and decreased $17 million sequentially compared to the third quarter 2015. The results were impacted by core operating performance weakness and unfavorable non-routine items discussed below. The level of performance was below expectations and uncharacteristic for the fourth quarter, which has historically been strong due in large part to increased census and the annual Medicare rate increases on October 1. HCRMC ended 2015 with $125 million of cash and cash equivalents and continues to be current on its obligations under the amended master lease (the “Amended Master Lease”). Core Operating Performance. Before the impact from non-routine items described below, HCRMC’s fourth quarter EBITDAR was below its forecast, primarily due to the continued change in payor mix from traditional Medicare to Managed Care plans, which reduced reimbursement rates and lowered census. As a result, HCRMC reported a decline in its core SNF operating metrics (which excludes the 50 non-strategic disposition assets), with fourth quarter census decreasing 175 basis points from the prior year to 82.6%. Non-Routine Items. As discussed below, HCRMC is in the process of exiting 50 non-strategic assets, of which 21 sales were completed in the fourth quarter and an additional 11 closed in the first quarter 2016. As such, disruption resulting from transitioning operations to new owners and closing costs led to additional underperformance from this pool of assets. EBITDAR losses from the sale of non-strategic assets totaled $11 million in the fourth quarter 2015, and $22 million for full year 2015. HCP continues to expect total proceeds of $350 million from the sales of the non-strategic assets, of which $280 million have closed to-date with the remaining $70 million expected to close in mid-2016. In addition, HCRMC continues to defend against the DOJ civil complaint previously disclosed in April 2015. HCRMC incurred legal and regulatory defense costs of $3 million during the fourth quarter 2015 and $9 million for the full year 2015. The outcome of the DOJ civil complaint remains uncertain, and HCRMC expects to incur additional legal and regulatory defense costs in 2016. As a result of HCRMC’s fourth quarter performance deterioration and the related decline in its FCC, we placed our real estate portfolio operated by HCRMC on “Watch List” status at year end 2015, and changed our accounting treatment to recognize rental income on a cash basis beginning January 2016. As such, we will no longer recognize non-cash accretion income under the HCRMC DFLs (see Note 2 to the Consolidated Financial Statements). The reduced growth outlook for the broader post-acute/SNF industry indicates challenges to the improvement in HCRMC’s financial performance over the next few years. At year end 2015, the Company determined that it is probable that its HCRMC DFL investments are impaired and the amount of the loss can be reasonably estimated. In the fourth quarter 2015, the Company recorded an allowance (impairment charge) for DFL losses of $817 million, reducing the carrying amount of its HCRMC DFL investments from $6.0 billion to $5.2 billion (see Notes 6 and 17 to the Consolidated Financial Statements). We also recorded a fourth quarter 2015 impairment charge of $19 million related to our equity investment in HCRMC OpCo (see Note 8 to the Consolidated Financial Statements). HCP has engaged advisors and continues to work closely with HCRMC to jointly explore all opportunities that reduce our concentration, improve the credit quality and coverage of our Amended Master Lease, and ensure HCRMC can continue to deliver high quality care and services. HCRMC Third Quarter 2015 In October 2015, we concluded that our equity investment in HCRMC was other-than-temporarily impaired as of September 30, 2015, and we recorded an impairment charge of $27 million during the third quarter of 2015. The impairment charge reduced the carrying amount of our equity investment in HCRMC to $21 million. Our impairment determination primarily resulted from our review of HCRMC operating results and market and industry data which, among other factors, showed a declining trend in admissions from hospitals and continuing trends in mix and length of stay driven by Medicare Advantage and other Manage Care plans. HCRMC First Quarter 2015 During the quarter ended March 31, 2015, HCP and HCRMC agreed to market for sale the real estate and operations associated with 50 non-strategic facilities that were under the Master Lease and Security Agreement (the “Master Lease”) for an estimated total gross sales price of approximately $350 million. HCRMC receives annual rent reduction under the Master Lease based on 7.75% of the net sales proceeds received by HCP. During the year ended December 31, 2015, we completed sales of 22 non-strategic HCRMC facilities for $219 million. Through February 8, 2016, 33 of the facility sales have closed, and the remaining facility sales are expected to close mid-2016. Additionally, HCP and HCRMC agreed to amend the Master Lease (the “HCRMC Lease Amendment”). Commencing April 1, 2015, HCP provided an annual net rent reduction of $68 million, which equates to initial lease year rent of $473 million, compared to $541 million that would have commenced April 1, 2015 prior to the HCRMC Lease Amendment. The contractual rent will increase by 3.0% annually during the initial term. In exchange, HCP received the following consideration: · Fee ownership in nine post-acute facilities valued at $275 million with a median age of four years, owned and operated by HCRMC. HCP retained a lease receivable of equal value, earning income of $19 million annually (included in the amended initial lease year rent of $473 million above), which will be reduced as the facility purchases are completed. Following the purchase of a facility, HCRMC will lease such facility from HCP pursuant to the Amended Master Lease. The nine facilities will contribute an aggregate of $19 million of annual rent (subject to escalation) under the Amended Master Lease. During the year ended December 31, 2015 and through February 8, 2016, HCRMC and HCP completed seven of the nine facility purchases for $184 million. The purchases of the remaining two facilities are expected to close mid-2016, subject to customary licensing and regulatory approvals; · A second lease receivable with an initial amount of $250 million, payable by HCRMC upon the earlier of: (i) the end of the initial term of the first renewal pool under the Amended Master Lease; or (ii) certain capital or liquidity events of HCRMC, including an initial public offering or sale. The $250 million lease receivable amount will increase each year as follows: 3.0% in April 2016 through 2018, 4.0% in 2019, 5.0% in 2020 and 6.0% in 2021 until the end of the initial lease term; and · Extension of the initial lease term by five years, to an average of 16 years. In March 2015, we recorded a non-cash impairment charge of $478 million related to our HCRMC DFL investments. The non-cash charge reduced the carrying value of the HCRMC DFL investments from $6.6 billion to $6.1 billion, which represented the present value of the future lease payments under the Amended Master Lease. The impairment determination resulted from discussions with HCRMC in which they expressed an increasing desire to reduce rent in consideration of potential economic trades to HCP prior to the April 1, 2015 rental increase of 3.5% under the Master Lease (without regard to the HCRMC Lease Amendment). See Note 6 to the Consolidated Financial Statements for additional discussion of the HCRMC Lease Amendment and impairment of our HCRMC DFL investments, Note 8 to the Consolidated Financial Statements for additional discussion regarding our equity interest in HCRMC and the DOJ complaint against HCRMC, and Note 17 to the Consolidated Financial Statements for additional discussion regarding the impairments, which information is incorporated by reference herein. Investment Transactions Acquisition of Private Pay Senior Housing Portfolio On June 30, 2015, HCP acquired a portfolio of 35 private pay senior housing communities from Chartwell Retirement Residences, including two leasehold interests, representing 5,025 units for $847 million. The portfolio was acquired in a RIDEA structure (RIDEA III), with Brookdale owning a 10% noncontrolling interest. Brookdale has operated these communities since 2011, and continues to manage the communities under a long-term management agreement. The Cove Development In February 2015, we began construction on the first phase, $184 million (estimated total investment), of The Cove at Oyster Point (“The Cove”), a life science development in South San Francisco, California. The first phase includes two “class A” buildings totaling 247,000 square feet that are expected to be completed in the third quarter of 2016. Edgewater Business Park In December 2015, we acquired a six-building lab campus, totaling 170,000 square feet in South San Francisco, California for $83 million. U.K. Investments In December 2015, we purchased £28 million ($42 million) of Four Seasons Health Care’s (“Four Seasons”) £40 million senior secured term loan. In September 2015, we amended and increased the commitment under our HC-One Facility by £11 million, primarily to fund a development project in the U.K. and other capital improvements. In May 2015, we provided a £27 million ($42 million) loan to fund Maria Mallaband Care Group’s (“Maria Mallaband”) acquisition of two care homes in the U.K. In July 2015, the loan was converted into fee ownership of the real estate at an equal value and the properties are triple-net leased to Maria Mallaband for an initial term of 15 years. In April 2015, we converted £174 million of our total £502 million HC-One Facility to fee ownership in a portfolio of 36 care homes subject to long-term triple-net leases that provide aggregate rent in the first year of £13 million. The contractual rent will increase annually by the Retail Price Index (“RPI”), with rent resets to fair market value at the end of lease years 15 and 25. The triple-net leases have initial terms of 30 years with lessee termination options at the end of lease years 15 and 25. In February 2015, we increased our U.K. HC-One debt investment (“HC-One Facility”) by £108 million ($164 million) to £502 million ($795 million) in conjunction with HC-One’s acquisition of Meridian Healthcare. At closing, the HC-One Facility was secured by 303 nursing and residential care homes representing over 13,900 beds in the U.K., primarily located in England and Scotland. Acquisitions of On-Campus Medical Office Buildings In June 2015, we expanded our relationship with Memorial Hermann Health System (“Memorial Hermann”) through the acquisition of a portfolio of 11 on-campus MOBs located in Houston, Texas in a sale-leaseback transaction for $225 million. Memorial Hermann, an ‘A rated’ health system, is the largest not-for-profit system in Southeast Texas and maintains the largest market share at 24% in the Houston metro area. The MOB portfolio, located on four campuses, has an aggregate 1.2 million rentable square feet and is subject to triple-net master leases with 10-year initial lease terms and four 5-year renewal terms. In October 2015, we issued a 49% noncontrolling interest in this portfolio (“HCP Ventures V”) for $110 million. In April 2015, we acquired a MOB in Philadelphia, Pennsylvania for $161 million. The MOB is anchored by Thomas Jefferson University Hospital, which is ranked second among best hospitals in the Philadelphia metropolitan area by U.S. News and is owned by ‘A rated’ Thomas Jefferson University. The MOB contains 705,000 rentable square feet and was 85% occupied at closing. MBK Joint Venture In March 2015, we formed a new RIDEA joint venture (“MBK JV”) with MBK Senior Living (“MBK”), a subsidiary of Mitsui & Co. Ltd, that acquired three senior housing facilities for $126 million with HCP and MBK each owning a 50% equity interest. MBK manages these communities on behalf of this joint venture. At closing, we contributed $27 million of cash and MBK contributed the three senior housing facilities, which were encumbered by $78 million of mortgage debt. The MBK JV intends to acquire additional senior housing facilities by focusing on off-market transactions. Other Investment Transactions In November 2015, we exercised the purchase option under our $18 million par value development loan to acquire a newly built assisted living facility in Olney, Maryland for $39 million. The facility was 97% occupied at closing and was placed in a 100% owned RIDEA structure with Brookdale managing the facility. In November 2015, we expanded our senior housing joint venture partnerships with Brookdale in the CCRC JV, an unconsolidated joint venture, through the acquisition of a CCRC in Spring, Texas for $40 million and in a RIDEA portfolio through the acquisition of a senior housing facility in Victoria, Texas for $10 million, of which our contribution was $19 million and $9 million, respectively. In May 2015, we increased and extended our mezzanine loan facility with Tandem Health Care (“Tandem”) to (i) fund an additional $55 million, which proceeds were used to repay a portion of Tandem’s existing senior and mortgage debt tranches; (ii) extend its maturity to October 2018; and (iii) extend the prepayment penalty period to January 2017. The mezzanine loan facility now totals $256 million and has an 11.5% blended coupon, or 11.9% blended yield-to-maturity. In April 2015, we exercised the purchase option under our $33 million par value development loan to acquire a newly built assisted living and memory care facility in Germantown, Tennessee for $72 million. The facility was 93% occupied at closing and was placed in a RIDEA structure with Brookdale acquiring a 10% noncontrolling interest and managing the facility. In March 2015, we exercised the purchase option under our $14 million par value development loan to acquire a newly built assisted living and memory care facility in Houston, Texas for $36 million. The facility was 99% occupied at closing and was placed in a RIDEA structure with Brookdale acquiring a 10% noncontrolling interest and managing the facility. Financing and Capital Recycling Activities In December 2015, we issued $600 million of 4.00% senior unsecured notes due 2022. The notes were priced at 99.577% of the principal amount with a yield-to-maturity of 4.070%. Net proceeds were used to prefund our $500 million 3.750% senior notes due February 2016. Prior to such repayment, we used a portion of such proceeds to temporarily reduce outstanding borrowings under our revolving line of credit, which borrowings were principally used for acquisitions and investments. During the second half of 2015, we received £34 million ($52 million) and $23 million in loan paydowns from asset disposition proceeds relating to our HC-One Facility and loan to Delphis Operations, L.P., respectively. In October 2015, we issued a 49% noncontrolling interest in HCP Ventures V to an institutional capital investor for $110 million. HCP Ventures V owns the MOB portfolio we acquired through a sale-leaseback transaction with Memorial Hermann in June 2015. We retained a 51% controlling interest in HCP Ventures V and will act as the managing member of the joint venture. In July 2015, we sold a parcel of land at The Cove for $11 million; additionally, in October 2015, we sold a parcel of land in our life science segment for $40 million. In June 2015, we established an at-the-market equity offering program (“ATM Program”), in connection with the renewal of our Shelf Registration Statement. Under this program, we may sell shares of our common stock from time to time having an aggregate gross sales price of up to $750 million through a consortium of banks acting as sales agents or directly to the banks acting as principals. During the year ended December 31, 2015, we issued 1.8 million shares of common stock at a weighted average price of $40.14 for proceeds of $73 million, net of fees and commissions of $1 million. In May 2015, we issued $750 million of 4.00% senior unsecured notes due 2025. The notes were priced at 99.126% of the principal amount with a yield-to-maturity of 4.107%. Net proceeds were used to fund a portion of our investment transactions completed to date. In January 2015, we issued $600 million of 3.40% senior unsecured notes due 2025. The notes were priced at 99.185% of the principal amount with a yield-to-maturity of 3.497%. Net proceeds were used to repay the entire $105 million U.S. dollar amount outstanding on our revolving credit facility at closing and $200 million of 6.00% senior unsecured notes that matured on March 1, 2015. We used the remaining proceeds to repay $200 million of 7.07% senior unsecured notes maturing in June 2015 and for general corporate purposes. In January 2015, to economically hedge a portion of our foreign currency risk from the HC-One Facility, we completed a £220 million four-year unsecured term loan that accrues interest at GBP LIBOR plus 0.975%, subject to adjustments based on our credit ratings. Concurrently, we entered into a three-year interest rate swap agreement that fixes the rate of the term loan at 1.79%, and a foreign currency swap agreement that fixes the British pound sterling (“GBP”) into U.S. dollars (“USD”) exchange rate at 1.5149 on interest income from the HC-One Facility in excess of interest payments on the term loan. Proceeds from this term loan repaid £220 million of the GBP balance drawn on our revolving credit facility that was used to fund our HC-One Facility in November 2014. Dividends Quarterly dividends paid during 2015 aggregated $2.26 per share, which represents a 3.7% increase from 2014. On January 28, 2016, our Board of Directors declared a quarterly cash dividend of $0.575 per common share. The annualized distribution rate per share for 2016 increased 1.8% to $2.30, compared to $2.26 for 2015. The dividend will be paid on February 23, 2016 to stockholders of record as of the close of business on February 8, 2016. Results of Operations We evaluate our business and allocate resources among our business segments: (i) senior housing, (ii) post-acute/skilled nursing, (iii) life science, (iv) medical office and (v) hospital. Under the senior housing, post-acute/skilled nursing, life science and hospital segments, we primarily invest, through acquisition and development, in single operator or tenant properties and debt issued by operators in these sectors. Under the medical office segment, we invest, through acquisition and development, in single or multi-tenant MOBs, which generally require a greater level of property management. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 2 to the Consolidated Financial Statements). Non-GAAP Financial Measures Net Operating Income (“NOI”) NOI and adjusted NOI are non-GAAP supplemental financial measures used to evaluate the operating performance of real estate. NOI is defined as rental and related revenues, including tenant recoveries, resident fees and services, and income from DFLs, less property level operating expenses; NOI excludes all other financial statement amounts included in net income (loss) as presented in Note 14 to the Consolidated Financial Statements. Management believes NOI provides relevant and useful information because it reflects only income and operating expense items that are incurred at the property level and presents them on an unleveraged basis. Adjusted NOI is calculated as NOI after eliminating the effects of straight-line rents, DFL accretion, amortization of market lease intangibles and lease termination fees. Adjusted NOI is oftentimes referred to as “cash NOI.” We use NOI and adjusted NOI to make decisions about resource allocations, assess and compare property level performance, and evaluate our same property portfolio (“SPP”), as described below. We believe that net income (loss) is the most directly comparable U.S. generally accepted accounting principles (“GAAP”) measure to NOI. NOI should not be viewed as an alternative measure of operating performance to net income (loss) as defined by GAAP since it does not reflect various excluded items. Further, our definition of NOI may not be comparable to the definition used by other REITs or real estate companies, as they may use different methodologies for calculating NOI. NOI and adjusted NOI are non-GAAP supplemental financial measures; for a reconciliation of net income (loss) to NOI and adjusted NOI and other relevant disclosure, refer to Note 14 to the Consolidated Financial Statements. Operating expenses generally relate to leased medical office and life science properties and senior housing RIDEA properties. We generally recover all or a portion of our leased medical office and life science property expenses through tenant recoveries. We present expenses as operating or general and administrative based on the underlying nature of the expense. Periodically, we review the classification of expenses between categories and make revisions based on changes in the underlying nature of the expenses. Same Property Portfolio (“SPP”) SPP NOI and adjusted NOI information allows us to evaluate the performance of our property portfolio under a consistent population by eliminating changes in the composition of our portfolio of properties. We identify our SPP as stabilized properties that remained in operations and were consistently reported as leased properties or RIDEA properties for the duration of the year-over-year comparison periods presented, excluding assets held for sale. Accordingly, it takes a stabilized property a minimum of 12 months in operations under a consistent reporting structure to be included in our SPP. Newly acquired operating assets are generally considered stabilized at the earlier of lease up (typically when the tenant(s) controls the physical use of at least 80% of the space) or 12 months from the acquisition date. Newly completed developments and redevelopments are considered stabilized at the earlier of lease up or 24 months from the date the property is placed in service. SPP NOI excludes certain non-property specific operating expenses that are allocated to each operating segment on a consolidated basis. SPP adjusted NOI excludes the effects of foreign exchange rate movements by using the average current period exchange rate to translate from GBP into USD for the comparison periods. A property is removed from our SPP when it is sold, placed into redevelopment or changes its reporting structure. Funds From Operations We believe FFO applicable to common shares, diluted FFO applicable to common shares, and diluted FFO per common share are important supplemental non-GAAP measures of operating performance for a REIT. Because the historical cost accounting convention used for real estate assets utilizes straight-line depreciation (except on land), such accounting presentation implies that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen and fallen with market conditions, presentations of operating results for a REIT that use historical cost accounting for depreciation could be less informative. The term FFO was designed by the REIT industry to address this issue. FFO, as defined by the NAREIT, is net income (loss) applicable to common shares (computed in accordance with GAAP), excluding gains or losses from sales of property, impairments of, or related to, depreciable real estate, plus real estate and other depreciation and amortization, and after adjustments for joint ventures. Adjustments for joint ventures are calculated to reflect FFO on the same basis. FFO does not represent cash generated from operating activities in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income (loss). We compute FFO in accordance with the current NAREIT definition; however, other REITs may report FFO differently or have a different interpretation of the current NAREIT definition from ours. In addition, we present FFO before the impact of severance-related charges, litigation settlement charges, preferred stock redemption charges, impairments (recoveries) of non-depreciable assets, foreign currency remeasurement losses (gains) and transaction-related items (defined below) (“FFO as adjusted”). Transaction-related items include acquisition and pursuit costs (e.g., due diligence and closing) and gains/charges incurred as a result of mergers and acquisitions and lease amendment or termination activities. Management believes that FFO as adjusted provides a meaningful supplemental measurement of our FFO run-rate. This measure is a modification of the NAREIT definition of FFO and should not be used as an alternative to net income (loss) (determined in accordance with GAAP) or NAREIT FFO. FFO and FFO as adjusted are non-GAAP supplemental financial measures; for a reconciliation of net income (loss) to FFO and FFO as adjusted and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Funds Available for Distribution FAD is defined as FFO as adjusted after excluding the impact of the following: (i) amortization of acquired market lease intangibles, net; (ii) amortization of deferred compensation expense; (iii) amortization of deferred financing costs, net; (iv) straight-line rents; (v) accretion and depreciation related to DFLs and lease incentive amortization (reduction of straight-line rents); and (vi) deferred revenues, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents. Also, FAD: (i) is computed after deducting recurring capital expenditures, including leasing costs and second generation tenant and capital improvements; and (ii) includes lease restructure payments and adjustments to compute our share of FAD from our unconsolidated joint ventures and those related to CCRC non-refundable entrance fees. Other REITs or real estate companies may use different methodologies for calculating FAD, and accordingly, our FAD may not be comparable to those reported by other REITs. Although our FAD computation may not be comparable to that of other REITs, management believes FAD provides a meaningful supplemental measure of our performance and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. FAD does not represent cash generated from operating activities determined in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs, and should not be considered as an alternative to net income (loss) determined in accordance with GAAP. FAD is a non-GAAP supplemental financial measure; for a reconciliation of net income (loss) to FAD, as defined, and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Comparison of the Year Ended December 31, 2015 to the Year Ended December 31, 2014 and the Year Ended December 31, 2014 to the Year Ended December 31, 2013 Overview(1) 2015 and 2014 Results for the years ended December 31, 2015 and 2014 (dollars in thousands except per share data): (1) For the reconciliation, see “Non-GAAP Financial Measures Reconciliations” section below. FFO as adjusted and FAD increased $0.12 and $0.15 per share, respectively, primarily as a result of increased NOI from our 2014 and 2015 acquisitions and incremental interest income from the repayments of three development loans resulting from our share in the appreciation of the underlying real estate assets. The increases were partially offset by the decline in income from DFLs as a result of the HCRMC Lease Amendment and by placing our marketable debt securities issued by Elli Investments Limited as part of the financing for its acquisition of Four Seasons Health Care (“Four Seasons Notes”) on cost-recovery method in the third quarter of 2015. FFO and earnings per share (“EPS”) decreased $3.02 and $3.21 per share, respectively, primarily as a result of: (i) $1.3 billion of impairments related to our HCRMC DFL investments, (ii) $112 million of impairments related to our investment in Four Seasons Notes, (iii) $46 million of impairments related to our equity investment in HCRMC, (iv) $38 million recognized in 2014 in net fees for terminating the leases on the 49 senior housing properties in the Brookdale Transaction, (v) transaction-related items of $33 million and (vi) a severance-related charge of $7 million. The decreases were partially offset by: (i) the aforementioned events impacting FFO as adjusted and FAD, (ii) $6 million impairment recovery from a repayment of a loan in our hospital segment and (iii) foreign currency remeasurement gains of $5 million. Additionally, EPS decreased primarily as a result of: (i) decreased gain on sales of real estate and (ii) increased depreciation expense, partially offset by the increased equity income from unconsolidated joint venture as a result of gain on sales of real estate from HCP Ventures III, LLC and HCP Ventures IV, LLC. 2014 and 2013 Results for the years ended December 31, 2014 and 2013 (dollars in thousands except per share data): FFO increased $0.05 per share primarily as a result of: (i) net gains from the 2014 Brookdale transaction, (ii) increased NOI from our SPP and our 2013 and 2014 acquisitions, and (iii) a general and administrative charge in 2013 resulting from the termination of our former chief executive officer. The aforementioned were partially offset by: (i) an impairment charge in 2014 for our equity investment in HCRMC and (ii) favorable one-time items including interest income in 2013 from the par payoff of our Barchester debt investments and sale of marketable equity securities. FFO as adjusted and FAD increased $0.02 and $0.03 per share, respectively, primarily as a result of increased NOI from our SPP and 2013 and 2014 acquisitions, which were partially offset by favorable one-time items including interest income in 2013 from the par payoff of our Barchester debt investments and sale of marketable equity securities. EPS decreased $0.13 primarily as a result of: (i) decreased gain on sales of real estate and (ii) increased depreciation expense, partially offset by the net result of the aforementioned events impacting FFO. Segment NOI and Adjusted NOI The tables below provide selected operating information for our SPP and total property portfolio for each of our five business segments. For the year ended December 31, 2015, our consolidated SPP consists of 993 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2014 and that remained in operations under a consistent reporting structure. For the year ended December 31, 2014, our consolidated SPP consisted of 1,011 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2013 and that remained in operations under a consistent reporting structure. Our consolidated total property portfolio represents 1,178, 1,108 and 1,079 properties at December 31, 2015, 2014 and 2013, respectively, and excludes properties classified as discontinued operations. Senior Housing 2015 and 2014 On June 30, 2015 (the “Closing Date”), we completed the RIDEA III acquisition of 35 senior housing properties (see Note 4 to the Consolidated Financial Statements). We report the resident level fees and services revenues and corresponding operating expenses in our consolidated financial statements from the Closing Date. For periods subsequent to the Closing Date, we expect increases in resident fees and services revenue and operating expenses. Results as of and for the years ended December 31, 2015 and 2014 (dollars in thousands except per unit data): (1) From our 2014 presentation of SPP, we removed 12 senior housing properties that were sold and three senior housing properties that were contributed to partnerships under a RIDEA structure, and no longer meet our criteria for SPP as of the date of contribution. (2) Represents rental and related revenues and income from DFLs. (3) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. (4) Average annual rent per unit for RIDEA properties is based on NOI. SPP Adjusted NOI. SPP adjusted NOI improved as a result of annual rent increases and improved performance from RIDEA properties. Total Portfolio NOI and Adjusted NOI. Our total portfolio NOI decreased primarily as a result of: (i) $38 million of net revenues recognized from the 2014 Brookdale transaction (see Note 3 to the Consolidated Financial Statements) and (ii) an $8 million net termination fee related to our RIDEA III acquisition in 2015 (see Note 4 to the Consolidated Financial Statements), partially offset by the impact from our SPP and senior housing acquisitions in 2014 and 2015 primarily from our RIDEA III transaction in June 2015 (see Note 4 to the Consolidated Financial Statements). In addition to the impact of our SPP, our total portfolio adjusted NOI increased as a result of senior housing acquisitions in 2014 and 2015 primarily from our RIDEA III transaction in June 2015 (see Note 4 to the Consolidated Financial Statements). We placed our HCRMC DFL investments on cash basis of accounting as of January 1, 2016 and will no longer recognize accretion income, unless the timing and amounts owed under the HCRMC DFL investments are reasonably assured (see Note 6 to the Consolidated Financial Statements). 2014 and 2013 Results as of and for the years ended December 31, 2014 and 2013 (dollars in thousands except per unit data): (1) From our 2013 presentation of SPP, we removed a senior housing property that was sold and 51 senior housing properties that were contributed to partnerships under a RIDEA structure as part of the 2014 Brookdale transaction and no longer meet our criteria for SPP upon contribution. (2) Represents rental and related revenues and income from DFLs. (3) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. (4) Average annual rent per unit for RIDEA properties is based on NOI. SPP NOI and Adjusted NOI. SPP NOI increased primarily from improved performance from RIDEA properties; SPP adjusted NOI improved as a result of annual rent increases and improved performance from RIDEA properties. Total Portfolio NOI and Adjusted NOI. In addition to the impact of our SPP, our total portfolio NOI increased as a result of recognizing net fees of $38 million from the 2014 Brookdale transaction (see Note 3 to the Consolidated Financial Statements). Our total portfolio NOI and adjusted NOI also increased as a result of our senior housing acquisitions in 2014 and 2013. Post-Acute/Skilled Nursing 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars in thousands, except per bed data): (1) From our 2014 presentation of SPP, we removed 18 post-acute/skilled nursing facilities that were sold. (2) Represents rental and related revenues and income from DFLs. (3) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. NOI and Adjusted NOI. SPP and total portfolio NOI and adjusted NOI decreased primarily as a result of the HCRMC Lease Amendment. See “2015 Transaction Overview” above for further discussion of developments with HCRMC. We placed our HCRMC DFL investments on cash basis of accounting as of January 1, 2016 and will no longer recognize accretion income, unless the timing and amounts owed under the HCRMC DFL investments are reasonably assured (see Note 6 to the Consolidated Financial Statements). 2014 and 2013 Results as of and for the years ended December 31, 2014 and 2013 (dollars in thousands, except per bed data): (1) From our 2013 presentation of SPP, we removed a post-acute/skilled nursing property that was sold. (2) Represents rental and related revenues and income from DFLs. (3) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. NOI and Adjusted NOI. SPP and total portfolio NOI and adjusted NOI increased primarily as a result of annual rent escalations from our HCRMC DFL investments. Life Science 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) From our 2014 presentation of SPP, we removed a life science facility that was placed into land held for development, which no longer meets our criteria for SPP as of the date placed into development. SPP NOI and Adjusted NOI. SPP NOI and adjusted NOI increased primarily as a result of increased occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI. In addition to the impact of our SPP, our total portfolio NOI and adjusted NOI increased primarily as a result of the impact of our life science development projects placed into service during 2014 and life science acquisitions in 2014 and 2015. During the year ended December 31, 2015, 694,000 square feet of new and renewal leases commenced at an average annual base rent of $33.52 per square foot compared to 412,000 square feet of expired and terminated leases with an average annual base rent of $33.47 per square foot. During the year ended December 31, 2015, we acquired six properties with 158,000 occupied square feet with an average annual base rent of $38.80 per square foot. 2014 and 2013 Results as of and for the years ended December 31, 2014 and 2013 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) From our 2013 presentation of SPP, we removed three life science facilities that were placed into land held for development and a life science facility that was placed into redevelopment in 2014, which no longer meet our criteria for SPP as of the date placed into development. SPP NOI and Adjusted NOI. SPP NOI and adjusted NOI increased as a result of increased average occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI. In addition to the impact of our SPP, our total portfolio NOI and adjusted NOI increased primarily as a result of the impact of our life science development projects placed in service during 2014 and 2013 and a life science acquisition in 2014. During the year ended December 31, 2014, 1.5 million square feet of new and renewal leases commenced at an average annual base rent of $30.40 per square foot compared to 1.1 million square feet of expiring leases with an average annual base rent of $30.83 per square foot. During the year ended December 31, 2014, we acquired a property with 83,000 occupied square feet with an average annual base rent of $33.87 per square foot. Medical Office 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) From our 2014 presentation of SPP, we removed a MOB that was sold. SPP NOI and Adjusted NOI. SPP NOI and adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI. Our total portfolio NOI and adjusted NOI increased primarily as a result of the impact of our MOB acquisitions in 2014 and 2015. During the year ended December 31, 2015, 2.4 million square feet of new and renewal leases commenced at an average annual base rent of $23.82 per square foot compared to 2.4 million square feet of expiring and terminated leases with an average annual base rent of $24.15 per square foot. During the year ended December 31, 2015, we acquired properties with 1.9 million occupied square feet with an average annual base rent of $16.19 per square foot, including 1.2 million square feet with a triple net annual base rent of $10.74 per square foot, and disposed of 17,000 square feet with an average annual base rent of $17.50 per square foot. 2014 and 2013 Results as of and for the years ended December 31, 2014 and 2013 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) From our 2013 presentation of SPP, we removed a MOB that was sold. SPP NOI and Adjusted NOI. SPP NOI and adjusted NOI increased primarily as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI. In addition to the impact of our SPP, our total portfolio NOI and adjusted NOI increased primarily as a result of our medical office acquisitions in 2014. During the year ended December 31, 2014, 2.6 million square feet of new and renewal leases commenced at an average annual base rent of $23.15 per square foot compared to 2.6 million square feet of expiring and terminated leases with an average annual base rent of $25.06 per square foot. During the year ended December 31, 2014, we acquired properties with 953,000 occupied square feet that have average annual base rent of $25.00 per square foot. Hospital 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars in thousands, except per bed data): (1) Represents rental and related revenues and income from DFLs. (2) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. Certain operators in our hospital portfolio are not required under their respective leases to provide operational data. NOI and Adjusted NOI. SPP and total portfolio NOI and adjusted NOI increased primarily as a result of additional rents earned in 2015 due to exceeding pre-established thresholds and annual rent escalations, partially offset by increased operating expenses. 2014 and 2013 Results as of and for the years ended December 31, 2014 and 2013 (dollars in thousands, except per bed data): (1) Represents rental and related revenues and income from DFLs. (2) Represents average capacity as reported by the respective tenants or operators for a twelve-month period that is a quarter in arrears from the periods presented. Certain operators in our hospital portfolio are not required under their respective leases to provide operational data. NOI and Adjusted NOI. SPP and total portfolio NOI increased primarily due to a net $12 million correction in 2013 that reduced previously recognized non-cash revenues including straight-line rents and accelerated amortization of below market lease intangibles related to our Medical City Dallas hospital. SPP and total portfolio adjusted NOI increased primarily as a result of annual rent escalations. Other Income and Expense Items Interest income. Interest income increased $38 million to $112 million for the year ended December 31, 2015. The increase was primarily the result of: (i) fundings through our HC-One Facility in November 2014 and February 2015 (see Note 7 to the Consolidated Financial Statements), (ii) incremental interest income from the repayments of three development loans resulting from the appreciation of the underlying real estate assets and (iii) additional fundings under our mezzanine loan facility with Tandem in May 2015 (see Note 7 to the Consolidated Financial Statements). The increases in interest income were partially offset by a change in interest income recognition on our investment in the Four Seasons Notes (see Note 17 to the Consolidated Financial Statements). Interest income decreased $12 million to $74 million for the year ended December 31, 2014. The decrease was primarily the result of the repayment of our Barchester loan in September 2013, partially offset by interest earned from the June 2013 funding under the Tandem Health Care mezzanine loan facility and the November 2014 HC-One Facility (see Note 7 to the Consolidated Financial Statements). Interest expense. For the year ended December 31, 2015, interest expense increased $40 million to $480 million. The increase was primarily the result of: (i) our senior unsecured notes offerings during 2014 and 2015, (ii) increased borrowings from our term loan originated in 2015, (iii) increased borrowings under our line of credit facility and (iv) lower capitalized interest. The increases in interest expense were partially offset by repayments of senior unsecured notes and mortgage debt that matured during 2014 and 2015. The increased borrowings were used to fund our investment activities and to refinance our debt maturities. 2015 and 2014 The table below sets forth information with respect to our debt, excluding premiums, discounts and debt issuance costs (dollars in thousands): (1) At December 31, 2015 and 2014, excludes $94 million and $97 million of other debt, respectively, that represents non-interest bearing life care bonds and occupancy fee deposits at certain of our senior housing facilities and demand notes that have no scheduled maturities. At both December 31, 2015 and 2014, $71 million of variable-rate mortgages are presented as fixed-rate debt as the interest payments were swapped from variable to fixed. At December 31, 2015 and 2014, £357 million ($526 million) and £137 million ($214 million) term loans, respectively, are presented as fixed-rate debt as the interest payments were swapped from variable to fixed. For the year ended December 31, 2014, interest expense increased $4 million to $440 million. The increase was primarily the result of net increase in indebtedness as presented below. 2014 and 2013 The table below sets forth information with respect to our debt, excluding premiums, discounts and debt issuance costs (dollars in thousands): (1) At December 31, 2014, excludes $97 million of other debt that represents non-interest bearing life care bonds and occupancy fee deposits at certain of our senior housing facilities and demand notes that have no scheduled maturities. At December 31, 2013, excludes $75 million of other debt that represents non-interest bearing life care bonds and occupancy fee deposits at certain of our senior housing facilities. At December 31, 2014 and 2013, $71 million and $72 million of variable-rate mortgages, respectively, and a £137 million ($214 million and $227 million, respectively) term loan are presented as fixed-rate debt as the interest payments were swapped from variable to fixed. Our exposure to interest expense fluctuations related to our variable rate indebtedness is mitigated by our interest rate swap contracts. For a more detailed discussion of our interest rate risk, see

<s>[INST] · 2015 Transaction Overview · Dividends · Results of Operations · Liquidity and Capital Resources · Contractual Obligations · OffBalance Sheet Arrangements · Inflation · NonGAAP Financial Measures Reconciliations · Critical Accounting Policies · Recent Accounting Pronouncements 2015 Transaction Overview HCR ManorCare, Inc. HCRMC Fourth Quarter 2015 The postacute/skilled nursing (“SNF”) industry and HCRMC continued to experience a challenging operating environment in 2015, due to the ongoing change in reimbursement models which reduces rates and lowers census, the result of shorter lengths of stay. HCRMC’s normalized fixed charge coverage for the 12month period ended December 31, 2015 was 1.07x. For the fourth quarter 2015, HCRMC reported normalized EBITDAR of $110 million, which decreased $36 million on a yearoveryear basis compared to the fourth quarter 2014, and decreased $17 million sequentially compared to the third quarter 2015. The results were impacted by core operating performance weakness and unfavorable nonroutine items discussed below. The level of performance was below expectations and uncharacteristic for the fourth quarter, which has historically been strong due in large part to increased census and the annual Medicare rate increases on October 1. HCRMC ended 2015 with $125 million of cash and cash equivalents and continues to be current on its obligations under the amended master lease (the “Amended Master Lease”). Core Operating Performance. Before the impact from nonroutine items described below, HCRMC’s fourth quarter EBITDAR was below its forecast, primarily due to the continued change in payor mix from traditional Medicare to Managed Care plans, which reduced reimbursement rates and lowered census. As a result, HCRMC reported a decline in its core SNF operating metrics (which excludes the 50 nonstrategic disposition assets), with fourth quarter census decreasing 175 basis points from the prior year to 82.6%. NonRoutine Items. As discussed below, HCRMC is in the process of exiting 50 nonstrategic assets, of which 21 sales were completed in the fourth quarter and an additional 11 closed in the first quarter 2016. As such, disruption resulting from transitioning operations to new owners and closing costs led to additional underperformance from this pool of assets. EBITDAR losses from the sale of nonstrategic assets totaled $11 million in the fourth quarter 2015, and $22 million for full year 2015. HCP continues to expect total proceeds of $350 million from the sales of the nonstrategic assets, of which $280 million have closed todate with the remaining $70 million expected to close in mid2016. In addition, HCRMC continues to defend against the DOJ civil complaint previously disclosed in April 2015. HCRMC incurred legal and regulatory defense costs of $3 million during the fourth quarter 2015 and $9 million for the full year 2015. The outcome of the DOJ civil complaint remains uncertain, and HCRMC expects to incur additional legal and regulatory defense costs in 2016. As a result of HCRMC’s fourth quarter performance deterioration and the related decline in its FCC, we placed our real estate portfolio operated by HCRMC on “Watch List” status at year end 2015, and changed our accounting treatment to recognize rental income on a cash basis beginning January 2016. As such, we will no longer recognize noncash accretion income under the HCRMC DFLs (see Note 2 to the Consolidated Financial Statements). The reduced growth outlook for the broader postacute/SNF industry indicates challenges to the improvement in HCRMC’s financial performance over the next few years. At year end 2015, the Company determined that it is probable that its HCRMC DFL investments are impaired and the amount [/INST] Negative. </s>

HCP, INC.

2017-02-13

2016-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: · 2016 Transaction Overview · Dividends · Results of Operations · Liquidity and Capital Resources · Contractual Obligations · Off-Balance Sheet Arrangements · Inflation · Non-GAAP Financial Measure Reconciliations · Critical Accounting Policies · Recent Accounting Pronouncements 2016 Transaction Overview Spin-Off of Real Estate Portfolio On October 31, 2016, we completed our previously announced Spin-Off of QCP. QCP’s assets include 338 properties, primarily comprised of the HCRMC DFL investments and an equity investment in HCRMC. Following the completion of the Spin-Off on October 31, 2016, QCP is an independent, publicly-traded, self-managed and self-administrated REIT. As a result of the Spin-Off, the operations of QCP are now classified as discontinued operations in all periods presented herein. We entered into a Separation and Distribution Agreement (the “Separation and Distribution Agreement”) with QCP in connection with the Spin-Off. The Separation and Distribution Agreement divides and allocates the assets and liabilities of HCP prior to the Spin-Off between QCP and HCP, governs the rights and obligations of the parties regarding the Spin-Off, and contains other key provisions relating to the separation of QCP’s business from HCP. In connection with the Spin-Off, we entered into a Transition Services Agreement ("TSA") with QCP. Per the terms of the TSA, we agreed to provide certain administrative and support services to QCP on a transitional basis for established fees, which are expected to approximate the actual cost incurred by us in providing the transition services to QCP for the relevant period. The TSA will terminate on the expiration of the term of the last service provided under the agreement, which will be on or prior to October 30, 2017. The TSA provides that QCP generally has the right to terminate a transition service upon thirty days' notice to us. The TSA contains provisions under which we will, subject to certain limitations, be obligated to indemnify QCP for losses incurred by QCP resulting from our breach of the TSA. See Notes 1 and 5 to the Consolidated Financial Statements for further information on the Spin-Off. Investment Transactions In January 2016, we acquired a portfolio of five private pay senior housing communities with 364 units and a skilled nursing facility with 120 beds for $95 million. All of the communities were developed within the past two years and are triple-net leased to four regional operators. In July 2016, we acquired two Class A life science buildings totaling 136,000 square feet and a four-acre parcel of land in San Diego, California for $49 million. In September 2016, we acquired a portfolio of seven private pay senior housing communities for $186 million, including the assumption of $74 million of debt, at a 4.0% interest rate, maturing in 2044. Consisting of 526 assisted living and memory care units, the portfolio is managed by Senior Lifestyle Corporation in a 100% owned RIDEA structure. In November 2016, we entered into agreements with Maria Mallaband Care Group (“Maria Mallaband”) to acquire a portfolio of predominantly private pay prime care homes located in London/South-East England for $131 million (£105 million). In mid-2017, through the exercise of a call option, subject to certain contingencies, we intend to convert our bridge loan provided to Maria Mallaband in November into fee ownership and enter into a Master Lease with Maria Mallaband. In December 2016, we acquired a portfolio of 10 MOBs, including nine on-campus MOBs, located throughout the U.S. in a sale-leaseback transaction with Community Health Systems for $163 million. The MOBs have an initial lease term of 15 years. Developments Through February 13, 2017, we have leased 73% of The Cove Phase I, which consists of two Class A buildings totaling 247,000 square feet and was delivered in the third quarter of 2016. In response to Phase I leasing success and continued strong demand from life science users in South San Francisco, in February 2016, we commenced a $220 million development, The Cove Phase II, which adds two Class A buildings totaling 230,000 square feet and is expected to be delivered by the third quarter of 2017. Through February 13, 2017, we have leased 100% of The Cove Phase II. In response to The Cove Phase I and Phase II leasing success, in October 2016, we commenced the $211 million development of The Cove Phase III, which adds two Class A buildings representing up to 336,000 square feet. In June 2016, we commenced a $62 million multi-building development project encompassing 301,000 square feet at our Ridgeview Business Park in Poway, California, which is 50% leased. The project includes a $32 million build-to-suit project with an existing tenant for 152,000 square feet and is expected to be completed in 2018 as part of a larger leasing transaction. Disposition Transactions In January 2017, we sold four life science facilities in Salt Lake City, Utah for $76 million. In May 2016, we entered into a master contribution agreement with Brookdale to contribute our ownership interest in RIDEA II to an unconsolidated JV owned by HCP and an investor group led by Columbia Pacific Advisors, LLC (“CPA”) (the “HCP/CPA JV”). The members agreed to recapitalize RIDEA II with $602 million of debt, of which $360 million was provided by a third-party and $242 million was provided by HCP. In return, we received $480 million in cash proceeds from the HCP/CPA JV and $242 million in note receivables and retained an approximate 40% beneficial interest in RIDEA II (the note receivable and 40% beneficial interest are herein referred to as the “RIDEA II Investments”). This transaction resulted in HCP deconsolidating the net assets of RIDEA II because it will no longer direct the activities that most significantly impact the venture. The closing of these transactions occurred in January 2017. In October 2016, we entered into definitive agreements to sell 64 SH NNN assets, currently under triple-net leases with Brookdale, for $1.125 billion to affiliates of Blackstone Real Estate Partners VIII, L.P. The closing of this transaction is expected to occur during 2017 and remains subject to regulatory and third party approvals and other customary closing conditions. Additionally, in October 2016, we entered into definitive agreements for a multi-element transaction with Brookdale to: (i) sell or transition 25 assets currently triple-net leased to Brookdale, for which Brookdale will receive a $10.5 million annual rent reduction upon lease termination, (ii) re-allocate annual rent of $9.6 million from those 25 assets to the remaining Brookdale triple-net lease portfolio (occurred on November 1, 2016) and (iii) transition eight triple-net leased assets into RIDEA structures (seven of which closed in December 2016 and one of which closed in January 2017). The closing of the sale or transition of the 25 assets and corresponding rent reduction is expected to occur throughout 2017 and remain subject to regulatory and third party approvals and other customary closing conditions. During the year ended December 31, 2016, we sold: (i) a portfolio of five post-acute/skilled nursing and two SH NNN facilities for $130 million, (ii) five life science facilities for $386 million, (iii) seven SH NNN facilities for $88 million, (iv) three MOBs for $20 million and (v) three SHOP facilities for $41 million and recognized total gain on sales of $165 million. In January 2016, we entered into a definitive agreement for purchase options that were exercised on eight life science facilities in South San Francisco, California, to be sold in two tranches for $311 million (sold in November 2016 and discussed above) and $269 million, respectively. The second tranche is expected to close in the third quarter of 2018. In June 2016 and September 2016, we received $51 million and $19 million, respectively, from the monetization of three senior housing development loans, recognizing $15 million and $4 million of incremental interest income, respectively, which represents our participation in the appreciation of the underlying real estate assets. Financing Activities In January 2017, we paid down $440 million on our revolving line of credit facility, primarily using proceeds from our RIDEA II joint venture disposition. During 2016, we repaid $2.0 billion of senior unsecured notes, $1.1 billion of which was prepaid using proceeds from the Spin-Off. In addition, we settled $388 million of mortgage debt, $108 million of which was prepaid using proceeds from the Spin-Off. As a result of the prepayment of debt using proceeds from the Spin-Off, we incurred aggregate loss on debt extinguishments of $46 million, primarily related to prepayment penalties. In July 2016, we exercised a one-year extension option on our £137 million ($169 million at December 31, 2016), four-year unsecured term loan that was entered into on July 30, 2012 (the “2012 Term Loan”). Based on our credit ratings at December 31, 2016, the 2012 Term Loan accrues interest at a rate of GBP LIBOR plus 1.40%. Dividends Quarterly cash dividends paid during 2016 aggregated to $2.095 per share. On February 2, 2017, our Board of Directors declared a quarterly cash dividend of $0.37 per common share. The dividend will be paid on March 2, 2017 to stockholders of record as of the close of business on February 15, 2017. Results of Operations We evaluate our business and allocate resources among our reportable business segments: (i) senior housing triple-net (SH NNN), (ii) senior housing operating portfolio (SHOP), (iii) life science and (iv) medical office. Under the medical office segment, we invest through the acquisition and development of MOBs, which generally require a greater level of property management. Otherwise, we primarily invest, through the acquisition and development of real estate, in single tenant and operator properties. We have other non-reportable segments that are comprised primarily of our U.K. care homes, debt investments and hospitals. We evaluate performance based upon: (i) property net operating income from continuing operations (“NOI”) and (ii) adjusted NOI (cash NOI) of the combined consolidated and unconsolidated investments in each segment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 2 to the Consolidated Financial Statements). Non-GAAP Financial Measures Net Operating Income NOI and adjusted NOI are non-U.S. generally accepted accounting principles (“GAAP”) supplemental financial measures used to evaluate the operating performance of real estate. We include properties from our consolidated portfolio, as well as our pro-rata share of properties owned by our unconsolidated joint ventures in our NOI and adjusted NOI. We believe providing this information assists investors and analysts in estimating the economic interest in our total portfolio of real estate. Our pro-rata share information is prepared on a basis consistent with the comparable consolidated amounts, is intended to reflect our proportionate economic interest in the operating results of properties in our portfolio and is calculated by applying our actual ownership percentage for the period. We do not control the unconsolidated joint ventures, and the pro-rata presentations of revenues and expenses included in NOI (see below) do not represent our legal claim to such items. The joint venture members or partners are entitled to profit or loss allocations and distributions of cash flows according to the joint venture agreements, which provide for such allocations generally according to their invested capital. The presentation of pro-rata information has limitations, which include, but are not limited to, the following (i) the amounts shown on the individual line items were derived by applying our overall economic ownership interest percentage determined when applying the equity method of accounting and do not necessarily represent our legal claim to the assets and liabilities, or the revenues and expenses and (ii) other companies in our industry may calculate their pro-rata interest differently, limiting the usefulness as a comparative measure. Because of these limitations, the pro-rata financial information should not be considered independently or as a substitute for our financial statements as reported under GAAP. We compensate for these limitations by relying primarily on our GAAP financial statements, using the pro-rata financial information as a supplement. NOI is defined as rental and related revenues, including tenant recoveries, resident fees and services, and income from DFLs, less property level operating expenses; NOI excludes all other financial statement amounts included in net income (loss) as presented in Note 14 to the Consolidated Financial Statements. Management believes NOI provides relevant and useful information because it reflects only income and operating expense items that are incurred at the property level and presents them on an unleveraged basis. Adjusted NOI is calculated as NOI after eliminating the effects of straight-line rents, DFL non-cash interest, amortization of market lease intangibles, non-refundable entrance fees and lease termination fees (“non-cash adjustments”). Adjusted NOI is oftentimes referred to as “cash NOI.” We use NOI and adjusted NOI to make decisions about resource allocations, to assess and compare property level performance, and to evaluate our same property portfolio (“SPP”), as described below. We believe that net income (loss) is the most directly comparable GAAP measure to NOI. NOI should not be viewed as an alternative measure of operating performance to net income (loss) as defined by GAAP since it does not reflect various excluded items. Further, our definition of NOI may not be comparable to the definition used by other REITs or real estate companies, as they may use different methodologies for calculating NOI. For a reconciliation of NOI and Adjusted NOI to net income (loss) by segment, refer to Note 14 to the Consolidated Financial Statements. Operating expenses generally relate to leased medical office and life science properties and senior housing RIDEA properties. We generally recover all or a portion of our leased medical office and life science property expenses through tenant recoveries. We present expenses as operating or general and administrative based on the underlying nature of the expense. Periodically, we review the classification of expenses between categories and make revisions based on changes in the underlying nature of the expenses. Same Property Portfolio SPP NOI and adjusted NOI information allows us to evaluate the performance of our property portfolio under a consistent population by eliminating changes in the composition of our portfolio of properties. We include properties from our consolidated portfolio, as well as properties owned by our unconsolidated joint ventures in our SPP NOI and adjusted NOI (see NOI above for further discussion regarding our use of pro-rata share information and its limitations). We identify our SPP as stabilized properties that remained in operations and were consistently reported as leased properties or RIDEA properties for the duration of the year-over-year comparison periods presented, excluding assets held for sale. Accordingly, it takes a stabilized property a minimum of 12 months in operations under a consistent reporting structure to be included in our SPP. Newly acquired operating assets are generally considered stabilized at the earlier of lease-up (typically when the tenant(s) control(s) the physical use of at least 80% of the space) or 12 months from the acquisition date. Newly completed developments and redevelopments are considered stabilized at the earlier of lease-up or 24 months from the date the property is placed in service. SPP NOI excludes (i) certain non-property specific operating expenses that are allocated to each operating segment on a consolidated basis and (ii) entrance fees and related activity such as deferred expenses, reserves and management fees related to entrance fees. A property is removed from our SPP when it is sold, placed into redevelopment or changes its reporting structure. For a reconciliation of SPP to total portfolio adjusted NOI and other relevant disclosures by segment, refer to our Segment Analysis below. Funds From Operations We believe FFO applicable to common shares, diluted FFO applicable to common shares, and diluted FFO per common share are important supplemental non-GAAP measures of operating performance for a REIT. Because the historical cost accounting convention used for real estate assets utilizes straight-line depreciation (except on land), such accounting presentation implies that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen and fallen with market conditions, presentations of operating results for a REIT that use historical cost accounting for depreciation could be less informative. The term FFO was designed by the REIT industry to address this issue. FFO, as defined by the National Association of Real Estate Investment Trusts (“NAREIT”), is net income (loss) applicable to common shares (computed in accordance with GAAP), excluding gains or losses from sales of depreciable property, including any current and deferred taxes directly associated with sales of depreciable property, impairments of, or related to, depreciable real estate, plus real estate and other depreciation and amortization, and adjustments to compute our share of FFO and FFO as adjusted (see below) from joint ventures. Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of FFO for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. We reflect our share for consolidated joint ventures in which we do not own 100% of the equity by adjusting our FFO to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods. Our pro-rata share information is prepared on a basis consistent with the comparable consolidated amounts, is intended to reflect our proportionate economic interest in the operating results of properties in our portfolio and is calculated by applying our actual ownership percentage for the period. We do not control the unconsolidated joint ventures, and the pro-rata presentations of reconciling items included in FFO (see above) do not represent our legal claim to such items. The joint venture members or partners are entitled to profit or loss allocations and distributions of cash flows according to the joint venture agreements, which provide for such allocations generally according to their invested capital. The presentation of pro-rata information has limitations which include, but are not limited to, the following: (i) the amounts shown on the individual line items were derived by applying our overall economic ownership interest percentage determined when applying the equity method of accounting or allocating noncontrolling interests, and do not necessarily represent our legal claim to the assets and liabilities, or the revenues and expenses; and (ii) other companies in our industry may calculate their pro-rata interest differently, limiting the usefulness as a comparative measure. Because of these limitations, the pro-rata financial information should not be considered independently or as a substitute for our financial statements as reported under GAAP. We compensate for these limitations by relying primarily on our GAAP financial statements, using the pro-rata financial information as a supplement. FFO does not represent cash generated from operating activities in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income (loss). We compute FFO in accordance with the current NAREIT definition; however, other REITs may report FFO differently or have a different interpretation of the current NAREIT definition from ours. In addition, we present FFO before the impact of non-comparable items including, but not limited to, severance-related charges, litigation provisions, preferred stock redemption charges, impairments (recoveries) of non-depreciable assets, prepayment costs (benefits) associated with early retirement or payment of debt, foreign currency remeasurement losses (gains) and transaction-related items (“FFO as adjusted”). Prepayment costs (benefits) associated with early retirement of debt include the write-off of unamortized deferred financing fees, or additional costs, expenses, discounts, make-whole payments, penalties or premiums incurred as a result of early retirement or payment of debt. Transaction-related items include acquisition and pursuit costs (e.g., due diligence and closing) and gains/charges incurred as a result of mergers and acquisitions and lease amendment or termination activities. Management believes that FFO as adjusted provides a meaningful supplemental measurement of our FFO run-rate and is frequently used by analysts, investors and other interested parties in the evaluation of our performance as a REIT. At the same time that NAREIT created and defined its FFO measure for the REIT industry, it also recognized that “management of each of its member companies has the responsibility and authority to publish financial information that it regards as useful to the financial community.” We believe stockholders, potential investors and financial analysts who review our operating performance are best served by an FFO run-rate earnings measure that includes, in addition to adjustments made to arrive at the NAREIT defined measure of FFO, other adjustments to net income (loss). FFO as adjusted is used by management in analyzing our business and the performance of our properties, and we believe it is important that stockholders, potential investors and financial analysts understand this measure used by management. We use FFO as adjusted to: (i) evaluate our performance in comparison with expected results and results of previous periods, relative to resource allocation decisions, (ii) evaluate the performance of our management, (iii) budget and forecast future results to assist in the allocation of resources, (iv) assess our performance as compared with similar real estate companies and the industry in general and (v) evaluate how a specific potential investment will impact our future results. Other REITs or real estate companies may use different methodologies for calculating an adjusted FFO measure, and accordingly, our FFO as adjusted may not be comparable to those reported by other REITs. For a reconciliation of net income (loss) to FFO and FFO as adjusted and other relevant disclosure, refer to “Non-GAAP Financial Measure Reconciliations” below. Funds Available for Distribution FAD is defined as FFO as adjusted after excluding the impact of the following: (i) amortization of acquired market lease intangibles, net, (ii) amortization of deferred compensation expense, (iii) amortization of deferred financing costs, net, (iv) straight-line rents, (v) non-cash interest and depreciation related to DFLs and lease incentive amortization (reduction of straight-line rents) and (vi) deferred revenues, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents. Also, FAD: (i) is computed after deducting recurring capital expenditures, including leasing costs and second generation tenant and capital improvements, and (ii) includes lease restructure payments and adjustments to compute our share of FAD from our unconsolidated joint ventures and those related to CCRC non-refundable entrance fees. Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of FAD for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. We reflect our share for consolidated joint ventures in which we do not own 100% of the equity by adjusting our FAD to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods (see FFO above for further disclosure regarding our use of pro-rata share information and its limitations). Other REITs or real estate companies may use different methodologies for calculating FAD, and accordingly, our FAD may not be comparable to those reported by other REITs. Although our FAD computation may not be comparable to that of other REITs, management believes FAD provides a meaningful supplemental measure of our performance and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. We believe FAD is an alternative run-rate earnings measure that improves the understanding of our operating results among investors and makes comparisons with: (i) expected results, (ii) results of previous periods and (iii) results among REITs, more meaningful. FAD does not represent cash generated from operating activities determined in accordance with GAAP and is not necessarily indicative of cash available to fund cash needs as it excludes the following items which generally flow through our cash flows from operating activities: (i) adjustments for changes in working capital or the actual timing of the payment of income or expense items that are accrued in the period, (ii) transaction-related costs, (iii) litigation provision, (iv) severance-related expenses and (v) actual cash receipts from interest income recognized on loans receivable (in contrast to our FAD adjustment to exclude non-cash interest and depreciation related to our investments in direct financing leases). Furthermore, FAD is adjusted for recurring capital expenditures, which are generally not considered when determining cash flows from operations or liquidity. FAD is a non-GAAP supplemental financial measure and should not be considered as an alternative to net income (loss) determined in accordance with GAAP. For a reconciliation of net income (loss) to FAD and other relevant disclosure, refer to “Non-GAAP Financial Measure Reconciliations” below. Comparison of the Year Ended December 31, 2016 to the Year Ended December 31, 2015 and the Year Ended December 31, 2015 to the Year Ended December 31, 2014 Overview(1) 2016 and 2015 Results for the years ended December 31, 2016 and 2015 (dollars in thousands except per share data): (1) For the reconciliation of non-GAAP financial measures, see “Non-GAAP Financial Measure Reconciliations” section below. Earnings per share (“EPS”) increased primarily as a result of the following: · impairment charges during 2015 not repeated in 2016; · increased NOI from: (i) our 2015 and 2016 acquisitions, (ii) annual rent escalations and (iii) developments placed in service; · increased gains on sales of real estate due to a higher volume of disposition activity during 2016; · a reduction in interest expense as a result of debt repayments during 2015 and 2016; and · a net termination fee expense recognized in 2015 not repeated in 2016. The increase in EPS was partially offset by the following: · a reduction in income from our HCRMC investments as a result of: (i) the HCRMC lease amendment effective April 1, 2015, (ii) the sale of non-strategic assets during the second half of 2015 and 2016, and (iii) a change in income recognition to a cash basis method beginning in January 2016; · the impact from the Spin-Off of QCP resulting in: (i) increased transaction costs and (ii) loss on debt extinguishment, representing penalties on the prepayment of debt using proceeds from the Spin-Off; · increased income tax expense related to our estimated exposure to state built-in gain tax; · a reduction in interest income from placing our Four Seasons senior notes (“Four Seasons Notes”) on cost recovery status in the third quarter of 2015 and loan repayments during 2015 and 2016; · increased severance-related charges during 2016 primarily related to the departure of our former President and Chief Executive Officer (“CEO”) in July 2016; · increased depreciation and amortization from our 2015 and 2016 acquisitions; and · a reduction of foreign currency remeasurement gains recognized as a result of effective hedges designated in September 2015. FFO increased primarily as a result of the aforementioned events impacting EPS, excluding depreciation and amortization and gains on sales of real estate, both of which are adjustments to our calculation of FFO. FFO as adjusted decreased primarily as a result of the following: · a reduction in income from our HCRMC investments as a result of: (i) the HCRMC lease amendment effective April 1, 2015, (ii) the sale of non-strategic assets during the second half of 2015 and 2016 and (iii) a change in income recognition to a cash basis method beginning in January 2016; · decreased income from the QCP assets included in the Spin-Off; and · a reduction in interest income from placing our Four Seasons Notes on cost recovery status in the third quarter of 2015 and loan repayments during 2015 and 2016. The decrease in FFO as adjusted was partially offset by the following: · increased NOI from: (i) our 2015 and 2016 consolidated acquisitions, (ii) annual rent escalations and (iii) developments placed in service; and · a reduction in interest expense as a result of debt repayments during 2015 and 2016. FAD increased primarily as a result of the following: · increased NOI from: (i) our 2015 and 2016 consolidated acquisitions, (ii) annual rent escalations and (iii) developments placed in service; and · increased incremental interest income from the payoff of participating development loans. The increase in FAD was partially offset by the following: · decreased income from our HCRMC investments as a result of the HCRMC lease amendment effective April 1, 2015 and the sale of non-strategic assets during the second half of 2015 and the first half of 2016; · decreased income from the QCP assets included in the Spin-Off; · decreased interest income from placing our Four Seasons Notes on cost recovery status in the third quarter of 2015 and loan repayments during 2015 and 2016; and · increased leasing costs and second generation capital expenditures. 2015 and 2014 Results for the years ended December 31, 2015 and 2014 (dollars in thousands except per share data): EPS and FFO decreased primarily as a result of the following: · impairments related to our: (i) HCRMC DFL investments, (ii) investment in Four Seasons Notes and (iii) equity investment in HCRMC; · net fees recognized in 2014 for terminating the leases on 49 senior housing properties in a transaction with Brookdale not repeated in 2015; · increased transaction-related items as a result of higher levels of transactional activity in 2015; and · a severance-related charge related to the departure of our former Executive Vice President and Chief Investment Officer in June 2015. The decreases were partially offset by following: · increased NOI from our 2014 and 2015 acquisitions; · incremental interest income from the repayments of three development loans resulting from our share in the appreciation of the underlying real estate assets; · impairment recovery from a repayment of a loan receivable; and · increased foreign currency remeasurement gains. Additionally, EPS decreased as a result of: (i) decreased gain on sales of real estate and (ii) increased depreciation expense, partially offset by increased equity income from unconsolidated joint venture as a result of gain on sales of real estate from HCP Ventures III, LLC and HCP Ventures IV, LLC. FFO as adjusted and FAD increased primarily as a result of increased NOI from: (i) our 2014 and 2015 acquisitions and (ii) incremental interest income from the repayments of three development loans resulting from our share in the appreciation of the underlying real estate assets. The increases were partially offset by: (i) the decrease in income from DFLs as a result of the HCRMC Lease Amendment and (ii) placing our Four Seasons Notes on cost recovery status in the third quarter of 2015. Segment Analysis The tables below provide selected operating information for our SPP and total property portfolio for each of our business segments. For the year ended December 31, 2016, our consolidated SPP consists of 644 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2015 and that remained in operations under a consistent reporting structure. For the year ended December 31, 2015, our consolidated SPP consisted of 653 properties acquired or placed in service and stabilized on or prior to January 1, 2014 and that remained in operations under a consistent reporting structure. Our total property portfolio consists of 802, 1,205 and 1,196 properties at December 31, 2016, 2015 and 2014, respectively, and excludes properties classified as held for sale and discontinued operations. Senior Housing Triple-Net 2016 and 2015 Results as of and for the years ended December 31, 2016 and 2015 (dollars in thousands except per unit data): (1) Represents rental and related revenues and income from DFLs. (2) From our 2015 presentation of SPP, we removed nine SH NNN properties from SPP that were sold, 17 SH NNN properties that were transitioned to a RIDEA structure in our SHOP segment and 64 SH NNN properties that were classified as held for sale. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP. SPP NOI decreased primarily as a result of lower rents in our portfolio of assets leased to Sunrise Senior Living (the “Sunrise Portfolio”). SPP adjusted NOI increased primarily as a result of annual rent escalations, partially offset by lower cash rent received from our Sunrise portfolio. Non-SPP. Non-SPP NOI and adjusted NOI decreased primarily as a result of: (i) nine SH NNN facilities sold in 2016 and (ii) the transition of 17 SH NNN facilities to a RIDEA structure (reported in our SHOP segment), partially offset by five SH NNN facilities acquired in the first quarter of 2016. Total Portfolio. NOI and adjusted NOI decreased based on the combined decrease to non-SPP, partially offset by the increase to SPP adjusted NOI discussed above. 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars in thousands except per unit data): (1) Represents rental and related revenues and income from DFLs. (2) From our 2014 presentation of SPP, we removed 12 senior housing properties that were sold. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP. SPP NOI decreased primarily as a result of lower rents in our Sunrise Portfolio. SPP adjusted NOI increased primarily as a result of annual rent escalations. Non-SPP. Non-SPP NOI and adjusted NOI decreased primarily as a result of $38 million of net revenues recognized from a 2014 transaction with Brookdale and the transition of RIDEA II properties from SH NNN to SHOP. Total Portfolio. NOI and adjusted NOI decreased based on the combined decrease to non-SPP, partially offset by the increase to SPP adjusted NOI discussed above. Senior Housing Operating Portfolio 2016 and 2015 Results as of and for the years ended December 31, 2016 and 2015 (dollars in thousands, except per unit data): (1) From our 2015 presentation of SPP, we removed two SHOP properties from SPP that were sold and a SHOP property that was classified as held for sale. SPP. SPP NOI and adjusted NOI increased primarily as a result of increased occupancy and rates for resident fees and services. Non-SPP. Non-SPP NOI and adjusted NOI increased as a result of 2015 acquisitions, primarily our RIDEA III acquisition. The increase to non-SPP NOI was partially offset by an $8 million net termination fee related to our RIDEA III acquisition, which was not repeated in 2016. Total Portfolio. NOI and adjusted NOI increased based on the combined increases to SPP and non-SPP discussed above. 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars in thousands, except per unit data): SPP. SPP NOI and adjusted NOI increased primarily as a result of increased occupancy and rates for resident fees and services. Non-SPP. Non-SPP NOI and adjusted NOI increased as a result of: (i) acquisitions, primarily the CCRC JV in 2014 and RIDEA III in 2015, (ii) the transition of RIDEA II properties from SH NNN to SHOP and (iii) an $8 million net termination fee related to our RIDEA III acquisition in 2015. Total Portfolio. NOI and adjusted NOI increased based on the combined increases to SPP and non-SPP discussed above. Life Science 2016 and 2015 Results as of and for the years ended December 31, 2016 and 2015 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) Represents rental and related revenues and tenant recoveries. (2) From our 2015 presentation of SPP, we removed five life science facilities that were sold and four life science facilities that were classified as held for sale. SPP. SPP NOI and adjusted NOI increased primarily as a result of mark-to-market lease renewals, new leasing activity and increased occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations and a decline in rent abatements. Non-SPP. Non-SPP NOI and adjusted NOI increased primarily as a result of life science acquisitions in 2015 and 2016 and increased occupancy in a development placed in operation in 2016, partially offset by five life science facilities sold in 2016. Total Portfolio. NOI and adjusted NOI increased based on the combined increases to SPP and non-SPP discussed above. During the year ended December 31, 2016, 1.4 million square feet of new and renewal leases commenced at an average annual base rent of $32.70 per square foot, including 114,000 square feet related to a development placed in service at an average annual base rent of $55.80 per square foot, compared to 1.3 million square feet of expired and terminated leases with an average annual base rent of $26.25 per square foot. During the year ended December 31, 2016, we classified 324,000 square feet as real estate and related assets held for sale, net with an average annual base rent of $18.81 per square foot, acquired properties with 61,000 occupied square feet with an average annual base rent of $47.79 per square foot and disposed of 535,000 square feet with an average annual base rent of $53.46 per square foot. 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) Represents rental and related revenues and tenant recoveries. (2) From our 2014 presentation of SPP, we removed a life science facility that was placed into land held for development, which no longer meets our criteria for SPP as of the date placed into development. SPP. SPP NOI and adjusted NOI increased primarily as a result of increased occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations. Non-SPP. Non-SPP NOI and adjusted NOI increased primarily as a result of our life science development projects placed into service during 2014 and life science acquisitions in 2014 and 2015. Total Portfolio. NOI and adjusted NOI increased based on the combined increases to SPP and non-SPP discussed above. During the year ended December 31, 2015, 694,000 square feet of new and renewal leases commenced at an average annual base rent of $33.52 per square foot compared to 412,000 square feet of expired and terminated leases with an average annual base rent of $33.47 per square foot. During the year ended December 31, 2015, we acquired properties with 158,000 occupied square feet with an average annual base rent of $38.80 per square foot. Medical Office 2016 and 2015 Results as of and for the years ended December 31, 2016 and 2015 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) Represents rental and related revenues and tenant recoveries. (2) From our 2015 presentation of SPP, we removed three MOBs that were sold and six MOBs that were placed into redevelopment. SPP. SPP NOI and adjusted NOI increased primarily as a result of increased occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations. Non-SPP. Non-SPP NOI and adjusted NOI increased primarily as a result of increased occupancy in former redevelopment and development properties that have been placed into operations and additional NOI from our MOB acquisitions in 2015 and 2016, partially offset by the sale of three MOBs. Total Portfolio. NOI and adjusted NOI increased based on the combined increases to SPP and non-SPP discussed above. During the year ended December 31, 2016, 2.4 million square feet of new and renewal leases commenced at an average annual base rent of $22.96 per square foot, including 211,000 square feet related to developments and redevelopments placed into service at an average annual base rent of $24.62, compared to 2.1 million square feet of expiring and terminated leases with an average annual base rent of $23.19 per square foot. During the year ended December 31, 2016, we acquired properties with 897,000 square feet with an average annual base rent of $14.70 per square foot, including 756,000 square feet with a triple-net annual base rent of $13.00 per square foot, and disposed of 82,000 square feet with an average annual base rent of $23.94 per square foot. 2015 and 2014 Results as of and for the years ended December 31, 2015 and 2014 (dollars and sq. ft. in thousands, except per sq. ft. data): (1) Represents rental and related revenues and tenant recoveries. (2) From our 2014 presentation of SPP, we removed a MOB that was sold. SPP. SPP adjusted NOI increased as a result of annual rent escalations. Non-SPP. Non-SPP NOI and adjusted NOI increased primarily as a result of our MOB acquisitions in 2014 and 2015. Total Portfolio. NOI and adjusted NOI increased based on the combined increases to SPP and non-SPP discussed above. During the year ended December 31, 2015, 2.4 million square feet of new and renewal leases commenced at an average annual base rent of $23.82 per square foot compared to 2.4 million square feet of expiring and terminated leases with an average annual base rent of $24.15 per square foot. During the year ended December 31, 2015, we acquired properties with 1.9 million occupied square feet with an average annual base rent of $16.19 per square foot, including 1.2 million square feet with a triple-net annual base rent of $10.74 per square foot, and disposed of 17,000 square feet with an average annual base rent of $17.50 per square foot. Other Income and Expense Items Results for the years ended December 31, 2016, 2015 and 2014 (in thousands): Interest income. The decrease in interest income for the year ended December 31, 2016 was primarily the result of: (i) placing our Four Seasons Notes on cost recovery status in the third quarter of 2015 and (ii) paydowns in our loan portfolio. The decrease in interest income was partially offset by additional interest income from: (i) the Four Seasons senior secured term loan purchased in the fourth quarter of 2015 and (ii) additional fundings in our loan portfolio, including our £105 million ($131 million) loan to Maria Mallaband in November 2016. The increase in interest income for the year ended December 31, 2015 was primarily the result of: (i) fundings through our U.K. loan facility to HC-One in November 2014 and February 2015, (ii) incremental interest income from the repayments of three development loans resulting from the appreciation of the underlying real estate assets and (iii) additional fundings under our mezzanine loan facility with Tandem in May 2015. The increase in interest income was partially offset by the impact of placing our Four Seasons Notes on cost recovery status in the third quarter of 2015. Interest expense. The decrease in interest expense for the year ended December 31, 2016 was primarily the result of: (i) mortgage debt repayments during 2015 and 2016, primarily from mortgage debt secured by properties in our SH NNN, life science and medical office segments, (ii) senior unsecured notes payoffs during 2015 and 2016 and higher capitalized interest. The decrease in interest expense was partially offset by: (i) senior unsecured notes issued during 2015 and (ii) increased borrowings under our line of credit facility. The increase in interest expense for the year ended December 31, 2015 was primarily the result of: (i) senior unsecured notes issued during 2014 and 2015, (ii) increased borrowings from our term loan originated in 2015, (iii) increased borrowings under our line of credit facility and (iv) lower capitalized interest. The increase in interest expense was partially offset by: (i) repayments of senior unsecured notes and (ii) mortgage debt that matured during 2014 and 2015. The increased borrowings were used to fund our investment activities and to refinance our debt maturities. The table below sets forth information with respect to our debt, excluding premiums, discounts and debt issuance costs (dollars in thousands): (1) At December 31, 2016, 2015 and 2014, excludes $92 million, $94 million and $97 million of other debt, respectively, that represents non-interest bearing life care bonds and occupancy fee deposits at certain of our senior housing facilities and demand notes that have no scheduled maturities. At December 31, 2016, 2015 and 2014, principal balances of $46 million, $71 million and $71 million of variable-rate mortgages, respectively, are presented as fixed-rate debt as the interest payments were swapped from variable to fixed. At December 31, 2016, 2015 and 2014, principal balances of £220 million ($272 million), £357 million ($526 million) and £137 million ($214 million) term loans, respectively, are presented as fixed-rate debt as the interest payments were swapped from variable to fixed. Depreciation and amortization. The increase in depreciation and amortization expense for the year ended December 31, 2016 was primarily the result of the impact of acquisitions primarily in our SHOP and medical office segments. The increase in depreciation and amortization expense for the year ended December 31, 2015 was primarily the result of the impact of our acquisitions primarily in our SHOP, life science and medical office segments and redevelopment projects placed in service during 2014 and 2015 primarily in our life science and medical office segments. The increase in depreciation and amortization expense was partially offset by additional depreciation expense recognized in 2014 as a result of a change in estimate of the depreciable life and residual value of certain properties in our SN NNN and medical office segments. General and administrative expenses. The increase in general and administrative expenses for the year ended December 31, 2016 was primarily the result of: (i) higher severance-related charges primarily resulting from the departure of our former President and CEO in July 2016 and (ii) higher professional fees in 2016, partially offset by lower compensation related expenses. The increase in general and administrative expenses for the year ended December 31, 2015 was primarily the result of: (i) a severance-related charge resulting from the resignation of our former Executive Vice President and Chief Investment Officer in June 2015 and (ii) higher compensation related expenses. Acquisition and pursuit costs. The decrease in acquisition and pursuit costs for the year ended December 31, 2016 was primarily a result of lower levels of transactional activity in 2016 compared to the same period in 2015. The increase in acquisition and pursuit costs for the year ended December 31, 2015 was primarily due to higher levels of transactional activity in 2015, including transactional costs related to the U.K. and RIDEA III investments. Beginning in the first quarter of 2017, upon the Company’s planned adoption of the Financial Accounting Standards Board’s Accounting Standards Update No. 2017-01, Clarifying the Definition of a Business, the Company expects a decrease in acquisition and pursuit costs recognized within its consolidated statements of operations. See Note 2 to the Consolidated Financial Statements for further information. Impairments, net. During the year ended December 31, 2015, we recognized the following impairment charges: (i) $112 million related to our investment in Four Seasons Notes and (ii) $3 million related to a MOB. The impairment charges were partially offset by a $6 million impairment recovery related to the repayment of a loan. Gain on sales of real estate, net. During the year ended December 31, 2016, we sold a portfolio of five facilities in one of our non-reportable segments and two SH NNN facilities for $130 million, five life science facilities for $386 million, seven SH NNN facilities for $88 million, three MOBs for $20 million and three SHOP facilities for $41 million, recognizing total gain on sales of $165 million. During the year ended December 31, 2015, we sold the following assets: (i) nine SH NNN facilities for $60 million, resulting from Brookdale’s exercise of its purchase option, (ii) two parcels of land in our life science segment for $51 million and (iii) a MOB for $0.4 million, recognizing total gain on sales of $6 million. Loss on debt extinguishments. During the fourth quarter of 2016, using proceeds from the Spin-Off, we repaid $1.1 billion of senior unsecured notes that were due to mature in January 2017 and January 2018 and repaid $108 million of mortgage debt; incurring aggregate loss on debt extinguishments of $46 million, primarily related to prepayment penalties. Other income, net. The decrease in other income, net for the year ended December 31, 2016 was primarily the result of a reduction of foreign currency remeasurement gains from remeasuring assets and liabilities denominated in GBP to U.S. dollars (“USD”) as a result of effective hedges designated in September 2015. The increase in other income, net for the year ended December 31, 2015 was primarily the result of the impact from remeasuring assets and liabilities denominated in GBP to USD. Income tax (expense) benefit. The increase in income taxes for the year ended December 31, 2016 was primarily the result of recognizing tax liabilities representing our estimated exposure to state built-in gain tax. The decrease in income taxes for the year ended December 31, 2015 was primarily the result of the tax benefit related to our share of operating losses from our RIDEA joint ventures formed as part of the 2014 Brookdale transaction and related to our U.K. real estate investments in 2015. Equity income (loss) from unconsolidated joint ventures. The increase in equity income from unconsolidated joint ventures for the year ended December 31, 2016 was primarily the result of increased income from our share of gains on sales of real estate. The increase in equity income from unconsolidated joint ventures for the year ended December 31, 2015 was primarily the result of our share of gains on sales of real estate from HCP Ventures III, LLC and HCP Ventures IV, LLC, partially offset by our share of operating losses recognized from the CCRC JV. Total discontinued operations. Discontinued operations for the years ended December 31, 2016, 2015 and 2014 resulted in income of $266 million, loss of $699 million and income of $665 million, respectively. Income and loss from discontinued operations primarily relates to the operations of QCP. Income from discontinued operations increased during the year ended December 31, 2016 as a result of impairment charges during 2015 not repeated in 2016. The increase in discontinued operations was partially offset by the following: (i) a reduction in income from our HCRMC investments as a result of the HCRMC lease amendment effective April 1, 2015, the sale of non-strategic assets during the second half of 2015 and the first half of 2016, and a change in income recognition to a cash basis method beginning in January 2016, (ii) transaction costs of $87 million related to the Spin-Off and (iii) increased income tax expense related to our estimated exposure to state built-in gain tax. During the years ended December 31, 2015 and 2014, we recognized impairments of $1.3 billion and $36 million, respectively, related to our HCRMC portfolio. Liquidity and Capital Resources We anticipate: (i) funding recurring operating expenses, (ii) meeting debt service requirements including principal payments and maturities, and (iii) satisfying our distributions to our stockholders and non-controlling interest members, for the next 12 months primarily by using cash flow from operations, available cash balances and cash from our various sources of financing. Our principal investing liquidity needs for the next 12 months are to: · fund capital expenditures, including tenant improvements and leasing costs; and · fund future acquisition, transactional and development activities. We anticipate satisfying these future investing needs using one or more of the following: · issuance of common or preferred stock; · issuance of additional debt, including unsecured notes and mortgage debt; · draws on our credit facilities; and/or · sale or exchange of ownership interests in properties. Access to capital markets impacts our cost of capital and ability to refinance maturing indebtedness, as well as our ability to fund future acquisitions and development through the issuance of additional securities or secured debt. Credit ratings impact our ability to access capital and directly impact our cost of capital as well. For example, as noted below, our revolving line of credit facility accrues interest at a rate per annum equal to LIBOR plus a margin that depends upon our credit ratings. We also pay a facility fee on the entire revolving commitment that depends upon our credit ratings. As of January 31, 2017, we had a credit rating of BBB from Fitch, Baa2 from Moody’s and BBB from S&P Global on our senior unsecured debt securities. Cash Flow Summary The following summary discussion of our cash flows is based on the Consolidated Statements of Cash Flows and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below. Cash and cash equivalents were $95 million and $340 million at December 31, 2016 and 2015, respectively, reflecting a decrease of $245 million. The following table sets forth changes in cash flows (dollars in thousands): The decrease in operating cash flow is primarily the result of increased transaction costs and decreased income related to the Spin-Off, partially offset by our 2015 and 2016 acquisitions, annual rent increases and increased working capital. Our cash flow from operations is dependent upon the occupancy levels of our buildings, rental rates on leases, our tenants’ performance on their lease obligations, the level of operating expenses and other factors. The following are significant investing and financing activities for the year ended December 31, 2016: · made investments of $1.3 billion (development, leasing and acquisition of real estate, investments in unconsolidated joint ventures and loans, and purchases of securities) and received proceeds of $908 million primarily from real estate and DFL sales; · paid cash dividends on common stock of $980 million, which were generally funded by cash provided by our operating activities and cash on hand; and · received net proceeds of $1.7 billion from the Spin-Off of QCP, raised proceeds of $1.2 billion primarily from our net borrowings under our bank line of credit, and repaid $2.9 billion under our bank line of credit, senior unsecured notes and mortgage debt. Debt Bank line of credit and Term Loans. Our $2.0 billion unsecured revolving line of credit facility (the “Facility”) matures on March 31, 2018 and contains a one-year extension option. Borrowings under the Facility accrue interest at LIBOR plus a margin that depends on our credit ratings. We pay a facility fee on the entire revolving commitment that depends on our credit ratings. Based on our credit ratings at January 31, 2017, the margin on the Facility was 1.05%, and the facility fee was 0.20%. The Facility also includes a feature that allows us to increase the borrowing capacity by an aggregate amount of up to $500 million, subject to securing additional commitments from existing lenders or new lending institutions. At December 31, 2016, we had $900 million, including £372 million ($460 million), outstanding under the Facility with a weighted average effective interest rate of 1.821%. In January 2017, we paid down $440 million on the Facility primarily using proceeds from our RIDEA II transaction. On July 30, 2012, we entered into a credit agreement with a syndicate of banks for a £137 million ($169 million at December 31, 2016) unsecured term loan, which matures in 2017. Based on our credit ratings at January 31, 2017, the 2012 Term Loan accrues interest at a rate of GBP LIBOR plus 1.40%. On January 12, 2015, we entered into a credit agreement with a syndicate of banks for a £220 million ($272 million at December 31, 2016) four-year unsecured term loan (the “2015 Term Loan”) that accrues interest at a rate of GBP LIBOR plus 1.15%, subject to adjustments based on our credit ratings (the 2012 and 2015 Term Loans are collectively, the “Term Loans”). Proceeds from the 2015 Term Loan were used to repay a £220 million draw on the Facility that partially funded the November 2014 HC-One Facility (see Note 7 to the Consolidated Financial Statements). Concurrently, we entered into a three-year interest rate swap agreement that effectively fixes the interest rate of the 2015 Term Loan (1.97% at December 31, 2016). The 2015 Term Loan contains a one-year committed extension option. The Facility and Term Loans contain certain financial restrictions and other customary requirements, including cross-default provisions to other indebtedness. Among other things, these covenants, using terms defined in the agreements, (i) limit the ratio of Consolidated Total Indebtedness to Consolidated Total Asset Value to 60%, (ii) limit the ratio of Secured Debt to Consolidated Total Asset Value to 30%, (iii) limit the ratio of Unsecured Debt to Consolidated Unencumbered Asset Value to 60% and (iv) require a minimum Fixed Charge Coverage ratio of 1.5 times. The Facility and Term Loans also require a Minimum Consolidated Tangible Net Worth of $6.5 billion at December 31, 2016, which requirement was reduced, via an amendment to the Facility, effective upon the completion of the Spin-Off of QCP on October 31, 2016. At December 31, 2016, we were in compliance with each of these restrictions and requirements of the Facility and Term Loans. Senior unsecured notes. At December 31, 2016, we had senior unsecured notes outstanding with an aggregate principal balance of $7.2 billion. Interest rates on the notes ranged from 2.79% to 6.88%, with a weighted average effective interest rate of 4.34% and a weighted average maturity of six years at December 31, 2016. The senior unsecured notes contain certain covenants including limitations on debt, maintenance of unencumbered assets, cross-acceleration provisions and other customary terms. At December 31, 2016, we believe we were in compliance with these covenants. Mortgage debt. At December 31, 2016, we had $619 million in aggregate principal amount of mortgage debt outstanding that is secured by 36 healthcare facilities (including redevelopment properties) with a carrying value of $899 million. Interest rates on the mortgage debt ranged from 3.02% to 7.50%, with a weighted average effective interest rate of 3.40% and a weighted average maturity of six years at December 31, 2016. Mortgage debt generally requires monthly principal and interest payments, is collateralized by real estate assets and is generally non-recourse. Mortgage debt typically restricts transfer of the encumbered assets, prohibits additional liens, restricts prepayment, requires payment of real estate taxes, requires maintenance of the assets in good condition, requires maintenance of insurance on the assets, and includes conditions to obtain lender consent to enter into or terminate material leases. Some of the mortgage debt is also cross-collateralized by multiple assets and may require tenants or operators to maintain compliance with the applicable leases or operating agreements of such real estate assets. Equity At December 31, 2016, we had 468 million shares of common stock outstanding, equity totaled $5.9 billion, and our equity securities had a market value of $14.1 billion. At December 31, 2016, non-managing members held an aggregate of 4 million units in five limited liability companies (“DownREITs”) for which we are the managing member. The DownREIT units are exchangeable for an amount of cash approximating the then-current market value of shares of our common stock or, at our option, shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). At-The-Market Program. In June 2015, we established an at-the-market program, in connection with the renewal of our Shelf Registration Statement. Under this program, we may sell shares of our common stock from time to time having an aggregate gross sales price of up to $750 million through a consortium of banks acting as sales agents or directly to the banks acting as principals. There was no activity during the year ended December 31, 2016 and, as of December 31, 2016, shares of our common stock having an aggregate gross sales price of $676 million were available for sale under the at-the-market program. Actual future sales will depend upon a variety of factors, including but not limited to market conditions, the trading price of our common stock and our capital needs. We have no obligation to sell the remaining shares available for sale under our program. Shelf Registration We filed a prospectus with the SEC as part of a registration statement on Form S-3ASR, using a shelf registration process, which expires in June 2018. Under the “shelf” process, we may sell any combination of the securities described in the prospectus through one or more offerings. The securities described in the prospectus include common stock, preferred stock, depositary shares, debt securities and warrants. Contractual Obligations The following table summarizes our material contractual payment obligations and commitments at December 31, 2016 (in thousands): (1) Excludes $92 million of other debt that represents life care bonds and demand notes that have no scheduled maturities. Additionally, excludes a $100 million unsecured revolving credit facility commitment to QCP, which is available to be drawn upon by QCP through the fourth quarter of 2017 and matures in the fourth quarter of 2018. The unsecured revolving credit facility will automatically and permanently decrease each calendar month by an amount equal to 50% of QCP's and its restricted subsidiaries’ retained cash flow for the prior calendar month. All borrowings under the unsecured revolving credit facility will be subject to the satisfaction of certain conditions (see Note 1 to the Consolidated Financial Statements). (2) Includes £372 million ($460 million) translated into USD. (3) Represents £357 million translated into USD. (4) Represents £35 million translated into USD for commitments to fund our U.K. loan facilities. (5) Represents commitments to finance development projects and related working capital financings. (6) Represents construction and other commitments for developments in progress. (7) Interest on variable-rate debt is calculated using rates in effect at December 31, 2016. Off-Balance Sheet Arrangements We own interests in certain unconsolidated joint ventures as described under Note 8 to the Consolidated Financial Statements. Except in limited circumstances, our risk of loss is limited to our investment in the joint venture and any outstanding loans receivable. In addition, we have certain properties which serve as collateral for debt that is owed by a previous owner of certain of our facilities, as described under Note 12 to the Consolidated Financial Statements. Our risk of loss for these certain properties is limited to the outstanding debt balance plus penalties, if any. We have no other material off-balance sheet arrangements that we expect would materially affect our liquidity and capital resources except those described above under “Contractual Obligations”. Inflation Our leases often provide for either fixed increases in base rents or indexed escalators, based on the Consumer Price Index or other measures, and/or additional rent based on increases in the tenants’ operating revenues. Most of our MOB leases require the tenant to pay a share of property operating costs such as real estate taxes, insurance and utilities. Substantially all of our senior housing, life science, and remaining other leases require the tenant or operator to pay all of the property operating costs or reimburse us for all such costs. We believe that inflationary increases in expenses will be offset, in part, by the tenant or operator expense reimbursements and contractual rent increases described above. Non-GAAP Financial Measure Reconciliations Funds From Operations and Funds Available for Distribution The following is a reconciliation from net income (loss) applicable to common shares, the most directly comparable financial measure calculated and presented in accordance with GAAP, to FFO, FFO as adjusted and FAD (in thousands, except per share data): (1) For the year ended December 31, 2016, transaction-related items primarily relate to the Spin-Off. For the year ended December 31, 2015, transaction-related items primarily relate to acquisition and pursuit costs. For the year ended December 31, 2014, transaction-related items include a net benefit from the 2014 Brookdale transaction, partially offset by acquisition and pursuit costs. For the years ended December 31, 2013 and 2012, transaction-related items primarily relate to acquisition and pursuit costs. (2) For the year ended December 31, 2015, other impairments, net include impairment charges of: (i) $1.3 billion related to our HCRMC DFL investments, (ii) $112 million related to our Four Seasons Notes and (iii) $46 million related to our equity investment in HCRMC, partially offset by an impairment recovery of $6 million related to a loan payoff. For the year ended December 31, 2014, the other impairment relates to our equity investment in HCRMC. (3) Represents penalties of $46 million from the prepayment of $1.1 billion of senior unsecured notes and $108 million of mortgage debt using proceeds from the Spin-Off. (4) For the year ended December 31, 2016, severance-related charges primarily relate to the departure of our former President and CEO. For the year ended December 31, 2015, the severance-related charge relates to the departure of our former Executive Vice President and Chief Investment Officer. For the year ended December 31, 2013, the severance-related charge relates to the departure of our former Chairman, CEO and President. (5) Our weighted average shares for the year ended December 31, 2012 used to calculate diluted FFO as adjusted eliminate the impact of 22 million shares from our common stock offering completed on October 19, 2012; proceeds from this offering were used to fund the Blackstone JV acquisition. (6) Excludes $7 million primarily related to the acceleration of deferred compensation for restricted stock units that vested upon the departure of our former President and CEO, which is included in the severance-related charges for the year ended December 31, 2016. Excludes $3 million related to the acceleration of deferred compensation for restricted stock units and stock options that vested upon the departure of our former Executive Vice President and Chief Investment Officer, which is included in the severance-related charge for year ended December 31, 2015. Excludes $17 million related to the acceleration of deferred compensation for restricted stock units and options that vested upon the departure of our former CEO, which is included in severance-related charges for the year ended December 31, 2013. (7) Our equity investment in HCRMC was accounted for using the equity method, which required an elimination of DFL income that is proportional to our ownership in HCRMC. Further, our share of earnings from HCRMC (equity income) increased for the corresponding elimination of related lease expense recognized at the HCRMC entity level, which we presented as a non-cash joint venture FAD adjustment. Beginning in January 2016, as a result of placing our equity investment in HCRMC on a cash basis method of accounting, we no longer eliminated our proportional ownership share of income from DFLs to equity income (loss) from unconsolidated joint ventures. See Note 5 to the Consolidated Financial Statements for additional discussion. Critical Accounting Policies The preparation of financial statements in conformity with U.S. GAAP requires our management to use judgment in the application of accounting policies, including making estimates and assumptions. We base estimates on the best information available to us at the time, our experience and on various other assumptions believed to be reasonable under the circumstances. These estimates affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions or other matters had been different, it is possible that different accounting would have been applied, resulting in a different presentation of our consolidated financial statements. From time to time, we re-evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current estimates and assumptions about matters that are inherently uncertain. For a more detailed discussion of our significant accounting policies, see Note 2 to the Consolidated Financial Statements. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain. Principles of Consolidation The consolidated financial statements include the accounts of HCP, Inc., our wholly-owned subsidiaries and joint ventures that we control, through voting rights or other means. We consolidate investments in variable interest entities (“VIEs”) when we are the primary beneficiary of the VIE. A variable interest holder is considered to be the primary beneficiary of a VIE if it has the power to direct the activities that most significantly impact the entity’s economic performance and has the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to the VIE. We make judgments about which entities are VIEs based on an assessment of whether: (i) the equity investors as a group, do not have a controlling financial interest, (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support, or (iii) substantially all of the entity’s activities involve or are performed on behalf of an equity investor that holds disproportionately few voting rights. We make judgments with respect to our level of influence or control over an entity and whether we are (or are not) the primary beneficiary of a VIE. Consideration of various factors includes, but is not limited to, our ability to direct the activities that most significantly impact the entity’s economic performance, our form of ownership interest, our representation on the entity’s governing body, the size and seniority of our investment, and our ability and the rights of other investors to participate in policy making decisions, replace the manager and/or liquidate the entity, if applicable. Our ability to correctly assess our influence or control over an entity when determining the primary beneficiary of a VIE affects the presentation of these entities in our consolidated financial statements. When we perform a re-analysis of the primary beneficiary at a date other than at inception of the VIE, our assumptions may be different and may result in the identification of a different primary beneficiary. If we determine that we are the primary beneficiary of a VIE, our consolidated financial statements would include the operating results of the VIE rather than the results of the variable interest in the VIE. We would require the VIE to provide us timely financial information and would review the internal controls of the VIE to determine if we could rely on the financial information it provides. If the VIE has deficiencies in its internal controls over financial reporting, or does not provide us with timely financial information, this may adversely impact the quality and/or timing of our financial reporting and our internal controls over financial reporting. Revenue Recognition At the inception of a new lease arrangement, including new leases that arise from amendments, we assess the terms and conditions to determine the proper lease classification. A lease arrangement is classified as an operating lease if none of the following criteria are met: (i) transfer of ownership to the lessee prior to or shortly after the end of the lease term, (ii) lessee has a bargain purchase option during or at the end of the lease term, (iii) the lease term is equal to 75% or more of the underlying property’s economic life, or (iv) the present value of future minimum lease payments (excluding executory costs) is equal to 90% or more of the excess estimated fair value (over retained tax credits) of the leased asset. If one of the four criteria is met and the minimum lease payments are determined to be reasonably predictable and collectible, the lease arrangement is generally accounted for as a direct financing lease. If the assumptions utilized in the above classifications assessments were different, our lease classification for accounting purposes may have been different; thus the timing and amount of our revenue recognized would have been impacted, which may be material to our consolidated financial statements. We recognize rental revenue for operating leases on a straight-line basis over the lease term when collectibility of all minimum lease payments is reasonably assured and the tenant has taken possession or controls the physical use of a leased asset. If the lease provides for tenant improvements, we determine whether the tenant improvements are owned by the tenant or us. When we are the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the leased asset until the tenant improvements are substantially complete. When the tenant is the owner of the tenant improvements, any tenant improvement allowance funded is treated as a lease incentive and amortized as a reduction of revenue over the lease term. The determination of ownership of a tenant improvement is subject to significant judgment. If our assessment of the owner of the tenant improvements was different, the timing and amount of our revenue recognized would be impacted. Certain leases provide for additional rents that are contingent upon a percentage of the facility’s revenue in excess of specified base amounts or other thresholds. Such revenue is recognized when actual results reported by the tenant, or estimates of tenant results, exceed the base amount or other thresholds. The recognition of additional rents requires us to make estimates of amounts owed and, to a certain extent, is dependent on the accuracy of the facility results reported to us. Our estimates may differ from actual results, which could be material to our consolidated financial statements. We maintain an allowance for doubtful accounts, including an allowance for operating lease straight-line rent receivables, for estimated losses resulting from tenant defaults or the inability of tenants to make contractual rent and tenant recovery payments. We monitor the liquidity and creditworthiness of our tenants and operators on a continuous basis. This evaluation considers industry and economic conditions, property performance, credit enhancements and other factors. For straight-line rent receivable amounts, our assessment is based on income recoverable over the term of the lease. We exercise judgment in establishing allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. We use the direct finance method of accounting to record income from DFLs. For leases accounted for as DFLs, the net investment in the DFL represents receivables for the sum of future minimum lease payments receivable and the estimated residual values of the leased properties, less the unamortized unearned income. Unearned income is deferred and amortized to income over the lease terms to provide a constant yield when collectibility of the lease payments is reasonably assured. The determination of estimated useful lives and residual values are subject to significant judgment. If these assessments were to change, the timing and amount of our revenue recognized would be impacted. Loans receivable are classified as held-for-investment based on management’s intent and ability to hold the loans for the foreseeable future or to maturity. We recognize interest income on loans, including the amortization of discounts and premiums, using the interest method applied on a loan-by-loan basis when collectibility of the future payments is reasonably assured. Premiums, discounts and related costs are recognized as yield adjustments over the term of the related loans. If management determined that certain loans should no longer be classified as held-for-investment, the timing and amount of our interest income recognized would be impacted. Loans receivable and DFLs (collectively, “Finance Receivables”), are reviewed and assigned an internal rating of Performing, Watch List or Workout. Finance Receivables that are deemed Performing meet all present contractual obligations, and collection and timing, of all amounts owed is reasonably assured. Watch List Finance Receivables are defined as Finance Receivables that do not meet the definition of Performing or Workout. Workout Finance Receivables are defined as Finance Receivables in which we have determined, based on current information and events, that: (i) it is probable we will be unable to collect all amounts due according to the contractual terms of the agreement, (ii) the tenant, operator, or borrower is delinquent on making payments under the contractual terms of the agreement (iii) and we have commenced action or anticipate pursuing action in the near term to seek recovery of our investment. Finance Receivables are placed on nonaccrual status when management determines that the collectibility of contractual amounts is not reasonably assured (the asset will have an internal rating of either Watch List or Workout). Further, we perform a credit analysis to support the tenant’s, operator’s, borrower’s and/or guarantor’s repayment capacity and the underlying collateral values. We use the cash basis method of accounting for Finance Receivables placed on nonaccrual status unless one of the following conditions exist whereby we utilize the cost recovery method of accounting: (i) if we determine that it is probable that we will only recover the recorded investment in the Finance Receivable, net of associated allowances or charge-offs (if any), or (ii) we cannot reasonably estimate the amount of an impaired Finance Receivable. For cash basis method of accounting we apply payments received, excluding principal paydowns, to interest income so long as that amount does not exceed the amount that would have been earned under the original contractual terms. For cost recovery method of accounting any payment received is applied to reduce the recorded investment. Generally, we return a Finance Receivable to accrual status when all delinquent payments become current under the terms of the loan or lease agreements and collectibility of the remaining contractual loan or lease payments is reasonably assured. Allowances are established for Finance Receivables on an individual basis utilizing an estimate of probable losses, if they are determined to be impaired. Finance Receivables are impaired when it is deemed probable that we will be unable to collect all amounts due in accordance with the contractual terms of the loan or lease. An allowance is based upon our assessment of the lessee’s or borrower’s overall financial condition, economic resources, payment record, the prospects for support from any financially responsible guarantors and, if appropriate, the net realizable value of any collateral. These estimates consider all available evidence, including the expected future cash flows discounted at the Finance Receivable’s effective interest rate, fair value of collateral, general economic conditions and trends, historical and industry loss experience, and other relevant factors, as appropriate. Should a Finance Receivable be deemed partially or wholly uncollectible, the uncollectible balance is charged off against the allowance in the period in which the uncollectible determination has been made. Real Estate We make estimates as part of our process for allocating a purchase price to the various identifiable assets of an acquisition based upon the relative fair value of each asset. The most significant components of our allocations are typically buildings as-if-vacant, land and in-place leases. In the case of allocating fair value to buildings and intangibles, our fair value estimates will affect the amount of depreciation and amortization we record over the estimated useful life of each asset acquired or the remaining lease term. In the case of allocating fair value to in-place leases, we make our best estimates based on our evaluation of the specific characteristics of each tenant’s lease. Factors considered include estimates of carrying costs during hypothetical expected lease-up periods, market conditions and costs to execute similar leases. Our assumptions affect the amount of future revenue that we will recognize over the remaining lease term for the acquired in-place leases. A variety of costs are incurred in the development and leasing of properties. After determination is made to capitalize a cost, it is allocated to the specific component of a project that is benefited. Determination of when a development project is substantially complete and capitalization must cease involves a degree of judgment. The costs of land and buildings under development include specifically identifiable costs. The capitalized costs include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs, real estate taxes and other costs incurred during the period of development. We consider a construction project to be considered substantially complete and available for occupancy and cease capitalization of costs upon the completion of the related tenant improvements. Impairment of Long-Lived Assets We assess the carrying value of our real estate assets and related intangibles (“real estate assets”) when events or changes in circumstances indicate that the carrying amount of the real estate assets may not be recoverable, but at least annually. Recoverability of real estate assets is measured by comparing the carrying amount of the real estate assets to the respective estimated future undiscounted cash flows. The estimated future undiscounted cash flows are calculated utilizing the lowest level of identifiable cash flows that are largely independent of the cash flows of other assets and liabilities. In order to review our real estate assets for recoverability, we consider market conditions, as well as our intent with respect to holding or disposing of the asset. If our analysis indicates that the carrying value of the real estate assets is not recoverable on an undiscounted cash flow basis, we recognize an impairment charge for the amount by which the carrying value exceeds the fair value of the real estate asset. The determination of the fair value of real estate assets involves significant judgment. This judgment is based on our analysis and estimates of fair value of real estate assets, future operating results and resulting cash flows of each real estate asset whose carrying amount may not be recoverable. Our ability to accurately predict future operating results, resulting cash flows and estimate and allocate fair values impacts the timing and recognition of impairments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our financial results. Investments in Unconsolidated Joint Ventures The initial carrying value of investments in unconsolidated joint ventures is based on the amount paid to purchase the joint venture interest or the carrying value of the assets prior to the sale or contribution of the interests to the joint venture. We evaluate our equity method investments for impairment indicators based upon a comparison of the fair value of the equity method investment to our carrying value. If we determine there is a decline in the fair value of our investment in an unconsolidated joint venture below its carrying value and it is other-than-temporary, an impairment is recorded. The determination of the fair value of investments in unconsolidated joint ventures and as to whether a deficiency in fair value is “other-than-temporary” involves significant judgment. Our estimates consider all available evidence including, as appropriate, the present value of the expected future cash flows discounted at market rates, general economic conditions and trends, severity and duration of a fair value deficiency, and other relevant factors. Capitalization rates, discount rates and credit spreads utilized in our valuation models are based upon rates that we believe to be within a reasonable range of current market rates for the respective investments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our financial results. Income Taxes As part of the process of preparing our consolidated financial statements, significant management judgment is required to evaluate our compliance with REIT requirements. Our determinations are based on interpretation of tax laws, and our conclusions may have an impact on the income tax expense recognized. Adjustments to income tax expense may be required as a result of: (i) audits conducted by federal, state and local tax authorities, (ii) our ability to qualify as a REIT, (iii) the potential for built-in gain recognition, and (iv) changes in tax laws. Adjustments required in any given period are included within the income tax provision. Recent Accounting Pronouncements See Note 2 to the Consolidated Financial Statements for the impact of new accounting standards.

<s>[INST] · 2016 Transaction Overview · Dividends · Results of Operations · Liquidity and Capital Resources · Contractual Obligations · OffBalance Sheet Arrangements · Inflation · NonGAAP Financial Measure Reconciliations · Critical Accounting Policies · Recent Accounting Pronouncements 2016 Transaction Overview SpinOff of Real Estate Portfolio On October 31, 2016, we completed our previously announced SpinOff of QCP. QCP’s assets include 338 properties, primarily comprised of the HCRMC DFL investments and an equity investment in HCRMC. Following the completion of the SpinOff on October 31, 2016, QCP is an independent, publiclytraded, selfmanaged and selfadministrated REIT. As a result of the SpinOff, the operations of QCP are now classified as discontinued operations in all periods presented herein. We entered into a Separation and Distribution Agreement (the “Separation and Distribution Agreement”) with QCP in connection with the SpinOff. The Separation and Distribution Agreement divides and allocates the assets and liabilities of HCP prior to the SpinOff between QCP and HCP, governs the rights and obligations of the parties regarding the SpinOff, and contains other key provisions relating to the separation of QCP’s business from HCP. In connection with the SpinOff, we entered into a Transition Services Agreement ("TSA") with QCP. Per the terms of the TSA, we agreed to provide certain administrative and support services to QCP on a transitional basis for established fees, which are expected to approximate the actual cost incurred by us in providing the transition services to QCP for the relevant period. The TSA will terminate on the expiration of the term of the last service provided under the agreement, which will be on or prior to October 30, 2017. The TSA provides that QCP generally has the right to terminate a transition service upon thirty days' notice to us. The TSA contains provisions under which we will, subject to certain limitations, be obligated to indemnify QCP for losses incurred by QCP resulting from our breach of the TSA. See Notes 1 and 5 to the Consolidated Financial Statements for further information on the SpinOff. Investment Transactions In January 2016, we acquired a portfolio of five private pay senior housing communities with 364 units and a skilled nursing facility with 120 beds for $95 million. All of the communities were developed within the past two years and are triplenet leased to four regional operators. In July 2016, we acquired two Class A life science buildings totaling 136,000 square feet and a fouracre parcel of land in San Diego, California for $49 million. In September 2016, we acquired a portfolio of seven private pay senior housing communities for $186 million, including the assumption of $74 million of debt, at a 4.0% interest rate, maturing in 2044. Consisting of 526 assisted living and memory care units, the portfolio is managed by Senior Lifestyle Corporation in a 100% owned RIDEA structure. In November 2016, we entered into agreements with Maria Mallaband Care Group (“Maria Mallaband”) to acquire a portfolio of predominantly private pay prime care homes located in London/SouthEast England for $131 million (£105 million). In mid2017, through the exercise of a call option, subject to certain contingencies, we intend to convert our bridge loan provided to Maria Mallaband in November into fee ownership and enter into a Master Lease with Maria Mallaband. In December 2016, we acquired a portfolio of 10 MOBs, including nine oncampus MOBs, located throughout the U.S. in a saleleaseback transaction with Community Health Systems for $163 million. The MOBs have an initial lease term of 15 years. Developments Through February 13, 2017, we have [/INST] Negative. </s>

HCP, INC.

2018-02-13

2017-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: • 2017 Transaction Overview • Dividends • Results of Operations • Liquidity and Capital Resources • Contractual Obligations • Off-Balance Sheet Arrangements • Inflation • Non-GAAP Financial Measure Reconciliations • Critical Accounting Policies • Recent Accounting Pronouncements 2017 Transaction Overview Master Transactions and Cooperation Agreement with Brookdale On November 1, 2017, HCP and Brookdale entered into a Master Transactions and Cooperation Agreement (the “MTCA”) to provide us with the ability to significantly reduce our concentration of assets leased to and/or managed by Brookdale (the "Brookdale Transaction"). Through a series of dispositions and transitions of assets currently leased to and/or managed by Brookdale, as contemplated by the MTCA, our exposure to Brookdale is expected to be significantly reduced. In connection with the overall transaction pursuant to the MTCA, HCP (through certain of its subsidiaries), and Brookdale (through certain of its subsidiaries) (the “Lessee”) entered into an Amended and Restated Master Lease and Security Agreement (the “Amended Master Lease”), which amended and restated the then-existing triple-net leases between the parties for 78 assets (before giving effect to the contemplated sale or transition of 34 assets discussed below), which account for primarily all of the assets subject to triple-net leases between HCP and the Lessee. Under the Amended Master Lease, we have the benefit of a guaranty from Brookdale of the Lessee’s obligations and, upon a change in control, will have various additional protections under the MTCA and the Amended Master Lease. The Amended Master Lease preserves the renewal terms and, with certain exceptions, the rents under the previously existing triple-net leases. In addition, HCP and Brookdale agreed to the following: • We have the right to sell, or transition to other operators, 32 triple-net assets. If such sale or transition does not occur within one year, the triple-net lease with respect to such assets will convert to a cash flow lease (under which we will bear the risks and rewards of operating the assets) with a term of two years, provided that we have the right to terminate the cash flow lease at any time during the term without penalty; • We have provided an aggregate $5 million annual reduction in rent on three assets, effective January 1, 2018; and • We will sell two triple-net assets to Brookdale or its affiliates for $35 million, which we anticipate completing during the first half of 2018. Also pursuant to the MTCA, HCP and Brookdale agreed to the following: • HCP, which owned 90% of the interests in its RIDEA I and RIDEA III joint ventures with Brookdale at the time the MTCA was executed, agreed to purchase Brookdale’s 10% noncontrolling interest in each joint venture for an aggregate purchase price of $95 million. These joint ventures collectively own and operate 58 independent living, assisted living, memory care and/or skilled nursing facilities (the “RIDEA Facilities”). We completed our acquisition of the RIDEA III noncontrolling interest in December 2017 and anticipate completing our acquisition of the RIDEA I noncontrolling interest during the first half of 2018; • We have the right to sell, or transition to other managers, 36 of the RIDEA Facilities and terminate related management agreements with an affiliate of Brookdale without penalty. If the related management agreements are not terminated within one year, the base management fee (5% of gross revenues) increases by 1% of gross revenues per year over the following two years to a maximum of 7% of gross revenues; • We will sell four of the RIDEA Facilities to Brookdale or its affiliates for $239 million, one of which was sold in January 2018 for $27 million. We anticipate completing the sale of the remaining three RIDEA Facilities during the first half of 2018; • A Brookdale affiliate continues to manage the remaining 18 RIDEA Facilities pursuant to amended and restated management agreements, which provide for extended terms on select assets, modified performance hurdles for extensions and incentive fees, and modified termination rights (including stricter performance-based termination rights, a staggered right to terminate seven agreements over a 10 year period beginning in 2021, and a right to terminate at will upon payment of a termination fee, in lieu of sale-related termination rights), and two other existing facilities managed in separate RIDEA structures; and • We have the right to sell, to certain permitted transferees, our 49% ownership interest in joint ventures that own and operate a portfolio of continuing care retirement communities and in which Brookdale owns the other 51% interest (the “CCRC JV”), subject to certain conditions and a right of first offer in favor of Brookdale. Brookdale will have a corresponding right to sell its 51% interest in the CCRC JV to certain permitted transferees, subject to certain conditions, a right of first offer and a right to terminate management agreements following such sale of Brookdale’s interest, each in favor of HCP. Following a change in control of Brookdale, we will have the right to initiate a sale of the CCRC portfolio, subject to certain rights of first offer and first refusal in favor of Brookdale. See Note 3 to the Consolidated Financial Statements for additional information. RIDEA II Sale Transaction In January 2017, we completed the contribution of our ownership interest in RIDEA II to an unconsolidated JV owned by HCP and an investor group led by Columbia Pacific Advisors, LLC (“CPA”) (“HCP/CPA PropCo” and “HCP/CPA OpCo,” together, the “HCP/CPA JV”). In addition, RIDEA II was recapitalized with $602 million of debt, of which $360 million was provided by a third-party and $242 million was provided by HCP. In return for both transaction elements, we received combined proceeds of $480 million from the HCP/CPA JV and $242 million in loan receivables and retained an approximately 40% ownership interest in RIDEA II (the note receivable and 40% ownership interest are herein referred to as the “RIDEA II Investments”). This transaction resulted in us deconsolidating the net assets of RIDEA II and recognizing a net gain on sale of $99 million. The RIDEA II Investments are currently recognized and accounted for as equity method investments. On November 1, 2017, we entered into a definitive agreement with an investor group led by CPA to sell our remaining 40% ownership interest in RIDEA II. We expect the transaction to close in 2018. CPA has also agreed to refinance our $242 million loan receivables from RIDEA II within one year following the closing of the transaction. Investment Transactions During the second quarter of 2017, we acquired a 124,000 square foot campus in the Sorrento Mesa submarket of San Diego, California for $26 million. Upon acquisition, we commenced repositioning one of the buildings into class-A lab space following an office-to-lab conversion strategy. During the third quarter of 2017, we acquired a portfolio of three medical office buildings in Texas for $49 million and a life science facility in South San Francisco, California for $64 million. During the fourth quarter of 2017, we completed the following investments: • In November 2017, we acquired a 90-unit SHOP facility in a suburb of Boston, Massachusetts for $45 million. HCP owns a majority interest in this facility through a joint venture with LCB Senior Living. • In December 2017, we acquired a $228 million life science campus known as the Hayden Research Campus located in the Boston suburb of Lexington, Massachusetts. HCP owns a majority interest in this campus through a joint venture with King Street Properties (“King Street”). The campus includes two existing buildings totaling 400,000 square feet and was 66% leased at closing, anchored by major life science tenants including Shire US, Inc., a subsidiary of Shire plc, and Merck, Sharp and Dohme, a subsidiary of Merck and Co., Inc. Additionally, King Street is currently seeking entitlement approvals from local authorities for the joint venture to develop an additional 209,000 square feet of life science space on the campus. • In December 2017, we acquired a portfolio of 11 MOBs located throughout the United States, totaling approximately 378,000 square feet, for $151 million. • In December 2017, we entered into a participating debt financing arrangement with Columbia Pacific Advisors, LLC to fund the construction of 620 Terry, a $147 million, 243-unit senior living development located in Seattle. Upon expected completion in 2019, 620 Terry will be operated by Leisure Care, LLC, a leading senior housing operator, and offer a mix of independent-living, assisted-living and memory care units. We will provide up to $115 million of financing and earn 6.5% interest on the outstanding loan balance. Upon sale or refinancing, we will receive 20% of fair market value in excess of the total development cost. Disposition and Loan Repayment Transactions During the first quarter of 2017, we completed the following disposition and loan repayment transactions: • In January 2017, we sold four life science facilities in Salt Lake City, Utah for $76 million. • In March 2017, we sold 64 senior housing triple-net assets, previously under triple-net leases with Brookdale, for $1.125 billion to affiliates of Blackstone Real Estate Partners VIII, L.P. • In March 2017, we sold our aggregate £138.5 million par value Four Seasons senior notes (“Four Seasons Notes”) for £83 million ($101 million). The disposition of the Four Seasons Notes generated a £42 million ($51 million) gain on sale as the sales price was above the previously-impaired (2015) carrying value of £41 million ($50 million). In addition, we sold our Four Seasons senior secured term loan at par plus accrued interest for £29 million ($35 million). During the second quarter of 2017, we completed the following disposition and loan repayment transactions: • In April 2017, we sold a land parcel in San Diego, California for $27 million and one life science building in San Diego, California for $5 million. • In June 2017, we received £283 million ($367 million) from the repayment of our HC-One Facility. During the third quarter of 2017, we sold two senior housing triple-net facilities for $15 million. During the fourth quarter 2017, we completed the following disposition transactions: • In October 2017, we sold two senior housing triple-net facilities for $12 million. • In November 2017, we sold a MOB for $11 million and a SHOP facility for $24 million. • In December 2017, we sold three SHOP assets for $17 million and two MOBs for $3 million. Financing Activities • During the year ended December 31, 2017, we had net debt repayments of $1.4 billion primarily using proceeds from the dispositions of real estate (primarily the sale of 64 senior housing triple-net assets), the partial sale of RIDEA II, the sale of our Four Seasons Notes and the repayment of our HC-One Facility. Debt repayments during the year ended December 31, 2017 consisted of the following: ◦ During the first quarter of 2017, we repaid our £137 million unsecured term loan (the “2012 Term Loan”) and $472 million of mortgage debt. ◦ During the second quarter of 2017, we repaid $250 million of maturing senior unsecured notes and paid down £51 million of our £220 million unsecured term loan (the “2015 Term Loan”). ◦ During the third quarter of 2017, we repurchased $500 million of our 5.375% senior notes due 2021 and recorded a $54 million loss on debt extinguishment. • During the fourth quarter of 2017, we terminated our then existing bank line of credit facility (the "Facility") and entered into a new $2.0 billion unsecured revolving line of credit facility (the “New Facility”) maturing on October 19, 2021. Borrowings under the New Facility accrue interest at LIBOR plus a margin that depends on our credit ratings (1.00% initially). We pay a facility fee on the entire revolving commitment that depends on our credit ratings (0.20% initially and as of December 31, 2017). The New Facility contains two, six-month extension options and includes a feature that allows us to increase the borrowing capacity by an aggregate amount of up to $750 million, subject to securing additional commitments. Developments and Redevelopments The Cove Phase I and Phase II have reached 100% leased during the year ended December 31, 2017. During the year ended December 31, 2017, we added $384 million of new projects to our development and redevelopment pipelines including: • Commenced the $219 million Phase I development at Sierra Point, consisting of two buildings totaling 215,000 square feet of Class A life science and office space in South San Francisco, California, with an estimated completion in late 2019. • Commenced a $40 million redevelopment of a MOB located in the University City submarket of Philadelphia, near the University of Pennsylvania, with an estimated completion in the second quarter of 2018. • Entered into a joint venture agreement and commenced development on a 111-unit senior housing facility in Otay Ranch, California (San Diego MSA) for $31 million. Our share of the estimated total construction cost is approximately $28 million, with an estimated completion in the second half of 2018. • Commenced development on a 79-unit senior housing facility in Waldwick, New Jersey (New York MSA) for $31 million in a joint venture. Our share of the estimated total construction costs is approximately $26 million, with an estimated completion in late 2018. • Commenced $22 million of redevelopment projects at two recently-acquired life science assets in the Sorrento Mesa submarket of San Diego, California, with an estimated completion in late 2018. • Commenced a $16 million life science development expansion project in the Sorrento Mesa submarket of San Diego, California, with an estimated completion in the second half of 2019. Dividends Quarterly cash dividends paid during 2017 aggregated to $1.48 per share. On February 1, 2018, our Board of Directors declared a quarterly cash dividend of $0.37 per common share. The dividend will be paid on March 2, 2018 to stockholders of record as of the close of business on February 15, 2018. Results of Operations We evaluate our business and allocate resources among our reportable business segments: (i) senior housing triple-net, (ii) senior housing operating portfolio (SHOP), (iii) life science and (iv) medical office. Under the medical office and life science segments, we invest through the acquisition and development of MOBs and life science facilities, which generally require a greater level of property management. Our senior housing facilities are managed utilizing triple-net leases and RIDEA structures. We have other non-reportable segments that are comprised primarily of our U.K. care homes, debt investments, unconsolidated joint ventures and hospitals. We evaluate performance based upon: (i) property net operating income from continuing operations (“NOI”) and (ii) adjusted NOI (cash NOI) in each segment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 2 to the Consolidated Financial Statements). Non-GAAP Financial Measures Net Operating Income NOI and Adjusted NOI are non-U.S. generally accepted accounting principles (“GAAP”) supplemental financial measures used to evaluate the operating performance of real estate. NOI is defined as rental and related revenues, including tenant recoveries, resident fees and services, and income from DFLs, less property level operating expenses; NOI excludes all other financial statement amounts included in net income (loss) as presented in Note 13 to the Consolidated Financial Statements. Management believes NOI provides relevant and useful information because it reflects only income and operating expense items that are incurred at the property level and presents them on an unleveraged basis. Adjusted NOI is calculated as NOI after eliminating the effects of straight-line rents, DFL non-cash interest, amortization of market lease intangibles, termination fees and the impact of deferred community fee income and expense. The adjustments to NOI and resulting Adjusted NOI for SHOP have been recast for prior periods presented to conform to the current period presentation which excludes the impact of deferred community fee income and expense, resulting in recognition as cash is received and expenses are paid. Adjusted NOI is oftentimes referred to as “cash NOI.” During the fourth quarter of 2017, as a result of a change in how operating results are reported to our chief operating decision makers for the purpose of evaluating performance and allocating resources, we began excluding unconsolidated joint ventures from the evaluation of our segments' operating results. Unconsolidated joint ventures are now reflected in other non-reportable segments, and as a result, excluded from NOI and Adjusted NOI. Prior period NOI and Adjusted NOI have also been recast to conform to current period presentation which excludes unconsolidated joint ventures. We use NOI and Adjusted NOI to make decisions about resource allocations, to assess and compare property level performance, and to evaluate our same property portfolio (“SPP”), as described below. We believe that net income (loss) is the most directly comparable GAAP measure to NOI. NOI should not be viewed as an alternative measure of operating performance to net income (loss) as defined by GAAP since it does not reflect various excluded items. Further, our definition of NOI may not be comparable to the definition used by other REITs or real estate companies, as they may use different methodologies for calculating NOI. For a reconciliation of NOI and Adjusted NOI to net income (loss) by segment, refer to Note 13 to the Consolidated Financial Statements. Operating expenses generally relate to leased medical office and life science properties and SHOP facilities. We generally recover all or a portion of our leased medical office and life science property expenses through tenant recoveries. We present expenses as operating or general and administrative based on the underlying nature of the expense. Same Property Portfolio SPP NOI and Adjusted NOI information allows us to evaluate the performance of our property portfolio under a consistent population by eliminating changes in the composition of our consolidated portfolio of properties. SPP NOI excludes certain non-property specific operating expenses that are allocated to each operating segment on a consolidated basis. SPP NOI for properties that undergo a change in ownership is reported based on the current ownership percentage. Properties are included in SPP once they are stabilized for the full period in both comparison periods. Newly acquired operating assets are generally considered stabilized at the earlier of lease-up (typically when the tenant(s) control(s) the physical use of at least 80% of the space) or 12 months from the acquisition date. Newly completed developments and redevelopments are considered stabilized at the earlier of lease-up or 24 months from the date the property is placed in service. Properties that experience a change in reporting structure, such as a transition from a triple-net lease to a RIDEA reporting structure, are considered stabilized after 12 months in operations under a consistent reporting structure. A property is removed from SPP when it is classified as held for sale, sold, placed into redevelopment, experiences a casualty event that significantly impacts operations or changes its reporting structure (such as triple-net to SHOP). For a reconciliation of SPP to total portfolio Adjusted NOI and other relevant disclosures by segment, refer to our Segment Analysis below. Funds From Operations We believe FFO applicable to common shares, diluted FFO applicable to common shares, and diluted FFO per common share are important supplemental non-GAAP measures of operating performance for a REIT. Because the historical cost accounting convention used for real estate assets utilizes straight-line depreciation (except on land), such accounting presentation implies that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen and fallen with market conditions, presentations of operating results for a REIT that use historical cost accounting for depreciation could be less informative. The term FFO was designed by the REIT industry to address this issue. FFO, as defined by the National Association of Real Estate Investment Trusts (“NAREIT”), is net income (loss) applicable to common shares (computed in accordance with GAAP), excluding gains or losses from sales of depreciable property, including any current and deferred taxes directly associated with sales of depreciable property, impairments of, or related to, depreciable real estate, plus real estate and other depreciation and amortization, and adjustments to compute our share of FFO and FFO as adjusted (see below) from joint ventures. Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of FFO for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. For consolidated joint ventures in which we do not own 100%, we reflect our share of the equity by adjusting our FFO to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods. Our pro-rata share information is prepared on a basis consistent with the comparable consolidated amounts, is intended to reflect our proportionate economic interest in the operating results of properties in our portfolio and is calculated by applying our actual ownership percentage for the period. We do not control the unconsolidated joint ventures, and the pro-rata presentations of reconciling items included in FFO do not represent our legal claim to such items. The joint venture members or partners are entitled to profit or loss allocations and distributions of cash flows according to the joint venture agreements, which provide for such allocations generally according to their invested capital. The presentation of pro-rata information has limitations, which include, but are not limited to, the following: (i) the amounts shown on the individual line items were derived by applying our overall economic ownership interest percentage determined when applying the equity method of accounting and do not necessarily represent our legal claim to the assets and liabilities, or the revenues and expenses and (ii) other companies in our industry may calculate their pro-rata interest differently, limiting the usefulness as a comparative measure. Because of these limitations, the pro-rata financial information should not be considered independently or as a substitute for our financial statements as reported under GAAP. We compensate for these limitations by relying primarily on our GAAP financial statements, using the pro-rata financial information as a supplement. FFO does not represent cash generated from operating activities in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income (loss). We compute FFO in accordance with the current NAREIT definition; however, other REITs may report FFO differently or have a different interpretation of the current NAREIT definition from ours. In addition, we present FFO before the impact of non-comparable items including, but not limited to, transaction-related items, impairments (recoveries) of non-depreciable assets, severance and related charges, prepayment costs (benefits) associated with early retirement or payment of debt, litigation costs, casualty-related charges (recoveries), foreign currency remeasurement losses (gains) and changes in tax legislation (“FFO as adjusted”). Transaction-related items include transaction expenses and gains/charges incurred as a result of mergers and acquisitions and lease amendment or termination activities. Prepayment costs (benefits) associated with early retirement of debt include the write-off of unamortized deferred financing fees, or additional costs, expenses, discounts, make-whole payments, penalties or premiums incurred as a result of early retirement or payment of debt. Management believes that FFO as adjusted provides a meaningful supplemental measurement of our FFO run-rate and is frequently used by analysts, investors and other interested parties in the evaluation of our performance as a REIT. At the same time that NAREIT created and defined its FFO measure for the REIT industry, it also recognized that “management of each of its member companies has the responsibility and authority to publish financial information that it regards as useful to the financial community.” We believe stockholders, potential investors and financial analysts who review our operating performance are best served by an FFO run-rate earnings measure that includes certain other adjustments to net income (loss), in addition to adjustments made to arrive at the NAREIT defined measure of FFO. FFO as adjusted is used by management in analyzing our business and the performance of our properties, and we believe it is important that stockholders, potential investors and financial analysts understand this measure used by management. We use FFO as adjusted to: (i) evaluate our performance in comparison with expected results and results of previous periods, relative to resource allocation decisions, (ii) evaluate the performance of our management, (iii) budget and forecast future results to assist in the allocation of resources, (iv) assess our performance as compared with similar real estate companies and the industry in general and (v) evaluate how a specific potential investment will impact our future results. Other REITs or real estate companies may use different methodologies for calculating an adjusted FFO measure, and accordingly, our FFO as adjusted may not be comparable to those reported by other REITs. For a reconciliation of net income (loss) to FFO and FFO as adjusted and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Funds Available for Distribution FAD is defined as FFO as adjusted after excluding the impact of the following: (i) amortization of deferred compensation expense, (ii) amortization of deferred financing costs, net, (iii) straight-line rents, (iv) amortization of acquired market lease intangibles, net, (v) non-cash interest and depreciation related to DFLs and lease incentive amortization (reduction of straight-line rents) and (vi) deferred revenues, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents. Also, FAD: (i) is computed after deducting recurring capital expenditures, including leasing costs and second generation tenant and capital improvements, and (ii) includes lease restructure payments and adjustments to compute our share of FAD from our unconsolidated joint ventures and those related to CCRC non-refundable entrance fees. Certain prior period amounts in the “Non-GAAP Financial Measures Reconciliation” below for FAD have been reclassified to conform to the current period presentation. More specifically, we have combined wholly-owned and our share from unconsolidated joint ventures recurring capital expenditures, including leasing costs and second generation tenant and capital improvements ("FAD capital expenditures") into a single line item. In addition, we have combined cash CCRC JV entrance fees with CCRC JV entrance fee amortization into a single line item, separately disclosed deferred income taxes (previously reported in “other”) and collapsed immaterial line items into ‘other’. Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of FAD for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. We reflect our share for consolidated joint ventures in which we do not own 100% of the equity by adjusting our FAD to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods (see FFO above for further disclosure regarding our use of pro-rata share information and its limitations). Other REITs or real estate companies may use different methodologies for calculating FAD, and accordingly, our FAD may not be comparable to those reported by other REITs. Although our FAD computation may not be comparable to that of other REITs, management believes FAD provides a meaningful supplemental measure of our performance and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. We believe FAD is an alternative run-rate earnings measure that improves the understanding of our operating results among investors and makes comparisons with: (i) expected results, (ii) results of previous periods and (iii) results among REITS more meaningful. FAD does not represent cash generated from operating activities determined in accordance with GAAP and is not necessarily indicative of cash available to fund cash needs as it excludes the following items which generally flow through our cash flows from operating activities: (i) adjustments for changes in working capital or the actual timing of the payment of income or expense items that are accrued in the period, (ii) transaction-related costs, (iii) litigation settlement expenses, (iv) severance-related expenses and (v) actual cash receipts from interest income recognized on loans receivable (in contrast to our FAD adjustment to exclude non-cash interest and depreciation related to our investments in direct financing leases). Furthermore, FAD is adjusted for recurring capital expenditures, which are generally not considered when determining cash flows from operations or liquidity. FAD is a non-GAAP supplemental financial measure and should not be considered as an alternative to net income (loss) determined in accordance with GAAP. For a reconciliation of net income (loss) to FAD and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Comparison of the Year Ended December 31, 2017 to the Year Ended December 31, 2016 and the Year Ended December 31, 2016 to the Year Ended December 31, 2015 Overview(1) 2017 and 2016 The following table summarizes results for the years ended December 31, 2017 and 2016 (dollars in thousands except per share data): _______________________________________ (1) For the reconciliation of non-GAAP financial measures, see “Non-GAAP Financial Measure Reconciliations” section below. Net income (loss) applicable to common shares (“EPS”) decreased primarily as a result of the following: • a reduction in net income from discontinued operations due to the Spin-Off of QCP on October 31, 2016; • a loss on debt extinguishment in July 2017, representing a premium for early payment on the repurchase of our senior notes; • a reduction in rental and related revenues primarily as a result of assets sold during 2017, including the sale of 64 senior housing triple-net assets in the first quarter of 2017; • a reduction in NOI primarily related to the net impact of the Brookdale Transaction during the fourth quarter of 2017; • a reduction in earnings due to the partial sale and deconsolidation of RIDEA II during the first quarter of 2017; • impairments related to: (i) our mezzanine loan facility to Tandem Health Care (the “Tandem Mezzanine Loan”) and (ii) 11 underperforming senior housing triple-net facilities in the third quarter of 2017; • increased litigation-related costs, including costs from securities class action litigation, and a legal settlement in 2017; • casualty-related charges due to hurricanes in the third quarter of 2017; and • a reduction in interest income due to (i) the payoffs of our HC-One Facility in June 2017 and a participating development loan during the third quarter of 2016 and (ii) decreased interest received from our Tandem Mezzanine Loan during the fourth quarter of 2017, partially offset by additional interest income in 2017 from our $131 million loan to Maria Mallaband in November 2016. The decrease in EPS was partially offset by: • a reduction in interest expense as a result of debt repayments in the fourth quarter of 2016 and throughout 2017; • a reduction in severance and related charges primarily related to the departure of our former President and Chief Executive Officer ("CEO") in 2016 compared to severance and related charges primarily related to the departure of our former Executive Vice President and Chief Accounting Officer ("CAO") in 2017; • a larger net gain on sales of real estate during 2017 compared to 2016, primarily related to the sale of 64 senior housing triple-net assets and the partial sale of RIDEA II during 2017; • an increase in income tax benefit primarily from real estate dispositions during 2017, partially offset by an income tax expense related to the impact of tax rate legislation during the fourth quarter of 2017; and • an increase in other income, net primarily related to the gain on sale of our Four Seasons investments during 2017. FFO decreased primarily as a result of the aforementioned events impacting EPS, except for gain on sales of real estate and impairments of real estate, which are excluded from FFO. FFO as adjusted decreased primarily as a result of the following: • a reduction in net income from discontinued operations due to the Spin-Off of QCP on October 31, 2016; • a reduction in rental and related revenues primarily as a result of assets sold during 2017, including the sale of 64 senior housing triple-net assets; • a reduction in earnings due to the partial sale and deconsolidation of RIDEA II during the first quarter of 2017; and • a reduction in interest income due to (i) the payoffs of our HC-One Facility in June 2017 and a participating development loan during the third quarter of 2016 and (ii) decreased interest received from our Tandem Mezzanine Loan during the fourth quarter of 2017, partially offset by additional interest income in 2017 from our $131 million loan to Maria Mallaband in November 2016. The decrease in FFO as adjusted was partially offset by a reduction in interest expense as a result of debt repayments in the fourth quarter of 2016 and throughout 2017. FAD decreased primarily as a result of the aforementioned events impacting FFO as adjusted, (i) increased leasing costs and tenant capital improvements and (ii) decreased installment payments received from Brookdale for 2014 lease terminations that were paid over a period of three years and concluded in 2017. 2016 and 2015 The following table summarizes results for the years ended December 31, 2016 and 2015 (dollars in thousands except per share data): EPS increased primarily as a result of the following: • impairment charges during 2015, not repeated in 2016; • increased NOI from: (i) our 2015 and 2016 acquisitions, (ii) annual rent escalations and (iii) developments placed in service; • increased gain on sales of real estate due to a higher volume of disposition activity during 2016; • a reduction in interest expense as a result of debt repayments during 2015 and 2016; and • a net termination fee expense recognized in 2015, not repeated in 2016. The increase in EPS was partially offset by following: • a reduction in income from our HCR Manor Care, Inc. ("HCRMC") investments as a result of: (i) the HCRMC lease amendment effective April 1, 2015, (ii) the sale of non-strategic assets during the second half of 2015 and 2016, and (iii) a change in income recognition to a cash basis method beginning in January 2016; • the impact from the Spin-Off of QCP resulting in: (i) increased transaction costs and (ii) loss on debt extinguishment, representing penalties on the prepayment of debt using proceeds from the Spin-Off; • increased income tax expense related to our estimated exposure to state built-in gain tax; • a reduction in interest income from placing our Four Seasons Notes on cost recovery status in the third quarter of 2015 and loan repayments during 2015 and 2016; • increased severance-related charges during 2016 primarily related to the departure of our former CEO in July 2016; • increased depreciation and amortization from our 2015 and 2016 acquisitions; and • a reduction of foreign currency remeasurement gains recognized as a result of effective hedges designated in September 2015. FFO increased primarily as a result of the aforementioned events impacting EPS, except for depreciation and amortization and gain on sales of real estate, which are excluded from FFO. FFO as adjusted decreased primarily as a result of the following: • a reduction in income from our HCRMC investments as a result of: (i) the HCRMC lease amendment effective April 1, 2015, (ii) the sale of non-strategic assets during the second half of 2015 and 2016 and (iii) a change in income recognition to a cash basis method beginning in January 2016; • decreased income from the QCP assets included in the Spin-Off; and • a reduction in interest income from placing our Four Seasons Notes on cost recovery status in the third quarter of 2015 and loan repayments during 2015 and 2016. The decrease in FFO as adjusted was partially offset by the following: • increased NOI from: (i) our 2015 and 2016 consolidated acquisitions, (ii) annual rent escalations and (iii) developments placed in service; and • a reduction in interest expense as a result of debt repayments during 2015 and 2016. FAD decreased primarily as a result of the following: • decreased income from our HCRMC investments as a result of the HCRMC lease amendment effective April 1, 2015 and the sale of non-strategic assets during the second half of 2015 and the first half of 2016; • decreased income from the QCP assets included in the Spin-Off; • decreased interest income from placing our Four Seasons Notes on cost recovery status in the third quarter of 2015 and loan repayments during 2015 and 2016; and • increased leasing costs and second generation capital expenditures. The decrease in FAD was partially offset by the following: • increased NOI from: (i) our 2015 and 2016 consolidated acquisitions, (ii) annual rent escalations and (iii) developments placed in service; and • increased incremental interest income from the payoff of participating development loans. Segment Analysis The tables below provide selected operating information for our SPP and total property portfolio for each of our reportable segments. For the year ended December 31, 2017, our SPP consists of 617 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2016 and that remained in operations under a consistent reporting structure through December 31, 2017. For the year ended December 31, 2016, our SPP consisted of 621 properties acquired or placed in service and stabilized on or prior to January 1, 2015 and that remained in operations under a consistent reporting structure through December 31, 2017. Our total consolidated property portfolio consists of 744, 851 and 869 properties at December 31, 2017, 2016 and 2015, respectively, excluding properties in the Spin-Off. Senior Housing Triple-Net 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars in thousands except per unit data): _______________________________________ (1) Represents rental and related revenues and income from DFLs. (2) From our 2016 presentation of SPP, we removed four senior housing triple-net properties that were sold, 25 senior housing triple-net properties that were transitioned to our SHOP segment and two senior housing triple-net properties that were classified as held for sale. Our 2016 Total Portfolio property count has been adjusted to include 64 properties classified as held for sale as of December 31, 2016. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI decreased primarily as a result of the net impact of triple-net lease terminations from the Brookdale Transaction during the fourth quarter of 2017. SPP Adjusted NOI increased primarily as a result of the following: • annual rent escalations; and • higher cash rent received from our portfolio of assets leased to Sunrise Senior Living. Additionally, Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • senior housing triple-net facilities sold during 2016 and 2017; and • the transfer of 42 senior housing triple-net facilities to our SHOP segment. The decrease to Total Portfolio NOI and Adjusted NOI is partially offset by (i) increased non-SPP income from five senior housing triple-net facilities acquired in the first quarter of 2016 and (ii) the aforementioned increases to SPP Adjusted NOI. 2016 and 2015 The following table summarizes results at and for the years ended December 31, 2016 and 2015 (dollars in thousands except per unit data): _______________________________________ (1) Represents rental and related revenues and income from DFLs. (2) From our 2015 presentation of SPP, we removed nine senior housing triple-net properties that were sold, 17 senior housing triple-net properties that were transitioned to a RIDEA structure in our SHOP segment and 64 senior housing triple-net properties that were classified as held for sale. Our 2016 Total Portfolio property count has been adjusted to include 64 properties classified as held for sale as of December 31, 2016. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI decreased primarily as a result of lower rents in our portfolio of assets leased to Sunrise Senior Living (the “Sunrise Portfolio”). SPP adjusted NOI increased primarily as a result of annual rent escalations, partially offset by lower cash rent received from our Sunrise portfolio. Additionally, Total Portfolio NOI and adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • nine senior housing triple-net facilities sold in 2016; and • the transition of 17 senior housing triple-net facilities to a RIDEA structure (reported in our SHOP segment); partially offset by • five senior housing triple-net facilities acquired in the first quarter of 2016. Senior Housing Operating Portfolio 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars in thousands, except per unit data): _______________________________________ (1) From our 2016 presentation of SPP, we removed a SHOP property that was placed into redevelopment, two SHOP properties that were classified as held for sale and 49 SHOP properties that were deconsolidated. Our 2016 Total Portfolio property count has been adjusted to include a property classified as held for sale as of December 31, 2016. (2) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI decreased primarily as a result of increased operating expenses related to the management fee terminations from the Brookdale Transaction during the fourth quarter of 2017. SPP Adjusted NOI increased primarily as a result of the following: • increased rates for resident fees and services; partially offset by • higher expense growth and a decline in occupancy. Additionally, Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • decreased non-SPP income from our partial sale of RIDEA II; partially offset by • non-SPP income for 42 senior housing triple-net assets transferred to SHOP during the fourth quarter of 2016 and year-to-date 2017. 2016 and 2015 The following table summarizes results at and for the years ended December 31, 2016 and 2015 (dollars in thousands, except per unit data): _______________________________________ (1) From our 2015 presentation of SPP, we removed two SHOP properties that were sold and a SHOP property that was classified as held for sale. Our 2016 and 2015 Total Portfolio property count has been adjusted to include a property classified as held for sale as of December 31, 2016 and 2015. (2) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI and adjusted NOI increased primarily as a result of increased occupancy and rates for resident fees and services. Total Portfolio NOI and adjusted NOI increased primarily as a result of the aforementioned increases to SPP along with 2015 acquisitions, primarily our RIDEA III acquisition. The increase in Total Portfolio NOI was partially offset by a termination fee related to our RIDEA III acquisition, which was not repeated in 2016. Life Science 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Represents rental and related revenues and tenant recoveries. (2) From our 2016 presentation of SPP, we removed one life science facility that was sold and four life science facilities that were classified as held for sale. Our 2016 Total Portfolio property count has been adjusted to include eight properties in development and four properties classified as held for sale as of December 31, 2016. SPP NOI and Adjusted NOI increased primarily as a result of the following: • mark-to-market lease renewals; • new leasing activity; and • specific to adjusted NOI, annual rent escalations. Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following impacts to Non-SPP: • decreased income from the sale of life science facilities in 2016 and 2017; partially offset by • increased income from (i) increased occupancy in portions of developments placed in operations in 2016 and 2017 and (ii) life science acquisitions in 2016 and 2017. The decrease in Total Portfolio NOI and Adjusted NOI was also partially offset by the aforementioned increases to SPP. 2016 and 2015 The following table summarizes results at and for the years ended December 31, 2016 and 2015 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Represents rental and related revenues and tenant recoveries. (2) From our 2015 presentation of SPP, we removed four life science facilities that were sold and four life science facilities that were classified as held for sale. Our 2016 Total Portfolio property count has been adjusted to include eight properties in development and four properties classified as held for sale as of December 31, 2016. Our 2015 Total Portfolio property count has been adjusted to include two properties in development as of December 31, 2015. SPP NOI and Adjusted NOI increased primarily as a result of the following: • mark-to-market lease renewals; • new leasing activity; and • increased occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations and a decline in rent abatements. Total Portfolio NOI and adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following impacts to Non-SPP: • life science acquisitions in 2015 and 2016; and • increased occupancy in a development placed in operation in 2016; partially offset by • five life science facilities sold in 2016. Medical Office 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Represents rental and related revenues and tenant recoveries. (2) From our 2016 presentation of SPP, we removed four MOBs that were sold and two MOBs that were placed into redevelopment. Our 2016 Total Portfolio property count has been adjusted to include four properties in development as of December 31, 2016. SPP NOI and Adjusted NOI increased primarily as a result of mark-to-market lease renewals and new leasing activity. Additionally, SPP Adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following impacts to Non-SPP: • increased income from our 2016 and 2017 acquisitions; and • increased occupancy in former redevelopment and development properties that have been placed into operations; partially offset by • decreased income from the sale of seven MOBs during 2016 and 2017 and the placement of a MOB into redevelopment. 2016 and 2015 The following table summarizes results at and for the years ended December 31, 2016 and 2015 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Represents rental and related revenues and tenant recoveries. (2) From our 2015 presentation of SPP, we removed three MOBs that were sold and six MOBs that were placed into redevelopment. Our 2016 Total Portfolio property count has been adjusted to include four and five properties in development as of December 31, 2016 and December 31, 2015, respectively. SPP NOI and adjusted NOI increased primarily as a result of increased occupancy. Additionally, SPP adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following impacts to Non-SPP: • increased occupancy in former redevelopment and development properties that have been placed into operations; • additional NOI from our MOB acquisitions in 2015 and 2016; partially offset by • the sale of three MOBs. Other Income and Expense Items The following table summarizes results for the years ended December 31, 2017, 2016 and 2015 (in thousands): Interest income. The decrease in interest income for the year ended December 31, 2017 was primarily the result of: (i) the payoff of our HC-One Facility in June 2017, (ii) incremental interest income received during the second quarter of 2016 due to the payoff of three participating development loans, and (iii) decreased interest received from our Tandem Mezzanine Loan during the fourth quarter of 2017, partially offset by additional interest income in 2017 from our $131 million loan to Maria Mallaband in November 2016. The decrease in interest income for the year ended December 31, 2016 was primarily the result of: (i) placing our Four Seasons Notes on cost recovery status in the third quarter of 2015 and (ii) paydowns in our loan portfolio. The decrease in interest income was partially offset by additional interest income from: (i) the Four Seasons senior secured term loan purchased in the fourth quarter of 2015 and (ii) additional fundings in our loan portfolio, including our £105 million ($131 million) loan to Maria Mallaband in November 2016. Interest expense. The decrease in interest expense for the year ended December 31, 2017 was primarily the result of senior unsecured notes and mortgage debt repayments, which occurred primarily in the second half of 2016 and throughout 2017. The decrease in interest expense for the year ended December 31, 2016 was primarily the result of: (i) mortgage debt repayments during 2015 and 2016, primarily from mortgage debt secured by properties in our senior housing triple-net, life science and medical office segments, (ii) senior unsecured notes payoffs during 2015 and 2016 and higher capitalized interest. The decrease in interest expense was partially offset by: (i) senior unsecured notes issued during 2015 and (ii) increased borrowings under our Facility. Approximately 84%, 83% and 96% of our total debt, inclusive of $44 million, $46 million and $71 million of variable rate debt swapped to fixed through interest rate swaps, was fixed rate debt as of December 31, 2017, 2016 and 2015, respectively. At December 31, 2017, our fixed rate debt and variable rate debt had weighted average interest rates of 4.19% and 2.56%, respectively. At December 31, 2016, our fixed rate debt and variable rate debt had weighted average interest rates of 4.26% and 2.23%, respectively. At December 31, 2015, our fixed rate debt and variable rate debt had weighted average interest rates of 4.68% and 1.72%, respectively. For a more detailed discussion of our interest rate risk, see “Quantitative and Qualitative Disclosures About Market Risk” in Item 3 below. Depreciation and amortization. The decrease in depreciation and amortization expense for the year ended December 31, 2017 was primarily as a result of the sale of 64 senior housing triple-net assets and the deconsolidation of RIDEA II during the first quarter of 2017, partially offset by depreciation and amortization of assets acquired and placed in service during 2016 and 2017. The increase in depreciation and amortization expense for the year ended December 31, 2016 was primarily the result of the impact of acquisitions primarily in our SHOP and medical office segments. General and administrative expenses. The decrease in general and administrative expenses for the year ended December 31, 2017 was primarily as a result of severance and related charges primarily resulting from the departure of our former President and CEO in the third quarter of 2016 which exceeded severance and related charges primarily related to the departure of our former CAO in the third quarter of 2017. The increase in general and administrative expenses for the year ended December 31, 2016 was primarily the result of: (i) higher severance-related charges primarily resulting from the departure of our former President and CEO in the third quarter of 2016 and (ii) higher professional fees in 2016, partially offset by lower compensation related expenses. We expect to record severance and related charges of approximately $9 million in the first quarter of 2018 related to the previously announced departure of our Executive Chairman, effective March 1, 2018. Transaction costs. The decrease in transaction costs for the year ended December 31, 2016 was primarily a result of lower levels of transactional activity in 2016 compared to the same period in 2015. Impairments (recoveries), net. During the year ended December 31, 2017, we recognized (i) $144 million of impairments on our Tandem Mezzanine Loan due to a variety of factors including recent operating results of the underlying collateral and events of default under the loan agreement (see Note 7 to the Consolidated Financial Statements for further information) and (ii) $23 million of impairments on 11 underperforming senior housing triple-net facilities. For the year ended December 31, 2016, there were no impairments recognized. During the year ended December 31, 2015, we recognized the following impairment charges: (i) $112 million related to our investment in Four Seasons Notes and (ii) $3 million related to a MOB. The impairment charges were partially offset by a $6 million impairment recovery related to the repayment of a loan. Gain (loss) on sales of real estate, net. During the year ended December 31, 2017, we sold 68 senior housing triple-net assets for $1.152 billion, five life science facilities for $81 million, five SHOP facilities for $43 million, four MOBs for $15 million and a 40% interest in RIDEA II and recognized total net gain on sales of real estate of $357 million. During the year ended December 31, 2016, we sold a portfolio of five facilities in one of our non-reportable segments and two senior housing triple-net facilities for $130 million, five life science facilities for $386 million, seven senior housing triple-net facilities for $88 million, three MOBs for $20 million and three SHOP facilities for $41 million, recognizing total gain on sales of $165 million. During the year ended December 31, 2015, we sold the following assets: (i) nine senior housing triple-net facilities for $60 million, resulting from Brookdale’s exercise of its purchase option, and (ii) a MOB for $0.4 million, recognizing total gain on sales of $6 million. Loss on debt extinguishments. During the year ended December 31, 2017, we repurchased $500 million of our 5.375% senior notes due 2021 and recognized a $54 million loss on debt extinguishment, primarily related to a premium for early payment. During the fourth quarter of 2016, using proceeds from the Spin-Off, we repaid $1.1 billion of senior unsecured notes that were due to mature in January 2017 and January 2018 and repaid $108 million of mortgage debt, incurring aggregate loss on debt extinguishments of $46 million, primarily related to prepayment penalties. Other income (expense), net. The increase in other income, net for the year ended December 31, 2017 was primarily as a result of the £42 million ($51 million) gain on sale of our Four Seasons Notes, partially offset by $12 million of casualty-related charges due to hurricanes in the third quarter of 2017 and $13 million of increased litigation-related expenses, including costs from securities class action litigation, and a legal settlement in 2017. The decrease in other income, net for the year ended December 31, 2016 was primarily the result of a reduction of foreign currency remeasurement gains from remeasuring assets and liabilities denominated in GBP to U.S. dollars (“USD”) as a result of effective hedges designated in September 2015. Income tax benefit (expense). The increase in income tax benefit for the year ended December 31, 2017 was primarily the result of: (i) a $6 million income tax benefit from the partial sale of RIDEA II in 2017, (ii) a $5 million income tax benefit related to our share of operating losses from our RIDEA joint ventures, (iii) a $1 million deferred tax benefit from casualty-related charges recognized in the second half of 2017 and (iv) a $11 million income tax expense recognized in 2016 associated with federal income tax and state built-in gain tax for the disposition of certain real estate assets. The total tax benefit was partially offset by a $17 million income tax expense related to the impact of tax rate legislation during the fourth quarter of 2017. The increase in income tax expense for the year ended December 31, 2016 was primarily the result of recognizing tax liabilities representing state built-in gain tax for the disposition of certain real estate assets. Equity income (loss) from unconsolidated joint ventures. The decrease in equity income from unconsolidated joint ventures for the year ended December 31, 2017 was primarily the result of income from our share of gains on sales of real estate in 2016, partially offset by income from our investment in RIDEA II, which was deconsolidated in the first quarter of 2017. The increase in equity income from unconsolidated joint ventures for the year ended December 31, 2016 was primarily the result of increased income from our share of gains on sales of real estate. Total discontinued operations. Discontinued operations for the years ended December 31, 2016 and 2015 resulted in income of $266 million and loss of $699 million, respectively. Income and loss from discontinued operations primarily relates to the operations of QCP. Income from discontinued operations increased during the year ended December 31, 2016 as a result of impairment charges during 2015 not repeated in 2016. The increase in discontinued operations was partially offset by the following: (i) a reduction in income from our HCRMC investments as a result of the HCRMC lease amendment effective April 1, 2015, the sale of non-strategic assets during the second half of 2015 and the first half of 2016, and a change in income recognition to a cash basis method beginning in January 2016, (ii) transaction costs of $87 million related to the Spin-Off and (iii) increased income tax expense related to our estimated exposure to state built-in gain tax. During the year ended December 31, 2015, we recognized impairments of $1.3 billion related to our HCRMC portfolio. There were no discontinued operations for the year ended December 31, 2017. Liquidity and Capital Resources We anticipate that our cash flow from operations, available cash balances and cash from our various financing activities will be adequate for at least the next 12 months for purposes of: (i) funding recurring operating expenses; (ii) meeting debt service requirements, including principal payments and maturities; and (iii) satisfying our distributions to our stockholders and non-controlling interest members. Our principal investing liquidity needs for the next 12 months are to: • fund capital expenditures, including tenant improvements and leasing costs; and • fund future acquisition, transactional and development activities. We anticipate satisfying these future investing needs using one or more of the following: • issuance of common or preferred stock; • issuance of additional debt, including unsecured notes and mortgage debt; • draws on our credit facilities; and/or • sale or exchange of ownership interests in properties. Access to capital markets impacts our cost of capital and ability to refinance maturing indebtedness, as well as our ability to fund future acquisitions and development through the issuance of additional securities or secured debt. Credit ratings impact our ability to access capital and directly impact our cost of capital as well. For example, our revolving line of credit facility accrues interest at a rate per annum equal to LIBOR plus a margin that depends upon our credit ratings. We also pay a facility fee on the entire revolving commitment that depends upon our credit ratings. As of January 31, 2018, we had a credit rating of BBB from Fitch, Baa2 from Moody’s and BBB from S&P Global on our senior unsecured debt securities. Cash Flow Summary During the fourth quarter of 2017, we adopted Accounting Standards Update ("ASU") No. 2016-18, Restricted Cash and ASU No. 2016-15, Classification of Certain Cash Receipts and Cash Payments using the full retrospective approach. See Note 2 to the Consolidated Financial Statements for additional information. The following summary discussion of our cash flows is based on the Consolidated Statements of Cash Flows and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below. Cash, cash equivalents and restricted cash were $82 million, $137 million and $407 million at December 31, 2017, 2016 and 2015, respectively. The following table sets forth changes in cash flows (in thousands): Operating cash flow decreased $367 million between the years ended December 31, 2017 and 2016 primarily as the result of: (i) decreased Adjusted NOI related to the QCP Spin-Off and dispositions in 2016 and 2017 and (ii) decreased interest received as a result of loan repayments during 2016 and 2017; partially offset by (i) 2016 and 2017 acquisitions, (ii) annual rent increases, (iii) and decreased interest paid as a result of lower balances on our senior unsecured notes and term loans. Our cash flow from operations is dependent upon the occupancy levels of our buildings, rental rates on leases, our tenants’ performance on their lease obligations, the level of operating expenses and other factors. Operating cash flow decreased $8 million between the years ended December 31, 2016 and 2015 primarily as the result of: (i) decreased Adjusted NOI related to the QCP Spin-Off and dispositions in 2015 and 2016 and (ii) decreased interest received as a result of loan repayments during 2016; partially offset by (i) 2015 and 2016 acquisitions, (ii) annual rent increases, (iii) and decreased interest paid as a result of lower balances on our senior unsecured notes and term loans. The following are significant investing and financing activities for the year ended December 31, 2017: • received net proceeds of $1.8 billion from the sale of real estate, including the sale and recapitalization of RIDEA II; • received net proceeds of $559 million primarily from the sale of our Four Seasons investments, the repayment of our HC-One Facility, and a DFL repayment; • made investments of $1.1 billion primarily for the acquisition and development of real estate; • repaid $1.4 billion of debt under our 2012 Term Loan, 2015 Term Loan, senior unsecured notes and mortgage debt, partially offset by net borrowings under our bank line of credit; and • paid cash dividends on common stock of $695 million. The following are significant investing and financing activities for the year ended December 31, 2016: • made investments of $1.3 billion (development, leasing and acquisition of real estate, investments in unconsolidated joint ventures and loans, and purchases of securities) and received proceeds of $908 million primarily from real estate and DFL sales; • paid cash dividends on common stock of $980 million, which were generally funded by cash provided by our operating activities and cash on hand; and • received net proceeds of $1.7 billion from the Spin-Off of QCP, raised proceeds of $1.1 billion primarily from our net borrowings under our bank line of credit, and repaid $2.9 billion under our bank line of credit, senior unsecured notes and mortgage debt. The following are significant investing and financing activities for the year ended December 31, 2015: • made investments of $2.4 billion (development, leasing and acquisition of real estate, and investments in unconsolidated joint ventures and loans); • paid dividends on common stock of $1 billion, which were generally funded by cash provided by our operating activities and cash on hand; and • raised proceeds of $2.7 billion primarily from issuing senior unsecured notes, the term loan originated in January 2015, net borrowings under our bank line of credit, issuances of common stock and noncontrolling interest, and an additional $684 million from sales of real estate, and loan and DFL repayments; and repaid $969 million of senior unsecured notes, bank line of credit and mortgage debt. Debt See Note 10 in the Consolidated Financial Statements for information about our outstanding debt. See “2017 Transaction Overview” for further information regarding our significant financing activities during the year ended December 31, 2017. Equity At December 31, 2017, we had 469 million shares of common stock outstanding, equity totaled $5.6 billion, and our equity securities had a market value of $12.4 billion. At December 31, 2017, non-managing members held an aggregate of 4 million units in five limited liability companies (“DownREITs”) for which we are the managing member. The DownREIT units are exchangeable for an amount of cash approximating the then-current market value of shares of our common stock or, at our option, shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). At-The-Market Program. In June 2015, we established an at-the-market program, in connection with the renewal of our Shelf Registration Statement. Under this program, we may sell shares of our common stock from time to time having an aggregate gross sales price of up to $750 million through a consortium of banks acting as sales agents or directly to the banks acting as principals. There was no activity during the year ended December 31, 2017 and, as of December 31, 2017, shares of our common stock having an aggregate gross sales price of $676 million were available for sale under the at-the-market program. Actual future sales will depend upon a variety of factors, including but not limited to market conditions, the trading price of our common stock and our capital needs. We have no obligation to sell the remaining shares available for sale under our program. Shelf Registration We filed a prospectus with the SEC as part of a registration statement on Form S-3ASR, using a shelf registration process. Our current shelf registration statement expires in June 2018. We expect to file a new shelf registration statement on or before such time. Under the “shelf” process, we may sell any combination of the securities described in the prospectus through one or more offerings. The securities described in the prospectus include common stock, preferred stock, depositary shares, debt securities and warrants. Contractual Obligations The following table summarizes our material contractual payment obligations and commitments at December 31, 2017 (in thousands): _______________________________________ (1) Excludes $94 million of other debt that represents life care bonds and demand notes that have no scheduled maturities. (2) Includes £105 million ($142 million) translated into USD. (3) Represents £169 million translated into USD. (4) Represents £2 million translated into USD for commitments to fund our U.K. loan facilities. (5) Represents commitments to finance development projects. (6) Represents construction and other commitments for developments in progress. (7) Interest on variable-rate debt is calculated using rates in effect at December 31, 2017. Off-Balance Sheet Arrangements We own interests in certain unconsolidated joint ventures as described in Note 8 to the Consolidated Financial Statements. Except in limited circumstances, our risk of loss is limited to our investment in the joint venture and any outstanding loans receivable. In addition, we have certain properties which serve as collateral for debt that is owed by a previous owner of certain of our facilities, as described under Note 11 to the Consolidated Financial Statements. Our risk of loss for these certain properties is limited to the outstanding debt balance plus penalties, if any. We have no other material off-balance sheet arrangements that we expect would materially affect our liquidity and capital resources except those described above under “Contractual Obligations”. Inflation Our leases often provide for either fixed increases in base rents or indexed escalators, based on the Consumer Price Index or other measures, and/or additional rent based on increases in the tenants’ operating revenues. Most of our MOB leases require the tenant to pay a share of property operating costs such as real estate taxes, insurance and utilities. Substantially all of our senior housing, life science, and remaining other leases require the tenant or operator to pay all of the property operating costs or reimburse us for all such costs. We believe that inflationary increases in expenses will be offset, in part, by the tenant or operator expense reimbursements and contractual rent increases described above. Non-GAAP Financial Measure Reconciliations Funds From Operations and Funds Available for Distribution The following is a reconciliation from net income (loss) applicable to common shares, the most directly comparable financial measure calculated and presented in accordance with GAAP, to FFO, FFO as adjusted and FAD (in thousands, except per share data): _______________________________________ (1) For the year ended December 31, 2017, represents income tax benefit associated with the disposition of real estate assets in our RIDEA II transaction. For the year ended December 31, 2016, represents income tax expense associated with the state built-in gain tax payable upon the disposition of specific real estate assets, of which $49 million relates to the HCRMC real estate portfolio. (2) For the year ended December 31, 2017, includes $55 million of net non-cash charges related to the right to terminate certain triple-net leases and management agreements in conjunction with the November 2017 Brookdale transaction. For the year ended December 31, 2016, primarily relates to the Spin-Off. For the year ended December 31, 2015, primarily related to acquisition and pursuit costs. For the year ended December 31, 2014, includes a net benefit from the 2014 Brookdale transaction, partially offset by acquisition and pursuit costs. For the year ended December 31, 2013, primarily relates to acquisition and pursuit costs. (3) For the year ended December 31, 2017, relates to $144 million of impairments on our Tandem Mezzanine Loan throughout 2017, net of a $51 million impairment recovery upon the sale of our Four Seasons Notes in the first quarter of 2017. For the year ended December 31, 2015, include impairment charges of: (i) $1.3 billion related to our HCRMC DFL investments, (ii) $112 million related to our Four Seasons Notes and (iii) $46 million related to our equity investment in HCRMC, partially offset by an impairment recovery of $6 million related to a loan payoff. For the year ended December 31, 2014, relates to our equity investment in HCRMC. (4) For the year ended December 31, 2017, primarily relates to the departure of our former Executive Vice President and Chief Accounting Officer. For the year ended December 31, 2016, primarily relates to the departure of our former President and Chief Executive Officer. For the year ended December 31, 2015, relates to the departure of our former Executive Vice President and Chief Investment Officer. For the year ended December 31, 2013, relates to the departure of our former Chairman, CEO and President. (5) For the year ended December 31, 2017, represents the premium associated with the prepayment of $500 million of senior unsecured notes. For the year ended December 31, 2016, represents penalties of $46 million from the prepayment of $1.1 billion of senior unsecured notes and $108 million of mortgage debt using proceeds from the Spin-Off. (6) For the year ended December 31, 2017, relates to costs from securities class action litigation and a legal settlement. For the year ended December 31, 2016, primarily relates to costs from securities class action litigation. See Note 3 in the Consolidated Financial Statements for additional information. (7) Represents the remeasurement of deferred tax assets and liabilities as a result of the Tax Cuts and Jobs Act that was signed into legislation on December 22, 2017. (8) Excludes $0.7 million related to the acceleration of deferred compensation for restricted stock units that vested upon the departure of our former Executive Vice President and Chief Accounting Officer, which is included in the severance and related charges for the year ended December 31, 2017. Excludes $7 million related to the acceleration of deferred compensation for restricted stock units that vested upon the departure of our former President and Chief Executive Officer, which is included in severance and related charges for the year ended December 31, 2016. Excludes $3 million related to the acceleration of deferred compensation for restricted stock units and stock options that vested upon the departure of our former Executive Vice President and Chief Investment Officer, which is included in the severance-related charge for year ended December 31, 2015. Excludes $17 million related to the acceleration of deferred compensation for restricted stock units and options that vested upon the departure of our former CEO, which is included in severance-related charges for the year ended December 31, 2013. (9) Includes our share of recurring capital expenditures, leasing costs, and tenant and capital improvements from unconsolidated joint ventures. (10) Represents our 49% share of non-refundable entrance fees as the fees are collected by our CCRC JV, net of reserves and CCRC JV entrance fee amortization. (11) Excludes $17 million of deferred tax expenses, which is included in tax rate legislation impact for the year ended December 31, 2017. Additionally, the year ended December 31, 2017, excludes $1 million of deferred tax benefit from the casualty-related charges, which is included in casualty-related charges (recoveries), net. (12) Our equity investment in HCRMC was accounted for using the equity method, which required an elimination of DFL income that is proportional to our ownership in HCRMC. Further, our share of earnings from HCRMC (equity income) increased for the corresponding elimination of related lease expense recognized at the HCRMC entity level, which we presented as a non-cash joint venture FAD adjustment. Beginning in January 2016, as a result of placing our equity investment in HCRMC on a cash basis method of accounting, we no longer eliminated our proportional ownership share of income from DFLs to equity income (loss) from unconsolidated joint ventures. See Note 5 to the Consolidated Financial Statements for additional discussion. Critical Accounting Policies The preparation of financial statements in conformity with U.S. GAAP requires our management to use judgment in the application of accounting policies, including making estimates and assumptions. We base estimates on the best information available to us at the time, our experience and on various other assumptions believed to be reasonable under the circumstances. These estimates affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions or other matters had been different, it is possible that different accounting would have been applied, resulting in a different presentation of our consolidated financial statements. From time to time, we re-evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current estimates and assumptions about matters that are inherently uncertain. For a more detailed discussion of our significant accounting policies, see Note 2 to the Consolidated Financial Statements. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain. Principles of Consolidation The consolidated financial statements include the accounts of HCP, Inc., our wholly-owned subsidiaries and joint ventures that we control, through voting rights or other means. We consolidate investments in variable interest entities (“VIEs”) when we are the primary beneficiary of the VIE. A variable interest holder is considered to be the primary beneficiary of a VIE if it has the power to direct the activities that most significantly impact the entity’s economic performance and has the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to the VIE. We make judgments about which entities are VIEs based on an assessment of whether: (i) the equity investors as a group, do not have a controlling financial interest, (ii) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support, or (iii) substantially all of the entity’s activities involve or are performed on behalf of an equity investor that holds disproportionately few voting rights. We make judgments with respect to our level of influence or control over an entity and whether we are (or are not) the primary beneficiary of a VIE. Consideration of various factors includes, but is not limited to, our ability to direct the activities that most significantly impact the entity’s economic performance, our form of ownership interest, our representation on the entity’s governing body, the size and seniority of our investment, and our ability and the rights of other investors to participate in policy making decisions, replace the manager and/or liquidate the entity, if applicable. Our ability to correctly assess our influence or control over an entity when determining the primary beneficiary of a VIE affects the presentation of these entities in our consolidated financial statements. When we perform a re-analysis of the primary beneficiary at a date other than at inception of the VIE, our assumptions may be different and may result in the identification of a different primary beneficiary. If we determine that we are the primary beneficiary of a VIE, our consolidated financial statements include the operating results of the VIE rather than the results of our variable interest in the VIE. We require VIEs to provide us timely financial information and review the internal controls of VIEs to determine if we can rely on the financial information it provides. If a VIE has deficiencies in its internal controls over financial reporting, or does not provide us with timely financial information, it may adversely impact the quality and/or timing of our financial reporting and our internal controls over financial reporting. Revenue Recognition At the inception of a new lease arrangement, including new leases that arise from amendments, we assess the terms and conditions to determine the proper lease classification. A lease arrangement is classified as an operating lease if none of the following criteria are met: (i) transfer of ownership to the lessee prior to or shortly after the end of the lease term, (ii) the lessee has a bargain purchase option during or at the end of the lease term, (iii) the lease term is equal to 75% or more of the underlying property’s economic life, or (iv) the present value of future minimum lease payments (excluding executory costs) is equal to 90% or more of the estimated fair value of the leased asset. If one of the four criteria is met and the minimum lease payments are determined to be reasonably predictable and collectible, the lease arrangement is generally accounted for as a DFL. If the assumptions utilized in the above classifications assessments were different, our lease classification for accounting purposes may have been different; thus the timing and amount of our revenue recognized would have been impacted, which may be material to our consolidated financial statements. We recognize rental revenue for operating leases on a straight-line basis over the lease term when collectibility of all minimum lease payments is reasonably assured and the tenant has taken possession or controls the physical use of a leased asset. If the lease provides for tenant improvements, we determine whether the tenant improvements are owned by the tenant or us. When we are the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the leased asset until the tenant improvements are substantially complete. When the tenant is the owner of the tenant improvements, any tenant improvement allowance funded is treated as a lease incentive and amortized as a reduction of revenue over the lease term. The determination of ownership of a tenant improvement is subject to significant judgment. If our assessment of the owner of the tenant improvements was different, the timing and amount of our revenue recognized would be impacted. Certain leases provide for additional rents that are contingent upon a percentage of the facility’s revenue in excess of specified base amounts or other thresholds. Such revenue is recognized when actual results reported by the tenant, or estimates of tenant results, exceed the base amount or other thresholds. The recognition of additional rents requires us to make estimates of amounts owed and, to a certain extent, is dependent on the accuracy of the facility results reported to us. Our estimates may differ from actual results, which could be material to our consolidated financial statements. We maintain an allowance for doubtful accounts, including an allowance for operating lease straight-line rent receivables, for estimated losses resulting from tenant defaults or the inability of tenants to make contractual rent and tenant recovery payments. We monitor the liquidity and creditworthiness of our tenants and operators on a continuous basis. This evaluation considers industry and economic conditions, property performance, credit enhancements and other factors. For straight-line rent receivable amounts, our assessment is based on income recoverable over the term of the lease. We exercise judgment in establishing allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. We use the direct finance method of accounting to record income from DFLs. For leases accounted for as DFLs, the net investment in the DFL represents receivables for the sum of future minimum lease payments receivable and the estimated residual values of the leased properties, less the unamortized unearned income. Unearned income is deferred and amortized to income over the lease terms to provide a constant yield when collectibility of the lease payments is reasonably assured. The determination of estimated useful lives and residual values are subject to significant judgment. If these assessments were to change, the timing and amount of our revenue recognized would be impacted. Loans receivable are classified as held-for-investment based on management’s intent and ability to hold the loans for the foreseeable future or to maturity. We recognize interest income on loans, including the amortization of discounts and premiums, using the interest method applied on a loan-by-loan basis when collectibility of the future payments is reasonably assured. Premiums, discounts and related costs are recognized as yield adjustments over the term of the related loans. If management determined that certain loans should no longer be classified as held-for-investment, the timing and amount of our interest income recognized would be impacted. Loans receivable and DFLs (collectively, “Finance Receivables”), are reviewed and assigned an internal rating of Performing, Watch List or Workout. Finance Receivables that are deemed Performing meet all present contractual obligations, and collection and timing, of all amounts owed is reasonably assured. Watch List Finance Receivables are defined as Finance Receivables that do not meet the definition of Performing or Workout. Workout Finance Receivables are defined as Finance Receivables in which we have determined, based on current information and events, that: (i) it is probable we will be unable to collect all amounts due according to the contractual terms of the agreement, (ii) the tenant, operator, or borrower is delinquent on making payments under the contractual terms of the agreement and (iii) we have commenced action or anticipate pursuing action in the near term to seek recovery of our investment. Finance Receivables are placed on nonaccrual status when management determines that the collectibility of contractual amounts is not reasonably assured (the asset will have an internal rating of either Watch List or Workout). Further, we perform a credit analysis to support the tenant’s, operator’s, borrower’s and/or guarantor’s repayment capacity and the underlying collateral values. We use the cash basis method of accounting for Finance Receivables placed on nonaccrual status unless one of the following conditions exist whereby we utilize the cost recovery method of accounting: (i) if we determine that it is probable that we will only recover the recorded investment in the Finance Receivable, net of associated allowances or charge-offs (if any), or (ii) we cannot reasonably estimate the amount of an impaired Finance Receivable. For cash basis method of accounting we apply payments received, excluding principal paydowns, to interest income so long as that amount does not exceed the amount that would have been earned under the original contractual terms. For cost recovery method of accounting any payment received is applied to reduce the recorded investment. Generally, we return a Finance Receivable to accrual status when all delinquent payments become current under the terms of the loan or lease agreements and collectibility of the remaining contractual loan or lease payments is reasonably assured. Allowances are established for Finance Receivables on an individual basis utilizing an estimate of probable losses, if they are determined to be impaired. Finance Receivables are impaired when it is deemed probable that we will be unable to collect all amounts due in accordance with the contractual terms of the loan or lease. An allowance is based upon our assessment of the lessee’s or borrower’s overall financial condition, economic resources, payment record, the prospects for support from any financially responsible guarantors and, if appropriate, the net realizable value of any collateral. These estimates consider all available evidence, including the expected future cash flows discounted at the Finance Receivable’s effective interest rate, fair value of collateral, general economic conditions and trends, historical and industry loss experience, and other relevant factors, as appropriate. Should a Finance Receivable be deemed partially or wholly uncollectible, the uncollectible balance is charged off against the allowance in the period in which the uncollectible determination has been made. Real Estate We make estimates as part of our process for allocating a purchase price to the various identifiable assets of an acquisition based upon the relative fair value of each asset. The most significant components of our allocations are typically buildings as-if-vacant, land and in-place leases. In the case of allocating fair value to buildings and intangibles, our fair value estimates will affect the amount of depreciation and amortization we record over the estimated useful life of each asset acquired. In the case of allocating fair value to in-place leases, we make our best estimates based on our evaluation of the specific characteristics of each tenant’s lease. Factors considered include estimates of carrying costs during hypothetical expected lease-up periods, market conditions and costs to execute similar leases. Our assumptions affect the amount of future revenue and/or depreciation and amortization expense that we will recognize over the remaining lease term for the acquired in-place leases. A variety of costs are incurred in the development and leasing of properties. After determination is made to capitalize a cost, it is allocated to the specific component of a project that is benefited. Determination of when a development project is substantially complete and capitalization must cease involves a degree of judgment. The costs of land and buildings under development include specifically identifiable costs. The capitalized costs include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs, real estate taxes and other costs incurred during the period of development. We consider a construction project to be considered substantially complete and available for occupancy and cease capitalization of costs upon the completion of the related tenant improvements. Impairment of Long-Lived Assets We assess the carrying value of our real estate assets and related intangibles (“real estate assets”) when events or changes in circumstances indicate that the carrying amount of the real estate assets may not be recoverable, but at least annually. Recoverability of real estate assets is measured by comparing the carrying amount of the real estate assets to the respective estimated future undiscounted cash flows. The estimated future undiscounted cash flows are calculated utilizing the lowest level of identifiable cash flows that are largely independent of the cash flows of other assets and liabilities. In order to review our real estate assets for recoverability, we consider market conditions, as well as our intent with respect to holding or disposing of the asset. If our analysis indicates that the carrying value of the real estate assets is not recoverable on an undiscounted cash flow basis, we recognize an impairment charge for the amount by which the carrying value exceeds the fair value of the real estate asset. The determination of the fair value of real estate assets involves significant judgment. This judgment is based on our analysis and estimates of fair value of real estate assets, future operating results and resulting cash flows of each real estate asset whose carrying amount may not be recoverable. Our ability to accurately predict future operating results and resulting cash flows, and estimate and allocate fair values, impacts the timing and recognition of impairments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our financial results. Investments in Unconsolidated Joint Ventures The initial carrying value of investments in unconsolidated joint ventures is based on the amount paid to purchase the joint venture interest or the carrying value of the assets prior to the sale or contribution of the interests to the joint venture. We evaluate our equity method investments for impairment by first reviewing for indicators of impairment based upon the performance of the underlying real estate assets held by the joint venture. If an equity method investment shows indicators of impairment, we compare the fair value of the equity method investment to our carrying value. If we determine there is a decline in the fair value of our investment in an unconsolidated joint venture below its carrying value and it is other-than-temporary, an impairment is recorded. The determination of the fair value of investments in unconsolidated joint ventures and as to whether a deficiency in fair value is other-than-temporary involves significant judgment. Our estimates consider all available evidence including, as appropriate, the present value of the expected future cash flows discounted at market rates, general economic conditions and trends, severity and duration of a fair value deficiency, and other relevant factors. Capitalization rates, discount rates and credit spreads utilized in our valuation models are based upon rates that we believe to be within a reasonable range of current market rates for the respective investments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our financial results. Income Taxes As part of the process of preparing our consolidated financial statements, significant management judgment is required to evaluate our compliance with REIT requirements. Our determinations are based on interpretation of tax laws, and our conclusions may have an impact on the income tax expense recognized. Adjustments to income tax expense may be required as a result of: (i) audits conducted by federal, state and local tax authorities, (ii) our ability to qualify as a REIT, (iii) the potential for built-in gain recognition, and (iv) changes in tax laws. Adjustments required in any given period are included within the income tax provision. Recent Accounting Pronouncements See Note 2 to the Consolidated Financial Statements for the impact of new accounting standards.

<s>[INST] The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: 2017 Transaction Overview Dividends Results of Operations Liquidity and Capital Resources Contractual Obligations OffBalance Sheet Arrangements Inflation NonGAAP Financial Measure Reconciliations Critical Accounting Policies Recent Accounting Pronouncements 2017 Transaction Overview Master Transactions and Cooperation Agreement with Brookdale On November 1, 2017, HCP and Brookdale entered into a Master Transactions and Cooperation Agreement (the “MTCA”) to provide us with the ability to significantly reduce our concentration of assets leased to and/or managed by Brookdale (the "Brookdale Transaction"). Through a series of dispositions and transitions of assets currently leased to and/or managed by Brookdale, as contemplated by the MTCA, our exposure to Brookdale is expected to be significantly reduced. In connection with the overall transaction pursuant to the MTCA, HCP (through certain of its subsidiaries), and Brookdale (through certain of its subsidiaries) (the “Lessee”) entered into an Amended and Restated Master Lease and Security Agreement (the “Amended Master Lease”), which amended and restated the thenexisting triplenet leases between the parties for 78 assets (before giving effect to the contemplated sale or transition of 34 assets discussed below), which account for primarily all of the assets subject to triplenet leases between HCP and the Lessee. Under the Amended Master Lease, we have the benefit of a guaranty from Brookdale of the Lessee’s obligations and, upon a change in control, will have various additional protections under the MTCA and the Amended Master Lease. The Amended Master Lease preserves the renewal terms and, with certain exceptions, the rents under the previously existing triplenet leases. In addition, HCP and Brookdale agreed to the following: We have the right to sell, or transition to other operators, 32 triplenet assets. If such sale or transition does not occur within one year, the triplenet lease with respect to such assets will convert to a cash flow lease (under which we will bear the risks and rewards of operating the assets) with a term of two years, provided that we have the right to terminate the cash flow lease at any time during the term without penalty; We have provided an aggregate $5 million annual reduction in rent on three assets, effective January 1, 2018; and We will sell two triplenet assets to Brookdale or its affiliates for $35 million, which we anticipate completing during the first half of 2018. Also pursuant to the MTCA, HCP and Brookdale agreed to the following: HCP, which owned 90% of the interests in its RIDEA I and RIDEA III joint ventures with Brookdale at the time the MTCA was executed, agreed to purchase Brookdale’s 10% noncontrolling interest in each joint venture for an aggregate purchase price of $95 million. These joint ventures collectively own and operate 58 independent living, assisted living, memory care and/or skilled nursing facilities (the “RIDEA Facilities”). We completed our acquisition of the RIDEA III noncontrolling interest in December 2017 and anticipate completing our acquisition of the RIDEA I noncontrolling interest during the first half of 2018; We have the right to sell, or transition to other managers, 36 of the RIDEA Facilities and terminate related management agreements with an affiliate of Brookdale without penalty. If the related management agreements are not terminated within one year, the base management fee (5% of gross revenues) increases by 1% of gross revenues per year over the following two years to a maximum of 7% of gross revenues; We will sell four of the RIDEA Facilities to Brookdale or its affiliates for $239 million, one of which was sold in January 2018 for $27 million. We anticipate completing the sale of the remaining three RIDEA Facilities during [/INST] Negative. </s>

HCP, INC.

2019-02-14

2018-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: • 2018 Transaction Overview • Dividends • Results of Operations • Liquidity and Capital Resources • Contractual Obligations • Off-Balance Sheet Arrangements • Inflation • Non-GAAP Financial Measure Reconciliations • Critical Accounting Policies • Recent Accounting Pronouncements 2018 Transaction Overview Mountain View Campus Sale • In November 2018, we sold our Shoreline Technology Center life science campus located in Mountain View, California for $1.0 billion and recognized a gain on sale of $726 million. MSREI MOB JV • In August 2018, HCP and Morgan Stanley Real Estate Investment (“MSREI”) formed a joint venture (the “MSREI JV”) to own a portfolio of MOBs, which HCP owns 51% of and consolidates. To form the MSREI JV, MSREI contributed cash of $298 million and HCP contributed nine wholly-owned MOBs (the “Contributed Assets”). The Contributed Assets are primarily located in Texas and Florida and were valued at approximately $320 million at the time of contribution. The MSREI JV used substantially all of the cash contributed by MSREI to acquire an additional portfolio of 16 MOBs in Greenville, South Carolina (the “Greenville Portfolio”) for $285 million. Concurrent with acquiring the additional MOBs, the MSREI JV entered into 10-year leases with an anchor tenant on each MOB in the Greenville Portfolio, which accounts for approximately 93% of the total leasable space in the portfolio. Brookdale Transactions Update • In 2018, we sold six agreed upon facilities to Brookdale for $275 million. • In March 2018, we completed the acquisition of Brookdale’s noncontrolling interest in RIDEA I for $63 million. • During the fourth quarter of 2018, we completed the sale of 11 senior housing triple-net and eight SHOP facilities previously leased to Brookdale for $377 million. • As of December 31, 2018, we had completed the transition of 38 assets previously operated by Brookdale to other operators. See Note 3 to the Consolidated Financial Statements for additional information. U.K. Investment Update • In June 2018, we entered into a joint venture with an institutional investor (the “U.K. JV”) through which we sold a 51% interest in U.K. assets previously owned by us (the "U.K. Portfolio”) based on a total value of £382 million ($507 million). We retained a 49% noncontrolling interest in the joint venture and received gross proceeds of $402 million, including proceeds from the refinancing of our previously held intercompany loans. Upon closing the U.K. JV, we deconsolidated the U.K. Portfolio, recognized our retained noncontrolling interest investment at fair value ($105 million) and recognized a gain on sale of $11 million. We expect to sell our remaining 49% interest by no later than 2020. Other Real Estate and Loan Transactions • In March 2018, we sold our Tandem Health Care mezzanine loan (“Tandem Mezzanine Loan”) to a third party for approximately $112 million, resulting in an impairment recovery, net of transaction costs and fees, of $3 million. • In June 2018, we sold our remaining 40% ownership interest in RIDEA II for $91 million and caused Columbia Pacific Advisors, LLC to refinance our $242 million of loans receivable from RIDEA II, which resulted in total proceeds of $332 million. • In 2016, we provided a £105 million ($131 million at closing) bridge loan (the “U.K. Bridge Loan”) to Maria Mallaband Care Group Ltd. ("MMCG") to fund the acquisition of a portfolio of seven care homes in the U.K. Under the bridge loan, we retained a call option to acquire those seven care homes at a future date for £105 million. In March 2018, in conjunction with MMCG and HCP satisfying the conditions necessary to exercise our call option to acquire the seven care homes, we began consolidating the real estate. In June 2018, we completed the process of exercising the call option. The seven care homes acquired through the call option were included in the U.K. JV transaction (see U.K. Investment Update above). See Notes 5, 7 and 19 to the Consolidated Financial Statements for additional information. • In November 2018, we acquired the outstanding equity interests in three life science joint ventures (which owned four buildings) for $92 million, bringing our equity ownership to 100% for all three joint ventures. As a result, we recognized a gain on consolidation of $50 million. • Additionally, during the year ended December 31, 2018, we sold: (i) 19 SHOP facilities, (ii) four life science assets, (iii) four MOBs and (iv) an undeveloped land parcel for a total of $451 million. • In November 2018, we entered into definitive agreements to acquire two life science buildings in South San Francisco, California, adjacent to The Shore at Sierra Point development, for $245 million. We made a $15 million nonrefundable deposit upon completing due diligence and expect to close the transaction during the first half of 2019. • In January and February 2019, we acquired a life science facility for $71 million and development rights at an adjacent undeveloped land parcel for consideration of up to $27 million. The existing facility and land parcel are located in Cambridge, Massachusetts. Financing Activities • On July 3, 2018, we exercised our right to repay the outstanding £169 million balance under our term loan and re-borrow $224 million with all other key terms unchanged. We repaid the full balance of our term loan in November 2018. • On July 16, 2018, we repaid all $700 million outstanding of our 5.375% senior unsecured notes due 2021 and recorded a loss on debt extinguishment of approximately $44 million. • On November 8, 2018, we repaid all $450 million outstanding of our 3.75% senior unsecured notes due in 2019 at par. • During the fourth quarter of 2018, we issued 5.4 million shares of common stock under our at-the-market equity offering program for total net proceeds of $154 million. • In December 2018, we issued two million shares for total net proceeds of $57 million and entered into a forward equity sales agreement to sell up to an aggregate of 15.25 million additional shares on or before December 13, 2019 at an initial net price of $28.60 per share, after underwriting discounts and commissions. • During 2018, we used proceeds from dispositions primarily to repay $933 million of outstanding net borrowings under our revolving line of credit facility. Developments and Redevelopments • In March 2018, we acquired the rights to develop a new 214,000 square foot life science facility on our existing Hayden Research Campus in Lexington, Massachusetts for $21 million. The development, 75 Hayden, will be a four-story, purpose-built Class A life science facility and parking garage. • In September and October 2018, we signed two leases totaling 222,000 square feet at The Shore at Sierra Point in South San Francisco, bringing the $224 million first phase of the development to 100% pre-leased. The Shore at Sierra Point is a 23-acre waterfront life science development offering state-of-the-art laboratory and office space along with premier amenities. • During the third quarter of 2018, we commenced a program with HCA Healthcare to develop primarily on-campus MOBs. As of December 31, 2018, we had begun construction on one MOB with an estimated cost of $26 million. Dividends Quarterly cash dividends paid during 2018 aggregated to $1.48 per share. On January 31, 2019, our Board of Directors declared a quarterly cash dividend of $0.37 per common share. The dividend will be paid on February 28, 2019 to stockholders of record as of the close of business on February 19, 2019. Results of Operations We evaluate our business and allocate resources among our reportable business segments: (i) senior housing triple-net, (ii) senior housing operating portfolio (SHOP), (iii) life science and (iv) medical office. Under the medical office and life science segments, we invest through the acquisition and development of MOBs and life science facilities, which generally require a greater level of property management. Our senior housing facilities are managed utilizing triple-net leases and RIDEA structures. We have other non-reportable segments that are comprised primarily of our debt investments, hospital properties, unconsolidated joint ventures and U.K. investments. We evaluate performance based upon: (i) property net operating income from continuing operations (“NOI”) and (ii) adjusted NOI (cash NOI) in each segment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 2 to the Consolidated Financial Statements). Non-GAAP Financial Measures Net Operating Income NOI and Adjusted NOI are non-U.S. generally accepted accounting principles (“GAAP”) supplemental financial measures used to evaluate the operating performance of real estate. NOI is defined as real estate revenues (inclusive of rental and related revenues, resident fees and services, and income from direct financing leases), less property level operating expenses (which exclude transition costs); NOI excludes all other financial statement amounts included in net income (loss) as presented in Note 13 to the Consolidated Financial Statements. Management believes NOI provides relevant and useful information because it reflects only income and operating expense items that are incurred at the property level and presents them on an unlevered basis. Adjusted NOI is calculated as NOI after eliminating the effects of straight-line rents, DFL non-cash interest, amortization of market lease intangibles, termination fees, actuarial reserves for insurance claims that have been incurred but not reported, and the impact of deferred community fee income and expense. Adjusted NOI is oftentimes referred to as “Cash NOI.” NOI and Adjusted NOI exclude our share of income (loss) generated by unconsolidated joint ventures, which is recognized in equity income (loss) from unconsolidated joint ventures in the consolidated statements of operations. We use NOI and Adjusted NOI to make decisions about resource allocations, to assess and compare property level performance, and to evaluate our same property portfolio (“SPP”), as described below. We believe that net income (loss) is the most directly comparable GAAP measure to NOI and Adjusted NOI. NOI and Adjusted NOI should not be viewed as alternative measures of operating performance to net income (loss) as defined by GAAP since they do not reflect various excluded items. Further, our definitions of NOI and Adjusted NOI may not be comparable to the definitions used by other REITs or real estate companies, as they may use different methodologies for calculating NOI and Adjusted NOI. For a reconciliation of NOI and Adjusted NOI to net income (loss) by segment, refer to Note 13 to the Consolidated Financial Statements. Operating expenses generally relate to leased medical office and life science properties and SHOP facilities. We generally recover all or a portion of our leased medical office and life science property expenses through tenant recoveries. We present expenses as operating or general and administrative based on the underlying nature of the expense. Same Property Portfolio SPP NOI and Adjusted (Cash) NOI information allows us to evaluate the performance of our property portfolio under a consistent population by eliminating changes in the composition of our consolidated portfolio of properties. SPP NOI excludes certain non-property specific operating expenses that are allocated to each operating segment on a consolidated basis. Properties are included in SPP once they are stabilized for the full period in both comparison periods. Newly acquired operating assets are generally considered stabilized at the earlier of lease-up (typically when the tenant(s) control(s) the physical use of at least 80% of the space) or 12 months from the acquisition date. Newly completed developments and redevelopments are considered stabilized at the earlier of lease-up or 24 months from the date the property is placed in service. Properties that experience a change in reporting structure, such as a transition from a triple-net lease to a RIDEA reporting structure, are considered stabilized after 12 months in operations under a consistent reporting structure. A property is removed from SPP when it is classified as held for sale, sold, placed into redevelopment, experiences a casualty event that significantly impacts operations or changes its reporting structure (such as triple-net to SHOP). For a reconciliation of SPP to total portfolio Adjusted NOI and other relevant disclosures by segment, refer to our Segment Analysis below. Funds From Operations ("FFO") FFO encompasses NAREIT FFO and FFO as adjusted, each of which is described in detail below. We believe FFO applicable to common shares, diluted FFO applicable to common shares, and diluted FFO per common share are important supplemental non-GAAP measures of operating performance for a REIT. Because the historical cost accounting convention used for real estate assets utilizes straight-line depreciation (except on land), such accounting presentation implies that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen and fallen with market conditions, presentations of operating results for a REIT that use historical cost accounting for depreciation could be less informative. The term FFO was designed by the REIT industry to address this issue. NAREIT FFO. FFO, as defined by the National Association of Real Estate Investment Trusts (“NAREIT”), is net income (loss) applicable to common shares (computed in accordance with GAAP), excluding gains or losses from sales of depreciable property, including any current and deferred taxes directly associated with sales of depreciable property, impairments of, or related to, depreciable real estate, plus real estate and other real estate-related depreciation and amortization, and adjustments to compute our share of NAREIT FFO and FFO as adjusted (see below) from joint ventures. Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of NAREIT FFO for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. For consolidated joint ventures in which we do not own 100%, we reflect our share of the equity by adjusting our NAREIT FFO to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods. Our pro-rata share information is prepared on a basis consistent with the comparable consolidated amounts, is intended to reflect our proportionate economic interest in the operating results of properties in our portfolio and is calculated by applying our actual ownership percentage for the period. We do not control the unconsolidated joint ventures, and the pro-rata presentations of reconciling items included in NAREIT FFO do not represent our legal claim to such items. The joint venture members or partners are entitled to profit or loss allocations and distributions of cash flows according to the joint venture agreements, which provide for such allocations generally according to their invested capital. The presentation of pro-rata information has limitations, which include, but are not limited to, the following: (i) the amounts shown on the individual line items were derived by applying our overall economic ownership interest percentage determined when applying the equity method of accounting and do not necessarily represent our legal claim to the assets and liabilities, or the revenues and expenses and (ii) other companies in our industry may calculate their pro-rata interest differently, limiting the usefulness as a comparative measure. Because of these limitations, the pro-rata financial information should not be considered independently or as a substitute for our financial statements as reported under GAAP. We compensate for these limitations by relying primarily on our GAAP financial statements, using the pro-rata financial information as a supplement. NAREIT FFO does not represent cash generated from operating activities in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income (loss). We compute NAREIT FFO in accordance with the current NAREIT definition; however, other REITs may report NAREIT FFO differently or have a different interpretation of the current NAREIT definition from ours. FFO as adjusted. In addition, we present NAREIT FFO on an adjusted basis before the impact of non-comparable items including, but not limited to, transaction-related items, impairments (recoveries) of non-depreciable assets, losses (gains) from the sale of non-depreciable assets, severance and related charges, prepayment costs (benefits) associated with early retirement or payment of debt, litigation costs (recoveries), casualty-related charges (recoveries), foreign currency remeasurement losses (gains) and changes in tax legislation (“FFO as adjusted”). Transaction-related items include transaction expenses and gains/charges incurred as a result of mergers and acquisitions and lease amendment or termination activities. Prepayment costs (benefits) associated with early retirement of debt include the write-off of unamortized deferred financing fees, or additional costs, expenses, discounts, make-whole payments, penalties or premiums incurred as a result of early retirement or payment of debt. Management believes that FFO as adjusted provides a meaningful supplemental measurement of our FFO run-rate and is frequently used by analysts, investors and other interested parties in the evaluation of our performance as a REIT. At the same time that NAREIT created and defined its FFO measure for the REIT industry, it also recognized that “management of each of its member companies has the responsibility and authority to publish financial information that it regards as useful to the financial community.” We believe stockholders, potential investors and financial analysts who review our operating performance are best served by an FFO run-rate earnings measure that includes certain other adjustments to net income (loss), in addition to adjustments made to arrive at the NAREIT defined measure of FFO. FFO as adjusted is used by management in analyzing our business and the performance of our properties, and we believe it is important that stockholders, potential investors and financial analysts understand this measure used by management. We use FFO as adjusted to: (i) evaluate our performance in comparison with expected results and results of previous periods, relative to resource allocation decisions, (ii) evaluate the performance of our management, (iii) budget and forecast future results to assist in the allocation of resources, (iv) assess our performance as compared with similar real estate companies and the industry in general and (v) evaluate how a specific potential investment will impact our future results. Other REITs or real estate companies may use different methodologies for calculating an adjusted FFO measure, and accordingly, our FFO as adjusted may not be comparable to those reported by other REITs. For a reconciliation of net income (loss) to NAREIT FFO and FFO as adjusted and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Funds Available for Distribution FAD is defined as FFO as adjusted after excluding the impact of the following: (i) amortization of deferred compensation expense, (ii) amortization of deferred financing costs, net, (iii) straight-line rents, (iv) deferred income taxes, (v) amortization of acquired market lease intangibles, net, (vi) non-cash interest related to DFLs and lease incentive amortization (reduction of straight-line rents), (vii) actuarial reserves for insurance claims that have been incurred but not reported, and (viii) deferred revenues, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents. Also, FAD: (i) is computed after deducting recurring capital expenditures, including second generation leasing costs and second generation tenant and capital improvements, and (ii) includes lease restructure payments and adjustments to compute our share of FAD from our unconsolidated joint ventures and those related to CCRC non-refundable entrance fees. Certain prior period amounts in the “Non-GAAP Financial Measures Reconciliation” below for FAD have been reclassified to conform to the current period presentation. More specifically, recurring capital expenditures, including second generation leasing costs and second generation tenant and capital improvements ("FAD capital expenditures") excludes our share from unconsolidated joint ventures (reported in “other FAD adjustments”). Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of FAD for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. We reflect our share for consolidated joint ventures in which we do not own 100% of the equity by adjusting our FAD to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods (reported in “other FAD adjustments”). See FFO for further disclosure regarding our use of pro-rata share information and its limitations. Other REITs or real estate companies may use different methodologies for calculating FAD, and accordingly, our FAD may not be comparable to those reported by other REITs. Although our FAD computation may not be comparable to that of other REITs, management believes FAD provides a meaningful supplemental measure of our performance and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. We believe FAD is an alternative run-rate earnings measure that improves the understanding of our operating results among investors and makes comparisons with: (i) expected results, (ii) results of previous periods and (iii) results among REITs more meaningful. FAD does not represent cash generated from operating activities determined in accordance with GAAP and is not necessarily indicative of cash available to fund cash needs as it excludes the following items which generally flow through our cash flows from operating activities: (i) adjustments for changes in working capital or the actual timing of the payment of income or expense items that are accrued in the period, (ii) transaction-related costs, (iii) litigation settlement expenses, (iv) severance-related expenses and (v) actual cash receipts from interest income recognized on loans receivable (in contrast to our FAD adjustment to exclude non-cash interest and depreciation related to our investments in direct financing leases). Furthermore, FAD is adjusted for recurring capital expenditures, which are generally not considered when determining cash flows from operations or liquidity. FAD is a non-GAAP supplemental financial measure and should not be considered as an alternative to net income (loss) determined in accordance with GAAP. For a reconciliation of net income (loss) to FAD and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Comparison of the Year Ended December 31, 2018 to the Year Ended December 31, 2017 and the Year Ended December 31, 2017 to the Year Ended December 31, 2016 Overview(1) 2018 and 2017 The following table summarizes results for the years ended December 31, 2018 and 2017 (dollars in thousands): _______________________________________ (1) For the reconciliation of non-GAAP financial measures, see “Non-GAAP Financial Measure Reconciliations” section below. Net income (loss) applicable to common shares ("net income (loss)") increased primarily as a result of the following: • a larger net gain on sales of real estate during 2018 compared to 2017, primarily related to the sale of our Shoreline Technology Center life science campus in November 2018; • increased NOI from: (i) annual rent escalations, (ii) 2017 and 2018 acquisitions, and (iii) development and redevelopment projects placed in service during 2017 and 2018; • a gain on consolidation related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018; • impairments of our mezzanine loan facility to Tandem Health Care (the “Tandem Mezzanine Loan”) in 2017; • a net charge to NOI from the November 2017 transactions with Brookdale (the "2017 Brookdale Transactions" - see Note 3 to the Consolidated Financial Statements); • a reduction in interest expense as a result of debt repayments, primarily in the second and third quarters of 2017 and throughout 2018, partially offset by an increased average balance under our revolving credit facility during 2018; • higher income tax expense in 2017 related to the impact of new tax rate legislation, partially offset by tax benefits from higher sales volume during 2017; • a reduction in litigation-related costs from securities class action litigation, and a one-time legal settlement in 2017; • a reduction in loss on debt extinguishment related to the repurchases of our senior notes in July 2018 compared to July 2017; and • casualty-related charges incurred due to hurricanes in the third quarter of 2017. The increase in net income (loss) was partially offset by: • a reduction in NOI in our senior housing triple-net segment, primarily as a result of the sale of senior housing triple-net assets and the transition of senior housing triple-net assets to SHOP during 2017 and 2018; • a reduction in NOI in our SHOP segment, primarily as a result of occupancy declines and higher labor costs; • a loss on consolidation of seven care homes in the U.K. during the first quarter of 2018; • a reduction in income related to the gain on sale of our £138.5 million par value Four Seasons Health Care’s senior notes (the “Four Seasons Notes”) during 2017; • increased impairment charges on real estate asset recognized during 2018 compared to 2017; • a reduction in income as a result of: (i) asset sales during 2017 and 2018 and (ii) selling interests into the U.K. JV and MSREI JV (see Notes 4 and 5 to the Consolidated Financial Statements); • a reduction in interest income due to the: (i) payoff of our HC-One mezzanine loan (the "HC-One Facility") in June 2017 and (ii) sale of our Tandem Mezzanine Loan in March 2018; • increased depreciation and amortization expense as a result of: (i) assets acquired during 2017 and 2018 and (ii) development and redevelopment projects placed into operations during 2017 and 2018, primarily in our life science and medical office segments, partially offset by decreased depreciation and amortization from asset sales during 2017 and 2018; • a reduction in equity income from unconsolidated joint ventures as a result of the sale of our equity method investment in RIDEA II in June 2018, partially offset by additional equity income from the U.K. JV; and • an increase in severance and related charges during 2018 primarily related to the departure of our former Executive Chairman compared to severance and related charges primarily related to the departure of our former Chief Accounting Officer ("CAO") in 2017. NAREIT FFO increased primarily as a result of the aforementioned events impacting net income (loss), except for the following, which are excluded from NAREIT FFO: • gains on sales of real estate, including related tax impacts; • depreciation and amortization expense; • impairments of facilities within our senior housing triple-net and SHOP segments; and • net gain on consolidation. FFO as adjusted decreased primarily as a result of the aforementioned events impacting NAREIT FFO, except for the following, which are excluded from FFO as adjusted: • the net charge to NOI from the 2017 Brookdale Transactions; • the impact of tax rate legislation during the fourth quarter of 2017; • severance and related charges; • losses on debt extinguishments; • litigation-related costs; • casualty-related charges; • the gain on sale of our Four Seasons Notes during the first quarter of 2017; and • the impairments of our Tandem Mezzanine Loan in 2017 and an undeveloped life science land parcel in 2018. FAD decreased primarily as a result of the aforementioned events impacting FFO as adjusted, except for the impact of straight-line rents, which is excluded from FAD. The decrease in FAD was partially offset by lower FAD capital expenditures. 2017 and 2016 On October 31, 2016, we completed the Spin-Off of QCP. The Spin-Off included 338 properties, primarily comprised of the HCR ManorCare, Inc. (“HCRMC”) DFL investments and an equity investment in HCRMC. The following table summarizes results for the years ended December 31, 2017 and 2016 (dollars in thousands): Net income (loss) decreased primarily as a result of the following: • a reduction in net income from discontinued operations due to the Spin-Off of QCP on October 31, 2016; • a loss on debt extinguishment in July 2017, representing a premium for early payment on the repurchase of our senior notes; • a reduction in rental and related revenues primarily as a result of assets sold during 2017, including the sale of 64 senior housing triple-net assets in the first quarter of 2017; • a reduction in NOI primarily related to the net impact of the 2017 Brookdale Transactions; • a reduction in earnings due to the partial sale and deconsolidation of RIDEA II during the first quarter of 2017; • impairments related to: (i) the Tandem Mezzanine Loan and (ii) 11 underperforming senior housing triple-net facilities in the third quarter of 2017; • increased litigation-related costs, including costs from securities class action litigation, and a one-time legal settlement in 2017; • casualty-related charges due to hurricanes in the third quarter of 2017; and • a reduction in interest income due to: (i) the payoffs of our HC-One Facility in June 2017 and a participating development loan during the third quarter of 2016 and (ii) decreased interest received from our Tandem Mezzanine Loan during the fourth quarter of 2017, partially offset by additional interest income in 2017 from our U.K. Bridge Loan. The decrease in net income (loss) was partially offset by: • a reduction in interest expense as a result of debt repayments in the fourth quarter of 2016 and throughout 2017; • a reduction in severance and related charges primarily related to the departure of our former President and Chief Executive Officer ("CEO") in 2016 compared to severance and related charges primarily related to the departure of our former CAO in 2017; • a larger net gain on sales of real estate during 2017 compared to 2016, primarily related to the sale of 64 senior housing triple-net assets and the partial sale of RIDEA II during 2017; • an increase in income tax benefit primarily from real estate dispositions during 2017, partially offset by an income tax expense related to the impact of tax rate legislation during the fourth quarter of 2017; and • an increase in other income primarily related to the gain on sale of our Four Seasons Notes during 2017. NAREIT FFO decreased primarily as a result of the aforementioned events impacting net income (loss), except for gain on sales of real estate and impairments of real estate, which are excluded from NAREIT FFO. FFO as adjusted decreased primarily as a result of the following: • a reduction in net income from discontinued operations due to the Spin-Off of QCP on October 31, 2016; • a reduction in rental and related revenues primarily as a result of assets sold during 2017, including the sale of 64 senior housing triple-net assets; • a reduction in earnings due to the partial sale and deconsolidation of RIDEA II during the first quarter of 2017; and • a reduction in interest income due to: (i) the payoffs of our HC-One Facility in June 2017 and a participating development loan during the third quarter of 2016 and (ii) decreased interest received from our Tandem Mezzanine Loan during the fourth quarter of 2017, partially offset by additional interest income in 2017 from our U.K. Bridge Loan. The decrease in FFO as adjusted was partially offset by a reduction in interest expense as a result of debt repayments in the fourth quarter of 2016 and throughout 2017. FAD decreased primarily as a result of the aforementioned events impacting FFO as adjusted, (i) increased leasing costs and tenant capital improvements and (ii) decreased installment payments received from Brookdale for 2014 lease terminations that were paid over a period of three years and concluded in 2017. Segment Analysis The tables below provide selected operating information for our SPP and total property portfolio for each of our reportable segments. For the year ended December 31, 2018, our SPP consists of 522 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2017 and that remained in operations under a consistent reporting structure through December 31, 2018. For the year ended December 31, 2017, our SPP consisted of 617 properties acquired or placed in service and stabilized on or prior to January 1, 2016 and that remained in operations under a consistent reporting structure through December 31, 2017. Our total consolidated property portfolio consisted of 645, 744 and 851 properties at December 31, 2018, 2017 and 2016, respectively, excluding properties in the Spin-Off. Senior Housing Triple-Net 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars in thousands except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) Represents rental and related revenues and income from DFLs. (3) From our 2017 presentation of SPP, we removed 11 senior housing triple-net properties that were sold and 22 senior housing triple-net properties that were transitioned to our SHOP segment. (4) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI and Adjusted NOI increased primarily as a result of annual rent escalations. The increase in Adjusted NOI was partially offset by rent reductions under the 2017 Brookdale Transactions. Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • decreased NOI from senior housing triple-net facilities sold during 2017 and 2018; and • decreased NOI from the transfer of 25 and 22 senior housing triple-net facilities to our SHOP segment during 2017 and 2018, respectively. The decrease in Total Portfolio NOI and Adjusted NOI is partially offset by the aforementioned increases to SPP. The decrease in Total Portfolio NOI was further offset by the net charge of triple-net lease terminations from the 2017 Brookdale Transactions. 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars in thousands except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) Represents rental and related revenues and income from DFLs. (3) From our 2016 presentation of SPP, we removed four senior housing triple-net properties that were sold, 25 senior housing triple-net properties that were transitioned to our SHOP segment and two senior housing triple-net properties that were classified as held for sale. (4) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI decreased primarily as a result of the net impact of triple-net lease terminations from the 2017 Brookdale Transactions. SPP Adjusted NOI increased primarily as a result of the following: • annual rent escalations; and • higher cash rent received from our portfolio of assets leased to Sunrise Senior Living. Additionally, Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • senior housing triple-net facilities sold during 2016 and 2017; and • the transfer of 42 senior housing triple-net facilities to our SHOP segment during 2016 and 2017. The decrease to Total Portfolio NOI and Adjusted NOI is partially offset by (i) increased non-SPP income from five senior housing triple-net facilities acquired in the first quarter of 2016 and (ii) the aforementioned increases to SPP Adjusted NOI. Senior Housing Operating Portfolio 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars in thousands, except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2017 presentation of SPP, we removed nine properties that were sold, eight SHOP properties that were placed into redevelopment and three SHOP properties that were classified as held for sale. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP Adjusted NOI decreased primarily as a result of the following: • occupancy declines and higher labor costs; partially offset by • increased rates for resident fees and services. SPP NOI increased primarily as a result of the net charge for management fee terminations from the 2017 Brookdale Transactions, partially offset by the aforementioned decreases to SPP Adjusted NOI. Total Portfolio Adjusted NOI decreased primarily as a result of the aforementioned impacts to SPP and the following Non-SPP impacts: • decreased NOI from our partial sale of RIDEA II in the first quarter of 2017; and • decreased NOI from SHOP assets sold in 2017 and 2018; partially offset by • increased NOI from the transfer of 25 and 22 senior housing triple-net assets to our SHOP segment during 2017 and 2018, respectively. Total Portfolio NOI increased primarily a result of the net charge for management fee terminations from the 2017 Brookdale Transactions, partially offset by the aforementioned decreases to Total Portfolio Adjusted NOI. 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars in thousands, except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2016 presentation of SPP, we removed a SHOP property that was placed into redevelopment, two SHOP properties that were classified as held for sale and 49 SHOP properties that were deconsolidated. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI decreased primarily as a result of increased operating expenses related to the management fee terminations from the 2017 Brookdale Transactions. SPP Adjusted NOI increased primarily as a result of the following: • increased rates for resident fees and services; partially offset by • higher expense growth and a decline in occupancy. Additionally, Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • decreased non-SPP income from our partial sale of RIDEA II; partially offset by • non-SPP income for 42 senior housing triple-net assets transferred to SHOP during 2016 and 2017. Life Science 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2017 presentation of SPP, we removed 12 life science facilities that were sold and three life science facilities that were placed into redevelopment. SPP NOI and Adjusted NOI increased primarily as a result of the following: • new leasing activity; and • specific to Adjusted NOI, annual rent escalations; partially offset by • a mark-to-market rent decrease on a 147,000 square foot lease in South San Francisco. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following Non-SPP impacts: • increased NOI from: (i) increased occupancy in portions of a development placed into operations in 2017 and 2018 and (ii) acquisitions in 2017; partially offset by • decreased NOI from: (i) sales of life science facilities in 2017 and 2018 and (ii) the placement of life science facilities into redevelopment in 2017 and 2018. 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2016 presentation of SPP, we removed one life science facility that was sold and four life science facilities that were classified as held for sale. SPP NOI and Adjusted NOI increased primarily as a result of the following: • mark-to-market lease renewals; • new leasing activity; and • specific to adjusted NOI, annual rent escalations. Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following impacts to Non-SPP: • decreased income from sales of life science facilities in 2016 and 2017; partially offset by • increased income from (i) increased occupancy in portions of developments placed in operations in 2016 and 2017 and (ii) life science acquisitions in 2016 and 2017. The decrease in Total Portfolio NOI and Adjusted NOI was also partially offset by the aforementioned increases to SPP. Medical Office 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2017 presentation of SPP, we removed four MOBs that were sold and three MOBs that were placed into redevelopment. SPP NOI and Adjusted NOI increased primarily as a result of mark-to-market lease renewals. Additionally, SPP Adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following Non-SPP impacts: • increased NOI from our 2017 and 2018 acquisitions; and • increased occupancy in redevelopment and development properties placed into operations in 2017 and 2018; partially offset by • decreased NOI from sales of eight MOBs during 2017 and 2018 and the placement of one MOB into redevelopment. 2017 and 2016 The following table summarizes results at and for the years ended December 31, 2017 and 2016 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2016 presentation of SPP, we removed four MOBs that were sold and two MOBs that were placed into redevelopment. SPP NOI and Adjusted NOI increased primarily as a result of mark-to-market lease renewals and new leasing activity. Additionally, SPP Adjusted NOI increased as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following impacts to Non-SPP: • increased income from our 2016 and 2017 acquisitions; and • increased occupancy in former redevelopment and development properties placed into operations; partially offset by • decreased income from sales of seven MOBs during 2016 and 2017 and the placement of one MOB into redevelopment. Other Income and Expense Items The following table summarizes results for the years ended December 31, 2018, 2017 and 2016 (in thousands): Interest income. The decrease in interest income for the year ended December 31, 2018 was primarily the result of: (i) the sale of our Tandem Mezzanine Loan during the first quarter of 2018, (ii) the payoff of our HC-One Facility in June 2017, and (iii) the conversion of the U.K. Bridge Loan into real estate during the first quarter of 2018. The decrease in interest income for the year ended December 31, 2017 was primarily the result of: (i) the payoff of our HC-One Facility in June 2017, (ii) incremental interest income received during the second quarter of 2016 due to the payoff of three participating development loans, and (iii) decreased interest received from our Tandem Mezzanine Loan during the fourth quarter of 2017. Interest expense. The decrease in interest expense for the year ended December 31, 2018 was primarily the result of senior unsecured notes repayments during 2017 and 2018, partially offset by an increased average balance under our revolving credit facility during 2018. The decrease in interest expense for the year ended December 31, 2017 was primarily the result of senior unsecured notes and mortgage debt repayments, which occurred primarily in the second half of 2016 and throughout 2017. Depreciation and amortization. The increase in depreciation and amortization expense for the year ended December 31, 2018 was primarily as a result of: (i) assets acquired during 2017 and 2018 (primarily in our life science and medical office segments) and (ii) development and redevelopment projects placed into operations during 2017 and 2018 (primarily in our life science and medical office segments), partially offset by dispositions of real estate throughout 2017 and 2018. The decrease in depreciation and amortization expense for the year ended December 31, 2017 was primarily as a result of the sale of 64 senior housing triple-net assets and the deconsolidation of RIDEA II during the first quarter of 2017, partially offset by depreciation and amortization of assets acquired and placed in service during 2016 and 2017. General and administrative expenses. The increase in general and administrative expenses for the year ended December 31, 2018 was primarily as a result of increased severance and related charges, primarily resulting from the departure of our former Executive Chairman in March 2018, which exceeded severance and related charges in 2017, which were primarily related to the departure of our former CAO in the third quarter of 2017. The decrease in general and administrative expenses for the year ended December 31, 2017 was primarily as a result of severance and related charges, primarily resulting from the departure of our former President and CEO in the third quarter of 2016, which exceeded severance and related charges in 2017, primarily related to the departure of our former CAO in the third quarter of 2017. Impairments (recoveries), net. During the year ended December 31, 2018, we recognized $55 million of impairments, primarily related to the following real estate assets: (i) 20 SHOP assets (including 17 classified as held for sale at the time they were impaired) and (ii) an undeveloped life science land parcel classified as held for sale. During the year ended December 31, 2017, we recognized: (i) $144 million of impairments on our Tandem Mezzanine Loan (see Note 7 to the Consolidated Financial Statements) and (ii) $23 million of impairments on 11 underperforming senior housing triple-net facilities. For the year ended December 31, 2016, there were no impairments recognized. Gain (loss) on sales of real estate, net. During the year ended December 31, 2018, we sold: (i) our remaining interest in RIDEA II, (ii) a 51% interest in our U.K. Portfolio, (iii) 31 SHOP facilities, (iv) 16 life science assets, (v) 13 senior housing triple-net facilities, and (vi) four MOBs and recognized total net gain on sales of $926 million. During the year ended December 31, 2017, we sold: (i) 68 senior housing triple-net facilities, (ii) five life science facilities, (iii) five SHOP facilities, (iv) four MOBs, and (v) a 40% interest in RIDEA II and recognized total net gain on sales of $357 million. During the year ended December 31, 2016, we sold: (i) a portfolio of five facilities in one of our non-reportable segments and two senior housing triple-net facilities, (ii) five life science facilities, (iii) seven senior housing triple-net facilities, (iv) three MOBs, and (v) three SHOP facilities, recognizing total net gain on sales of $165 million. Loss on debt extinguishments. During the year ended December 31, 2018, we repurchased $700 million of our 5.375% senior notes due 2021 and recognized a $44 million loss on debt extinguishment. During the year ended December 31, 2017, we repurchased $500 million of our 5.375% senior notes due 2021 and recognized a $54 million loss on debt extinguishment. During the fourth quarter of 2016, using proceeds from the Spin-Off, we repaid $1.1 billion of senior unsecured notes that were due to mature in January 2017 and January 2018 and repaid $108 million of mortgage debt, incurring an aggregate loss on debt extinguishments of $46 million. Other income (expense), net. The decrease in other income (expense), net for the year ended December 31, 2018 was primarily as a result of: (i) a loss on consolidation of seven U.K. care homes in March 2018 (see Note 19 to the Consolidated Financial Statements) and (ii) a gain on sale of our Four Seasons Notes in March 2017. The decrease in other income (expense), net was partially offset by: (i) a gain on consolidation related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018, (ii) casualty-related charges due to hurricanes incurred in the third quarter of 2017, and (iii) decreased litigation costs in 2018. The increase in other income (expense), net for the year ended December 31, 2017 was primarily as a result of the gain on sale of our Four Seasons Notes, partially offset by casualty-related charges due to hurricanes in the third quarter of 2017 and increased litigation-related expenses in 2017. Income tax benefit (expense). The increase in income tax benefit for the year ended December 31, 2018 was primarily the result of: (i) a $6 million income tax benefit related to our share of operating losses from our RIDEA joint ventures and U.K. real estate investments, (ii) a $17 million income tax expense related to the impact of tax rate legislation during the fourth quarter of 2017, and (iii) partially offset by a $6 million benefit from the partial sale of RIDEA II in 2017. The decrease in income tax expense for the year ended December 31, 2017 was primarily the result of: (i) a $6 million income tax benefit from the partial sale of RIDEA II in 2017, (ii) a $5 million income tax benefit related to our share of operating losses from our RIDEA joint ventures, (iii) a $1 million deferred tax benefit from casualty-related charges recognized in the second half of 2017, and (iv) a $11 million income tax expense recognized in 2016 associated with federal income tax and state built-in gain tax for the disposition of certain real estate assets. The total tax benefit was partially offset by a $17 million income tax expense related to the impact of tax rate legislation during the fourth quarter of 2017. Equity income (loss) from unconsolidated joint ventures. The decrease in equity income from unconsolidated joint ventures for the year ended December 31, 2018 was primarily the result of the sale of our equity method investment in RIDEA II in June 2018, partially offset by additional equity income from our investment in the U.K. JV. The decrease in equity income from unconsolidated joint ventures for the year ended December 31, 2017 was primarily the result of income from our share of gains on sales of real estate in 2016, partially offset by income from our investment in RIDEA II, which was deconsolidated in the first quarter of 2017. Total discontinued operations. Discontinued operations for the year ended December 31, 2016 resulted in income of $266 million. Income from discontinued operations primarily relates to the operations of QCP. There were no discontinued operations for the years ended December 31, 2017 and 2018. Liquidity and Capital Resources We anticipate that our cash flow from operations, available cash balances and cash from our various financing activities will be adequate for at least the next 12 months for purposes of: (i) funding recurring operating expenses; (ii) meeting debt service requirements, including principal payments and maturities; and (iii) satisfying our distributions to our stockholders and non-controlling interest members. Our principal investing liquidity needs for the next 12 months are to: • fund capital expenditures, including tenant improvements and leasing costs; and • fund future acquisition, transactional and development activities. We anticipate satisfying these future investing needs using one or more of the following: • sale or exchange of ownership interests in properties; • draws on our credit facilities; • issuance of additional debt, including unsecured notes and mortgage debt; and/or • issuance of common or preferred stock. Access to capital markets impacts our cost of capital and ability to refinance maturing indebtedness, as well as our ability to fund future acquisitions and development through the issuance of additional securities or secured debt. Credit ratings impact our ability to access capital and directly impact our cost of capital as well. For example, our revolving line of credit facility accrues interest at a rate per annum equal to LIBOR plus a margin that depends upon our credit ratings. We also pay a facility fee on the entire revolving commitment that depends upon our credit ratings. As of February 11, 2019, we had a credit rating of BBB from Fitch, Baa1 from Moody’s and BBB+ from S&P Global on our senior unsecured debt securities. Cash Flow Summary The following summary discussion of our cash flows is based on the Consolidated Statements of Cash Flows and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below. The following table sets forth changes in cash flows (in thousands): Operating Cash Flows Operating cash flow increased $2 million between the years ended December 31, 2018 and 2017 primarily as the result of: (i) 2017 and 2018 acquisitions, (ii) annual rent increases, (iii) developments and redevelopments placed in service during 2017 and 2018, and (iv) decreased interest paid as a result of debt repayments during 2017 and 2018. The increase in operating cash flow is partially offset by: (i) dispositions during 2017 and 2018, (ii) the partial sale and deconsolidation of the U.K. JV in 2018, (iii) the partial sale and deconsolidation of RIDEA II during the first quarter of 2017, (iv) occupancy declines and higher labor costs within our SHOP segment, (v) decreased interest received as a result of loan repayments during 2017, and (vi) decreased distributions of earnings from our unconsolidated joint ventures. Our cash flow from operations is dependent upon the occupancy levels of our buildings, rental rates on leases, our tenants’ performance on their lease obligations, the level of operating expenses, and other factors. Operating cash flow decreased $367 million between the years ended December 31, 2017 and 2016 primarily as the result of: (i) decreased Adjusted NOI related to the Spin-Off and dispositions in 2016 and 2017 and (ii) decreased interest received as a result of loan repayments during 2016 and 2017; partially offset by: (i) 2016 and 2017 acquisitions, (ii) annual rent increases, (iii) and decreased interest paid as a result of lower balances on our senior unsecured notes and term loans. Investing Cash Flows The following are significant investing activities for the year ended December 31, 2018: • received net proceeds of $2.9 billion primarily from: (i) sales of real estate assets, (ii) the sale of RIDEA II, (iii) the sale of the Tandem Mezzanine Loan, and (iv) the U.K. JV transaction; and • made investments of $1.1 billion primarily related to the acquisition, development, and redevelopment of real estate. The following are significant investing activities for the year ended December 31, 2017: • received net proceeds of $1.8 billion from sales of real estate, including the sale and recapitalization of RIDEA II; • received net proceeds of $559 million primarily from: (i) the sale of our Four Seasons Notes, (ii) the repayment of our HC-One Facility, and (iii) a DFL repayment; and • made investments of $1.1 billion primarily for the acquisition and development of real estate. The following are significant investing activities for the year ended December 31, 2016: • made investments of $1.3 billion primarily from: (i) development, leasing and acquisition of real estate, (ii) investments in unconsolidated joint ventures and loans, and (iii) purchases of securities; and • received proceeds of $908 million primarily from real estate and DFL sales. Financing Cash Flows The following are significant financing activities for the year ended December 31, 2018: • repaid $2.4 billion of debt under our: (i) bank line of credit, (ii) term loan, (iii) senior unsecured notes (including debt extinguishment costs) and (iv) mortgage debt; • paid cash dividends on common stock of $697 million; • paid $83 million for distributions to and purchases of noncontrolling interests, primarily related to our acquisition of Brookdale’s noncontrolling interest in RIDEA I; • raised net proceeds of $218 million from the issuances of common stock, primarily from our at-the-market equity program; and • received proceeds of $300 million for issuances of noncontrolling interests, primarily related to the MSREI MOB JV. The following are significant financing activities for the year ended December 31, 2017: • repaid $1.4 billion of debt under our: (i) term loans, (ii) senior unsecured notes (including debt extinguishment costs) and (iii) mortgage debt, partially offset by net borrowings under our bank line of credit; and • paid cash dividends on common stock of $695 million. The following are significant financing activities for the year ended December 31, 2016: • received net proceeds of $1.7 billion from the Spin-Off; • repaid $1.8 billion of debt under our senior unsecured notes (including debt extinguishment costs) and mortgage debt, partially offset by net borrowings under our bank line of credit; and • paid cash dividends on common stock of $980 million. Debt See Note 10 in the Consolidated Financial Statements for information about our outstanding debt. See “2018 Transaction Overview” for further information regarding our significant financing activities during the year ended December 31, 2018. Approximately 98%, 84% and 83% of our total debt, inclusive of $43 million, $44 million and $46 million of variable rate debt swapped to fixed through interest rate swaps, was fixed rate debt as of December 31, 2018, 2017 and 2016, respectively. At December 31, 2018, our fixed rate debt and variable rate debt had weighted average interest rates of 4.04% and 2.15%, respectively. At December 31, 2017, our fixed rate debt and variable rate debt had weighted average interest rates of 4.19% and 2.56%, respectively. At December 31, 2016, our fixed rate debt and variable rate debt had weighted average interest rates of 4.26% and 2.23%, respectively. For a more detailed discussion of our interest rate risk, see “Quantitative and Qualitative Disclosures About Market Risk” in Item 3 below. Equity At December 31, 2018, we had 477 million shares of common stock outstanding, equity totaled $6.5 billion, and our equity securities had a market value of $13.5 billion. At December 31, 2018, non-managing members held an aggregate of four million units in five limited liability companies (“DownREITs”) for which we are the managing member. The DownREIT units are exchangeable for an amount of cash approximating the then-current market value of shares of our common stock or, at our option, shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). We renewed our at-the-market equity program in May 2018, pursuant to which we may sell shares of our common stock having an aggregate gross sales price of up to $750 million through a consortium of banks acting as sales agents or directly to the banks acting as principals. During the year ended December 31, 2018, we issued 5.4 million shares of common stock at a weighted average net price of $28.27 for net proceeds of $154 million (gross proceeds of $156 million, net of $2 million of fees paid to sales agents). At December 31, 2018, $594 million of our common stock remained available for sale under the at-the-market program. Actual future sales will depend upon a variety of factors, including but not limited to market conditions, the trading price of our common stock and our capital needs. We have no obligation to sell any shares under our at-the-market program. In December 2018, we entered into a forward equity sales agreement to sell up to an aggregate of 15.25 million shares of our common stock (including shares issued through the exercise of underwriters’ options) at an initial net price of $28.60 per share, after underwriting discounts and commissions. The agreement has a one year term and expires on December 13, 2019. The forward sale price that we expect to receive upon settlement of the agreement will be subject to adjustments for: (i) the forward purchasers’ stock borrowing costs and (ii) certain fixed price reductions during the term of the agreement. At December 31, 2018, no shares have been issued under the forward equity sales agreement. In December 2018, contemporaneous with the forward equity offering discussed above, we completed a public offering of two million shares of common stock at a net price of $28.60 per share, resulting in net proceeds of $57 million. Shelf Registration We filed a prospectus with the SEC as part of a registration statement on Form S-3, using an automatic shelf registration process. Our current shelf registration statement expires in May 2021, at which time we expect to file a new shelf registration statement. Under the “shelf” process, we may sell any combination of the securities described in the prospectus through one or more offerings. The securities described in the prospectus include common stock, preferred stock, depositary shares, debt securities and warrants. Contractual Obligations The following table summarizes our material contractual payment obligations and commitments at December 31, 2018 (in thousands): _______________________________________ (1) Excludes $91 million of other debt that represents life care bonds and demand notes that have no scheduled maturities. (2) Includes £55 million translated into USD. (3) Represents commitments to finance development projects. (4) Represents construction and other commitments for developments in progress. (5) Interest on variable-rate debt is calculated using rates in effect at December 31, 2018. Off-Balance Sheet Arrangements We own interests in certain unconsolidated joint ventures as described in Note 8 to the Consolidated Financial Statements. Except in limited circumstances, our risk of loss is limited to our investment in the joint venture and any outstanding loans receivable. In addition, we have certain properties which serve as collateral for debt that is owed by a previous owner of certain of our facilities, as described under Note 11 to the Consolidated Financial Statements. Our risk of loss for these certain properties is limited to the outstanding debt balance plus penalties, if any. We have no other material off-balance sheet arrangements that we expect would materially affect our liquidity and capital resources except those described above under “Contractual Obligations”. Inflation Our leases often provide for either fixed increases in base rents or indexed escalators, based on the Consumer Price Index or other measures, and/or additional rent based on increases in the tenants’ operating revenues. Most of our MOB leases require the tenant to pay a share of property operating costs such as real estate taxes, insurance and utilities. Substantially all of our senior housing triple-net, life science, and remaining other leases require the tenant or operator to pay all of the property operating costs or reimburse us for all such costs. We believe that inflationary increases in expenses will be offset, in part, by the tenant or operator expense reimbursements and contractual rent increases described above. Non-GAAP Financial Measure Reconciliations Funds From Operations and Funds Available for Distribution The following is a reconciliation from net income (loss) applicable to common shares, the most directly comparable financial measure calculated and presented in accordance with GAAP, to NAREIT FFO, FFO as adjusted and FAD (in thousands, except per share data): _______________________________________ (1) For the year ended December 31, 2018, represents the gain related to the acquisition of our partner's interests in four previously unconsolidated life science assets, partially offset by the loss on consolidation of seven U.K. care homes. (2) For the year ended December 31, 2016, represents income tax expense associated with the state built-in gain tax payable upon the disposition of specific real estate assets, of which $49 million relates to the HCRMC real estate portfolio. (3) For the year ended December 31, 2017, includes $55 million of net non-cash charges related to the right to terminate certain triple-net leases and management agreements in conjunction with the 2017 Brookdale Transactions. For the year ended December 31, 2016, primarily relates to the Spin-Off. For the year ended December 31, 2015, primarily related to acquisition and pursuit costs. For the year ended December 31, 2014, includes a net benefit from the 2014 Brookdale transaction, partially offset by acquisition and pursuit costs. (4) For the year ended December 31, 2018, primarily relates to the impairment of an undeveloped life science land parcel classified as held for sale. For the year ended December 31, 2017, relates to $144 million of impairments on our Tandem Mezzanine Loan, net of a $51 million impairment recovery upon the sale of our Four Seasons Notes. For the year ended December 31, 2015, include impairment charges of: (i) $1.3 billion related to our HCRMC DFL investments, (ii) $112 million related to our Four Seasons Notes and (iii) $46 million related to our equity investment in HCRMC, partially offset by an impairment recovery of $6 million related to a loan payoff. For the year ended December 31, 2014, relates to our equity investment in HCRMC. (5) For the year ended December 31, 2018, primarily relates to the departure of our former Executive Chairman and corporate restructuring activities. For the year ended December 31, 2017, primarily relates to the departure of our former Chief Accounting Officer. For the year ended December 31, 2016, primarily relates to the departure of our former President and Chief Executive Officer. For the year ended December 31, 2015, relates to the departure of our former Chief Investment Officer. (6) For the year ended December 31, 2018, represents the premium associated with the prepayment of $750 million of senior unsecured notes. For the year ended December 31, 2017, represents the premium associated with the prepayment of $500 million of senior unsecured notes. For the year ended December 31, 2016, represents penalties of $46 million from the prepayment of $1.1 billion of senior unsecured notes and $108 million of mortgage debt using proceeds from the Spin-Off. (7) For the year ended December 31, 2017, relates to costs from securities class action litigation and a legal settlement. For the year ended December 31, 2016, primarily relates to costs from securities class action litigation. See Note 11 in the Consolidated Financial Statements for additional information. (8) Represents the remeasurement of deferred tax assets and liabilities as a result of the Tax Cuts and Jobs Act that was signed into legislation on December 22, 2017. (9) Excludes amounts related to the acceleration of deferred compensation for restricted stock units and/or stock options that vested upon the departure of certain former individuals, which have already been excluded from FFO as adjusted in severance and related charges. For the year ended December 31, 2018, excludes $2 million upon the departure of our former Executive Chairman. For the year ended December 31, 2017, excludes $0.7 million related to the departure of our former Chief Accounting Officer. For the year ended December 31, 2016, excludes $7 million related to the departure of our former President and Chief Executive Officer. For the year ended December 31, 2015, excludes $3 million related to the departure of our former Chief Investment Officer. (10) Represents our 49% share of non-refundable entrance fees as the fees are collected by our CCRC JV, net of reserves and CCRC JV entrance fee amortization. (11) Excludes $17 million of deferred tax expenses, which is included in tax rate legislation impact for the year ended December 31, 2017. Additionally, the year ended December 31, 2017, excludes $1 million of deferred tax benefit from the casualty-related charges, which is included in casualty-related charges (recoveries), net. (12) Our equity investment in HCRMC was accounted for using the equity method, which required an elimination of DFL income that is proportional to our ownership in HCRMC. Further, our share of earnings from HCRMC (equity income) increased for the corresponding elimination of related lease expense recognized at the HCRMC entity level, which we presented as a non-cash joint venture FAD adjustment. Beginning in January 2016, as a result of placing our equity investment in HCRMC on a cash basis method of accounting, we no longer eliminated our proportional ownership share of income from DFLs to equity income (loss) from unconsolidated joint ventures. See Note 5 to the Consolidated Financial Statements for additional discussion. Critical Accounting Policies The preparation of financial statements in conformity with U.S. GAAP requires our management to use judgment in the application of accounting policies, including making estimates and assumptions. We base estimates on the best information available to us at the time, our experience and on various other assumptions believed to be reasonable under the circumstances. These estimates affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions or other matters had been different, it is possible that different accounting would have been applied, resulting in a different presentation of our consolidated financial statements. From time to time, we re-evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current estimates and assumptions about matters that are inherently uncertain. For a more detailed discussion of our significant accounting policies, see Note 2 to the Consolidated Financial Statements. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain. Principles of Consolidation The consolidated financial statements include the accounts of HCP, Inc., our wholly-owned subsidiaries and joint ventures that we control, through voting rights or other means. We consolidate investments in variable interest entities (“VIEs”) when we are the primary beneficiary of the VIE. A variable interest holder is considered to be the primary beneficiary of a VIE if it has the power to direct the activities that most significantly impact the entity’s economic performance and has the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to the VIE. We make judgments about which entities are VIEs based on an assessment of whether: (i) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support, (ii) substantially all of an entity’s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights, or (iii) the equity investors as a group lack any of the following: (a) the power through voting or similar rights to direct the activities of an entity that most significantly impact the entity’s economic performance, (b) the obligation to absorb the expected losses of an entity, or (c) the right to receive the expected residual returns of an entity. Criterion (iii) above is generally applied to limited partnerships and similarly structured entities by assessing whether a simple majority of the limited partners hold substantive rights to participate in the significant decisions of the entity or have the ability to remove the decision maker or liquidate the entity without cause. If neither of those criteria are met, the entity is a VIE. We also make judgments with respect to our level of influence or control over an entity and whether we are (or are not) the primary beneficiary of a VIE. Consideration of various factors includes, but is not limited to: • which activities most significantly impact the entity’s economic performance, and our ability to direct those activities; • our form of ownership interest; • our representation on the entity’s governing body; • the size and seniority of our investment; • our ability to manage our ownership interest relative to other interest holders; and • our ability and the rights of other investors to participate in policy making decisions, replace the manager and/or liquidate the entity, if applicable. Our ability to correctly assess our influence or control over an entity when determining the primary beneficiary of a VIE affects the presentation of these entities in our consolidated financial statements. When we perform a reassessment of the primary beneficiary at a date other than at inception of the VIE, our assumptions may be different and may result in the identification of a different primary beneficiary. If we determine that we are the primary beneficiary of a VIE, our consolidated financial statements include the operating results of the VIE rather than the results of our variable interest in the VIE. We require VIEs to provide us timely financial information and review the internal controls of VIEs to determine if we can rely on the financial information it provides. If a VIE has deficiencies in its internal controls over financial reporting, or does not provide us with timely financial information, it may adversely impact the quality and/or timing of our financial reporting and our internal controls over financial reporting. Revenue Recognition Lease Classification At the inception of a new lease arrangement, including new leases that arise from amendments, we assess the terms and conditions to determine the proper lease classification. For leases entered into prior to January 1, 2019, a lease arrangement is classified as an operating lease if none of the following criteria are met: (i) transfer of ownership to the lessee prior to or shortly after the end of the lease term, (ii) the lessee has a bargain purchase option during or at the end of the lease term, (iii) the lease term is equal to 75% or more of the underlying property’s economic life, or (iv) the present value of future minimum lease payments (excluding executory costs) is equal to 90% or more of the estimated fair value of the leased asset. If one of the four criteria is met and the minimum lease payments are determined to be reasonably predictable and collectible, the lease arrangement is generally accounted for as a DFL. Concurrent with our adoption of Accounting Standards Update No. 2016-02, Leases (“ASU 2016-02”) on January 1, 2019, we will begin classifying a lease entered into subsequent to adoption as an operating lease if none of the following criteria are met: (i) transfer of ownership to the lessee by the end of the lease term, (ii) lessee has a purchase option during or at the end of the lease term that it is reasonably certain to exercise, (iii) the lease term is for the major part of the remaining economic life of the underlying asset, (iv) the present value of future minimum lease payments is equal to substantially all of the fair value of the underlying asset, or (v) the underlying asset is of such a specialized nature that it is expected to have no alternative use to us at the end of the lease term. If the assumptions utilized in the above classification assessments were different, our lease classification for accounting purposes may have been different; thus the timing and amount of our revenue recognized would have been impacted, which may be material to our consolidated financial statements. Rental and Related Revenues We recognize rental revenue for operating leases on a straight-line basis over the lease term when collectibility of all minimum lease payments is reasonably assured and the tenant has taken possession or controls the physical use of a leased asset. If the lease provides for tenant improvements, we determine whether the tenant improvements are owned by the tenant or us. When we are the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the leased asset until the tenant improvements are substantially complete. When the tenant is the owner of the tenant improvements, any tenant improvement allowance funded is treated as a lease incentive and amortized as a reduction of revenue over the lease term. The determination of ownership of a tenant improvement is subject to significant judgment. If our assessment of the owner of the tenant improvements was different, the timing and amount of our revenue recognized would be impacted. Certain leases provide for additional rents that are contingent upon a percentage of the facility’s revenue in excess of specified base amounts or other thresholds. Such revenue is recognized when actual results reported by the tenant, or estimates of tenant results, exceed the base amount or other thresholds. The recognition of additional rents requires us to make estimates of amounts owed and, to a certain extent, is dependent on the accuracy of the facility results reported to us. Our estimates may differ from actual results, which could be material to our consolidated financial statements. Income from Direct Financing Leases We use the direct finance method of accounting to record income from DFLs. For leases accounted for as DFLs, the net investment in the DFL represents receivables for the sum of future minimum lease payments receivable and the estimated residual values of the leased properties, less the unamortized unearned income. Unearned income is deferred and amortized to income over the lease terms to provide a constant yield when collectibility of the lease payments is reasonably assured. The determination of estimated useful lives and residual values are subject to significant judgment. If these assessments were to change, the timing and amount of our revenue recognized would be impacted. Interest Income Loans receivable are classified as held-for-investment based on management’s intent and ability to hold the loans for the foreseeable future or to maturity. We recognize interest income on loans, including the amortization of discounts and premiums, using the interest method (applied on a loan-by-loan basis) when collectibility of the future payments is reasonably assured. Premiums, discounts and related costs are recognized as yield adjustments over the term of the related loans. If management determines that certain loans should no longer be classified as held-for-investment, the timing and amount of our interest income recognized would be impacted. Allowance for Doubtful Accounts We maintain an allowance for doubtful accounts, including an allowance for operating lease straight-line rent receivables, for estimated losses resulting from tenant defaults or the inability of tenants to make contractual rent and tenant recovery payments. We monitor the liquidity and creditworthiness of our tenants and operators on a continuous basis. This evaluation considers industry and economic conditions, property performance, credit enhancements and other factors. For straight-line rent receivable amounts, our assessment is based on income recoverable over the term of the lease. We exercise judgment in establishing allowances and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. Loans receivable and DFLs (collectively, “Finance Receivables”), are reviewed and assigned an internal rating of Performing, Watch List or Workout. Finance Receivables that are deemed Performing meet all present contractual obligations, and collection and timing of all amounts owed is reasonably assured. Watch List Finance Receivables are defined as Finance Receivables that do not meet the definition of Performing or Workout. Workout Finance Receivables are defined as Finance Receivables in which we have determined, based on current information and events, that: (i) it is probable we will be unable to collect all amounts due according to the contractual terms of the agreement, (ii) the tenant, operator, or borrower is delinquent on making payments under the contractual terms of the agreement, and (iii) we have commenced action or anticipate pursuing action in the near term to seek recovery of our investment. Finance Receivables are placed on nonaccrual status when management determines that the collectibility of contractual amounts is not reasonably assured (the asset will have an internal rating of either Watch List or Workout). Further, we perform a credit analysis to support the tenant’s, operator’s, borrower’s and/or guarantor’s repayment capacity and the underlying collateral values. We use the cash basis method of accounting for Finance Receivables placed on nonaccrual status unless one of the following conditions exist whereby we utilize the cost recovery method of accounting: (i) if we determine that it is probable that we will only recover the recorded investment in the Finance Receivable, net of associated allowances or charge-offs (if any), or (ii) we cannot reasonably estimate the amount of an impaired Finance Receivable. For cash basis method of accounting we apply payments received, excluding principal paydowns, to interest income so long as that amount does not exceed the amount that would have been earned under the original contractual terms. For cost recovery method of accounting any payment received is applied to reduce the recorded investment. Generally, we return a Finance Receivable to accrual status when all delinquent payments become current under the terms of the loan or lease agreements and collectibility of the remaining contractual loan or lease payments is reasonably assured. Allowances are established for Finance Receivables on an individual basis utilizing an estimate of probable losses, if they are determined to be impaired. Finance Receivables are impaired when it is deemed probable that we will be unable to collect all amounts due in accordance with the contractual terms of the loan or lease. An allowance is based upon our assessment of the lessee’s or borrower’s overall financial condition, economic resources, payment record, the prospects for support from any financially responsible guarantors and, if appropriate, the net realizable value of any collateral. These estimates consider all available evidence, including the expected future cash flows discounted at the Finance Receivable’s effective interest rate, fair value of collateral, general economic conditions and trends, historical and industry loss experience, and other relevant factors, as appropriate. Should a Finance Receivable be deemed partially or wholly uncollectible, the uncollectible balance is charged off against the allowance in the period in which the uncollectible determination has been made. Real Estate We make estimates as part of our process for allocating a purchase price to the various identifiable assets of an acquisition based upon the relative fair value of each asset. The most significant components of our allocations are typically buildings as-if-vacant, land and in-place leases. In the case of allocating fair value to buildings and intangibles, our fair value estimates will affect the amount of depreciation and amortization we record over the estimated useful life of each asset acquired. In the case of allocating fair value to in-place leases, we make our best estimates based on our evaluation of the specific characteristics of each tenant’s lease. Factors considered include estimates of carrying costs during hypothetical expected lease-up periods, market conditions and costs to execute similar leases. Our assumptions affect the amount of future revenue and/or depreciation and amortization expense that we will recognize over the remaining useful life for the acquired in-place leases. A variety of costs are incurred in the development and leasing of properties. After determination is made to capitalize a cost, it is allocated to the specific component of a project that is benefited. Determination of when a development project is substantially complete and capitalization must cease involves a degree of judgment. The costs of land and buildings under development include specifically identifiable costs. The capitalized costs include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs, real estate taxes and other costs incurred during the period of development. We consider a construction project to be considered substantially complete and available for occupancy and cease capitalization of costs upon the completion of the related tenant improvements. Impairment of Long-Lived Assets We assess the carrying value of our real estate assets and related intangibles (“real estate assets”) when events or changes in circumstances indicate that the carrying value may not be recoverable, but at least annually. Recoverability of real estate assets is measured by comparing the carrying amount of the real estate assets to the respective estimated future undiscounted cash flows. The expected future undiscounted cash flows reflect external market factors and are probability-weighted to reflect multiple possible cash-flow scenarios, including selling the assets at various points in the future. Additionally, the estimated future undiscounted cash flows are calculated utilizing the lowest level of identifiable cash flows that are largely independent of the cash flows of other assets and liabilities. In order to review our real estate assets for recoverability, we make assumptions regarding external market conditions, as well as our intent with respect to holding or disposing of the asset. If our analysis indicates that the carrying value of the real estate assets is not recoverable on an undiscounted cash flow basis, we recognize an impairment charge for the amount by which the carrying value exceeds the fair value of the real estate asset. The determination of the fair value of real estate assets involves significant judgment. This judgment is based on our analysis and estimates of fair value of real estate assets, future operating results and resulting cash flows, and the period over which we will hold each real estate asset. Our ability to accurately predict future operating results and resulting cash flows, and estimate fair values, impacts the timing and recognition of impairments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our consolidated financial statements. Investments in Unconsolidated Joint Ventures The initial carrying value of investments in unconsolidated joint ventures is based on the amount paid to purchase the joint venture interest or the carrying value of the assets prior to the sale or contribution of the interests to the joint venture. We evaluate our equity method investments for impairment by first reviewing for indicators of impairment based upon the performance of the underlying real estate assets held by the joint venture. If an equity-method investment shows indicators of impairment, we compare the fair value of the investment to the carrying value. If we determine there is a decline in the fair value of our investment in an unconsolidated joint venture below its carrying value and it is other-than-temporary, an impairment charge is recorded. The determination of the fair value of investments in unconsolidated joint ventures and as to whether a deficiency in fair value is other-than-temporary involves significant judgment. Our estimates consider all available evidence including, as appropriate, the present value of the expected future cash flows, discounted at market rates, general economic conditions and trends, severity and duration of a fair value deficiency, and other relevant factors. Capitalization rates, discount rates, and credit spreads utilized in our valuation models are based upon rates that we believe to be within a reasonable range of current market rates for the respective investments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our consolidated financial statements. Income Taxes As part of the process of preparing our consolidated financial statements, significant management judgment is required to evaluate our compliance with REIT requirements. Our determinations are based on interpretation of tax laws and our conclusions may have an impact on the income tax expense recognized. Adjustments to income tax expense may be required as a result of: (i) audits conducted by federal, state and local tax authorities, (ii) our ability to qualify as a REIT, (iii) the potential for built-in gain recognition, and (iv) changes in tax laws. Adjustments required in any given period are included within the income tax provision. Recent Accounting Pronouncements See Note 2 to the Consolidated Financial Statements for the impact of new accounting standards.

<s>[INST] The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: 2018 Transaction Overview Dividends Results of Operations Liquidity and Capital Resources Contractual Obligations OffBalance Sheet Arrangements Inflation NonGAAP Financial Measure Reconciliations Critical Accounting Policies Recent Accounting Pronouncements 2018 Transaction Overview Mountain View Campus Sale In November 2018, we sold our Shoreline Technology Center life science campus located in Mountain View, California for $1.0 billion and recognized a gain on sale of $726 million. MSREI MOB JV In August 2018, HCP and Morgan Stanley Real Estate Investment (“MSREI”) formed a joint venture (the “MSREI JV”) to own a portfolio of MOBs, which HCP owns 51% of and consolidates. To form the MSREI JV, MSREI contributed cash of $298 million and HCP contributed nine whollyowned MOBs (the “Contributed Assets”). The Contributed Assets are primarily located in Texas and Florida and were valued at approximately $320 million at the time of contribution. The MSREI JV used substantially all of the cash contributed by MSREI to acquire an additional portfolio of 16 MOBs in Greenville, South Carolina (the “Greenville Portfolio”) for $285 million. Concurrent with acquiring the additional MOBs, the MSREI JV entered into 10year leases with an anchor tenant on each MOB in the Greenville Portfolio, which accounts for approximately 93% of the total leasable space in the portfolio. Brookdale Transactions Update In 2018, we sold six agreed upon facilities to Brookdale for $275 million. In March 2018, we completed the acquisition of Brookdale’s noncontrolling interest in RIDEA I for $63 million. During the fourth quarter of 2018, we completed the sale of 11 senior housing triplenet and eight SHOP facilities previously leased to Brookdale for $377 million. As of December 31, 2018, we had completed the transition of 38 assets previously operated by Brookdale to other operators. See Note 3 to the Consolidated Financial Statements for additional information. U.K. Investment Update In June 2018, we entered into a joint venture with an institutional investor (the “U.K. JV”) through which we sold a 51% interest in U.K. assets previously owned by us (the "U.K. Portfolio”) based on a total value of £382 million ($507 million). We retained a 49% noncontrolling interest in the joint venture and received gross proceeds of $402 million, including proceeds from the refinancing of our previously held intercompany loans. Upon closing the U.K. JV, we deconsolidated the U.K. Portfolio, recognized our retained noncontrolling interest investment at fair value ($105 million) and recognized a gain on sale of $11 million. We expect to sell our remaining 49% interest by no later than 2020. Other Real Estate and Loan Transactions In March 2018, we sold our Tandem Health Care mezzanine loan (“Tandem Mezzanine Loan”) to a third party for approximately $112 million, resulting in an impairment recovery, net of transaction costs and fees, of $3 million. In June 2018, we sold our remaining 40% ownership interest in RIDEA II for $91 million and caused Columbia Pacific Advisors, LLC to refinance our $242 million of loans receivable from RIDEA II, which resulted in total proceeds of $332 million. In 2016, we provided a £105 million ($131 million at closing) bridge loan (the “U.K. Bridge Loan”) to Maria Mallab [/INST] Positive. </s>

HEALTHPEAK PROPERTIES, INC.

2020-02-13

2019-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: • 2019 Transaction Overview • Dividends • Results of Operations • Liquidity and Capital Resources • Contractual Obligations • Off-Balance Sheet Arrangements • Inflation • Non-GAAP Financial Measure Reconciliations • Critical Accounting Policies • Recent Accounting Pronouncements 2019 Transaction Overview Master Transaction and Cooperation Agreement with Brookdale In October 2019, Healthpeak and Brookdale Senior Living Inc. (“Brookdale”) entered into a Master Transactions and Cooperation Agreement (the “2019 MTCA”), which includes a series of transactions related to its jointly owned 15-campus continuing care retirement community (“CCRC”) portfolio (the “CCRC JV”) and the portfolio of 43 senior housing properties that Brookdale triple-net leases from us. In connection with the 2019 MTCA, Healthpeak and Brookdale, and certain of their respective subsidiaries, agreed to the following related to the CCRC JV: • Healthpeak, which owns a 49% interest in the CCRC JV, agreed to purchase Brookdale’s 51% interest in 13 of the 15 communities in the CCRC JV based on a valuation of $1.06 billion (the “CCRC Acquisition”); • The management agreements related to the CCRC Acquisition communities will be terminated, with management transitioned (under new management agreements) from Brookdale to Life Care Services LLC (“LCS”) simultaneous with closing the CCRC Acquisition; • We will pay a $100 million management termination fee to Brookdale upon closing the CCRC Acquisition; and • The remaining two CCRCs will be jointly marketed for sale to third parties. In addition, pursuant to the 2019 MTCA, Healthpeak and Brookdale agreed to the following transactions related to properties that Brookdale triple-net leases from us: • Brookdale will acquire 18 of the properties (the “Brookdale Acquisition Assets”) from us for cash proceeds of $385 million; • We will terminate the triple-net lease related to one property and transition it to a RIDEA structure with LCS as the manager; • The remaining 24 properties will be restructured into a single master lease with 2.4% annual rent escalators and a maturity date of December 31, 2027 (the “2019 Amended Master Lease”); • A portion of annual rent (amount in excess of 6.5% of sales proceeds) related to 14 of the 18 Brookdale Acquisition Assets will be reallocated to the remaining properties under the 2019 Amended Master Lease; • Upon sale of the Brookdale Acquisition Assets, Brookdale will pay down $20 million of future rent under the 2019 Amended Master Lease; and • We will provide up to $35 million of capital investment in the 2019 Amended Master Lease properties over a five-year term, which will increase rent by 7% of the amount spent, per annum. With the exception of the capital investment to be made over the next five years and the sale of the two CCRCs to be marketed to third parties, each of the above transactions, including payment of the $100 million management termination fee, closed on January 31, 2020. Discovery Portfolio Acquisition • In April 2019, we acquired a portfolio of nine senior housing properties, with a total of 1,242 units, for $445 million. The properties are located across Florida, Georgia, and Texas and are operated by Discovery Senior Living, LLC. Oakmont Portfolio Acquisitions • In May 2019, we acquired three newly-built, senior housing communities in California for $113 million. The portfolio is operated by Oakmont Senior Living LLC (“Oakmont”) and includes 132 assisted living units and 68 memory care units with an average occupancy of 96% at closing. • In July 2019, we acquired five additional senior housing communities in California for $284 million. The portfolio is operated by Oakmont and includes 430 units. The properties are located in the Los Angeles, San Jose, and San Francisco markets. Sierra Point Towers Acquisition • In June 2019, we completed the acquisition of two life science buildings in South San Francisco, California adjacent to our The Shore at Sierra Point development, for $245 million. Hartwell Innovation Campus Acquisition • In July 2019, we acquired a life science campus in the suburban Boston submarket of Lexington, Massachusetts, for $228 million. The 277,000 square foot campus, comprised of four buildings, is 100% leased to seven biopharmaceutical and medical diagnostics tenants. Cambridge Acquisitions • In January and February 2019, we acquired a life science facility for $71 million and development rights at an adjacent undeveloped land parcel for consideration of up to $27 million. The existing facility and land parcel are located in Cambridge, Massachusetts. • In December 2019, we acquired one life science building, adjacent to our existing properties in Cambridge, Massachusetts, for $333 million. Sovereign Wealth Fund Senior Housing Joint Venture • In December 2019, we formed a new joint venture with a sovereign wealth fund ("SWF SH JV") that owns 19 SHOP assets operated by Brookdale. We own 53.5% of the joint venture and contributed all 19 assets with a fair value of $790 million. The joint venture partner owns the other 46.5% and purchased its interest for cash of $367 million. United Kingdom Joint Venture • In December 2019, we sold our remaining 49% interest in our United Kingdom investments (the “U.K. JV”) for proceeds of £70 million ($91 million), net of debt assumed. We no longer own any real estate in the United Kingdom. Other Real Estate and Loan Transactions • In May 2019, we acquired one medical office building (“MOB”) in Kansas for $15 million. • In June 2019, we acquired the outstanding equity interests of, and began consolidating, a senior housing joint venture structure (which owned one senior housing facility), in which we previously held an unconsolidated equity investment, for $24 million. • In July 2019, we acquired a $16 million, Class A two-story building in the Sorrento Mesa submarket of San Diego. The 56,000 square foot property is located on our Directors Place life science campus and is adjacent to our future development site. • In September 2019, we sold 13 senior housing facilities under DFLs for $274 million. • During the year ended December 31, 2019, we transitioned 35 senior housing triple-net assets, including a 14-property DFL portfolio, to a RIDEA structure, with Sunrise Senior Living, LLC (“Sunrise”) as the operator. Those 35 assets generated revenue of $67 million during the year ended 2018. We expect to transition two additional senior housing triple-net assets to a RIDEA structure with Sunrise in 2020. • During the year ended December 31, 2019, we sold 18 SHOP assets for $181 million, 2 senior housing triple-net assets for $26 million, 10 MOBs for $23 million, 1 life science asset for $7 million, 1 undeveloped life science land parcel for $35 million, and 2 facilities from the other non-reportable segment for $20 million. • In January 2020, we sold six SHOP assets for $36 million. • In January 2020, we entered into definitive agreements to acquire a life science campus in Waltham, Massachusetts, for $320 million. We made a $20 million nonrefundable deposit upon completing due diligence and expect to close the transaction in the second quarter of 2020. Financing Activities • In February 2019, we terminated our previous at-the-market equity program established in February 2018 (the “2018 ATM Program”) and established a new at-the-market program (the “2019 ATM Program”) pursuant to which shares of our common stock having an aggregate gross sales price of up to $1.0 billion may be sold (i) by Healthpeak through a consortium of banks acting as sales agents or directly to the banks acting as principals or (ii) by a consortium of banks acting as forward sellers on behalf of any forward purchasers pursuant to a forward sale agreement. • During the year ended December 31, 2019, we directly issued or settled previous forward sales agreements for 26.7 million shares, resulting in net proceeds of $782 million. Total net proceeds were comprised of: (i) $422 million of net proceeds from the settlement of 15.3 million shares under a 2018 forward sales agreement at a weighted average net price of $27.66 per share, after commissions, (ii) $171 million of net proceeds from the settlement of 5.5 million shares under ATM forward sales agreements at a weighted average net price of $30.91 per share, after commissions, and (iii) $189 million of net proceeds from the direct issuance of 5.9 million shares on the ATM at a weighted average net price of $31.84 per share, after commissions. • An aggregate of 30.4 million shares of our common stock, sold at an initial weighted average net price of $33.05 per share, after commissions, remain available for issuance under forward sales agreements as of December 31, 2019. • In May 2019, we entered into a new $2.5 billion unsecured revolving line of credit facility (the “Revolving Facility”) maturing on May 23, 2023. The Revolving Facility contains two, six-month extension options, subject to certain customary conditions. Borrowings under the Revolving Facility accrue interest at LIBOR plus a margin that depends on our credit ratings (0.825% as of December 31, 2019). We pay a facility fee on the entire revolving commitment that depends on our credit ratings (0.15% as of December 31, 2019). • In May 2019, we entered into a new $250 million unsecured term loan facility (the “2019 Term Loan” and, together with the Revolving Facility, the “Facilities”), and borrowed the full $250 million capacity in June 2019. The 2019 Term Loan matures on May 23, 2024 and accrues interest at LIBOR plus a margin that depends on our credit ratings (0.90% as of December 31, 2019). The Facilities include a feature that allows us to increase the borrowing capacity by an aggregate amount of up to $750 million, subject to securing additional commitments. • In July 2019, we completed a public offering of $650 million aggregate principal amount of 3.25% senior unsecured notes due 2026 (the “2026 Notes”) and $650 million aggregate principal amount of 3.50% senior unsecured notes due 2029 (the “2029 Notes” and, together with the 2026 Notes, the “Notes”). The proceeds were used to: (i) redeem all of our $800 million, 2.63% senior unsecured notes due February 2020 (the “2020 Notes”), (ii) repurchase $250 million aggregate principal amount of our 4.25% senior notes due 2023 (the “2023 Notes”), and (iii) repurchase $250 million aggregate principal amount of our 4.00% senior notes due 2022 (the “2022 Notes”). • In September 2019, we established an unsecured commercial paper program (the “Commercial Paper Program”) under which we may issue, from time to time, unsecured short-term debt securities with a maximum aggregate face or principal amount outstanding at any one time not exceeding $1.0 billion. • In November 2019, we completed a public offering of $750 million aggregate principal amount of 3.00% senior unsecured notes due 2030 (the “2030 Notes”). The proceeds were used to repurchase the remaining $350 million aggregate principal amount of our 2022 Notes. Developments • As part of the previously-announced development program with HCA, during the year ended December 31, 2019, we commenced the development of seven MOBs, six of which will be on-campus, with an aggregate estimated cost of approximately $166 million. • At December 31, 2019, we had eight life science development projects in process with an aggregate total estimated cost of approximately $1.1 billion. Dividends Quarterly cash dividends paid during 2019 aggregated to $1.48 per share. On January 30, 2020, our Board of Directors declared a quarterly cash dividend of $0.37 per common share. The dividend will be paid on February 28, 2020 to stockholders of record as of the close of business on February 18, 2020. Results of Operations We evaluate our business and allocate resources among our reportable business segments: (i) senior housing triple-net, (ii) SHOP, (iii) life science, and (iv) medical office. Our senior housing facilities are managed utilizing triple-net leases and RIDEA structures. Under the life science and medical office segments, we invest through the acquisition and development of life science facilities and MOBs, which generally require a greater level of property management. We have other non-reportable segments that are comprised primarily of our debt investments, hospital properties, and unconsolidated joint ventures. We evaluate performance based upon: (i) property net operating income from continuing operations (“NOI”) and (ii) Adjusted NOI (cash NOI) in each segment. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 2 to the Consolidated Financial Statements). Non-GAAP Financial Measures Net Operating Income NOI and Adjusted NOI are non-U.S. generally accepted accounting principles (“GAAP”) supplemental financial measures used to evaluate the operating performance of real estate. NOI is defined as real estate revenues (inclusive of rental and related revenues, resident fees and services, and income from direct financing leases), less property level operating expenses (which exclude transition costs); NOI excludes all other financial statement amounts included in net income (loss) as presented in Note 15 to the Consolidated Financial Statements. Management believes NOI provides relevant and useful information because it reflects only income and operating expense items that are incurred at the property level and presents them on an unlevered basis. Adjusted NOI is calculated as NOI after eliminating the effects of straight-line rents, DFL non-cash interest, amortization of market lease intangibles, termination fees, actuarial reserves for insurance claims that have been incurred but not reported, and the impact of deferred community fee income and expense. Adjusted NOI is oftentimes referred to as “Cash NOI.” NOI and Adjusted NOI exclude our share of income (loss) generated by unconsolidated joint ventures, which is recognized in equity income (loss) from unconsolidated joint ventures in the consolidated statements of operations. We use NOI and Adjusted NOI to make decisions about resource allocations, to assess and compare property level performance, and to evaluate our same property portfolio (“SPP”), as described below. We believe that net income (loss) is the most directly comparable GAAP measure to NOI and Adjusted NOI. NOI and Adjusted NOI should not be viewed as alternative measures of operating performance to net income (loss) as defined by GAAP since they do not reflect various excluded items. Further, our definitions of NOI and Adjusted NOI may not be comparable to the definitions used by other REITs or real estate companies, as they may use different methodologies for calculating NOI and Adjusted NOI. For a reconciliation of NOI and Adjusted NOI to net income (loss) by segment, refer to Note 15 to the Consolidated Financial Statements. Operating expenses generally relate to leased medical office and life science properties and SHOP facilities. We generally recover all or a portion of our leased medical office and life science property expenses through tenant recoveries. We present expenses as operating or general and administrative based on the underlying nature of the expense. Same Property Portfolio SPP NOI and Adjusted (Cash) NOI information allows us to evaluate the performance of our property portfolio under a consistent population by eliminating changes in the composition of our consolidated portfolio of properties. SPP NOI excludes certain non-property specific operating expenses that are allocated to each operating segment on a consolidated basis. Properties are included in SPP once they are stabilized for the full period in both comparison periods. Newly acquired operating assets are generally considered stabilized at the earlier of lease-up (typically when the tenant(s) control(s) the physical use of at least 80% of the space) or 12 months from the acquisition date. Newly completed developments and redevelopments are considered stabilized at the earlier of lease-up or 24 months from the date the property is placed in service. Properties that experience a change in reporting structure, such as a transition from a triple-net lease to a RIDEA reporting structure, are considered stabilized after 12 months in operations under a consistent reporting structure. A property is removed from SPP when it is classified as held for sale, sold, placed into redevelopment, experiences a casualty event that significantly impacts operations, or a change in reporting structure has been agreed to (such as triple-net to SHOP). For a reconciliation of SPP to total portfolio Adjusted NOI and other relevant disclosures by segment, refer to our Segment Analysis below. Funds From Operations ("FFO") FFO encompasses NAREIT FFO and FFO as Adjusted, each of which is described in detail below. We believe FFO applicable to common shares, diluted FFO applicable to common shares, and diluted FFO per common share are important supplemental non-GAAP measures of operating performance for a REIT. Because the historical cost accounting convention used for real estate assets utilizes straight-line depreciation (except on land), such accounting presentation implies that the value of real estate assets diminishes predictably over time. Since real estate values instead have historically risen and fallen with market conditions, presentations of operating results for a REIT that use historical cost accounting for depreciation could be less informative. The term FFO was designed by the REIT industry to address this issue. NAREIT FFO. FFO, as defined by the National Association of Real Estate Investment Trusts (“NAREIT”), is net income (loss) applicable to common shares (computed in accordance with GAAP), excluding gains or losses from sales of depreciable property, including any current and deferred taxes directly associated with sales of depreciable property, impairments of, or related to, depreciable real estate, plus real estate and other real estate-related depreciation and amortization, and adjustments to compute our share of NAREIT FFO and FFO as Adjusted (see below) from joint ventures. Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of NAREIT FFO for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. For consolidated joint ventures in which we do not own 100%, we reflect our share of the equity by adjusting our NAREIT FFO to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods. Our pro-rata share information is prepared on a basis consistent with the comparable consolidated amounts, is intended to reflect our proportionate economic interest in the operating results of properties in our portfolio and is calculated by applying our actual ownership percentage for the period. We do not control the unconsolidated joint ventures, and the pro-rata presentations of reconciling items included in NAREIT FFO do not represent our legal claim to such items. The joint venture members or partners are entitled to profit or loss allocations and distributions of cash flows according to the joint venture agreements, which provide for such allocations generally according to their invested capital. The presentation of pro-rata information has limitations, which include, but are not limited to, the following: (i) the amounts shown on the individual line items were derived by applying our overall economic ownership interest percentage determined when applying the equity method of accounting and do not necessarily represent our legal claim to the assets and liabilities, or the revenues and expenses and (ii) other companies in our industry may calculate their pro-rata interest differently, limiting the usefulness as a comparative measure. Because of these limitations, the pro-rata financial information should not be considered independently or as a substitute for our financial statements as reported under GAAP. We compensate for these limitations by relying primarily on our GAAP financial statements, using the pro-rata financial information as a supplement. NAREIT FFO does not represent cash generated from operating activities in accordance with GAAP, is not necessarily indicative of cash available to fund cash needs and should not be considered an alternative to net income (loss). We compute NAREIT FFO in accordance with the current NAREIT definition; however, other REITs may report NAREIT FFO differently or have a different interpretation of the current NAREIT definition from ours. FFO as Adjusted. In addition, we present NAREIT FFO on an adjusted basis before the impact of non-comparable items including, but not limited to, transaction-related items, impairments (recoveries) of non-depreciable assets, losses (gains) from the sale of non-depreciable assets, severance and related charges, prepayment costs (benefits) associated with early retirement or payment of debt, litigation costs (recoveries), casualty-related charges (recoveries), foreign currency remeasurement losses (gains), and changes in tax legislation (“FFO as Adjusted”). Transaction-related items include transaction expenses and gains/charges incurred as a result of mergers and acquisitions and lease amendment or termination activities. Prepayment costs (benefits) associated with early retirement of debt include the write-off of unamortized deferred financing fees, or additional costs, expenses, discounts, make-whole payments, penalties or premiums incurred as a result of early retirement or payment of debt. Management believes that FFO as Adjusted provides a meaningful supplemental measurement of our FFO run-rate and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. At the same time that NAREIT created and defined its FFO measure for the REIT industry, it also recognized that “management of each of its member companies has the responsibility and authority to publish financial information that it regards as useful to the financial community.” We believe stockholders, potential investors, and financial analysts who review our operating performance are best served by an FFO run-rate earnings measure that includes certain other adjustments to net income (loss), in addition to adjustments made to arrive at the NAREIT defined measure of FFO. FFO as Adjusted is used by management in analyzing our business and the performance of our properties and we believe it is important that stockholders, potential investors, and financial analysts understand this measure used by management. We use FFO as Adjusted to: (i) evaluate our performance in comparison with expected results and results of previous periods, relative to resource allocation decisions, (ii) evaluate the performance of our management, (iii) budget and forecast future results to assist in the allocation of resources, (iv) assess our performance as compared with similar real estate companies and the industry in general, and (v) evaluate how a specific potential investment will impact our future results. Other REITs or real estate companies may use different methodologies for calculating an adjusted FFO measure, and accordingly, our FFO as Adjusted may not be comparable to those reported by other REITs. For a reconciliation of net income (loss) to NAREIT FFO and FFO as Adjusted and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Funds Available for Distribution ("FAD") FAD is defined as FFO as Adjusted after excluding the impact of the following: (i) amortization of deferred compensation expense, (ii) amortization of deferred financing costs, net, (iii) straight-line rents, (iv) deferred income taxes, (v) amortization of acquired market lease intangibles, net, (vi) non-cash interest related to DFLs and lease incentive amortization (reduction of straight-line rents), (vii) actuarial reserves for insurance claims that have been incurred but not reported, and (viii) deferred revenues, excluding amounts amortized into rental income that are associated with tenant funded improvements owned/recognized by us and up-front cash payments made by tenants to reduce their contractual rents. Also, FAD: (i) is computed after deducting recurring capital expenditures, including second generation leasing costs and second generation tenant and capital improvements and (ii) includes lease restructure payments and adjustments to compute our share of FAD from our unconsolidated joint ventures and those related to CCRC non-refundable entrance fees. Certain prior period amounts in the “Non-GAAP Financial Measures Reconciliation” below for FAD have been reclassified to conform to the current period presentation. More specifically, recurring capital expenditures, including second generation leasing costs and second generation tenant and capital improvements ("FAD capital expenditures") excludes our share from unconsolidated joint ventures (reported in “other FAD adjustments”). Adjustments for joint ventures are calculated to reflect our pro-rata share of both our consolidated and unconsolidated joint ventures. We reflect our share of FAD for unconsolidated joint ventures by applying our actual ownership percentage for the period to the applicable reconciling items on an entity by entity basis. We reflect our share for consolidated joint ventures in which we do not own 100% of the equity by adjusting our FAD to remove the third party ownership share of the applicable reconciling items based on actual ownership percentage for the applicable periods (reported in “other FAD adjustments”). See FFO for further disclosure regarding our use of pro-rata share information and its limitations. Other REITs or real estate companies may use different methodologies for calculating FAD, and accordingly, our FAD may not be comparable to those reported by other REITs. Although our FAD computation may not be comparable to that of other REITs, management believes FAD provides a meaningful supplemental measure of our performance and is frequently used by analysts, investors, and other interested parties in the evaluation of our performance as a REIT. We believe FAD is an alternative run-rate earnings measure that improves the understanding of our operating results among investors and makes comparisons with: (i) expected results, (ii) results of previous periods, and (iii) results among REITs more meaningful. FAD does not represent cash generated from operating activities determined in accordance with GAAP and is not necessarily indicative of cash available to fund cash needs as it excludes the following items which generally flow through our cash flows from operating activities: (i) adjustments for changes in working capital or the actual timing of the payment of income or expense items that are accrued in the period, (ii) transaction-related costs, (iii) litigation settlement expenses, (iv) severance-related expenses, and (v) actual cash receipts from interest income recognized on loans receivable (in contrast to our FAD adjustment to exclude non-cash interest and depreciation related to our investments in direct financing leases). Furthermore, FAD is adjusted for recurring capital expenditures, which are generally not considered when determining cash flows from operations or liquidity. FAD is a non-GAAP supplemental financial measure and should not be considered as an alternative to net income (loss) determined in accordance with GAAP. For a reconciliation of net income (loss) to FAD and other relevant disclosure, refer to “Non-GAAP Financial Measures Reconciliations” below. Comparison of the Year Ended December 31, 2019 to the Year Ended December 31, 2018 and the Year Ended December 31, 2018 to the Year Ended December 31, 2017 Overview(1) 2019 and 2018 The following table summarizes results for the years ended December 31, 2019 and 2018 (dollars in thousands): _______________________________________ (1) For the reconciliation of non-GAAP financial measures, see “Non-GAAP Financial Measure Reconciliations” below. Net income (loss) applicable to common shares ("net income (loss)") decreased primarily as a result of the following: • a reduction in NOI as a result of asset sales during 2018 and 2019; • a larger net gain on sales of real estate during 2018 compared to 2019, primarily related to the sale of our Shoreline Technology Center life science campus in November 2018; • increased depreciation and amortization expense as a result of: (i) assets acquired during 2018 and 2019, (ii) development and redevelopment projects placed into operations during 2018 and 2019, and (iii) the conversion of 14 senior housing triple-net assets from a DFL to a RIDEA structure in 2019, partially offset by decreased depreciation and amortization from asset sales during 2018 and 2019; • an increase in loss on debt extinguishments, resulting from redemptions and repurchases of senior unsecured notes in 2019; and • increased impairment charges on real estate asset recognized during 2019 compared to 2018. The decrease in net income (loss) was partially offset by: • increased NOI from: (i) annual rent escalations, (ii) 2018 and 2019 acquisitions, and (iii) development and redevelopment projects placed in service during 2018 and 2019; • a reduction in interest expense as a result of debt repayments during 2018 and 2019; and • an increase in other income, primarily resulting from: (i) a gain on deconsolidation of 19 SHOP assets in 2019, and (ii) a loss on consolidation of seven care homes in the U.K. during the first quarter of 2018, partially offset by a gain on consolidation related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018. NAREIT FFO increased primarily as a result of the aforementioned events impacting net income (loss), except for the following, which are excluded from NAREIT FFO: • gains on sales of real estate, including related tax impacts; • depreciation and amortization expense; • impairments charges on real estate assets; and • gains and losses on change in control. FFO as Adjusted decreased primarily as a result of the aforementioned events impacting NAREIT FFO, except for losses on debt extinguishment, which are excluded from FFO as Adjusted. FAD decreased primarily as a result of the aforementioned events impacting FFO as Adjusted, except for the impact of straight-line rents, which is excluded from FAD. The decrease in FAD was also partially due to increased FAD capital expenditures during 2019. 2018 and 2017 The following table summarizes results for the years ended December 31, 2018 and 2017 (dollars in thousands): Net income (loss) applicable to common shares ("net income (loss)") increased primarily as a result of the following: • a larger net gain on sales of real estate during 2018 compared to 2017, primarily related to the sale of our Shoreline Technology Center life science campus in November 2018; • increased NOI from: (i) annual rent escalations, (ii) 2017 and 2018 acquisitions, and (iii) development and redevelopment projects placed in service during 2017 and 2018; • a gain on consolidation related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018; • impairments of our mezzanine loan facility to Tandem Health Care (the “Tandem Mezzanine Loan”) in 2017; • a net charge to NOI from the November 2017 transactions with Brookdale (the “2017 Brookdale Transactions”)(See Note 3 to the Consolidated Financial Statements); • a reduction in interest expense as a result of debt repayments, primarily in the second and third quarters of 2017 and throughout 2018, partially offset by an increased average balance under our Revolving Facility during 2018; • higher income tax expense in 2017 related to the impact of new tax rate legislation, partially offset by tax benefits from higher sales volume during 2017; • a reduction in litigation-related costs from securities class action litigation, and a one-time legal settlement in 2017; • a reduction in loss on debt extinguishment related to repurchases of our senior unsecured notes in July 2018 compared to July 2017; and • casualty-related charges incurred due to hurricanes in the third quarter of 2017. The increase in net income (loss) was partially offset by: • a reduction in NOI in our senior housing triple-net segment, primarily as a result of the sale of senior housing triple-net assets and the transition of senior housing triple-net assets to SHOP during 2017 and 2018; • a reduction in NOI in our SHOP segment, primarily as a result of occupancy declines and higher labor costs; • a loss on consolidation of seven care homes in the U.K. during the first quarter of 2018; • a reduction in income related to the gain on sale of our £138.5 million par value Four Seasons Health Care’s senior notes (the “Four Seasons Notes”) during 2017; • increased impairment charges on real estate asset recognized during 2018 compared to 2017; • a reduction in income as a result of: (i) asset sales during 2017 and 2018 and (ii) selling interests into the U.K. JV and a joint venture with Morgan Stanley Real Estate Investments ("MSREI MOB JV")(see Note 4 to the Consolidated Financial Statements); • a reduction in interest income due to the: (i) payoff of our HC-One mezzanine loan (the "HC-One Facility") in June 2017 and (ii) sale of our Tandem Mezzanine Loan in March 2018; • increased depreciation and amortization expense as a result of: (i) assets acquired during 2017 and 2018 and (ii) development and redevelopment projects placed into operations during 2017 and 2018, primarily in our life science and medical office segments, partially offset by decreased depreciation and amortization from asset sales during 2017 and 2018; • a reduction in equity income from unconsolidated joint ventures as a result of the sale of our equity method investment in RIDEA II in June 2018, partially offset by additional equity income from the U.K. JV; and • an increase in severance and related charges during 2018 primarily related to the departure of our former Executive Chairman compared to severance and related charges primarily related to the departure of our former Chief Accounting Officer ("CAO") in 2017. NAREIT FFO increased primarily as a result of the aforementioned events impacting net income (loss), except for the following, which are excluded from NAREIT FFO: • gains on sales of real estate, including related tax impacts; • depreciation and amortization expense; • impairments of facilities within our senior housing triple-net and SHOP segments; and • net gain on consolidation. FFO as Adjusted decreased primarily as a result of the aforementioned events impacting NAREIT FFO, except for the following, which are excluded from FFO as Adjusted: • the net charge to NOI from the 2017 Brookdale Transactions; • the impact of tax rate legislation during the fourth quarter of 2017; • severance and related charges; • losses on debt extinguishments; • litigation-related costs; • casualty-related charges; • the gain on sale of our Four Seasons Notes during the first quarter of 2017; and • the impairments of our Tandem Mezzanine Loan in 2017 and an undeveloped life science land parcel in 2018. FAD decreased primarily as a result of the aforementioned events impacting FFO as Adjusted, except for the impact of straight-line rents, which is excluded from FAD. The decrease in FAD was partially offset by lower FAD capital expenditures. Segment Analysis The following tables provide selected operating information for our SPP and total property portfolio for each of our reportable segments. For the year ended December 31, 2019, our SPP consists of 411 properties representing properties acquired or placed in service and stabilized on or prior to January 1, 2018 and that remained in operations under a consistent reporting structure through December 31, 2019. For the year ended December 31, 2018, our SPP consisted of 522 properties acquired or placed in service and stabilized on or prior to January 1, 2017 and that remained in operations under a consistent reporting structure through December 31, 2018. Our total consolidated property portfolio consisted of 617, 645 and 744 properties at December 31, 2019, 2018 and 2017, respectively. Senior Housing Triple-Net 2019 and 2018 The following table summarizes results at and for the years ended December 31, 2019 and 2018 (dollars in thousands except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) Represents rental and related revenues and income from DFLs. (3) From our 2018 presentation of SPP, we removed 15 senior housing triple-net properties that were sold, 45 senior housing triple-net properties that were transitioned or we agreed to transition to our SHOP segment, and 27 senior housing triple-net properties that were classified as held for sale. (4) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI and Adjusted NOI increased primarily as a result of annual rent escalations. Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • the transfer of 22 and 41 senior housing triple-net facilities to our SHOP segment during 2018 and 2019, respectively, and • senior housing triple-net facilities sold during 2018 and 2019. The decrease in Total Portfolio NOI and Adjusted NOI is partially offset by the aforementioned increases to SPP. 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars in thousands except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) Represents rental and related revenues and income from DFLs. (3) From our 2017 presentation of SPP, we removed 11 senior housing triple-net properties that were sold and 22 senior housing triple-net properties that were transitioned to our SHOP segment. (4) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP NOI and Adjusted NOI increased primarily as a result of annual rent escalations. The increase in Adjusted NOI was partially offset by rent reductions under the 2017 Brookdale Transactions. Total Portfolio NOI and Adjusted NOI decreased primarily as a result of the following Non-SPP impacts: • decreased NOI from senior housing triple-net facilities sold during 2017 and 2018; and • decreased NOI from the transfer of 25 and 22 senior housing triple-net facilities to our SHOP segment during 2017 and 2018, respectively. The decrease in Total Portfolio NOI and Adjusted NOI is partially offset by the aforementioned increases to SPP. The decrease in Total Portfolio NOI was further offset by the net charge of triple-net lease terminations from the 2017 Brookdale Transactions. Senior Housing Operating Portfolio 2019 and 2018 The following table summarizes results at and for the years ended December 31, 2019 and 2018 (dollars in thousands, except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2018 presentation of SPP, we removed 16 SHOP properties that were deconsolidated, 3 SHOP properties that were sold, 1 SHOP property that was placed into redevelopment and 8 SHOP properties that were classified as held for sale. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP Adjusted NOI decreased primarily as a result of the following: • higher labor costs and • a temporary decline in performance of facilities that transitioned between operators within the SHOP segment, partially offset by • increased community fees received and • increased occupancy and rates for resident fees and services SPP NOI increased primarily as a result of the aforementioned impacts to SPP Adjusted NOI and a non-cash increase to our IBNR ("Incurred But Not Reported") insurance liability estimate during the fourth quarter of 2018 in conjunction with the transition of certain insurance policies to a new plan. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the following Non-SPP impacts: • increased NOI from: (i) 2019 acquisitions and (ii) the transfer of 22 and 41 senior housing triple-net assets to our SHOP segment during 2018 and 2019, respectively, partially offset by • lost NOI from: (i) assets sold in 2018 and 2019 and (ii) the deconsolidation of 16 assets in 2019 upon formation of the Sovereign Wealth Fund Senior Housing Joint Venture. 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars in thousands, except per unit data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2017 presentation of SPP, we removed nine properties that were sold, eight SHOP properties that were placed into redevelopment and three SHOP properties that were classified as held for sale. (3) Represents average capacity as reported by the respective tenants or operators for the 12-month period and a quarter in arrears from the periods presented. SPP Adjusted NOI decreased primarily as a result of the following: • occupancy declines and higher labor costs; partially offset by • increased rates for resident fees and services. SPP NOI increased primarily as a result of the net charge for management fee terminations from the 2017 Brookdale Transactions, partially offset by the aforementioned decreases to SPP Adjusted NOI. Total Portfolio Adjusted NOI decreased primarily as a result of the aforementioned impacts to SPP and the following Non-SPP impacts: • decreased NOI from our partial sale of RIDEA II in the first quarter of 2017; and • decreased NOI from SHOP assets sold in 2017 and 2018; partially offset by • increased NOI from the transfer of 25 and 22 senior housing triple-net assets to our SHOP segment during 2017 and 2018, respectively. Total Portfolio NOI increased primarily a result of the net charge for management fee terminations from the 2017 Brookdale Transactions, partially offset by the aforementioned decreases to Total Portfolio Adjusted NOI. Life Science 2019 and 2018 The following table summarizes results at and for the years ended December 31, 2019 and 2018 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2018 presentation of SPP, we removed one life science facility that was sold, two life science facilities that were placed into redevelopment, and one life science facility related to a casualty event. SPP NOI and Adjusted NOI increased primarily as a result of the following: • new leasing activity; • mark-to-market lease renewals; • increased occupancy; and • specific to Adjusted NOI, annual rent escalations. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following Non-SPP impacts: • increased NOI from: (i) increased occupancy in former development and redevelopment facilities placed into service in 2018 and 2019 and (ii) acquisitions in 2019; and • lost NOI from: (i) facilities sold in 2018 and 2019 and (ii) the placement of facilities into redevelopment in 2019. 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2017 presentation of SPP, we removed 12 life science facilities that were sold and 3 life science facilities that were placed into redevelopment. SPP NOI and Adjusted NOI increased primarily as a result of the following: • new leasing activity; and • specific to Adjusted NOI, annual rent escalations; partially offset by • a mark-to-market rent decrease on a 147,000 square foot lease in South San Francisco. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following Non-SPP impacts: • increased NOI from: (i) increased occupancy in portions of a development placed into operations in 2017 and 2018 and (ii) acquisitions in 2017; partially offset by • decreased NOI from: (i) sales of life science facilities in 2017 and 2018 and (ii) the placement of life science facilities into redevelopment in 2017 and 2018. Medical Office 2019 and 2018 The following table summarizes results at and for the years ended December 31, 2019 and 2018 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2018 presentation of SPP, we removed seven MOBs that were sold, two MOBs that were placed into redevelopment, two MOBs that were classified as held for sale, and one MOB that we intend to demolish. SPP NOI and Adjusted NOI increased primarily as a result of the following: • mark-to-market lease renewals; • increased percentage-based rents; and • specific to adjusted NOI, annual rent escalations. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following Non-SPP impacts: • NOI from our 2018 and 2019 acquisitions; and • increased occupancy in former development and redevelopment properties placed into service; partially offset by • lost NOI from dispositions during 2018 and 2019. 2018 and 2017 The following table summarizes results at and for the years ended December 31, 2018 and 2017 (dollars and sq. ft. in thousands, except per sq. ft. data): _______________________________________ (1) Total Portfolio includes results of operations from disposed properties and properties that transitioned segments through the disposition or transition date. (2) From our 2017 presentation of SPP, we removed four MOBs that were sold and three MOBs that were placed into redevelopment. SPP NOI and Adjusted NOI increased primarily as a result of the following: • mark-to-market lease renewals; • increased percentage-based rents; and • specific to adjusted NOI, annual rent escalations. Total Portfolio NOI and Adjusted NOI increased primarily as a result of the aforementioned increases to SPP and the following Non-SPP impacts: • NOI from our 2017 and 2018 acquisitions and • increased occupancy in former development and redevelopment properties placed into service in 2017 and 2018, partially offset by • lost NOI from dispositions during 2017 and 2018. Other Income and Expense Items The following table summarizes results for the years ended December 31, 2019, 2018 and 2017 (in thousands): Interest income. The decrease in interest income for the year ended December 31, 2018 was primarily the result of: (i) the sale of our Tandem Mezzanine Loan during the first quarter of 2018, (ii) the payoff of our HC-One Facility in June 2017, and (iii) the conversion of the U.K. Bridge Loan into real estate during the first quarter of 2018. Interest expense. The decrease in interest expense for the year ended December 31, 2019 was primarily the result of senior unsecured notes repurchases and redemptions during 2018. The decrease in interest expense for the year ended December 31, 2018 was primarily the result of senior unsecured notes repurchases during 2017 and 2018, partially offset by an increased average balance under our Revolving Facility during 2018. Depreciation and amortization. The increase in depreciation and amortization expense for the year ended December 31, 2019 was primarily as a result of: (i) assets acquired during 2018 and 2019, (ii) development and redevelopment projects placed into operations during 2018 and 2019 (primarily in our life science and medical office segments), and (iii) the conversion of 14 senior housing triple-net assets from a DFL to a RIDEA structure in 2019, partially offset by dispositions of real estate throughout 2018 and 2019. The increase in depreciation and amortization expense for the year ended December 31, 2018 was primarily as a result of: (i) assets acquired during 2017 and 2018 (primarily in our life science and medical office segments) and (ii) development and redevelopment projects placed into operations during 2017 and 2018 (primarily in our life science and medical office segments), partially offset by dispositions of real estate throughout 2017 and 2018. General and administrative expenses. The decrease in general and administrative expenses for the year ended December 31, 2019 was primarily as a result of decreased severance and related charges, driven by the departure of our former Executive Chairman in March 2018, partially offset by higher compensation costs in 2019. The increase in general and administrative expenses for the year ended December 31, 2018 was primarily as a result of increased severance and related charges, primarily resulting from the departure of our former Executive Chairman in March 2018, which exceeded severance and related charges in 2017, primarily related to the departure of our former CAO in the third quarter of 2017. Impairments (recoveries), net. Impairments (recoveries), net increased for the year ended December 31, 2019 as a result of committing to a formal plan to sell certain assets as part of a broader initiative to improve our portfolio quality and therefore, classifying those assets as held for sale. While some properties that are classified as held for sale are expected to result in a gain recognized upon disposition, others had a carrying value that exceeded the expected sale proceeds less costs to sell, resulting in an impairment charge during the respective period. The impairment charges recognized in each period vary depending on facts and circumstances related to each asset and are impacted by negotiations with potential buyers, current operations of the assets, market conditions, and other factors. Impairments (recoveries), net decreased for the year ended December 31, 2018, primarily as a result of the $144 million impairment charge recognized in 2017 related to our Tandem Mezzanine Loan (see Note 7 to the Consolidated Financial Statements). Gain (loss) on sales of real estate, net. During the year ended December 31, 2019, we sold: (i) our remaining interest in the U.K. JV, (ii) 18 SHOP facilities, (iii) 2 senior housing triple-net facilities, (iv) 10 MOBs, (v) 1 life science asset, (vi) 1 undeveloped life science land parcel, and (vii) two facilities from the other non-reportable segment, and recognized total net gain on sales of $23 million. During the year ended December 31, 2018, we sold: (i) our remaining interest in RIDEA II, (ii) a 51% interest in our U.K. Portfolio, (iii) 31 SHOP facilities, (iv) 16 life science assets, (v) 13 senior housing triple-net facilities, and (vi) four MOBs and recognized total net gain on sales of $926 million. During the year ended December 31, 2017, we sold: (i) 68 senior housing triple-net facilities, (ii) five life science facilities, (iii) five SHOP facilities, (iv) four MOBs, and (v) a 40% interest in RIDEA II, and recognized total net gain on sales of $357 million. Loss on debt extinguishments. During the year ended December 31, 2019, we repurchased or redeemed $1.65 billion of our senior unsecured notes and recognized an aggregate loss on debt extinguishment of $58 million. During the year ended December 31, 2018, we repurchased $700 million of our 5.375% senior notes due 2021 and recognized a $44 million loss on debt extinguishment. During the year ended December 31, 2017, we repurchased $500 million of our 5.375% senior notes due 2021 and recognized a $54 million loss on debt extinguishment. Other income (expense), net. The increase in other income (expense), net for the year ended December 31, 2019 was primarily as a result of (i) a gain on deconsolidation recognized in 2019 related to a senior housing joint venture with a sovereign wealth fund (see Note 4 to the Consolidated Financial Statements) and (ii) a loss on consolidation of seven U.K. care homes in March 2018 (see Note 18 to the Consolidated Financial Statements). The increase in other income (expense), net was partially offset by a gain on consolidation related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018. The decrease in other income (expense), net for the year ended December 31, 2018 was primarily as a result of: (i) a loss on consolidation of seven U.K. care homes in March 2018 (see Note 18 to the Consolidated Financial Statements) and (ii) a gain on sale of our Four Seasons Notes in March 2017. The decrease in other income (expense), net was partially offset by: (i) a gain on consolidation related to the acquisition of the outstanding equity interests in three life science joint ventures in November 2018, (ii) casualty-related charges due to hurricanes incurred in the third quarter of 2017, and (iii) decreased litigation costs in 2018. Income tax benefit (expense). The increase in income tax benefit for the year ended December 31, 2018, compared to the year ended December 31, 2017, was primarily the result of: (i) a $17 million income tax expense related to the impact of tax rate legislation during the fourth quarter of 2017 and (ii) a $6 million income tax benefit related to our share of operating losses from our RIDEA joint ventures and U.K. real estate investments during 2018, partially offset by a $6 million benefit from the partial sale of RIDEA II in 2017. Equity income (loss) from unconsolidated joint ventures. The decrease in equity income from unconsolidated joint ventures for the year ended December 31, 2019 was primarily the result of an impairment charge recognized related to one asset classified as held-for-sale in the CCRC JV (see Note 8 to the Consolidated Financial Statements) and the sale of our equity method investment in RIDEA II in June 2018, partially offset by additional equity income from our investment in the U.K. JV. The decrease in equity income from unconsolidated joint ventures for the year ended December 31, 2018 was primarily the result of the sale of our equity method investment in RIDEA II in June 2018, partially offset by additional equity income from our investment in the U.K. JV. Liquidity and Capital Resources We anticipate that our cash flow from operations, available cash balances and cash from our various financing activities will be adequate for at least the next 12 months for purposes of: (i) funding recurring operating expenses; (ii) meeting debt service requirements; and (iii) satisfying our distributions to our stockholders and non-controlling interest members. Distributions were made using a combination of cash flows from operations, funds available under our revolving line of credit, proceeds from the sale of properties, and other sources of cash available to us. Our principal investing liquidity needs for the next 12 months are to: • fund capital expenditures, including tenant improvements and leasing costs and • fund future acquisition, transactional and development activities. We anticipate satisfying these future investing needs using one or more of the following: • cash flow from operations; • sale or exchange of ownership interests in properties or other investments; • borrowings under our Facilities and Commercial Paper Program; • issuance of additional debt, including unsecured notes, term loans, and mortgage debt; and/or • issuance of common or preferred stock or its equivalent. Access to capital markets impacts our cost of capital and ability to refinance maturing indebtedness, as well as our ability to fund future acquisitions and development through the issuance of additional securities or secured debt. Credit ratings impact our ability to access capital and directly impact our cost of capital as well. For example, our Revolving Facility and 2019 Term Loan accrue interest at a rate per annum equal to LIBOR plus a margin that depends upon the credit ratings of our senior unsecured long-term debt. We also pay a facility fee on the entire revolving commitment that depends upon our credit ratings. As of February 10, 2020, we had long-term credit ratings of Baa1 from Moody’s and BBB+ from S&P Global and Fitch, and short-term credit ratings of P-2, A-2 and from Moody's, S&P Global, and Fitch, respectively. Cash Flow Summary The following summary discussion of our cash flows is based on the Consolidated Statements of Cash Flows and is not meant to be an all-inclusive discussion of the changes in our cash flows for the periods presented below. The following table sets forth changes in cash flows (in thousands): Operating Cash Flows Operating cash flow decreased $3 million between the years ended December 31, 2019 and 2018 primarily as the result of: (i) dispositions during 2018 and 2019 and (ii) occupancy declines and higher labor costs within our SHOP segment. The decrease in operating cash flow is partially offset by: (i) 2018 and 2019 acquisitions, (ii) annual rent increases, (iii) developments and redevelopments placed in service during 2018 and 2019, and (iv) decreased interest paid as a result of debt repayments during 2018 and 2019. Our cash flow from operations is dependent upon the occupancy levels of our buildings, rental rates on leases, our tenants’ performance on their lease obligations, the level of operating expenses, and other factors. Operating cash flow increased $2 million between the years ended December 31, 2018 and 2017 primarily as the result of: (i) 2017 and 2018 acquisitions, (ii) annual rent increases, (iii) developments and redevelopments placed in service during 2017 and 2018, and (iv) decreased interest paid as a result of debt repayments during 2017 and 2018. The increase in operating cash flow is partially offset by: (i) dispositions during 2017 and 2018, (ii) the partial sale and deconsolidation of the U.K. JV in 2018, (iii) the partial sale and deconsolidation of RIDEA II during the first quarter of 2017, (iv) occupancy declines and higher labor costs within our SHOP segment, (v) decreased interest received as a result of loan repayments during 2017, and (vi) decreased distributions of earnings from our unconsolidated joint ventures. Investing Cash Flows The following are significant investing activities for the year ended December 31, 2019: • received net proceeds of $976 million primarily from: (i) sales of real estate assets (including real estate assets under DFLs), (ii) the sale of our investment in the U.K. JV, and (iii) the sale of a 46.5% interest in 19 previously consolidated SHOP assets; and • made investments of $2.4 billion primarily related to the (i) acquisition, development, and redevelopment of real estate and (ii) funding of loan investments. The following are significant investing activities for the year ended December 31, 2018: • received net proceeds of $2.9 billion primarily from: (i) sales of real estate assets, (ii) the sale of RIDEA II, (iii) the sale of the Tandem Mezzanine Loan, and (iv) the U.K. JV transaction; and • made investments of $1.1 billion primarily related to the acquisition, development, and redevelopment of real estate. The following are significant investing activities for the year ended December 31, 2017: • received net proceeds of $1.8 billion from sales of real estate, including the sale and recapitalization of RIDEA II; • received net proceeds of $559 million primarily from: (i) the sale of our Four Seasons Notes, (ii) the repayment of our HC-One Facility, and (iii) a DFL repayment; and made investments of $1.1 billion primarily for the acquisition and development of real estate. Financing Cash Flows The following are significant financing activities for the year ended December 31, 2019: • made net borrowings of $573 million primarily under our bank line of credit, commercial paper, term loan, senior unsecured notes (including debt extinguishment costs); • paid cash dividends on common stock of $720 million; and • issued common stock of $796 million. The following are significant financing activities for the year ended December 31, 2018: • repaid $2.4 billion of debt under our: (i) bank line of credit, (ii) term loan, (iii) senior unsecured notes (including debt extinguishment costs) and (iv) mortgage debt; • paid cash dividends on common stock of $697 million; • paid $83 million for distributions to and purchases of noncontrolling interests, primarily related to our acquisition of Brookdale’s noncontrolling interest in RIDEA I; • raised net proceeds of $218 million from the issuances of common stock, primarily from our at-the-market equity program; and • received proceeds of $300 million for issuances of noncontrolling interests, primarily related to the MSREI MOB JV. The following are significant financing activities for the year ended December 31, 2017: • repaid $1.4 billion of debt under our: (i) term loans, (ii) senior unsecured notes (including debt extinguishment costs) and (iii) mortgage debt, partially offset by net borrowings under our bank line of credit; and • paid cash dividends on common stock of $695 million. Debt Bank Line of Credit, Term Loans and Commercial Paper Program In May 2019, we entered into the Revolving Facility, a new $2.5 billion unsecured revolving line of credit facility maturing on May 23, 2023. The Revolving Facility contains two, six-month extension options, subject to certain customary conditions. Additionally, in May 2019, we entered into the 2019 Term Loan, a new $250 million unsecured term loan facility and we borrowed the full $250 million capacity in June 2019. The 2019 Term Loan matures on May 23, 2024. The Facilities include a feature that allows us to increase the borrowing capacity by an aggregate amount of up to $750 million, subject to securing additional commitments. In September 2019, we established the Commercial Paper Program. Under the terms of the Commercial Paper Program, we may issue, from time to time, unsecured short-term debt securities with varying maturities. Amounts available under the Commercial Paper Program may be borrowed, repaid and re-borrowed from time to time, with the maximum aggregate face or principal amount outstanding at any one time not to exceed $1.0 billion. Amounts borrowed under the Commercial Paper Program will be sold on terms that are customary for the U.S. commercial paper market and will be at least equal in right of payment with all of our other unsecured and unsubordinated indebtedness. We intend to use the Revolving Facility as a liquidity backstop for the repayment of unsecured short term debt securities issued under the Commercial Paper Program. Senior Unsecured Notes On July 5, 2019, we completed a public offering of $650 million aggregate principal amount of 3.25% senior unsecured notes due 2026 and $650 million aggregate principal amount of 3.50% senior unsecured notes due 2029. Using the net proceeds from the Notes offering in July 2019, we: (i) redeemed all of our $800 million 2020 Notes, (ii) repurchased $250 million aggregate principal amount of our 2023 Notes, and (iii) repurchased $250 million aggregate principal amount of our 2022 Notes. On November 21, 2019, we completed a public offering of $750 million aggregate principal amount of 3.00% senior unsecured notes due 2030 (the "2030 Notes"). Using a portion of the net proceeds from the 2030 Notes offering, we repurchased the remaining $350 million aggregate principal amount of our 2022 Notes. See Note 10 to the Consolidated Financial Statements for additional information about our outstanding debt. See “2019 Transaction Overview” for further information regarding our significant financing activities during the year ended December 31, 2019. Approximately 96%, 98% and 84% of our consolidated debt, inclusive of $42 million, $43 million and $44 million of variable rate debt swapped to fixed through interest rate swaps, was fixed rate debt as of December 31, 2019, 2018 and 2017, respectively. At December 31, 2019, our fixed rate debt and variable rate debt had weighted average interest rates of 3.92% and 2.78%, respectively. At December 31, 2018, our fixed rate debt and variable rate debt had weighted average interest rates of 4.04% and 2.15%, respectively. At December 31, 2017, our fixed rate debt and variable rate debt had weighted average interest rates of 4.19% and 2.56%, respectively. For a more detailed discussion of our interest rate risk, see “Quantitative and Qualitative Disclosures About Market Risk” in Item 3 below. Equity At December 31, 2019, we had 505 million shares of common stock outstanding, equity totaled $6.7 billion, and our equity securities had a market value of $17.7 billion. At December 31, 2019, non-managing members held an aggregate of five million units in seven limited liability companies (“DownREITs”) for which we are the managing member. The DownREIT units are exchangeable for an amount of cash approximating the then-current market value of shares of our common stock or, at our option, shares of our common stock (subject to certain adjustments, such as stock splits and reclassifications). At December 31, 2019, the DownREIT units were convertible into seven million shares of our common stock. At-The-Market Program In February 2019, we terminated our 2018 ATM Program and concurrently established our 2019 ATM Program. In addition to the issuance and sale of shares of our common stock, we may also enter into one or more forward sales agreements with sales agents for the sale of our shares of common stock under our 2019 ATM Program. During the year ended December 31, 2019, the Company directly issued 5.9 million shares of common stock at a weighted average net price of $31.84 per share, after commissions, resulting in net proceeds of $189 million. Additionally, during the year ended December 31, 2019, the Company settled 5.5 million shares under forward contracts at a weighted average net price of $30.91 per share, after commissions, resulting in net proceeds of $171 million. At December 31, 2019, we had 14.8 million shares outstanding under forward contracts under the 2019 ATM Program, with a weighted average net price of $31.56 per share, after commissions. At December 31, 2019, approximately $163 million of our common stock remained available for sale under the 2019 ATM Program, after giving effect to equity issued directly and pursuant to forward sale contracts as described in Note 12 to the Consolidated Financial Statements. Actual future sales of our common stock will depend upon a variety of factors, including but not limited to market conditions, the trading price of our common stock, and our capital needs. We have no obligation to sell any of the remaining shares under our 2019 ATM Program. See Note 12 to the Consolidated Financial Statements for additional information about our 2019 ATM Program, including with respect to equity sales during the year ended December 31, 2019. November 2019 Forward Equity Offering In November 2019, we entered into a forward equity sales agreement to sell an aggregate of 15.6 million shares of our common stock (including shares sold through the exercise of underwriters’ options) at an initial net price of $34.46 per share, after underwriting discounts and commissions. The agreement has a one year term that expires on November 4, 2020 during which time we may settle the forward sales agreement by delivery of physical shares of common stock to the forward seller or, at our election, by settling in cash or net shares. The forward sale price that we expect to receive upon settlement of the agreement will be the initial net price of $34.46 per share, subject to adjustments for: (i) accrued interest, (ii) the forward purchasers’ stock borrowing costs, and (iii) certain fixed price reductions during the term of the agreement. At December 31, 2019, all shares remained outstanding under the forward sales agreement. December 2018 Forward Equity Offering In December 2018, we entered into a forward equity sales agreement to sell an aggregate of 15.3 million shares of our common stock (including shares sold through the exercise of underwriters’ options) at an initial net price of $28.60 per share, after underwriting discounts and commissions. Contemporaneously, the agreement had a one year term that expired on December 13, 2019 during which time we could settle the forward sales agreement by delivery of physical shares of common stock to the forward seller or, at our election, settle in cash or net shares. During the year ended December 31, 2019, we settled all 15.3 million shares under the forward sales agreement at a weighted average net price of $27.66 per share resulting in net proceeds of $422 million. At December 31, 2019, no shares remained outstanding under the forward sales agreement. An aggregate of 30.4 million shares of our common stock, sold at an initial weighted average net price of $33.05 per share, after commissions, remain available for issuance under forward sales agreements as of December 31, 2019. Shelf Registration In May 2018, we filed a prospectus with the SEC as part of a registration statement on Form S-3, using an automatic shelf registration process. This shelf registration statement expires in May 2021 and at or prior to such time, we expect to file a new shelf registration statement. Under the “shelf” process, we may sell any combination of the securities described in the prospectus through one or more offerings. The securities described in the prospectus include common stock, preferred stock, depositary shares, debt securities and warrants. Contractual Obligations The following table summarizes our material contractual payment obligations and commitments at December 31, 2019 (in thousands): _______________________________________ (1) Excludes $85 million of life care bonds and demand notes that have no scheduled maturities and are classified as other debt in our consolidated balance sheets. (2) Excludes mortgage debt on assets held for sale and mortgage debt from unconsolidated joint ventures. (3) Represents commitments to finance development projects. (4) Represents our commitments, as lessor, under signed leases and contracts for operating properties and includes allowances for tenant improvements and leasing commissions. Excludes allowances for tenant improvements related to developments in progress for which we have executed an agreement with a general contractor to complete the tenant improvements (recognized in the "Development commitments" line). (5) Represents construction and other commitments for developments in progress and includes allowances for tenant improvements of $88 million that we have provided as a lessor. (6) Interest on variable-rate debt is calculated using rates in effect at December 31, 2019. Off-Balance Sheet Arrangements We own interests in certain unconsolidated joint ventures as described in Note 8 to the Consolidated Financial Statements. Except in limited circumstances, our risk of loss is limited to our investment in the joint venture and any outstanding loans receivable. In addition, we have certain properties which serve as collateral for debt that is owed by a previous owner of certain of our facilities, as described under Note 11 to the Consolidated Financial Statements. Our risk of loss for these certain properties is limited to the outstanding debt balance plus penalties, if any. We have no other material off-balance sheet arrangements that we expect would materially affect our liquidity and capital resources except those described above under “Contractual Obligations”. Inflation Our leases often provide for either fixed increases in base rents or indexed escalators, based on the Consumer Price Index or other measures, and/or additional rent based on increases in the tenants’ operating revenues. Most of our MOB leases require the tenant to pay a share of property operating costs such as real estate taxes, insurance and utilities. Substantially all of our senior housing triple-net, life science, and remaining other leases require the tenant or operator to pay all of the property operating costs or reimburse us for all such costs. We believe that inflationary increases in expenses will be offset, in part, by the tenant or operator expense reimbursements and contractual rent increases described above. Non-GAAP Financial Measure Reconciliations Funds From Operations and Funds Available for Distribution The following is a reconciliation from net income (loss) applicable to common shares, the most directly comparable financial measure calculated and presented in accordance with GAAP, to NAREIT FFO, FFO as Adjusted and FAD (in thousands, except per share data): _______________________________________ (1) For the year ended December 31, 2019, primarily relates to the gain related to the deconsolidation of 19 previously consolidated SHOP assets that were contributed into a new unconsolidated senior housing joint venture with a sovereign wealth fund. For the year ended December 31, 2019, also includes the gain related to the acquisition of the outstanding equity interests in a previously unconsolidated senior housing joint venture. For the year ended December 31, 2018, represents the gain related to the acquisition of our partner's interests in four previously unconsolidated life science assets, partially offset by the loss on consolidation of seven U.K. care homes. (2) For the year ended December 31, 2016, represents income tax expense associated with the state built-in gain tax payable upon the disposition of specific real estate assets, of which $49 million relates to the HCR ManorCare, Inc. ("HCRMC") real estate portfolio that we spun-off in 2016. (3) For the year ended December 31, 2019, includes a $6 million impairment charge related to depreciable real estate held by the CCRC JV, which we recognized in equity income (loss) from unconsolidated joint ventures in the consolidated statements of operations. (4) For the year ended December 31, 2017, includes $55 million of net non-cash charges related to the right to terminate certain triple-net leases and management agreements in conjunction with the 2017 Brookdale Transactions. For the year ended December 31, 2016, primarily relates to the spin-off of Quality Care Properties, Inc. (5) For the year ended December 31, 2019, represents the impairment of 13 senior housing triple-net facilities under DFLs recognized as a result of entering into sales agreements. For the year ended December 31, 2018, primarily relates to the impairment of an undeveloped life science land parcel classified as held for sale, partially offset by an impairment recovery upon the sale of a mezzanine loan investment in March 2018. For the year ended December 31, 2017, relates to $144 million of impairments on our Tandem Mezzanine Loan, net of a $51 million impairment recovery upon the sale of our Four Seasons Notes. For the year ended December 31, 2015, include impairment charges of: (i) $1.3 billion related to our HCRMC DFL investments, (ii) $112 million related to our Four Seasons Notes and (iii) $46 million related to our equity investment in HCRMC, partially offset by an impairment recovery of $6 million related to a loan payoff. (6) For the year ended December 31, 2018, primarily relates to the departure of our former Executive Chairman and corporate restructuring activities. For the year ended December 31, 2017, primarily relates to the departure of our former CAO. For the year ended December 31, 2016, primarily relates to the departure of our former President and Chief Executive Officer. For the year ended December 31, 2015, relates to the departure of our former Chief Investment Officer. (7) For all periods presented, represents the premium associated with the prepayment of senior unsecured notes and mortgage debt. (8) For all periods presented, relates to costs from securities class action litigation and a legal settlement. See Note 11 to the Consolidated Financial Statements for additional information. (9) For the year ended December 31, 2019, represents incremental insurance proceeds related to hurricanes in 2017, net of evacuation costs related to hurricanes in 2019. (10) Represents the remeasurement of deferred tax assets and liabilities as a result of the Tax Cuts and Jobs Act that was signed into legislation on December 22, 2017. (11) Excludes amounts related to the acceleration of deferred compensation for restricted stock units that vested upon the departure of certain former employees, which have already been excluded from FFO as Adjusted in severance and related charges. (12) Represents our 49% share of our CCRC JV's non-refundable entrance fees collected in excess of amortization. (13) Excludes $17 million of deferred tax expenses, which is included in tax rate legislation impact for the year ended December 31, 2017. Additionally, the year ended December 31, 2017, excludes $1 million of deferred tax benefit from the casualty-related charges, which is included in casualty-related charges (recoveries), net. (14) Primarily includes our share of FAD capital expenditures from unconsolidated joint ventures, partially offset by noncontrolling interests' share of FAD capital expenditures from consolidated joint ventures. Our equity investment in HCRMC was accounted for using the equity method, which required an elimination of DFL income that was proportional to our ownership in HCRMC. Further, our share of earnings from HCRMC (equity income) increased for the corresponding elimination of related lease expense recognized at the HCRMC entity level, which we presented as a non-cash joint venture FAD adjustment. Beginning in January 2016, as a result of placing our equity investment in HCRMC on a cash basis method of accounting, we no longer eliminated our proportional ownership share of income from DFLs to equity income (loss) from unconsolidated joint ventures. Critical Accounting Policies The preparation of financial statements in conformity with U.S. GAAP requires our management to use judgment in the application of accounting policies, including making estimates and assumptions. We base estimates on the best information available to us at the time, our experience and on various other assumptions believed to be reasonable under the circumstances. These estimates affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions or other matters had been different, it is possible that different accounting would have been applied, resulting in a different presentation of our consolidated financial statements. From time to time, we re-evaluate our estimates and assumptions. In the event estimates or assumptions prove to be different from actual results, adjustments are made in subsequent periods to reflect more current estimates and assumptions about matters that are inherently uncertain. For a more detailed discussion of our significant accounting policies, see Note 2 to the Consolidated Financial Statements. Below is a discussion of accounting policies that we consider critical in that they may require complex judgment in their application or require estimates about matters that are inherently uncertain. Principles of Consolidation The consolidated financial statements include the accounts of Healthpeak Properties, Inc., our wholly-owned subsidiaries, and joint ventures that we control, through voting rights or other means. We consolidate investments in variable interest entities (“VIEs”) when we are the primary beneficiary of the VIE. A variable interest holder is considered to be the primary beneficiary of a VIE if it has the power to direct the activities that most significantly impact the entity’s economic performance and has the obligation to absorb losses of, or the right to receive benefits from, the entity that could potentially be significant to the VIE. We make judgments about which entities are VIEs based on an assessment of whether: (i) the equity investment at risk is insufficient to finance that entity’s activities without additional subordinated financial support, (ii) substantially all of an entity’s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights, or (iii) the equity investors as a group lack any of the following: (a) the power through voting or similar rights to direct the activities of an entity that most significantly impact the entity’s economic performance, (b) the obligation to absorb the expected losses of an entity, or (c) the right to receive the expected residual returns of an entity. Criterion (iii) above is generally applied to limited partnerships and similarly structured entities by assessing whether a simple majority of the limited partners hold substantive rights to participate in the significant decisions of the entity or have the ability to remove the decision maker or liquidate the entity without cause. If neither of those criteria are met, the entity is a VIE. We continually assess whether events have occurred that require us to reconsider the initial determination of whether an entity is a VIE. Such events include, but are not limited to: (i) a change to the contractual arrangements of the entity or in the ability of a party to exercise its participation or kick-out rights, (ii) a change to the capitalization structure of the entity, or (iii) acquisitions or sales of interests that constitute a change in control. When a reconsideration event occurs, we reassess whether the entity is a VIE. We also make judgments with respect to our level of influence or control over an entity and whether we are (or are not) the primary beneficiary of a VIE. Consideration of various factors includes, but is not limited to: • which activities most significantly impact the entity’s economic performance, and our ability to direct those activities; •our form of ownership interest; •our representation on the entity’s governing body; •the size and seniority of our investment; •our ability to manage our ownership interest relative to other interest holders; and • our ability and the rights of other investors to participate in policy making decisions, replace the manager, and/or liquidate the entity, if applicable. Our ability to correctly assess our influence or control over an entity when determining the primary beneficiary of a VIE affects the presentation of these entities in our consolidated financial statements. When we perform a reassessment of the primary beneficiary at a date other than at inception of the VIE, our assumptions may be different and may result in the identification of a different primary beneficiary. If we determine that we are the primary beneficiary of a VIE, our consolidated financial statements include the operating results of the VIE rather than the results of our variable interest in the VIE. We require VIEs to provide us timely financial information and review the internal controls of VIEs to determine if we can rely on the financial information it provides. If a VIE has deficiencies in its internal controls over financial reporting, or does not provide us with timely financial information, it may adversely impact the quality and/or timing of our financial reporting and our internal controls over financial reporting. Revenue Recognition Lease Classification At the inception of a new lease arrangement, including new leases that arise from amendments, we assess the terms and conditions to determine the proper lease classification. For leases entered into prior to January 1, 2019, a lease arrangement is classified as an operating lease if none of the following criteria are met: (i) transfer of ownership to the lessee prior to or shortly after the end of the lease term, (ii) the lessee has a bargain purchase option during or at the end of the lease term, (iii) the lease term is equal to 75% or more of the underlying property’s economic life, or (iv) the present value of future minimum lease payments (excluding executory costs) is equal to 90% or more of the estimated fair value of the leased asset. If one of the four criteria is met and the minimum lease payments are determined to be reasonably predictable and collectible, the lease arrangement is generally accounted for as a DFL. Concurrent with our adoption of Accounting Standards Update ("ASU") No. 2016-02, Leases (“ASU 2016-02”) on January 1, 2019, we began classifying a lease entered into subsequent to adoption as an operating lease if none of the following criteria are met: (i) transfer of ownership to the lessee by the end of the lease term, (ii) lessee has a purchase option during or at the end of the lease term that it is reasonably certain to exercise, (iii) the lease term is for the major part of the remaining economic life of the underlying asset, (iv) the present value of future minimum lease payments is equal to substantially all of the fair value of the underlying asset, or (v) the underlying asset is of such a specialized nature that it is expected to have no alternative use to us at the end of the lease term. If the assumptions utilized in the above classification assessments were different, our lease classification for accounting purposes may have been different; thus the timing and amount of our revenue recognized would have been impacted, which may be material to our consolidated financial statements. Rental and Related Revenues We recognize rental revenue for operating leases on a straight-line basis over the lease term when collectibility of all minimum lease payments is probable and the tenant has taken possession or controls the physical use of a leased asset. If the lease provides for tenant improvements, we determine whether the tenant improvements are owned by the tenant or us. When we are the owner of the tenant improvements, the tenant is not considered to have taken physical possession or have control of the leased asset until the tenant improvements are substantially complete. When the tenant is the owner of the tenant improvements, any tenant improvement allowance funded is treated as a lease incentive and amortized as a reduction of revenue over the lease term. The determination of ownership of a tenant improvement is subject to significant judgment. If our assessment of the owner of the tenant improvements was different, the timing and amount of our revenue recognized would be impacted. Certain leases provide for additional rents that are contingent upon a percentage of the facility’s revenue in excess of specified base amounts or other thresholds. Such revenue is recognized when actual results reported by the tenant, or estimates of tenant results, exceed the base amount or other thresholds. The recognition of additional rents requires us to make estimates of amounts owed and, to a certain extent, is dependent on the accuracy of the facility results reported to us. Our estimates may differ from actual results, which could be material to our consolidated financial statements. Resident Fees and Services Resident fee revenue is recorded when services are rendered and includes resident room and care charges, community fees and other resident charges. Residency agreements are generally for a term of 30 days to one year, with resident fees billed monthly, in advance. Revenue for certain care related services is recognized as services are provided and is billed monthly in arrears. Certain of our CCRCs are operated as entrance fee communities, which typically require a resident to pay an upfront entrance fee that includes both a refundable portion and non-refundable portion. When we receive a nonrefundable entrance fee, it is recognized as deferred revenue and amortized into revenue over the estimated stay of the resident. Credit Losses We continuously assess the collectibility of operating lease straight-line rent receivables. If it is no longer probable that substantially all future minimum lease payments will be received, the straight-line rent receivable balance is written off and recognized as a decrease in revenue in that period. We monitor the liquidity and creditworthiness of our tenants and operators on a continuous basis. This evaluation considers industry and economic conditions, property performance, credit enhancements, and other factors. We exercise judgment in this assessment and consider payment history and current credit status in developing these estimates. These estimates may differ from actual results, which could be material to our consolidated financial statements. Loans receivable and DFLs (collectively, “Finance Receivables”), are reviewed and assigned an internal rating of Performing, Watch List, or Workout. Finance Receivables that are deemed Performing meet all present contractual obligations, and collection and timing of all amounts owed is reasonably assured. Watch List Finance Receivables are defined as Finance Receivables that do not meet the definition of Performing or Workout. Workout Finance Receivables are defined as Finance Receivables in which we have determined, based on current information and events, that: (i) it is probable we will be unable to collect all amounts due according to the contractual terms of the agreement, (ii) the tenant, operator, or borrower is delinquent on making payments under the contractual terms of the agreement, and (iii) we have commenced action or anticipate pursuing action in the near term to seek recovery of our investment. Finance Receivables are placed on nonaccrual status when management determines that the collectibility of contractual amounts is not reasonably assured (the asset will have an internal rating of either Watch List or Workout). Further, we perform a credit analysis to support the tenant’s, operator’s, borrower’s, and/or guarantor’s repayment capacity and the underlying collateral values. We use the cash basis method of accounting for Finance Receivables placed on nonaccrual status unless one of the following conditions exist whereby we utilize the cost recovery method of accounting: (i) if we determine that it is probable that we will only recover the recorded investment in the Finance Receivable, net of associated allowances or charge-offs (if any) or (ii) we cannot reasonably estimate the amount of an impaired Finance Receivable. For cash basis method of accounting we apply payments received, excluding principal paydowns, to interest income so long as that amount does not exceed the amount that would have been earned under the original contractual terms. For cost recovery method of accounting any payment received is applied to reduce the recorded investment. Generally, we return a Finance Receivable to accrual status when all delinquent payments become current under the terms of the loan or lease agreements and collectibility of the remaining contractual loan or lease payments is reasonably assured. Prior to the adoption of ASU No. 2016-13, Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”) on January 1, 2020, allowances were established for Finance Receivables on an individual basis utilizing an estimate of probable losses, if they were determined to be impaired. Finance Receivables are impaired when it is was deemed probable that we would be unable to collect all amounts due in accordance with the contractual terms of the loan or lease. An allowance was based upon our assessment of the lessee’s or borrower’s overall financial condition, economic resources, payment record, the prospects for support from any financially responsible guarantors and, if appropriate, the net realizable value of any collateral. These estimates considered all available evidence, including the expected future cash flows discounted at the Finance Receivable’s effective interest rate, fair value of collateral, general economic conditions and trends, historical and industry loss experience, and other relevant factors, as appropriate. If a Finance Receivable was deemed partially or wholly uncollectible, the uncollectible balance was charged off against the allowance in the period in which the uncollectible determination has been made. Subsequent to adopting ASU 2016-13 on January 1, 2020, we began using a loss model that relies on future expected credit losses, rather than incurred losses, as was required under historical U.S. GAAP. Under the new model, we are required to recognize future credit losses expected to be incurred over the life of a financing receivable at inception of that instrument. The model emphasized historical experience and future market expectations to determine a loss to be recognized at inception. However, the model continues to be applied on an individual basis and rely on counter-party specific information to ensure the most accurate estimate is recognized. Real Estate We make estimates as part of our process for allocating a purchase price to the various identifiable assets and liabilities of an acquisition based upon the relative fair value of each asset or liability. The most significant components of our allocations are typically buildings as-if-vacant, land, and in-place leases. In the case of allocating fair value to buildings and intangibles, our fair value estimates will affect the amount of depreciation and amortization we record over the estimated useful life of each asset acquired. In the case of allocating fair value to in-place leases, we make our best estimates based on our evaluation of the specific characteristics of each tenant’s lease. Factors considered include estimates of carrying costs during hypothetical expected lease-up periods, market conditions, and costs to execute similar leases. Our assumptions affect the amount of future revenue and/or depreciation and amortization expense that we will recognize over the remaining useful life for the acquired in-place leases. Certain of our acquisitions involve the assumption of contract liabilities. We typically estimate the fair value of contract liabilities by applying a reasonable profit margin to the total discounted estimated future costs associated with servicing the contract. We consider a variety of market and contract-specific conditions when making assumptions that impact the estimated fair value of the contract liability. A variety of costs are incurred in the development and leasing of properties. After determination is made to capitalize a cost, it is allocated to the specific component of a project that is benefited. Determination of when a development project is substantially complete and capitalization must cease involves a degree of judgment. The costs of land and buildings under development include specifically identifiable costs. The capitalized costs include pre-construction costs essential to the development of the property, development costs, construction costs, interest costs, real estate taxes, and other costs incurred during the period of development. We consider a construction project to be considered substantially complete and available for occupancy and cease capitalization of costs upon the completion of the related tenant improvements. Assets Held for Sale The Company classifies a real estate property as held for sale when: (i) management has approved the disposal, (ii) the property is available for sale in its present condition, (iii) an active program to locate a buyer has been initiated, (iv) it is probable that the property will be disposed of within one year, (v) the property is being marketed at a reasonable price relative to its fair value, and (vi) it is unlikely that the disposal plan will significantly change or be withdrawn. If an asset is classified as held for sale, it is reported at the lower of its carrying value or fair value less costs to sell and no longer depreciated. Impairment of Long-Lived Assets We assess the carrying value of our real estate assets and related intangibles (“real estate assets”) when events or changes in circumstances indicate that the carrying value may not be recoverable. Recoverability of real estate assets is measured by comparing the carrying amount of the real estate assets to the respective estimated future undiscounted cash flows. The expected future undiscounted cash flows reflect external market factors and are probability-weighted to reflect multiple possible cash-flow scenarios, including selling the assets at various points in the future. Additionally, the estimated future undiscounted cash flows are calculated utilizing the lowest level of identifiable cash flows that are largely independent of the cash flows of other assets and liabilities. In order to review our real estate assets for recoverability, we make assumptions regarding external market conditions (including capitalization rates and growth rates), forecasted cash flows and sales prices, and our intent with respect to holding or disposing of the asset. If our analysis indicates that the carrying value of the real estate assets is not recoverable on an undiscounted cash flow basis, we recognize an impairment charge for the amount by which the carrying value exceeds the fair value of the real estate asset. Determining the fair value of real estate assets, including assets classified as held-for-sale, involves significant judgment and generally utilizes market capitalization rates, comparable market transactions, estimated per-unit or per square foot prices, negotiations with prospective buyers, and forecasted cash flows (lease revenue rates, expense rates, growth rates, etc.). Our ability to accurately predict future operating results and resulting cash flows, and estimate fair values, impacts the timing and recognition of impairments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our consolidated financial statements. Investments in Unconsolidated Joint Ventures The initial carrying value of investments in unconsolidated joint ventures is based on the amount paid to purchase the joint venture interest or the carrying value of the assets prior to the sale or contribution of the interests to the joint venture. We evaluate our equity method investments for impairment by first reviewing for indicators of impairment based on the performance of the underlying real estate assets held by the joint venture. If an equity-method investment shows indicators of impairment, we compare the fair value of the investment to the carrying value. If we determine there is a decline in the fair value of our investment in an unconsolidated joint venture below its carrying value and it is other-than-temporary, an impairment charge is recorded. The determination of the fair value of investments in unconsolidated joint ventures and as to whether a deficiency in fair value is other-than-temporary involves significant judgment. Our estimates consider all available evidence including, as appropriate, the present value of the expected future cash flows, discounted at market rates, general economic conditions and trends, severity and duration of a fair value deficiency, and other relevant factors. Capitalization rates, discount rates, and credit spreads utilized in our valuation models are based on rates we believe to be within a reasonable range of current market rates for the respective investments. While we believe our assumptions are reasonable, changes in these assumptions may have a material impact on our consolidated financial statements. Income Taxes As part of the process of preparing our consolidated financial statements, significant management judgment is required to evaluate our compliance with REIT requirements. Our determinations are based on interpretation of tax laws and our conclusions may have an impact on the income tax expense recognized. Adjustments to income tax expense may be required as a result of: (i) audits conducted by federal, state, and local tax authorities, (ii) our ability to qualify as a REIT, (iii) the potential for built-in gain recognition, and (iv) changes in tax laws. Adjustments required in any given period are included within the income tax provision. Recent Accounting Pronouncements See Note 2 to the Consolidated Financial Statements for the impact of new accounting standards.

<s>[INST] The information set forth in this Item 7 is intended to provide readers with an understanding of our financial condition, changes in financial condition and results of operations. We will discuss and provide our analysis in the following order: 2019 Transaction Overview Dividends Results of Operations Liquidity and Capital Resources Contractual Obligations OffBalance Sheet Arrangements Inflation NonGAAP Financial Measure Reconciliations Critical Accounting Policies Recent Accounting Pronouncements 2019 Transaction Overview Master Transaction and Cooperation Agreement with Brookdale In October 2019, Healthpeak and Brookdale Senior Living Inc. (“Brookdale”) entered into a Master Transactions and Cooperation Agreement (the “2019 MTCA”), which includes a series of transactions related to its jointly owned 15campus continuing care retirement community (“CCRC”) portfolio (the “CCRC JV”) and the portfolio of 43 senior housing properties that Brookdale triplenet leases from us. In connection with the 2019 MTCA, Healthpeak and Brookdale, and certain of their respective subsidiaries, agreed to the following related to the CCRC JV: Healthpeak, which owns a 49% interest in the CCRC JV, agreed to purchase Brookdale’s 51% interest in 13 of the 15 communities in the CCRC JV based on a valuation of $1.06 billion (the “CCRC Acquisition”); The management agreements related to the CCRC Acquisition communities will be terminated, with management transitioned (under new management agreements) from Brookdale to Life Care Services LLC (“LCS”) simultaneous with closing the CCRC Acquisition; We will pay a $100 million management termination fee to Brookdale upon closing the CCRC Acquisition; and The remaining two CCRCs will be jointly marketed for sale to third parties. In addition, pursuant to the 2019 MTCA, Healthpeak and Brookdale agreed to the following transactions related to properties that Brookdale triplenet leases from us: Brookdale will acquire 18 of the properties (the “Brookdale Acquisition Assets”) from us for cash proceeds of $385 million; We will terminate the triplenet lease related to one property and transition it to a RIDEA structure with LCS as the manager; The remaining 24 properties will be restructured into a single master lease with 2.4% annual rent escalators and a maturity date of December 31, 2027 (the “2019 Amended Master Lease”); A portion of annual rent (amount in excess of 6.5% of sales proceeds) related to 14 of the 18 Brookdale Acquisition Assets will be reallocated to the remaining properties under the 2019 Amended Master Lease; Upon sale of the Brookdale Acquisition Assets, Brookdale will pay down $20 million of future rent under the 2019 Amended Master Lease; and We will provide up to $35 million of capital investment in the 2019 Amended Master Lease properties over a fiveyear term, which will increase rent by 7% of the amount spent, per annum. With the exception of the capital investment to be made over the next five years and the sale of the two CCRCs to be marketed to third parties, each of the above transactions, including payment of the $100 million management termination fee, closed on January 31, 2020. Discovery Portfolio Acquisition In April 2019, we acquired a portfolio of nine senior housing properties, with a total of 1,242 units, for $445 million. The properties are located across Florida, Georgia, and Texas and are operated by Discovery Senior Living, LLC. Oakmont Portfolio Acquisitions In May 2019, we acquired three newlybuilt, senior housing communities in California for $113 million. The portfolio is operated by Oakmont Senior Living LLC (“Oakmont”) and includes 132 assisted living units and 68 memory care units with an average occupancy of 96% at closing [/INST] Positive. </s>

CYPRESS SEMICONDUCTOR CORP /DE/

2015-02-17

2014-12-28

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties, which are discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress”) delivers high-performance, mixed-signal, programmable solutions that provide customers with rapid time-to-market and exceptional system value. Cypress offerings include our flagship PSoC® 1, PSoC 3, PSoC 4 and PSoC 5LP programmable system-on-chip families. Cypress is the world leader in capacitive user interface solutions including CapSense® touch sensing, TrueTouch® touchscreens, and trackpad solutions for notebook PCs and peripherals. Cypress is also a significant participant in Universal Serial Bus (USB) controllers, which enhance connectivity and performance in a wide range of consumer and industrial products. Cypress is also the world leader in static random access memory (SRAM) and nonvolatile RAM memories. Cypress serves numerous major markets, including industrial, mobile handsets, consumer, computation, data communications, automotive, industrial and military. On December 1, 2014, Cypress announced that it entered into a definitive agreement to merge with Spansion, Inc., a leading designer, manufacturer and developer of embedded systems semiconductors, in an all-stock, tax-free transaction. The post-merger company is expected to generate approximately $2 billion in revenue annually and realize more than $135 million in cost synergies on an annualized basis within three years, and create a leading global provider of microcontrollers and specialized memories needed in today's embedded systems. Under the terms of the agreement, Spansion shareholders will receive 2.457 Cypress shares for each Spansion share they own. The shareholders of each company will initially own approximately 50 percent of the post-merger company. The closing of the transaction is subject to customary conditions, including approval by Cypress and Spansion stockholders. The transaction has been unanimously approved by the boards of directors of both companies. As of the date of this report, we have successfully obtained all necessary approvals from regulators in the U.S., Germany and Japan, and our Registration Statement on Form S-4 (a joint proxy statement/prospectus) was declared effective by the United States Securities and Exchange Commission on February 5, 2015. We expect the deal to close in the first fiscal quarter of 2015. Upon consummation, we expect to account for the merger under the acquisition method of accounting in accordance with Financial Accounting Standards Board Accounting Standard Topic 805, Business Combinations, with Cypress treated as the accounting acquirer. During the fourth quarter of fiscal 2012 we acquired Ramtron which is included in our Memory Product Division. In addition, as part of our continued efforts to better allocate key management resources and to focus on our core markets, during the first quarter of fiscal 2013, we have realigned our Data Communications Division to include our module solutions including Trackpad and Ovation™ Optical Navigation Sensors (ONS), which were previously included in our Programmable Systems Division. We evaluate our reportable business segments in accordance with the accounting guidance. As of the end of fiscal 2014, our organization included the following business segments: Business Segments Description Memory Products Division (MPD) MPD focuses on static random access memory (SRAM), nonvolatile RAMs and general-purpose programmable clocks. Its purpose is to enhance our No. 1 position in SRAMs and nonvolatile RAMs and invent new and related products. Data Communications Division (DCD) DCD focuses on USB controllers and Bluetooth® Low Energy and WirelessUSB™ solutions for industrial, handset and consumer applications. It also includes module solutions such as Trackpads and Ovation™ Optical Navigation Sensors (ONS). Programmable Systems Division (PSD) PSD focuses primarily on our PSoC® programmable system-on-chip and PSoC-based products. This business segment focuses on (1) the PSoC platform family of devices and all derivatives, including PSoC Bluetooth Low Energy solutions for the Internet of Things, (2) PSoC-based user interface products such as CapSense® capacitive-sensing and TrueTouch® touchscreen products, and (3) automotive products. Emerging Technologies Division (ETD) Also known as our “startup” division, ETD includes subsidiaries AgigA Tech Inc. and Deca Technologies Inc. and our foundry business and other development-stage activities. Our primary focus has been to resume revenue growth and increase profitability. For revenue growth, our revenue model is based on the following underlying trends: increasing our SRAM market share and expanding our memory portfolio by introducing new products, a return to growth of our revenue from PSoC platform family of devices and derivatives, increasing our DCD revenue through introduction of new products such as USB 3.0 and Bluetooth® Low Energy solutions for the Internet of Things and other applications, and significant revenue growth from companies in our ETD. For profitability, we monitor our operating expenses closely to maintain our operating leverage as driven by various company-wide initiatives, including our World Wide Cost program to continuously reduce cost line items as well as a Human Resource effort to flatten our worldwide organization to reduce cost and efficiency. In order to achieve our goals on revenue growth and profitability, Cypress will continue to pursue the following strategies: • Drive profitability. Cypress has implemented and maintained a tight, corporate wide focus on gross margin and operating expenses. We are committed to maintaining our current strong operating expense management even with revenue growth, continued new product development, and investments in our Emerging Technologies Division. • Drive programmability, extend leadership and drive PSoC proliferation. We continue to define, design and develop new programmable products and solutions that offer our customers increased flexibility and efficiency, higher performance, and higher levels of integration with a focus on analog functionality. We continue to drive PSoC adoption in large market segments. • Focus on large and growing markets. We continue to pursue business opportunities in large and growing markets. • Collaborate with customers to build system-level solutions. We work closely with customers from initial product design through manufacturing and delivery in order to optimize our customers’ design efforts, helping them achieve product differentiation, improve time-to-market and develop whole product solutions. • Leverage flexible manufacturing. Our manufacturing strategy combines capacity from leading foundries with output from our internal manufacturing facilities allowing us to meet rapid swings in customer demand while lessening the burden of high fixed costs. • Identify and exit legacy or non-strategic, underperforming businesses. We continue to monitor and, if necessary, exit certain business units that are inconsistent with our future initiatives and long-term plans so that we can focus our resources and efforts on our core programmable and proprietary business model. • Pursue complementary strategic relationships. We continue to assess opportunities to develop strategic relationships through acquisitions, investments, licensing and joint development projects. We also continue to make significant investments in current ventures as well as new ventures. As we continue to implement our strategies, there are many internal and external factors that could impact our ability to meet any or all of our objectives. Some of these factors are discussed under Item 1A. Manufacturing Strategy Our core manufacturing strategy-“flexible manufacturing”-combines capacity from foundries with output from our internal manufacturing facilities. This strategy is intended to allow us to meet rapid swings in customer demand while lessening the burden of high fixed costs, a capability that is particularly important in high-volume consumer markets that we serve with our leading programmable product portfolio. Consistent with this strategy, in fiscal 2008 we substantially completed the exit of our manufacturing facility in Texas and transferred production to our more cost-competitive facility in Minnesota and outside foundries. During 2013 we completed the sale of this manufacturing facility. See Note 7 for further information. RESULTS OF OPERATIONS Revenues Our total revenues increased approximately 0.4% for the year ended December 28, 2014 compared to the prior year. The increase in revenues for the year ended December 28, 2014 compared to the prior year was driven by the increased sales in our Emerging Tech Division ("ETD"), which increased 107.3% compared to the prior year. The increase in ETD revenue for the year ended December 28, 2014 was offset by the decrease in the unit sales volume of our PSD products where we experienced weakness in our end customers’ handset/mobile business demand. The overall average selling price of our products for the year ended December 28, 2014 remained relatively stable at $1.09 compared to $1.11 for the prior year. We have experienced, and expect to continue to experience, moderate pricing pressure in certain product lines, primarily due to competitive conditions. We have in the past been able to, and expect in the future to be able to, moderate average selling price declines in our product lines by introducing new products with more features and higher prices. We may be unable to maintain average selling prices for our products as a result of increased pricing pressure in the future, which could adversely affect our operating results. Consistent with our accounting policies and generally accepted accounting principles, we have historically recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty in estimating the ultimate price of these product shipments and amount of potential returns. We continually reassess our ability to reliably estimate the ultimate price of these products and, over the past several years, we have made investments in our systems and processes around our distribution channel to improve the quality of the information we receive from our distributors. Given these ongoing investments, and based on the financial framework we use for estimating potential price adjustments, in the fourth quarter of 2014, we concluded that we have become able to reasonably estimate returns and pricing concessions on certain product families and with certain distributors, and recognized revenue at the time we shipped these specific products to the identified distributors, less our estimate of future price adjustments and returns. For the fourth quarter of 2014, we recognized $53.2 million of revenue on a sell-in basis which represented 41% of our distribution revenue for the quarter. Included in the $53.2 million of revenue was $12.3 million of revenue recognized from the conversion of deferred revenue (inventory) that was held by those distributors at the end of our fiscal year. The impact of this change resulted in a net income benefit of $6.2 million for fiscal 2014, or $0.04 per basic and diluted share. The following table summarizes our consolidated revenues by segments: Programmable Systems Division: Revenues from the Programmable Systems Division in fiscal 2014 decreased by $9.5 million or 3.2% compared to fiscal 2013. Revenues from the Programmable Systems Division in fiscal 2013 decreased by $52.7 million or 15.3% compared to fiscal 2012.The revenue decrease in both fiscal 2014 and 2013 was primarily attributable to declines in sales of our TrueTouch® touchscreen products due to a decrease in revenue from our handset customers and lower average selling prices. The decrease was partially offset by an increase in sales of PSD products to industrial and automotive customers where we experienced a ramp in volume from new design wins. Fiscal 2014 revenue also included $8.2 million of incremental revenue as a result of the change in accounting for certain distributor revenues as discussed above. Tables of Contents Memory Products Division: Revenues from the Memory Products Division in fiscal 2014 and 2013 increased by $8.9 million and $8.5 million, respectively, primarily due to an increase in sales of nonvolatile products associated with our acquisition of Ramtron, offset by a decrease in SRAM products driven by a continuing decrease in demand from wireless and wireline end customers. Fiscal 2014 revenue also included $4.1 million of incremental revenue as a result of the change in accounting for certain distributor revenues as discussed above. Data Communications Division: Revenue for the Data Communication Division in fiscal 2014 decreased by $9.0 million or 11.4% compared to fiscal 2013 due to declining revenue in our legacy high-speed USB controllers, optical navigation and trackpad products. Revenue for the Data Communication Division in fiscal 2013 decreased by $7.2 million or 8.3% compared to fiscal 2012 due to declining revenue in our legacy USB products offset by an increase in USB3.0 and trackpad products. Emerging Technologies and Other: Revenue from the Emerging Technologies Division in fiscal 2014 increased by $12.4 million or 107.3% compared to fiscal 2013 due to increased revenue in all three business - Deca Tech, Agiga Tech and our foundry business. The increase is due to the overall increase in demand as certain of our Emerging Technologies companies begin to ramp production with new customer design wins. Revenue from the Emerging Technologies Division in fiscal 2013 increased by $4.4 million or 61.8% compared to fiscal 2012 primarily due to increase in revenue from our foundry and Deca Technologies and Agiga Tech offset by the divestiture of Cypress Envirosystems which represented $2.9 million of revenue in 2012. Cost of Revenues/Gross Margin Gross margin percentage increased to 50.1% in fiscal 2014 from 46.8% in fiscal 2013 primarily driven by lower cost of revenue expenses associated with the inventory acquired in the Ramtron acquisition, higher factory absorption and product and customer mix. Charges to cost of revenue for inventory reserve provisions were $19.8 million during fiscal 2014, unfavorably impacting our gross margin by 3%. The benefit realized from sales of inventory previously reserved were $3.7 million for fiscal year 2014, favorably impacting our gross margin by 1%. Gross margin percentage declined to 46.8% in fiscal 2013 from 51.0% in fiscal 2012 primarily driven by lower factory absorption, product and customer mix, and the impact of the negative gross margins of our ETD. Charges to cost of sales for inventory provisions were $12.8 million during fiscal 2013, unfavorably impacting our gross margin by 2%. Sales of inventory previously written-off were $5.1 million for fiscal year 2013, favorably impacting our gross margin by 1%. The overall net effect on our gross margin from charges to cost of sales for inventory provisions and sales of items previously written-off was a 1% net unfavorable impact for fiscal year 2013. Research and Development (“R&D”) R&D expenditures decreased by $26.3 million in fiscal 2014 compared to fiscal 2013. The decrease was primarily attributable to a decrease of $9.9 million in stock-based compensation and a decrease of $1.0 million in deferred compensation expense. There was an additional decrease in consulting fees and other outside services of $2.9 million and $10.0 million, Tables of Contents respectively, as a result of a worldwide cost cutting effort. As a percentage of revenues, R&D expenses were lower in fiscal 2014 driven by the decrease in total expense in the same period. R&D expenditures increased by $1.0 million in fiscal 2013 compared to fiscal 2012. The increase was primarily attributable to an increase of $4.3 million in variable bonus-related expense and an increase of $5.3 million in stock-based compensation. This amount was offset by a $4.1 million decrease in outside consulting services, license and equipment expense as a result of a worldwide cost cutting effort. As a percentage of revenues, R&D expenses were higher in fiscal 2013 driven by the decrease in total revenues in the same period. Selling, General and Administrative (“SG&A”) SG&A expenses decreased by $11.9 million in fiscal 2014, or approximately 6.5% compared to fiscal 2013. The decrease was primarily attributable to a decrease in stock-based compensation of approximately $13.4 million, a $7.9 million decrease in headcount related expenditures, a $2.0 million decrease in deferred compensation expense, a $1.6 million decrease in variable bonus-related expense, offset by $7.3 million of acquisition related expenditures associated with our proposed merger with Spansion, an increase of $2.7 million in legal fees and $1.3 million in accrued estimated legal settlements. SG&A expenses decreased by $29.3 million in fiscal 2013, or approximately 14% compared to fiscal 2012. The decrease was primarily attributable to (1) a decrease in non-recurring charges which occurred in 2012 including $6.9 million acquisition related expenses and a $1.6 million loss on the divestiture of Cypress Envirosystems; (2) company wide cost cutting efforts including a decrease in travel expense of $2.9 million and a $3.9 million reduction of advertising, marketing and other outside services and (3) a decrease in labor and benefit expense of $8.7 million due to restructuring and reduced headcount. These amounts were partially offset by a $2.5 million increase in bonus expense and a $2.1 million increase in deferred compensation expense. Amortization of Acquisition-Related Intangible Assets During fiscal 2014, amortization of acquisition-related intangible assets decreased by $1.1 million compared to fiscal 2013. The decrease is primarily related to certain intangible assets acquired during fiscal 2012 that were fully amortized during fiscal 2013. During fiscal 2013, amortization of acquisition-related intangible assets increased by $3.8 million compared to fiscal 2012. The increase is related to our Ramtron acquisition, which occurred in the fourth quarter of fiscal 2012. The increase is directly attributable to amortizing the acquired intangible assets for an entire fiscal year during 2013. Restructuring During fiscal 2013, we implemented a restructuring plan to reduce operating expenses as part of our 2013 corporate priorities. The plan included the termination of employees and the disposal of certain equipment located in our Bloomington, Minnesota facility. We recorded restructuring charges of $15.4 million and $4.3 million during fiscal 2013 and 2012, respectively, and a benefit of $1.2 million from restructuring related activities in fiscal 2014. The determination of when we accrue for severance costs, and which accounting standard applies, depends on whether the termination benefits are provided under a one-time benefit arrangement or under an on-going benefit arrangement. The benefit of $1.2 million in restructuring activities in fiscal 2014 consisted mainly of a gain on the sale of restructured property, plant and equipment for approximately $0.6 million. The $15.4 million restructuring costs recognized in fiscal 2013 primarily consisted of $8 million in personnel costs and a $6.7 million in asset write-down. The $4.3 million restructuring costs recognized in fiscal 2012 consisted primarily of personnel costs and was mainly due to the restructuring program announced in fiscal 2011. Refer to Note 10 of Notes to Consolidated Financial Statements under Item 8 for more detailed discussions on our restructuring programs for fiscal 2014, 2013 and 2012. Assets Held for Sale During fiscal 2013, we incurred a $6.7 million charge to write down certain equipment that we intended to sell to its current fair value of $2.3 million which is included in "Other current assets" in the Consolidated Balance Sheet as of December Tables of Contents 29, 2013. These assets were sold during fiscal 2014 at a net gain of approximately $0.6 million. Refer to Note 7 of Notes to Consolidated Financial Statements under Item 8 for more information on our assets held for sale. Divestitures We did not have any divestitures during fiscal 2014 or 2013. On December 19, 2012, we completed the divestiture of our wholly-owned subsidiary Cypress Envirosystems and we received nominal consideration that is dependent upon future performance. Cypress Envirosystems was an immaterial part of our ETD segment and as a result of the sale we recorded a loss of $1.6 million in “(Gain) loss on divestiture,” in the Consolidated Statement of Operations. Interest and Other Income, Net The following table summarizes the components of interest and other income, net: Employee Deferred Compensation Plan We have a deferred compensation plan, which provides certain key employees, including our executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax-deferred basis. We do not make contributions to the deferred compensation plan and we do not guarantee returns on the investments. Participant deferrals and investment gains and losses remain as our liabilities and the underlying assets are subject to claims of general creditors. In fiscal 2014, 2013 and 2012, we recognized changes in fair value of the assets under the deferred compensation plan in “Interest and other income, net” of approximately $3.0 million, $6.4 million and $3.2 million, respectively. The increase or decrease in the fair value of the investments relates to the increased or decreased performance of the portfolio on a year over year basis. Refer to Note 17 of Notes to Consolidated Financial Statements under Item 8 for more information about our deferred compensation plan. Interest expense Interest expense for fiscal 2014 and fiscal 2013 was $5.8 million and $8.1 million, respectively, and represents interest expense incurred on our revolving line of credit and other term debt. Refer to Note 14 of Notes to Consolidated Financial Statements under Item 8 for more information about our credit facilities. Impairment of Investments We review our investments periodically for impairment and recognize an impairment loss when the carrying value of an investment exceeds its fair value and the decline in value is considered other-than-temporary. In fiscal 2013 no impairment charges were recognized. During the first quarter of fiscal 2012, two of our privately-held companies which we were invested in at a carrying value of $2.4 million, offered additional rounds of financing that we declined to participate in. Based on these new rounds of financing, we determined that our investments were impaired and wrote off the $2.4 million investment in fiscal 2012. For more information about our investments, refer to Note 6 of Notes to Consolidated Financial Statements under Item 8. Gain on Sale of Investments in Marketable Equity Securities Tables of Contents In the second quarter of fiscal 2013, we sold our investment in a certain marketable equity security for $2.2 million, which resulted in a realized gain of $1.1 million. In connection with the acquisition of Ramtron, we recognized a gain of $1.7 million on our initial investment in Ramtron of $3.4 million. For more information about our acquisition, refer to Note 2 of Notes to Consolidated Financial Statements under Item 8. Unrealized loss on marketable securities In the fourth quarter of fiscal 2014, the Company, through a wholly-owned subsidiary, purchased approximately 6.9 million ordinary shares of Hua Hong Semiconductor Limited (HHSL) for an aggregate price of $10.0 million in connection with their initial public offering. HHSL is the parent company of Grace Semiconductor Manufacturing Corporation, which is one of our strategic foundry partners. We recorded an unrealized loss on our investment in HHSL’s ordinary shares of approximately $1.5 million as a result of the decline in the fair market value of the investment as of December 28, 2014. Equity in Net Loss of Equity Method Investee During fiscal 2014, we invested an additional $15 million in a battery company. The additional investment in this company increased our ownership interest in the company’s outstanding stock from 17.6% to 26.2% as of December 28, 2014 and required us to change from the cost method of accounting to the equity method of accounting for this investment. Under the equity method of accounting, we are required to record our interest in the investee's reported net income or loss for each reporting period. Additionally, we are required to present our prior period financial results to reflect the equity method of accounting from the date of the initial investment in the company. Our results of operations include charges of $5.1 million, $1.9 million, and $1.1 million, respectively, for the fiscal years ended 2014, 2013, and 2012. Refer to Note 15 of Notes to Consolidated Financial Statements under Item 8 for more detailed discussion. Income Taxes Our income tax benefit was $1.2 million for 2014. Our income tax benefit was $7.8 million for 2013. Our income tax expense was $2.3 million in fiscal 2012. The tax benefit in fiscal 2014 was primarily attributable to a release of previously accrued taxes of approximately $8.3 million related to settlements with taxing authorities and the lapsing of statutes of limitations, primarily offset by income taxes associated with our non-U.S. operations. The tax benefit in fiscal 2013 was primarily attributable to a release of previously accrued taxes of approximately $13.8 million related to settlements with taxing authorities and the lapsing of statutes of limitation, primarily offset by income taxes associated with our non-U.S. operations. The tax expense in fiscal 2012 was primarily attributable to income taxes associated with our non-U.S. operation Our effective tax rate varies from the U.S. statutory rate primarily due to earnings of foreign subsidiaries taxed at different rates and a full valuation allowance on net operating losses incurred in the U.S. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We regularly assess our tax positions in light of legislative, bilateral tax treaty, regulatory and judicial developments in the many countries in which we and our affiliates do business. Non-U.S. tax authorities have completed their income tax examinations of our subsidiary in India for fiscal years 2002-2008 and our subsidiary in the Philippines up to 2009. The proposed adjustments in India have been appealed, and we believe the ultimate outcome of these appeals will not result in a material adjustment to our tax liability. The Philippines examinations up to 2009 resulted in no material adjustments to our tax liabilities. Income tax examinations of our Philippine subsidiary for the 2010 fiscal year and our India subsidiary for the 2009-2010 fiscal years are in progress. We believe the ultimate outcome of these examinations will not result in a material adjustment to our tax liability. International revenues account for a significant portion of our total revenues, such that a material portion of our pretax income is earned and taxed outside the U.S. at rates ranging from 0% to 25%. The impact on our provision for income taxes of foreign income being taxed at rates different than the U.S. federal statutory rate was a benefit of approximately $37.5 million, $15.4 million, and $26.4 million in 2014, 2013 and 2012, respectively. The foreign jurisdictions with lower tax rates as compared to the U.S. statutory federal rate that had the most significant impact on our provision for foreign income taxes in the periods presented include the Cayman Islands, China, Ireland, the Philippines and Switzerland. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our consolidated cash, cash equivalents and short-term investments and working capital: Tables of Contents Key Components of Cash Flows Fiscal 2014: Operating Activities In fiscal 2014, net cash provided by operating activities was $103.3 million compared to $67.6 million in fiscal 2013. The increase in operating cash flows for fiscal 2014 was primarily due to an increase in net income of $66.2 million compared to fiscal 2013. Our operating cash flow for 2014 of $103.3 million was primarily due to our net income of $16.5 million, net favorable non-cash adjustments to our net income including stock-based compensation of $50.2 million and depreciation and amortization of $46.7 million, and a net change in working capital of $7.9 million. Investing Activities In fiscal 2014, net cash used in investing activities was $42.2 million compared to net cash used in investing activities of $0.3 million in fiscal 2013. The net cash used in our investing activities in fiscal 2014 was primarily due to investment purchases of $23.4 million, purchases of property and equipment of $20.9 million and investments made in other entities accounted for under the cost or equity method of accounting of $18.4 million, offset by the proceeds from sales of investments of $16.6 million. Financing Activities In fiscal 2014, net cash used in financing activities was $43.4 million compared to $45.0 million in fiscal 2013. The cash we used in our financing activities in fiscal 2014 was primarily due to payment of dividends of $69.2 million and the repayment of debt and obligations under capital leases of $6.3 million, offset by net proceeds of $32 million from the issuance of common shares under our employee stock plans. Fiscal 2013: Operating Activities In fiscal 2013, net cash provided by operating activities was $67.6 million compared to $135 million in fiscal 2012. The decrease in operating cash flows for fiscal 2013 was primarily due to an increase in net loss of $24.8 million compared to fiscal 2012. Our operating cash flow for fiscal 2013 of $67.6 million was primarily due to our net loss of $50.1 million, offset by net favorable non-cash adjustments to our net loss including stock-based compensation of $73.0 million, depreciation and amortization of $48.4 million, and a net change in working capital of $5.9 million. Investing Activities In fiscal 2013, net cash provided by investing activities was $0.3 million compared to net cash used in investing activities of $113.0 million in fiscal 2012. The cash provided by our investing activities in fiscal 2013 was primarily due to sales of investments of $64.4 million offset by investment purchases of $23.1 million, and purchases of property and equipment of $36.6 million primarily for our Emerging Technologies Division. Financing Activities In fiscal 2013, net cash used in financing activities was $45.0 million compared to $58.5 million in fiscal 2012. The cash we used in our financing activities in fiscal 2013 was primarily due to payment of dividends of $64.8 million, repayment on our Tables of Contents long term revolving credit facility (Credit facility) of $145.0 million and repayment of other debt of $17.1 million, partially offset by net proceeds of $38.7 million from the issuance of common shares under our employee stock plans, and borrowings of $140.0 million on our Credit facility. Fiscal 2012: In fiscal 2012, cash and cash equivalents decreased by approximately $36.5 million primarily due to the $113.0 million cash used in our investing activities, principally related to the cash paid for the acquisition of Ramtron. (See Note 2 for a detailed discussion of the Ramtron acquisition.) Cash and cash equivalents also decreased due to the $58.5 million cash used in our financing activities, principally related to our stock buyback program and payment of dividends, which were partially offset by cash received from our credit facility. Cash used in our investing and financing activities was partially offset by the cash generated from our operating activities of $135.0 million. Operating Activities In fiscal 2012, net cash provided by operating activities was $135.0 million compared to $283.8 million in fiscal 2011. Operating cash flows for fiscal 2012 were primarily due to $138.3 million in net favorable non-cash adjustments to our net loss including stock-based compensation of $74.3 million and depreciation and amortization of $50.8 million, an increase in accounts payable and other liabilities, and a decrease in accounts receivable, partially offset by decreases in deferred income on sales to our distributors. The significant changes in our working capital, excluding the impact of the Ramtron acquisition, as of December 30, 2012 compared to January 1, 2012 were as follows: • Accounts receivable decreased by $23.9 million due to decreased revenue and distributor shipments. • Accounts payable and other current and long-term liabilities increased by $19.4 million due to timing of purchases and payments. • Deferred margin on sales to distributors decreased by $19.1 million due to lower distributor shipments. Investing Activities In fiscal 2012, net cash used in investing activities was $113.0 million compared to net cash provided by investing activities of $69.1 million in fiscal 2011. The cash we used for our investing activities in fiscal 2012 was primarily due to the purchase of investments of $112.8 million, and $100.9 million for the acquisition of Ramtron, partially offset by proceeds from the sales or maturities and purchases of available for sale investments of $139.8 million. Financing Activities In fiscal 2012, net cash used in financing activities was $58.5 million compared to $516.4 million in fiscal 2011. The cash we used in our financing activities in fiscal 2012 was primarily due to $209.2 million cash used to repurchase shares of our stock, $22.6 million related to statutory income tax withholdings paid on vested restricted stock awards in lieu of issuing shares of stock and $63.2 million dividends paid in fiscal 2012. These amounts were partially offset by $232.0 million of borrowings under our revolving facility and line of credit, net of the repayment of our previous line of credit. Liquidity Stock Repurchase Programs: On September 20, 2011, our Board authorized a new $400.0 million stock buyback program. The program allows us to purchase our common stock or enter into equity derivative transactions related to our common stock. The timing and actual amount expended with the new authorized funds will depend on a variety of factors including the market price of our common stock, regulatory, legal, and contractual requirements, alternatives uses of cash, availability of on shore cash and other market factors. The program does not obligate us to repurchase any particular amount of common stock and may be modified or suspended at any time at our discretion. From September 2011 through the end of fiscal 2014, we used approximately $316.8 million from this program to repurchase approximately 23.6 million shares at an average share price of approximately $13.43. As of December 28, 2014, $83.3 million remained available for future stock repurchases. Yield Enhancement Program (“YEP”): As discussed in Item 5 above and in Note 14 of the Notes to Consolidated Financial Statements under Item 8, we have periodically entered into short term yield enhanced structured agreements since fiscal 2009. In fiscal 2014, we entered into short-term yield enhanced structured agreements with maturities ranging from 30 to 45 at an aggregate price of approximately $19.4 million. Upon settlement of these agreements, we received approximately $19.7 million in cash. In fiscal 2013 we didn’t enter into any short-term yield enhanced structured agreements. In fiscal 2012, we entered into short-term yield enhanced Tables of Contents structured agreements with maturities of 30 days or less for an aggregate price of approximately $14.5 million. Upon settlement of these agreements, we received approximately $14.9 million in cash. Senior Secured Revolving Credit Facility On June 26, 2012, we entered into a five-year senior secured revolving credit facility (“Credit Facility”) with a group of lenders led by Morgan Stanley Senior Funding, Inc. The Credit Facility enables us to borrow up to $430 million on a revolving basis. Borrowing terms vary based on the type of borrowing with all outstanding balances being due at the credit facility termination date, or June 25, 2017. Outstanding amounts may be repaid prior to maturity without penalty and are mandatory for certain asset sales and casualty events. The current outstanding borrowings bear interest at LIBOR plus 2.25% on the drawn amount. There is a commitment fee payable of 0.375% per annum on any undrawn amounts. The Credit Facility contains customary affirmative, negative and financial covenants for similarly rated companies. On October 17, 2013, we amended our credit facility to reduce the revolving commitments to $300 million. In connection with the reduction, certain financial covenants were amended. The amended financial covenants include the following conditions: 1) maximum senior secured leverage ratio of 2.50 to 1.00 through January 1, 2017 and 2.25 to 1.00 thereafter, 2) maximum total leverage ratio of 4.25 to 1.00 through January 3, 2015, 3.5 to 1.00 through January 1, 2017 and 3.00 to 1.00 thereafter, 3) minimum fixed charge coverage ratio of 1.00 to 1.00, and 4) minimum liquidity of at least $100 million. Borrowings are collateralized by substantially all assets of the company. At December 28, 2014, our outstanding borrowings of $227 million were recorded as part of long-term liabilities and are presented as “Long-term revolving credit facility” in the Consolidated Balance Sheet. As of December 28, 2014, we were in compliance with all of the financial covenants under the Credit Facility. Refer to Note 14 of Notes to Consolidated Financial Statements under Item 8 for more information on our senior secured revolving credit facility. Auction Rate Securities (“ARS”): During fiscal 2012 ARS with a par value of $10.0 million were called for redemption at par and ARS with a par value of $5.0 million were sold at 98.25 of par, which resulted in the reversal of unrealized losses of $1.3 million. During the first quarter of fiscal 2013, ARS with a par value of $1.0 million were sold at 98.38% of par, which resulted in the reversal of unrealized losses of $0.1 million. During the fourth quarter of fiscal 2013, we sold all remaining ARS with a par value of $4.8 million and recognized a realized loss on the sale of $0.1 million. Refer to Note 5 of Notes to Consolidated Financial Statements under Item 8 for more information on our auction rate securities. Contractual Obligations The following table summarizes our contractual obligations as of December 28, 2014: 1. Purchase obligations primarily include non-cancelable purchase orders for materials, services, manufacturing equipment, building improvements and supplies in the ordinary course of business. Purchase obligations are defined as enforceable agreements that are legally binding on us and that specify all significant terms, including quantity, price and timing. Tables of Contents 2. On April 30, 2012, we entered into a patent license agreement whereby we paid a total patent license fee of $14.0 million in fiscal 2012 and committed to pay another $5.9 million on or before April 30, 2016 representing fees for future purchases of patents and patent related services. As of December 28, 2014, our unrecognized tax benefits were $11.6 million, which were classified as long-term liabilities. We believe it is possible that we may recognize approximately $1.0 million to $1.5 million of our existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of agreements with domestic and various foreign tax authorities. Capital Resources and Financial Condition Our long-term strategy is to maintain a minimum amount of cash for operational purposes and to invest the remaining amount of our cash in interest-bearing and highly liquid cash equivalents and debt securities, the purchase of our stock through our stock buyback program and payments of regularly scheduled cash dividends. In addition we may use excess cash to invest in our ETD, enter into strategic investments and partnerships and pursue acquisitions. As of December 28, 2014, in addition to $103.7 million in cash and cash equivalents, we had $15.1 million invested in short-term investments for a total cash and short-term investment position of $118.8 million that is available for use in current operations. As of December 28, 2014, approximately 20% of our cash and cash equivalents and available for sale investments are offshore funds. While these amounts are primarily invested in U.S. dollars, a portion is held in foreign currencies. All offshore balances are exposed to local political, banking, currency control and other risks. In addition, these amounts, if repatriated may be subject to tax and other transfer restrictions. We believe that liquidity provided by existing cash, cash equivalents and investments and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, should prevailing economic conditions, debt covenants constraints, and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. We may also choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives including the acquisition of other companies, repurchases of shares of stock or increase our dividends or pay a special dividend and provide us with additional flexibility to take advantage of other business opportunities that arise. Non-GAAP Financial Measures To supplement its consolidated financial results presented in accordance with GAAP, Cypress uses non-GAAP measures to assess the following financial measures which are adjusted from the most directly comparable GAAP financial measures: • Gross margin • Research and development expenses • Selling, general and administrative expenses • Operating income (loss) • Net income (loss) • Diluted net income (loss) per share The non-GAAP measures set forth above exclude charges primarily related to stock-based compensation, which represented approximately 72% of total adjustments for the year ended December 28, 2014, as well as restructuring charges, acquisition-related expenses and other adjustments. Management believes that these non-GAAP financial measures reflect an additional and useful way of viewing aspects of Cypress’s operations that, when viewed in conjunction with Cypress’s GAAP results, provide a more comprehensive understanding of the various factors and trends affecting Cypress’s business and operations. Management uses these non-GAAP measures for strategic and business decision-making, internal budgeting, forecasting and resource allocation processes. In addition, these non-GAAP financial measures facilitate management’s internal comparisons to Cypress’s historical operating results and comparisons to competitors’ operating results. Pursuant to the requirements of Regulation G and to make clear to our investors the adjustments we make to GAAP measures, we have provided a reconciliation of the non-GAAP measures to the most directly comparable GAAP financial measures. Tables of Contents We believe that providing these Non-GAAP financial measures, in addition to the GAAP financial results, are useful to investors because they allow investors to see our results “through the eyes” of management as these Non-GAAP financial measures reflect our internal measurement processes. Management believes that these Non-GAAP financial measures enable investors to better assess changes in each key element of our operating results across different reporting periods on a consistent basis and provides investors with another method for assessing our operating results in a manner that is focused on the performance of our ongoing operations. Tables of Contents CYPRESS SEMICONDUCTOR CORPORATION RECONCILIATION OF GAAP FINANCIAL MEASURES TO NON-GAAP FINANCIAL MEASURES (In thousands, except per-share data) (Unaudited) Tables of Contents CYPRESS SEMICONDUCTOR CORPORATION RECONCILIATION OF GAAP FINANCIAL MEASURES TO NON-GAAP FINANCIAL MEASURES (In thousands, except per-share data) (Unaudited) Tables of Contents (1) In the first quarter of fiscal 2014, the Company changed the manner in which it accounted for one of its investments in an entity from the cost method of accounting to the equity method of accounting. The Company has restated is historical financial statements for all periods presented as if the Company had accounted for its investment in the entity under the equity method of accounting. See Note 15. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K and the data used to prepare them. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and we are required to make estimates, judgments and assumptions in the course of such preparation. Note 1 of Notes to Consolidated Financial Statements under Item 8 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an ongoing basis, we re-evaluate our judgments and estimates including those related to revenue recognition, allowances for doubtful accounts receivable, inventory valuation, valuation of long-lived assets, goodwill and financial instruments, stock-based compensation, and settlement costs, and income taxes. We base our estimates and judgments on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies that are affected by significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements are as follows: Revenue Recognition: We generate revenues by selling products to distributors, various types of manufacturers including original equipment manufacturers (“OEMs”) and electronic manufacturing service providers (“EMSs”). We recognize revenue on sales to OEMs and EMSs provided that persuasive evidence of an arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations. Sales to certain distributors are made under agreements which provide the distributors with price protection, other allowances and stock rotation under certain circumstances. Given the uncertainties associated with the rights given to these distributors, revenues and costs related to distributor sales are deferred until products are sold by the distributors to the end customers. Revenues are recognized from those distributors when the products have been sold to the end customers. At the time of shipment to those distributors, we record a trade receivable for the selling price since there is a legally enforceable right to receive payment, relieve inventory for the value of goods shipped since legal title has passed to the distributors, and defer the related margin as deferred margin on sales to distributors in the Consolidated Balance Sheets. The effects of distributor price adjustments are recorded as a reduction to deferred revenue at the time the distributors sell the products to the end customers. We have historically recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty in estimating the ultimate price of these product shipments and amount of potential returns. We continually reassess our ability to reliably estimate the ultimate price of these products and, over the past several years, we have made investments in our systems and processes around our distribution channel to improve the quality of the information we receive from our distributors. Given these ongoing investments, and based on the financial framework we use for estimating potential price adjustments, in the fourth quarter of 2014, we concluded that we have become able to reasonably estimate returns and pricing concessions on certain product families and with certain distributors, and recognized revenue at the time we shipped these specific products to the identified distributors, less our estimate of future price adjustments and returns. As a result of this change, we recognized an incremental $12.3 million of revenue during the fourth quarter of fiscal 2014. The impact of this change resulted in an increase of $6.2 million to net income attributable to Cypress for fiscal 2014, or $0.04 per basic and diluted share. We record as a reduction to revenues reserves for sales returns, price protection and allowances, based upon historical experience rates and for any specific known customer amounts. We also provide certain distributors and EMSs with volume-pricing discounts, such as rebates and incentives, which are recorded as a reduction to revenues at the time of sale. Historically these volume discounts have not been significant. Our revenue reporting is highly dependent on receiving pertinent, accurate and timely data from our distributors. Distributors provide us periodic data regarding the product, price, quantity, and end customer when products are resold as well as the quantities of our products they still have in stock. Because the data set is large and complex and because there may be errors in the reported data, we must use estimates and apply judgments to reconcile distributors’ reported inventories to their activities. Actual results could vary materially from those estimates. Allowances for Doubtful Accounts Receivable: Tables of Contents We maintain an allowance for doubtful accounts for losses that we estimate will arise from our customers’ inability to make required payments. We make estimates of the collectability of our accounts receivable by considering factors such as historical bad debt experience, specific customer creditworthiness, the age of the accounts receivable balances and current economic trends that may affect a customer’s ability to pay. If the data we use to calculate the allowance for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and our results of operations could be materially affected. Valuation of Inventories: Management periodically reviews the adequacy of our inventory reserves. We record a write-down for our inventories which have become obsolete or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventories each quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans and current sales levels. Inventory reserves are not relieved until the related inventory has been sold or scrapped. Our inventories may be subject to rapid technological obsolescence and are sold in a highly competitive industry. If there were a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to record additional write-downs, and our gross margin could be adversely affected. Valuation of Long-Lived Assets: Our business requires heavy investment in manufacturing facilities and equipment that are technologically advanced but can quickly become significantly under-utilized or rendered obsolete by rapid changes in demand. In addition, we have recorded intangible assets with finite lives related to our acquisitions. We evaluate our long-lived assets, including property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors considered important that could result in an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the assets or the strategy for our business, significant negative industry or economic trends, and a significant decline in our stock price for a sustained period of time. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analysis. If there is a significant adverse change in our business in the future, we may be required to record impairment charges on our long-lived assets. Valuation of Goodwill: Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. The carrying amount of goodwill at December 28, 2014 was $65.7 million, $33.9 million in the Memory Products Division (“MPD”) and $31.8 million in the Programmable System Division (“PSD”). The goodwill related to MPD was recorded as part of the acquisition of Ramtron in the fourth quarter of fiscal 2012. The goodwill related to PSD was unchanged from the balance at December 29, 2013. MPD and PSD are the only reportable business segments with goodwill. We assess our goodwill for impairment on an annual basis and, if certain events or circumstances indicate that an impairment loss may have been incurred, on an interim basis. In accordance with ASU 2011-08, Testing Goodwill for Impairment, qualitative factors can be assessed to determine whether it is necessary to perform the current two-step test for goodwill impairment. If we believe, as a result of our qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. In fiscal 2014 and fiscal 2012, we elected to perform a qualitative analysis for impairment on goodwill rather than to perform the two-step quantitative goodwill impairment test. We assessed qualitative factors to determine whether it was necessary to perform the two-step goodwill impairment test. After assessing many qualitative factors pertinent to our Company we determined that it was more likely than not that the fair value of our reporting unit exceeds its carrying amount. In assessing the qualitative factors, we considered the impact of these key factors: 1) change in the industry and competitive environment, 2) market capitalization, 3) stock price and 4) overall financial performance. Based on the results of the testing, no goodwill impairment was recognized in fiscal 2014 and fiscal 2012. In fiscal 2013 we elected to perform the two-step quantitative goodwill impairment test in 2013. The first step of a quantitative goodwill impairment test is to identify a potential impairment by comparing the fair value of a reporting unit with its carrying amount. The second step compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. Based on the results of the testing, no goodwill impairment was recognized in fiscal 2013. Tables of Contents Fair Value of Financial Instruments: Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Our financial assets and financial liabilities that require recognition under the guidance generally include available-for-sale investments, employee deferred compensation plan and foreign currency derivatives. The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of us. Unobservable inputs are inputs that reflect our assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. As such, fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measure. The hierarchy is broken down into three levels based on the reliability of inputs as follows: • Level 1 includes instruments for which quoted prices in active markets for identical assets or liabilities that we have the ability to access. Our financial assets utilizing Level 1 inputs include U.S. treasuries, money market funds, marketable equity securities and our employee deferred compensation plan assets with the exception of our stable value funds which are considered Level 2 instruments. • Level 2 includes instruments for which the valuations are based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities. Level 2 assets consist of certain marketable debt instruments for which values are determined using inputs that are observable in the market or can be derived principally from or corroborated by observable market data. Our Level 2 instruments include certain U.S. government securities, commercial paper, corporate notes and bonds, assets held-for-sale and our employee deferred compensation plan liabilities and our stable value funds included in our deferred compensation plan assets. • Level 3 includes valuations based on inputs that are unobservable and significant to the overall fair value measurement. Financial assets utilizing Level 3 inputs primarily include auction rate securities. We sold our entire investment in auction rate securities during 2013. Prior to the sale, we used an income approach valuation model to estimate the exit price of the auction rate securities, which is derived as the weighted-average present value of expected cash flows over various periods of illiquidity, using a risk adjusted discount rate that is based on the credit risk and liquidity risk of the securities. Availability of observable inputs can vary from instrument to instrument and to the extent that valuation is based on inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment. Accordingly, the degree of judgment exercised by our management in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, for disclosure purposes the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety. In regards to our auction rate securities, the income approach valuation model was based on both Level 2 (credit quality and interest rates) and Level 3 inputs. We determined that the Level 3 inputs were the most significant to the overall fair value measurement, particularly the estimates of risk adjusted discount rates and ranges of expected periods of illiquidity. Stock-Based Compensation: Under the fair value recognition provisions of the guidance, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest over the requisite service period of the awards. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including measurement of level of achievement of performance milestones, the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, our future stock-based compensation expense could be significantly different from what we have recorded. Accounting for Income Taxes: Our global operations involve manufacturing, research and development and selling activities. Profits from non-U.S. activities are subject to local country taxes but are not subject to U.S. tax until repatriated to the U.S. It is our intention to permanently reinvest these earnings outside the U.S. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We consider historical levels of income, expectations and risks associated Tables of Contents with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. Should we determine that we would be able to realize deferred tax assets in the future in excess of the net recorded amount, we would record an adjustment to the deferred tax asset valuation allowance. This adjustment would increase income in the period such determination is made. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate tax assessment, a further charge to expense would result. Recent Accounting Pronouncements See "Recent Accounting Pronouncements" in Note 1 of Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.

<s>[INST] The Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties, which are discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress”) delivers highperformance, mixedsignal, programmable solutions that provide customers with rapid timetomarket and exceptional system value. Cypress offerings include our flagship PSoC® 1, PSoC 3, PSoC 4 and PSoC 5LP programmable systemonchip families. Cypress is the world leader in capacitive user interface solutions including CapSense® touch sensing, TrueTouch® touchscreens, and trackpad solutions for notebook PCs and peripherals. Cypress is also a significant participant in Universal Serial Bus (USB) controllers, which enhance connectivity and performance in a wide range of consumer and industrial products. Cypress is also the world leader in static random access memory (SRAM) and nonvolatile RAM memories. Cypress serves numerous major markets, including industrial, mobile handsets, consumer, computation, data communications, automotive, industrial and military. On December 1, 2014, Cypress announced that it entered into a definitive agreement to merge with Spansion, Inc., a leading designer, manufacturer and developer of embedded systems semiconductors, in an allstock, taxfree transaction. The postmerger company is expected to generate approximately $2 billion in revenue annually and realize more than $135 million in cost synergies on an annualized basis within three years, and create a leading global provider of microcontrollers and specialized memories needed in today's embedded systems. Under the terms of the agreement, Spansion shareholders will receive 2.457 Cypress shares for each Spansion share they own. The shareholders of each company will initially own approximately 50 percent of the postmerger company. The closing of the transaction is subject to customary conditions, including approval by Cypress and Spansion stockholders. The transaction has been unanimously approved by the boards of directors of both companies. As of the date of this report, we have successfully obtained all necessary approvals from regulators in the U.S., Germany and Japan, and our Registration Statement on Form S4 (a joint proxy statement/prospectus) was declared effective by the United States Securities and Exchange Commission on February 5, 2015. We expect the deal to close in the first fiscal quarter of 2015. Upon consummation, we expect to account for the merger under the acquisition method of accounting in accordance with Financial Accounting Standards Board Accounting Standard Topic 805, Business Combinations, with Cypress treated as the accounting acquirer. During the fourth quarter of fiscal 2012 we acquired Ramtron which is included in our Memory Product Division. In addition, as part of our continued efforts to better allocate key management resources and to focus on our core markets, during the first quarter of fiscal 2013, we have realigned our Data Communications Division to include our module solutions including Trackpad and Ovation™ Optical Navigation Sensors (ONS), which were previously included in our Programmable Systems Division. We evaluate our reportable business segments in accordance with the accounting guidance. As of the end of fiscal 2014, our organization included the following business segments: Business Segments Description Memory Products Division (MPD) MPD focuses on static random access memory (SRAM), nonvolatile RAMs and generalpurpose programmable clocks. Its purpose is to enhance our No. 1 position in SRAMs and nonvolatile RAMs and invent new and related products. Data Communications Division (DCD) DCD focuses on USB controllers and Bluetooth® Low Energy and WirelessUSB™ solutions for industrial, handset and consumer applications. It also includes module solutions such as Trackpads and Ovation™ Optical Navigation Sensors (ONS). Programmable Systems Division (PSD) PSD focuses primarily on our PSoC® programmable systemonchip and PSoC [/INST] Positive. </s>

CYPRESS SEMICONDUCTOR CORP /DE/

2016-03-02

2016-01-03

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that involve risks and uncertainties, which are discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress”) delivers high-performance, high-quality solutions at the heart of today’s most advanced embedded systems, from automotive, industrial and networking platforms to highly interactive consumer and mobile devices. With a broad, differentiated product portfolio that includes NOR flash memories, F-RAM™ and SRAM, Traveo™ microcontrollers, the industry’s only PSoC® programmable system-on-chip solutions, analog and PMIC Power Management ICs, CapSense® capacitive touch-sensing controllers, and Wireless BLE Bluetooth Low-Energy and USB connectivity solutions, Cypress is committed to providing its customers worldwide with consistent innovation, best-in-class support and exceptional system value. Merger with Spansion On March 12, 2015, we completed the merger (“Merger”) with Spansion Inc. (“Spansion”) pursuant to the Agreement and Plan of Merger and Reorganization, as of December 1, 2014 (the “Merger Agreement”), for a total consideration of approximately $2.8 billion. In accordance with the terms of the Merger Agreement, Spansion shareholders received 2.457 Cypress shares for each Spansion share they owned. The Merger has been accounted for under the acquisition method of accounting in accordance with Financial Accounting Standards Board Accounting Standard Topic 805, Business Combinations, with Cypress treated as the accounting acquirer. The post-Merger company is expected to realize more than $160 million in cost synergies on an annualized basis within two years, and create a leading global provider of microcontrollers and specialized memories needed in today's embedded systems. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations includes the financial results of legacy Spansion beginning March 12, 2015. The comparability of our operating results for the year ended January 3, 2016 to the same period in fiscal 2014 is significantly impacted by our Merger. In our discussion and analysis of comparative periods, we have quantified the contribution of additional revenue or expense resulting from this transaction wherever such amounts were material and identifiable. While identified amounts may provide indications of general trends, the analysis cannot completely address the effects attributable to integration efforts. Divestiture of TrueTouch® Business On August 1, 2015, we completed the sale of the TrueTouch® mobile touchscreen business, which is a business unit within our Programmable Systems Division, to Parade Technologies (“Parade”) for total cash proceeds of $98.6 million pursuant to the definitive agreement signed on June 11, 2015. Of the total cash proceeds, $10.0 million are held in an escrow account until January 2017 subject to any indemnity claims on post-closing adjustments, per the terms of the agreement. Post-sale, Cypress will continue to provide TrueTouch® solutions to its automotive, industrial and home appliance customers and to its mobile customers. In connection with the transaction, we sold certain assets associated with the disposed business mostly consisting of inventory with a net book value of $10.5 million and recognized a gain of $66.5 million in the third fiscal quarter of fiscal 2015. This gain has been presented as a separate line item “Gain on divestiture of TrueTouch® mobile business” in the Consolidated Statements of Operations. Also in connection with the transaction, we entered into a Manufacturing Service Agreement (MSA) in which we agreed to sell finished wafers and devices to Parade during the one-year period following the close of the transaction. The terms of the MSA indicated that we would sell finished products to Parade at agreed-upon prices that were considered below fair market value, indicating that there was an embedded fair value that would be realized by Parade through those terms. Accordingly, we have allocated $19.9 million from the $98.6 million proceeds to the fair value of the MSA based on the forecasted wafer sales to Parade for the subsequent one-year period. Such amount was deferred on our consolidated balance sheet initially and is being amortized to revenue as we sell products to Parade. During the year ended January 3, 2016, we recognized $5.7 million of revenue from amortization of such deferred revenue. As of the end of fiscal 2015, our organization included the following business segments: Business Segments Description PSD: Programmable Systems Division PSD focuses on high-performance, programmable solutions. The programmable portfolio includes high-performance Traveo™ automotive microcontrollers, PSoC® programmable system-on-chip products, ARM® Cortex®-M4, -M3, -M0+ microcontrollers and R4 CPUs, analog PMIC Power Management ICs, CapSense® capacitive-sensing controllers, TrueTouch® touchscreen and fingerprint reader products, and PSoC Bluetooth Low Energy solutions for the IoT. PSD added Spansion’s microcontroller and analog products starting March 12, 2015. MPD: Memory Products Division MPD focuses on high-performance parallel and serial NOR flash memories, NAND flash memories, static random access memory (SRAM), and high-reliability F-RAM™ ferroelectric memory devices. Its purpose is to enhance our position in these products and invent new products and derivatives. MPD added Spansion’s Flash memory products starting March 12, 2015. DCD: Data Communications Division DCD focuses on USB controllers, Bluetooth® Low Energy solutions that leverage Cypress’s PRoC™ programmable radio-on-chip technology, WirelessUSB™ solutions, module solutions such as trackpads and Bluetooth Low Energy modules, and controllers for the new USB Type-C standard, which enables data transmission and power delivery over a single cable with a slimmer plug. DCD focuses primarily on industrial, handset and consumer electronics markets and applications. ETD: Emerging Technologies Division Also known as our “startup” division, ETD includes subsidiaries AgigA Tech Inc. and Deca Technologies Inc., as well as our foundry business and other development-stage activities. Our primary focus is profitable growth in our key markets. With the addition of the legacy Spansion business, we plan to capitalize on our expanded product portfolio and leadership positions in embedded processing and specialized memories to significantly extend our penetration of global markets such as automotive, industrial, communications, consumer, computation, data communications, mobile handsets and military. Our revenue model is based on the following product and market strategies: (a) increasing market share in our memory products by leveraging our market position and expanding our portfolio with new and complementary products, (b) growing revenue from our high-performance, programmable solutions and derivatives including PSoC programmable system-on-chip products and microcontrollers in the automotive and industrial markets, (c) increasing our DCD revenue through the introduction of new products such as USB Type-C solutions, SuperSpeed USB 3.0 peripheral controllers and Bluetooth® Low Energy solutions that leverage Cypress’s PRoC™ programmable radio-on-chip technology for the IoT and other applications, and (d) revenue growth from ETD, which includes our internal startup companies. For profitability, our focus is to integrate the acquired Spansion business successfully and realize the anticipated product cost and operational cost synergies. Our integration effort includes the re-focusing of portions of legacy Spansion business to higher-margin opportunities, particularly in the Flash memory business. We monitor our operating expenses closely to improve our operating leverage as driven by various company-wide initiatives, including our World Class Cost program to continuously reduce cost line items as well as a Human Resources effort to reduce redundancy and improve efficiency across the company. In order to achieve our goals on revenue growth and profitability, Cypress will continue to pursue the following strategies: · Successfully integrate our business with Spansion. We are committed to integrating the business of Cypress and Spansion successfully to realize the anticipated cost synergies and improve the bottom line. · Cross-sell products from Cypress’s expanded product portfolio in the wake of the Spansion Merger. We will continue to take advantage of product and business synergies and grow our top-line revenue. · Focus on large and growing markets. We will continue to pursue business opportunities in large and growing markets, particularly the automotive and industrial markets. · Drive profitability. Cypress has implemented and maintained a tight, corporate wide focus on gross margin and operating expenses. We are committed to maintaining our current strong operating expense management without compromising our new product development and investments in our Emerging Technologies Division. · Drive programmable technologies, extend our leadership in programmable products and drive PSoC and microcontroller proliferation. We will continue to define, design and develop new programmable products and solutions that offer our customers increased flexibility and efficiency, higher performance, and higher levels of integration with a focus on analog functionality. We will continue to drive PSoC and microcontroller adoption in our key market segments. · Collaborate with customers to build system-level solutions. We work closely with our customers from initial product design through manufacturing and delivery to optimize their design efforts, help them achieve product differentiation, improve their time-to-market and help them to develop whole product solutions. · Leverage flexible manufacturing. Our manufacturing strategy combines capacity from leading foundries with output from our internal manufacturing facilities. This enables us to meet rapid swings in customer demand while reducing the burden of high fixed costs. · Identify and exit legacy or non-strategic, underperforming businesses. We will continue to monitor and, if necessary, to exit certain business units that are inconsistent with our future initiatives and long-term financial plans so that we can focus our resources and efforts on our core programmable and proprietary business model. The sale of our TrueTouch® mobile touchscreen business to Parade Technologies, Ltd. during the third quarter of 2015 is an example of this business strategy. · Pursue complementary strategic relationships. We will continue to assess opportunities to develop strategic relationships through acquisitions, investments, licensing and joint development projects. We also will continue to make significant investments in current ventures as well as new ventures. As we continue to implement our strategies, there are many internal and external factors that could impact our ability to meet any or all of our objectives. Some of these factors are discussed under Item 1A. Manufacturing Strategy Our core manufacturing strategy-”flexible manufacturing”-combines capacity from foundries with output from our internal manufacturing facilities. This strategy is intended to allow us to meet rapid swings in customer demand while lessening the burden of high fixed costs, a capability that is particularly important in high-volume consumer markets that we serve with our leading programmable product portfolio. RESULTS OF OPERATIONS Revenues Our total revenues increased by $882.4 million or 121.6% to $1,607.9 million for the year ended January 3, 2016 compared to the prior year. For the year ended January 3, 2016, $962.3 million of the increase was attributable to revenue contributions from the acquired Spansion business which is included in the PSD and MPD divisions. The overall increase was partially offset by decrease in revenue from TrueTouch® mobile business as a result of divestiture of the business on August 1, 2015. The overall average selling price of our products, including Spansion products, for the year ended January 3, 2016 was $1.09. Excluding Spansion products, our ASP for the year ended January 3, 2016 was $1.14, which increased by $0.05 compared with the same period in the prior year. The Company operates on a 52 or 53 week year ending on the Sunday nearest to December 31. Fiscal 2014 and 2013 were each 52 weeks and fiscal 2015 was a 53-week year, with the extra week in the fourth fiscal quarter. The additional week in 2015 did not materially affect the Company's results of operations or financial position. We have experienced, and expect to continue to experience, moderate pricing pressure in certain product lines, primarily due to competitive conditions. We have in the past been able to, and expect in the future to be able to, moderate average selling price declines in our product lines by introducing new products with more features and higher prices. We may be unable to maintain average selling prices for our products as a result of increased pricing pressure in the future, which could adversely affect our operating results. Consistent with our accounting policies and generally accepted accounting principles, we have historically recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty in estimating the ultimate price of these product shipments and amount of potential returns. We continually reassess our ability to reliably estimate the ultimate price of these products and, over the past several years, we have made investments in our systems and processes around our distribution channel to improve the quality of the information we receive from our distributors. Given these ongoing investments, and based on the financial framework we use for estimating potential price adjustments, beginning in the fourth quarter of 2014, we concluded that we have become able to reasonably estimate returns and pricing concessions on certain product families and with certain distributors, and recognized revenue at the time we shipped these specific products to the identified distributors, less our estimate of future price adjustments and returns. During the year ended January 3, 2016, we recognized an incremental $40.9 million of revenue on additional product families for which revenue was previously recognized on a sell-through basis as we determined that we could reasonably estimate returns and pricing concessions at the time of shipment to distributors. This change resulted in a decrease to the net loss of $25.0 million for the year ended January 3, 2016 or $0.07 per basic and diluted share. The following table summarizes our consolidated revenues by segments: Programmable Systems Division: Revenues from the Programmable Systems Division in fiscal 2015 increased by $330.7 million or 116.8% compared to fiscal 2014. The increase in fiscal 2015 was primarily due to the $402.3 million of revenue contribution from the Spansion microcontroller and analog business for fiscal 2015. Excluding the impact of Spansion revenues, PSD decreased by $71.6 million for fiscal 2015, or 25.3%, compared to the prior year primarily due to weakness in our end customers’ handset/mobile business demand, decrease in revenue from TrueTouch® mobile business as a result of divestiture of the business on August 1, 2015 and incremental revenue in fiscal 2014 as a result of the change in accounting for certain distributor revenues. The decrease was partially offset by an increase in sales of PSD products to the automotive applications, where we experienced a ramp in volume from recent design wins. Revenues from the Programmable Systems Division in fiscal 2014 decreased by $9.5 million or 3.2% compared to fiscal 2013. The revenue decrease in fiscal 2014 was primarily attributable to declines in sales of our TrueTouch® touchscreen products due to a decrease in revenue from our handset customers and lower average selling prices. The decrease was partially offset by an increase in sales of PSD products to industrial and automotive customers where we experienced a ramp in volume from new design wins. Fiscal 2014 revenue also included $8.2 million of incremental revenue as a result of the change in accounting for certain distributor revenues as discussed above. Memory Products Division: Revenues from the Memory Products Division increased in fiscal 2015 by $523.8 million or 150.6% compared to fiscal 2014. The increase was primarily due to $560.0 million of revenue contribution from the Spansion flash memory business for fiscal 2015. Excluding the impact of Spansion revenues, MPD decreased by $36.2 million or 10.4% in fiscal 2015 compared to the prior year primarily driven by sales decrease in the communication market segment. Revenues from the Memory Products Division in fiscal 2014 increased by $8.9 million or 2.6% as compared to fiscal 2013, primarily due to an increase in sales of nonvolatile products associated with our acquisition of Ramtron in fiscal 2012, offset by a decrease in SRAM products driven by a continuing decrease in demand from wireless and wireline end customers. Fiscal 2014 revenue also included $4.1 million of incremental revenue as a result of the change in accounting for certain distributor revenues as discussed above. Data Communications Division: Revenue for the Data Communication Division in fiscal 2015 increased by $2.4 million or 3.4% compared to fiscal 2014 due to increasing revenue in our super speed USB products, offset by a decline in our trackpad products.. Revenue for the Data Communication Division in fiscal 2014 decreased by $9.0 million or 11.4% compared to fiscal 2013 due to declining revenue in our legacy high-speed USB controllers, optical navigation and trackpad products. Emerging Technologies and Other: Revenues from the Emerging Technologies Division increased by $25.5 million or 106.2% in fiscal 2015 compared to the prior year primarily due to the overall increase in demand at all of our Emerging Technologies companies. The increase was also attributable to increase in our Foundry revenues as we began selling products to Parade Technologies in August 2015 under the Manufacturing Services Agreement, which was signed in connection with our disposition of TrueTouch® mobile business. Revenue from the Emerging Technologies Division in fiscal 2014 increased by $12.4 million or 107.3% compared to fiscal 2013 due to increased revenue in all three business - Deca Tech, Agiga Tech and our foundry business. The increase is due to the overall increase in demand as certain of our Emerging Technologies companies begin to ramp production with new customer design wins. Cost of Revenues/Gross Margin Gross margin consists of Revenues less Cost of revenues, and gross margin percentage is percentage of gross margin to revenue. Our gross margin can vary in any period depending on factors such as the mix of types of products sold and the impact of changes to inventory provisions, such as the write-down of inventory. Our gross margin is significantly impacted by the mix of products we sell, which is often difficult to estimate with accuracy. Therefore, if we achieve significant revenue growth in our lower margin product lines, or if we are unable to earn as much revenue as we expect from higher margin product lines, our gross margin may be negatively impacted. Gross margin percentage declined to 24.9% in fiscal 2015 from 50.1% in fiscal 2014. The decrease in gross margin for fiscal 2015 was primarily due to impact of the merger with Spansion, which historically had lower gross margins than Cypress, and $133.0 million of additional inventory reserves which were recorded on inventory assumed as a part of the Merger. The additional reserves on inventory were recognized as part of our strategy to focus on high margin, profitable business as a combined company. Total charges to cost of sales for inventory provisions, including reserves on inventory assumed as part of the Merger, totaled $152.5 million for fiscal 2015 and $19.8 million for fiscal 2014, unfavorably impacting our gross margin by 9.5% and 3.0%, respectively. Sales of inventory that was previously written-off or written-down totaled $6.4 million for fiscal 2015 and $3.7 million for fiscal 2014, favorably impacting our gross margin by 0.4% and 1.0%, respectively. Our gross margin for fiscal 2015 was also impacted by $84.4 million of amortization of fair value adjustments, net of reserves, relating to acquired legacy Spansion inventory. Gross margin percentage increased to 50.1% in fiscal 2014 from 46.8% in fiscal 2013 primarily driven by lower cost of revenue expenses associated with the inventory acquired in the Ramtron acquisition, higher factory absorption and product and customer mix. Charges to cost of revenue for inventory reserve provisions were $19.8 million during fiscal 2014 and $12.8 million for fiscal 2013, unfavorably impacting our gross margin by 3% and 2%, respectively. The benefit realized from sales of inventory previously reserved were $3.7 million and $5.1 million for fiscal year 2014 and fiscal 2013, favorably impacting our gross margin by 1% and 1%, respectively. Research and Development (“R&D”) R&D expenditures increased by $116.8 million in fiscal 2015 compared to fiscal 2014. The increase was mainly attributable to $108.3 million of additional expenses due to the Merger, primarily comprised of $63.0 million of labor costs due to additional headcount, $24.0 million of building, repairs and other overhead expenses, $7.7 million of material costs on R&D projects, $8.5 million of professional services related to Information technology and other outside services and $9.5 million of increase in stock-based compensation expense. R&D expenditures decreased by $26.3 million in fiscal 2014 compared to fiscal 2013. The decrease was primarily attributable to a decrease of $9.9 million in stock-based compensation and a decrease of $1.0 million in deferred compensation expense. There was an additional decrease in consulting fees and other outside services of $2.9 million and $10.0 million, respectively, as a result of a worldwide cost cutting effort. As a percentage of revenues, R&D expenses were lower in fiscal 2014 driven by the decrease in total expense in the same period. Selling, General and Administrative (“SG&A”) SG&A expenses increased by $152.8 million in fiscal 2015 compared to fiscal 2014. The increase was mainly due to $99.6 million of expenses from the Merger, primarily comprised of $50.0 million of labor costs due to additional headcount, $39.0 million of building, supplies, repairs and other overhead expenses, and $15.0 million of professional services expense related to information technology, legal and finance. Additionally, we also incurred $17.4 million of costs for professional fees for legal and audit services related to the Merger integration activities, $5.0M of termination costs on legacy Spansion patent license agreement and $30.6 million of increase in stock-based compensation expense primarily related to the 2015 PARS grants. SG&A expenses decreased by $11.9 million in fiscal 2014 or 6.5% compared to fiscal 2013. The decrease was primarily attributable to a decrease in stock-based compensation of $13.4 million, a $7.9 million decrease in headcount related expenditures, a $2.0 million decrease in deferred compensation expense, a $1.6 million decrease in variable bonus-related expense, offset by $7.3 million of acquisition related expenditures associated with our proposed merger with Spansion, an increase of $2.7 million in legal fees and $1.3 million in accrued estimated legal settlements. Amortization of Acquisition-Related Intangible Assets During fiscal 2015, amortization of acquisition-related intangible assets increased by $101.7 million compared to fiscal 2014. The increase is primarily due to the amortization on the intangibles acquired in connection with the Merger. During fiscal 2014, amortization of acquisition-related intangible assets decreased by $1.1 million compared to fiscal 2013. The decrease is primarily related to certain intangible assets acquired during fiscal 2012 that were fully amortized during fiscal 2013. Restructuring In March 2015, we began the implementation of planned cost reduction and restructuring activities in connection with the Merger. As part of this Spansion integration-related restructuring plan, we expect to eliminate approximately 1,000 positions from the combined workforce across all business and functional areas on a global basis. The restructuring charge of $90.1 million recorded for the year ended January 3, 2016 primarily consists of severance costs, lease termination costs and impairment of property, plant and equipment. The lease termination costs include approximately $18 million relating to the buildings Spansion had leased prior to the Merger, which we decided not to occupy in the post-Merger period. The initial term of the lease commenced on January 1, 2015 and will expire on December 31, 2026. The following table summarizes the restructuring charges recorded in our Consolidated Statements of Operations for the periods presented pursuant to the Spansion Integration-Related Restructuring Plan: We anticipate that the remaining restructuring accrual balance will be paid out in cash through 2016 for employee terminations and over the remaining lease term through 2026 for the excess lease obligation. In the fourth quarter of fiscal 2015, we have realized approximately $137.7 million of synergy savings on an annualized basis from the restructuring actions taken. Upon completion of all of our actions, we anticipate our annualized synergy savings in the fourth quarter of fiscal 2016 to be approximately $160 million. When complete, we estimate approximately 40% of the savings will impact cost of goods sold and the remaining 60% will impact operating expenses. There can be no assurance that we will achieve these anticipated savings. Gain on Divestiture of TruTouch® Mobile Business In connection with the sale of the TrueTouch® mobile touchscreen business to Parade for total cash proceeds of $98.6 million, we sold certain assets associated with the disposed business mostly consisting of inventory with a net book value of $10.5 million and recognized a gain of $66.5 million in fiscal 2015, net of the amount of gain deferred in connection with an ongoing manufacturing service agreement we entered into with Parade in connection with the divestiture. Interest expense Interest expense for fiscal 2015 was $16.4 million and represents accretion of interest expense on 2.00% Senior Exchangeable Notes, interest expense incurred on our revolving line of credit, Term Loan A and other debt. Interest expense for fiscal 2014 and fiscal 2013 was $5.8 million and $8.1 million, respectively, and represents interest expense incurred on our revolving line of credit and other term debt. Refer to Note 14 of Notes to Consolidated Financial Statements under Item 8 for more information about our credit facilities. Other Income (expense), Net The following table summarizes the components of other income (expense), net: Employee Deferred Compensation Plan We have a deferred compensation plan, which provides certain key employees, including our executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax-deferred basis. We do not make contributions to the deferred compensation plan and we do not guarantee returns on the investments. Participant deferrals and investment gains and losses remain as our liabilities and the underlying assets are subject to claims of general creditors. In fiscal 2015, 2014 and 2013, we recognized changes in fair value of the assets under the deferred compensation plan in “Other income (expense), net” of $1.4 million of interest expense, $3.0 million and $6.4 million of interest income, respectively. The increase or decrease in the fair value of the investments relates to the increased or decreased performance of the portfolio on a year over year basis. Refer to Note 17 of Notes to Consolidated Financial Statements under Item 8 for more information about our deferred compensation plan. Gain on Sale of Investments in Marketable Equity Securities In the second quarter of fiscal 2013, we sold our investment in a certain marketable equity security for $2.2 million, which resulted in a realized gain of $1.1 million. In connection with the acquisition of Ramtron, we recognized a gain of $1.7 million on our initial investment in Ramtron of $3.4 million. For more information about our acquisition, refer to Note 2 of Notes to Consolidated Financial Statements under Item 8. Unrealized loss on marketable securities In the fourth quarter of fiscal 2014, the Company, through a wholly-owned subsidiary, purchased 6.9 million ordinary shares of Hua Hong Semiconductor Limited (HHSL) for an aggregate price of $10.0 million in connection with their initial public offering. HHSL is the parent company of Grace Semiconductor Manufacturing Corporation, which is one of our strategic foundry partners. We recorded an unrealized loss on our investment in HHSL’s ordinary shares of $4.7 million and $1.5 million in fiscal 2015 and 2014, respectively, as a result of the decline in the fair market value of the investment. Equity in Net Loss of Equity Method Investee During fiscal 2015, we invested an additional $28.0 million in a battery company. The additional investment in this company increased our ownership interest in the company’s outstanding stock from 26.2% as of December 28, 2014 to 38.7% as of January 3, 2016. We have accounted for our investment in this entity under the equity method of accounting since the fourth quarter of fiscal 2014, when we changed from the cost method of accounting to the equity method of accounting. Under the equity method of accounting, we are required to record our interest in the investee's reported net income or loss for each reporting period. Additionally, we are required to present our prior period financial results to reflect the equity method of accounting from the date of the initial investment in the company. Our results of operations include charges of $7.1 million, $5.1 million and $1.9 million, respectively, for the fiscal years ended 2015, 2014 and 2013. Refer to Note 15 of Notes to Consolidated Financial Statements under Item 8 for more detailed discussion. Income Taxes Our income tax expense was $16.9 million in fiscal 2015. Our income tax benefit was $1.2 million and $7.8 million for fiscal 2014 and 2013, respectively. The tax expense for fiscal 2015 was primarily a result of non-U.S. income taxes on income earned in foreign jurisdictions. The tax benefit in fiscal 2014 was primarily attributable to a release of previously accrued taxes of approximately $8.3 million related to settlements with taxing authorities and the lapsing of statutes of limitations, primarily offset by income taxes associated with our non-U.S. operations. The tax benefit in fiscal 2013 was primarily attributable to a release of previously accrued taxes of approximately $13.8 million related to settlements with taxing authorities and the lapsing of statutes of limitation, primarily offset by income taxes associated with our non-U.S. operations. Our effective tax rate varies from the U.S. statutory rate primarily due to earnings of foreign subsidiaries taxed at different rates and a full valuation allowance on net operating losses incurred in the U.S. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We regularly assess our tax positions in light of legislative, bilateral tax treaty, regulatory and judicial developments in the many countries in which we and our affiliates do business. Non-U.S. tax authorities have completed their income tax examinations of our subsidiary in Israel for fiscal years 2008-2013 and our branch in Germany for fiscal years 2010 to 2013. Both Israel and Germany examinations did not result in material adjustments to our tax liabilities. Income tax examinations of our Malaysian subsidiary for the fiscal years 2007 to 2012 and our Thailand subsidiary for fiscal year 2010 are in progress. We do not believe the ultimate outcome of these examinations will result in a material increase to our tax liability. International revenues account for a significant portion of our total revenues, such that a material portion of our pretax income is earned and taxed outside the U.S. at rates ranging from 0% to 25%. The impact on our provision for income taxes of foreign income being taxed at rates different than the U.S. federal statutory rate was an expense of approximately $22.4 million, and benefit of $37.5 million and $15.4 million in 2015, 2014 and 2013, respectively. The foreign jurisdictions with lower tax rates as compared to the U.S. statutory federal rate that had the most significant impact on our provision for foreign income taxes in the periods presented include the Cayman Islands, Malaysia, Philippines and Thailand. On July 27, 2015, in Altera Corp. v. Commissioner, the U.S. Tax Court issued an opinion related to the treatment of stock-based compensation expense in an intercompany cost-sharing arrangement. On February 19, 2016, the Internal Revenue Service appealed the decision. A final decision has yet to be issued. At this time, the U.S. Department of the Treasury has not withdrawn the requirement to include stock-based compensation from its regulations. Due to the uncertainty surrounding the status of the current regulations, questions related to the scope of potential impact, and the risk of the Tax Court’s decision being overturned upon appeal, we have not recorded any impact related to this issue as of January 3, 2016. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our consolidated cash, cash equivalents and short-term investments and working capital: Key Components of Cash Flows Fiscal 2015: Operating Activities In fiscal 2015, net cash provided by operating activities was $8.8 million compared to net cash provided by operating activities of $103.3 million in fiscal 2014. Net cash provided by operating activities in fiscal 2015 was primarily due to a net loss of $378.9 million adjusted for a net non-cash items of $293.6 million and a net cash provided by change in operating assets and liabilities of $96.4 million. The non-cash adjustments primarily consisted of depreciation and amortization of $243.8 million, stock based compensation expense of $93.5 million, non-cash restructuring charges of $8.6 million and, gain on the sale of our TrueTouch® mobile business of $66.5 million. The net cash provided by changes in operating assets and liabilities was due a decrease in inventories of $228.3 million offset by an increase in accounts receivables of $117.4 million, increase in other assets of $6.0 million, decrease in accounts payable, accrued and other liabilities of $54.3 million and a decrease in deferred income of $14.2 million. The decrease in inventory was primarily due to $133.0 million of reserves recorded to write down inventory assumed from the Merger and was recognized as part of the Company's strategy to focus on high margin, profitable business as a combined company and to move away from the production and sale of inventory associated with non-strategic businesses. Investing Activities In fiscal 2015, we used $79.1 million of cash in our investing activities compared to $42.2 million in fiscal 2014. The cash we used in investing activities in fiscal 2015 was primarily due to $105.1 million in net cash paid on the Merger as part of purchase consideration, $47.2 million of cash used for property and equipment expenditures $28.0 million cash paid for equity investments and $6.1 million paid for a cost method investment. These increases were partially offset by $17.4 million of proceeds from the sales or maturities of investments and $98.6 million of cash proceeds from the sale of our TrueTouch® Mobile business, of the total cash proceeds received from the sale of our TrueTouch® mobile business, $10.0 million are held in an Escrow account until January 2017. Financing Activities In fiscal 2015, we generated $193.2 million of cash from our financing activities compared to $43.4 million in fiscal 2014. The cash we used in our financing activities in fiscal 2015 was primarily related our net borrowings on the revolving credit facility of $537.0 million, borrowings of $97.2 million on Term Loan A, net of costs, proceeds from settlement of capped calls which were assumed as part of the Merger of $25.3 million and net proceeds from the issuance of common shares under our employee stock plans of $52.3 million. The increases were offset by $315.0 million repayment of line of credit facility, $128.0 million of dividend payments, $55.1 million of repurchase of treasury stock and $9.6 million cash used for yield enhanced structured agreements settled in common stock. Fiscal 2014: Operating Activities In fiscal 2014, net cash provided by operating activities was $103.3 million compared to $67.6 million in fiscal 2013. The increase in operating cash flows for fiscal 2014 was primarily due to an increase in net income of $66.2 million compared to fiscal 2013. Our operating cash flow for 2014 of $103.3 million was primarily due to our net income of $16.5 million, net favorable non-cash adjustments to our net income including stock-based compensation of $50.2 million and depreciation and amortization of $46.7 million, and a net change in working capital of $15.7 million. Investing Activities In fiscal 2014, net cash used in investing activities was $42.2 million compared to net cash used in investing activities of $0.3 million in fiscal 2013. The net cash used in our investing activities in fiscal 2014 was primarily due to investment purchases of $23.4 million, purchases of property and equipment of $20.9 million and investments made in other entities accounted for under the cost or equity method of accounting of $18.4 million, offset by the proceeds from sales of investments of $16.6 million. Financing Activities In fiscal 2014, net cash used in financing activities was $43.4 million compared to $45.0 million in fiscal 2013. The cash we used in our financing activities in fiscal 2014 was primarily due to payment of dividends of $69.2 million and the repayment of debt and obligations under capital leases of $6.3 million, offset by net proceeds of $32 million from the issuance of common shares under our employee stock plans. Fiscal 2013: Operating Activities In fiscal 2013, net cash provided by operating activities was $67.6 million compared to $135 million in fiscal 2012. The decrease in operating cash flows for fiscal 2013 was primarily due to an increase in net loss of $24.8 million compared to fiscal 2012. Our operating cash flow for fiscal 2013 of $67.6 million was primarily due to our net loss of $50.1 million, offset by net favorable non-cash adjustments to our net loss including stock-based compensation of $73.0 million, depreciation and amortization of $48.4 million, and a net change in working capital of $20.1 million. Investing Activities In fiscal 2013, net cash provided by investing activities was $0.3 million compared to net cash used in investing activities of $113.0 million in fiscal 2012. The cash provided by our investing activities in fiscal 2013 was primarily due to sales of investments of $64.4 million offset by investment purchases of $23.1 million, and purchases of property and equipment of $36.6 million primarily for our Emerging Technologies Division. Financing Activities In fiscal 2013, net cash used in financing activities was $45.0 million compared to $58.5 million in fiscal 2012. The cash we used in our financing activities in fiscal 2013 was primarily due to payment of dividends of $64.8 million, repayment on our long term revolving credit facility (Credit facility) of $145.0 million and repayment of other debt of $17.1 million, partially offset by net proceeds of $38.7 million from the issuance of common shares under our employee stock plans, and borrowings of $140.0 million on our Credit facility. Liquidity and Contractual obligations Stock Repurchase Programs: On October 20, 2015, our Board authorized a new $450 million stock buyback program. In connection with the approval of the new share repurchase plan, the share repurchase plan previously approved in September 2011 was terminated. The program allows us to purchase our common stock or enter into equity derivative transactions related to our common stock. The timing and actual amount expended with the new authorized funds will depend on a variety of factors including the market price of our common stock, regulatory, legal, and contractual requirements, alternatives uses of cash, availability of on shore cash and other market factors. The program does not obligate us to repurchase any particular amount of common stock and may be modified or suspended at any time at our discretion. From September 2011 through the termination of the program, we used $327.4 million from the program to repurchase 24.4 million shares at an average share price of $13.4. Under the new program authorized in October, 2015 through the end of fiscal 2015, we used $56.5 million to repurchase 5.7 million share at an average price of $10.0. As of February 26, 2016, we repurchased a total of 29.3 million shares for a total cost of $237.8 million under the new program. As of February 26, 2016, the total dollar value of shares that may yet be purchased under the program is approximately $212.2 million. Yield Enhancement Program (“YEP”): As discussed under Item 5 above and in Note 14 of the Notes to Consolidated Financial Statements under Item 8, we have periodically entered into short term yield enhanced structured agreements since fiscal 2009. In fiscal 2014, we entered into short-term yield enhanced structured agreements with maturities ranging from 30 to 45 days at an aggregate price of $19.4 million. Upon settlement of these agreements, we received $19.7 million in cash. In fiscal 2013 we didn’t enter into any short-term yield enhanced structured agreements. In fiscal 2015, we entered into a short-term yield enhanced structured agreements with maturities ranging from 10 to 30 days at an aggregate price of $38.6 million. Upon settlement of these agreements, we received $29.4 million in cash and one million shares at an average price of $9.60. Senior Secured Revolving Credit Facility On October 17, 2013, we amended our credit facility to reduce the revolving commitments to $300 million. In connection with the reduction, certain financial covenants were amended. The amended financial covenants include the following conditions: 1) maximum senior secured leverage ratio of 2.50 to 1.00 through January 1, 2017 and 2.25 to 1.00 thereafter, 2) maximum total leverage ratio of 4.25 to 1.00 through January 3, 2015, 3.5 to 1.00 through January 1, 2017 and 3.00 to 1.00 thereafter, 3) minimum fixed charge coverage ratio of 1.00 to 1.00, and 4) minimum liquidity of at least $100 million. Borrowings are collateralized by substantially all assets of the company. On March 12, 2015, we amended and restated our existing senior secured revolving credit facility (“Credit Facility”) and increased the size of the Credit Facility from $300 million to $450 million. The restated agreement also contains an option permitting us to arrange additional commitments of $250 million (“Incremental Availability”) and specifies that the proceeds of these loans may be used for working capital, acquisitions, stock repurchases and general corporate purposes. The borrowings under the Credit Facility will bear interest, at the Company's option, at an adjusted base rate plus a spread of 1.25%, or an adjusted LIBOR rate plus a spread of 2.25%. The borrowings under the Credit Facility are collateralized by substantially all of the Company's assets. The financial covenants were amended to include the following conditions: 1) maximum total leverage ratio of 3.50 to 1.00 through January 1, 2017, and 3.00 to 1.00 thereafter, 2) minimum fixed charge coverage ratio of 1.00 to 1.00. At January 3, 2016, the Company's outstanding borrowings of $449.0 million were recorded as part of long-term liabilities and are presented as “Long-term revolving credit facility and long term debt” on the Consolidated Balance Sheet. We incurred financing costs of $2.3 million to the new lenders of the Credit Facility which has been capitalized and recognized in other long-term assets on the Consolidated Balance Sheet. These costs will be amortized over the life of the Credit Facility. As per the terms of the Credit Facility, we entered into a Joinder Agreement on December 22, 2015 under which we borrowed an additional $97.2 million (“Term Loan A”), net of costs. Term Loan A is subject to, at the Company’s option, either an interest rate equal to (i) 3.25% over LIBOR or (ii) an interest rate equal to 2.25% over the greater of (x) the prime lending rate published by the Wall Street Journal, (y) the federal funds effective rate plus 0.50%, and (z) the LIBOR rate for a one month interest period plus 1%. The Company paid a 1.00% upfront fee in connection with the Term Loan A. The Credit Facility, as amended, provides for a $450 million revolving credit facility and generally contains the same representations and warranties, covenants, and events of default that it contained prior to the effectiveness of the Amendment. The Amendment did not change the interest rate or maturity applicable to the Credit Facility and the Credit Facility remains guaranteed by certain present and future wholly-owned material domestic subsidiaries (the “Guarantors”) and secured by a security interest in substantially all of our assets and the Guarantors. On January 6, 2016, we entered into an Incremental Revolving Joinder Agreement to our Credit Facility to increase the amount of revolving commitments under our Credit Facility by an additional $90 million. The total aggregate amount of revolving commitments under the Credit Facility starting January 6, 2016 is $540 million. The proceeds of the loans made under the Credit Facility may be used for working capital, acquisitions, stock repurchases and general corporate purposes. As of the filing date of this Form 10-K, $449.5 million aggregate principal amount of loans and letters of credit are outstanding under the Credit Facility and none of the Incremental Availability has been used. As of January 3, 2016, we were in compliance with all of the financial covenants under the Credit Facility. Refer to Note 14 of Notes to Consolidated Financial Statements under Item 8 for more information on our senior secured revolving credit facility. Contractual Obligations The following table summarizes our contractual obligations as of January 3, 2016: (1) Purchase obligations primarily include non-cancelable purchase orders for materials, services, manufacturing equipment, building improvements and supplies in the ordinary course of business. Purchase obligations are defined as enforceable agreements that are legally binding on us and that specify all significant terms, including quantity, price and timing. (2) Operating leases includes payments relating to Spansion's lease for office space in San Jose for a new headquarters entered on May 22, 2014, which is no longer required. The lease is for a period of 12 years, with two options to extend for periods of five years each after the initial lease term. The term of the lease commenced on January1, 2015 and expires on December 31, 2026. (3) On April 30, 2012, we entered into a patent license agreement whereby we paid a total patent license fee of $14.0 million in fiscal 2012 and committed to pay another $5.9 million on or before April 30, 2016 representing fees for future purchases of patents and patent related services. In June 2015, the Company paid an additional license fee of $18.5 million under the existing license agreement due to the merger with Spansion in March 2015. As of January 3, 2016 our unrecognized tax benefits were $28.4 million, which were classified as long-term liabilities. We believe it is possible that we may recognize approximately $7 million of our existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of agreements with domestic and various foreign tax authorities. Sale of Spansion's Sunnyvale property On January 23, 2014, Spansion sold its property in Sunnyvale, California, consisting of 24.5 acres of land with approximately 471,000 square feet of buildings that included its headquarters building and submicron development center, a Pacific Gas & Electric transmission facility and a warehouse building, for net consideration of $59.0 million. Spansion concurrently leased back approximately 170,000 square feet of the headquarters building on a month-to-month basis with the option to continue the lease for up to 24 months; thereafter either party could terminate the lease. The first six months of the lease were rent free; thereafter the rents were lower than the market rates. For accounting purposes, these rents were deemed to have been netted against the sale proceeds and represent prepaid rent. As such, the use of the property after its sale constituted continuing involvement, and recognition of the sale of the property was deferred until the lease period ended. In the third quarter of fiscal 2015, we terminated the lease on the Sunnyvale building and recognized an immaterial gain. Equity Investment Commitments As disclosed in Note 19 of the Notes to the Consolidated Financial Statements, we have committed to purchase additional preferred stock from a company that operates in the area of advanced battery storage. During the fiscal year ended January 3, 2016, we purchased $28.0 million of preferred stock which was recorded as part of our investments in non-marketable securities. Subject to the attainment of certain milestones, we may purchase additional preferred stock of this company. Capital Resources and Financial Condition Our long-term strategy is to maintain a minimum amount of cash for operational purposes and to invest the remaining amount of our cash in interest-bearing and highly liquid cash equivalents and debt securities, the purchase of our stock through our stock buyback program and payments of regularly scheduled cash dividends. In addition we may use excess cash to invest in our ETD, enter into strategic investments and partnerships and pursue acquisitions. As of January 3, 2016 in addition to $226.7 million in cash and cash equivalents, we had $0.9 million invested in short-term investments for a total cash and short-term investment position of $227.6 million that is available for use in current operations. As of January 3, 2016, approximately 63.0% of our cash and cash equivalents and available-for-sale investments are held outside of the United States. While these amounts are primarily invested in U.S. dollars, a portion is held in foreign currencies. All offshore balances are exposed to local political, banking, currency control and other risks. In addition, these amounts, if repatriated may be subject to tax and other transfer restrictions. We believe that liquidity provided by existing cash, cash equivalents and investments and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, should prevailing economic conditions, debt covenants constraints, and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. We may also choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives including the acquisition of other companies, repurchases of shares of stock or increase our dividends or pay a special dividend and provide us with additional flexibility to take advantage of other business opportunities that arise. Non-GAAP Financial Measures To supplement its consolidated financial results presented in accordance with GAAP, Cypress uses non-GAAP measures to assess the following financial measures which are adjusted from the most directly comparable GAAP financial measures: · Revenue · Gross margin · Research and development expenses · Selling, general and administrative expenses · Operating income (loss) · Net income (loss) · Diluted net income (loss) per share The non-GAAP measures set forth above exclude charges primarily related to Spansion merger costs and related amortization, which represented approximately 83% of total adjustments for the year ended January 3, 2016 as well as stock-based compensation, restructuring charges, acquisition-related expenses and other adjustments. Management believes that these non-GAAP financial measures reflect an additional and useful way of viewing aspects of Cypress’s operations that, when viewed in conjunction with Cypress’s GAAP results, provide a more comprehensive understanding of the various factors and trends affecting Cypress’s business and operations. Management uses these non-GAAP measures for strategic and business decision-making, internal budgeting, forecasting and resource allocation processes. In addition, these non-GAAP financial measures facilitate management’s internal comparisons to Cypress’s historical operating results and comparisons to competitors’ operating results. Pursuant to the requirements of Regulation G and to make clear to our investors the adjustments we make to GAAP measures, we have provided a reconciliation of the non-GAAP measures to the most directly comparable GAAP financial measures. We believe that providing these Non-GAAP financial measures, in addition to the GAAP financial results, are useful to investors because they allow investors to see our results “through the eyes” of management as these Non-GAAP financial measures reflect our internal measurement processes. Management believes that these Non-GAAP financial measures enable investors to better assess changes in each key element of our operating results across different reporting periods on a consistent basis and provides investors with another method for assessing our operating results in a manner that is focused on the performance of our ongoing operations. CYPRESS SEMICONDUCTOR CORPORATION RECONCILIATION OF GAAP FINANCIAL MEASURES TO NON-GAAP FINANCIAL MEASURES (In thousands, except per-share data) (Unaudited) (1) Non-GAAP revenue includes for the three and twelve months ended January 3, 2016 includes $6.25 million and $17.5 million of Samsung intellectual property licensing revenue, not included in GAAP revenue as a result of the effect of purchase accounting for the Spansion Merger. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K and the data used to prepare them. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and we are required to make estimates, judgments and assumptions in the course of such preparation. Note 1 of Notes to Consolidated Financial Statements under Item 8 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an ongoing basis, we re-evaluate our judgments and estimates including those related to revenue recognition, allowances for doubtful accounts receivable, inventory valuation, valuation of long-lived assets, goodwill and financial instruments, stock-based compensation, and settlement costs, and income taxes. We base our estimates and judgments on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies that are affected by significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements are as follows: Revenue Recognition: We generate revenues by selling products to distributors, various types of manufacturers including original equipment manufacturers (“OEMs”) and electronic manufacturing service providers (“EMSs”). We recognize revenue on sales to OEMs and EMSs provided that persuasive evidence of an arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations. Sales to certain distributors are made under agreements which provide the distributors with price protection, stock rotation and other allowances under certain circumstances. When we determine that the uncertainties associated with the rights given to these distributors, revenues and costs related to distributor sales are deferred until products are sold by the distributors to the end customers. In those circumstances, revenues are recognized upon receiving notification from the distributors that products have been sold to the end customers. In these cases, at the time of shipment to distributors, we record a trade receivable for the selling price since there is a legally enforceable right to receive payment, relieves inventory for the value of goods shipped since legal title has passed to the distributors, and defers the related margin and price adjustment as deferred income on sales to distributors on the Consolidated Balance Sheets. Any effects of distributor price adjustments are recorded as a reduction to deferred income at the time the distributors sell the products to the end customers and the distributor submits a valid claim for the price adjustment. We have historically recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty in estimating the ultimate price of these product shipments and amount of potential returns. We continuously reassesses our ability to reliably estimate the ultimate price of these products and, over the past several years, have made investments in our systems and process around our distribution channel to improve the quality of the information it receives from our distributors. Given these ongoing investments, and based on the financial framework for estimating potential price adjustments, beginning the fourth quarter of 2014, we concluded that we were able to reasonable estimate returns and pricing concessions on certain product families and with certain distributors, and we recognized revenue at the time it shipped these specific products to the identified distributors, less its estimate of future price adjustments and returns. As a result of this change, we recognized an incremental $12.3 million of revenue during the fourth quarter of fiscal 2014. The impact of this change resulted in an increase of $6.2 million to net income attributable to Cypress for fiscal 2014, or $0.04 per basic and diluted share. During fiscal 2015, we recognized $40.9 million of incremental revenue from this change, which resulted in a decrease in net loss of $25.0 million or $0.07 per basic and diluted shares. During fiscal 2015, we recognized $780.8 million or 68% of distribution revenue on a sell-in basis. We record as a reduction to revenues reserves for sales returns, price protection and allowances, based upon historical experience rates and for any specific known customer amounts. We also provide certain distributors and EMSs with volume-pricing discounts, such as rebates and incentives, which are recorded as a reduction to revenues at the time of sale. Historically these volume discounts have not been significant. Our revenue reporting is highly dependent on receiving pertinent, accurate and timely data from our distributors. Distributors provide us periodic data regarding the product, price, quantity, and end customer when products are resold as well as the quantities of our products they still have in stock. Because the data set is large and complex and because there may be errors in the reported data, we must use estimates and apply judgments to reconcile distributors’ reported inventories to their activities. Actual results could vary materially from those estimates. Business Combinations: We apply the provisions of Accounting Standards Codification 805, Business Combinations (“ASC 805”), in the accounting for acquisitions. It requires us to recognize separately from goodwill the assets acquired and the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date as well as contingent consideration, where applicable, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our Consolidated Statements of Operations. Accounting for business combinations requires the Company's management to make significant estimates and assumptions, especially at the acquisition date including our estimates for intangible assets, contractual obligations assumed, restructuring liabilities, pre-acquisition contingencies and contingent consideration, where applicable. Although we believe the assumptions and estimates it has made have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets we have acquired include but are not limited to: future expected cash flows from product sales, customer contracts and acquired technologies, expected costs to develop in-process research and development into commercially viable products and estimated cash flows from the projects when completed and discount rates. Unanticipated events and circumstances may occur that may affect the accuracy or validity of such assumptions, estimates or actual results. Allowances for Doubtful Accounts Receivable: We maintain an allowance for doubtful accounts for losses that we estimate will arise from our customers’ inability to make required payments. We make estimates of the collectability of our accounts receivable by considering factors such as historical bad debt experience, specific customer creditworthiness, the age of the accounts receivable balances and current economic trends that may affect a customer’s ability to pay. If the data we use to calculate the allowance for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and our results of operations could be materially affected. Valuation of Inventories: Management periodically reviews the adequacy of our inventory reserves. We record a write-down for our inventories which have become obsolete or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventories each quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans and current sales levels. Inventory reserves are not relieved until the related inventory has been sold or scrapped. Our inventories may be subject to rapid technological obsolescence and are sold in a highly competitive industry. If there were a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to record additional write-downs, and our gross margin could be adversely affected. In fiscal 2015, we recorded approximately $133 million of inventory reserves to write down inventory assumed as part of the merger. Valuation of Long-Lived Assets: Our business requires heavy investment in manufacturing facilities and equipment that are technologically advanced but can quickly become significantly under-utilized or rendered obsolete by rapid changes in demand. In addition, we have recorded intangible assets with finite lives related to our acquisitions. We evaluate our long-lived assets, including property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors considered important that could result in an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the assets or the strategy for our business, significant negative industry or economic trends, and a significant decline in our stock price for a sustained period of time. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analysis. If there is a significant adverse change in our business in the future, we may be required to record impairment charges on our long-lived assets. Valuation of Goodwill: Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. We assess our goodwill for impairment on an annual basis and, if certain events or circumstances indicate that an impairment loss may have been incurred, on an interim basis. In accordance with ASU 2011-08, Testing Goodwill for Impairment, qualitative factors can be assessed to determine whether it is necessary to perform the current two-step test for goodwill impairment. If we believe, as a result of our qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. We have four reporting units of which two, Memory Products division (MPD) and Programmable Systems Division (PSD), have goodwill. Determining the number of reporting units and the fair value of a reporting unit requires us to make judgments and involves the use of significant estimates and assumptions. We also make judgments and assumptions in allocating assets and liabilities to each of our reporting units. We base our fair value estimates on assumptions we believe to be reasonable but that are also unpredictable and inherently uncertain. The changes in the carrying amount of goodwill for the year ended January 3, 2016 were as follows: (1) Refer Note 2 for further details. On the first day of our fourth quarter of fiscal 2015, we performed our annual goodwill impairment assessment using the two-step quantitative goodwill impairment test. The first step of the quantitative goodwill impairment test is to identify a potential impairment by comparing the fair value of a reporting unit with its carrying amount. The second step compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. We estimated the fair values of our reporting units using a combination of the income and market approach. These valuation approaches consider a number of factors that include, but are not limited to, forecasted financial information, growth rates, terminal or residual values, discount rates and comparable multiples from publicly traded companies in our industry and require us to make certain assumptions and estimates regarding industry economic factors and the future profitability of our business. The income approach utilizes estimates of discounted future cash flows. Key assumptions used in the market approach include the selection of appropriate benchmark companies and the selection of an appropriate market value multiple for each reporting unit based on a comparison of the reporting unit with the benchmark companies as of the impairment testing date. In performing our 2015 assessment, we applied a weighting of 75% to the income approach and 25% to the market approach. Given that the reporting units are transitioning out of a period of declining revenue and profit, we believe the income approach is a better indication of the going concern value of the reporting units as it better captures the expected improvement in revenue and profit. As such, we placed more weighing on the income approach. Furthermore, as the market approach reflected general macroeconomic concerns that were evidenced in valuations for multiple publicly traded companies, the Company concluded this approach was not as relevant to the impairment calculation. Based on our goodwill impairment testing, we determined that there was no impairment of our goodwill. The fair value of our MPD reporting unit exceeded its carrying value by 53% and the fair value of our PSD reporting unit exceeded its carrying value by 9%. As a result, if we applied a hypothetical 10% decrease to the fair value of each reporting unit, it would have resulted in the fair value of our PSD reporting unit being less than its carrying value. As an overall test of the reasonableness of estimated fair values of our two reporting units, we reconciled the combined fair value estimates of our reporting units to our market capitalization as of the valuation date. The reconciliation confirmed that the fair values were relatively representative of the market views when applying a reasonable control premium to the market capitalization. However, any significant reductions in the actual amount of future cash flows realized by our reporting units, reductions in the value of market comparables, or reductions in our market capitalization could impact future estimates of the fair values of our reporting units. Such events could ultimately result in a material charge to our results of operations in future periods due to the potential for a write-down of the goodwill associated with our reporting units. Based on our testing, we determined that there was a risk of our PSD reporting unit failing the first step of goodwill impairment test in future periods. For this reporting unit, the underlying assumptions we used in assessing fair value include, but are not limited to, declines in our stock price or our peers’ stock prices, relatively small declines in the future performance and cash flows of the reporting unit or small changes in other key assumptions, such as revenue growth rates and discount rates. Specifically, the income approach valuation for PSD included the following assumptions for 2015: Our PSD reporting unit is highly sensitive to management’s plans for increasing sales and gross margins by expanding PSOC 3/4/5 and the Automotive business as well as the achievement of our cost reduction initiatives. If the actual revenue growth and profitability improvements forecasted for the PSD reporting unit do not achieve the levels we estimated in assessing the fair value of the PSD reporting unit, the fair value of the PSD reporting unit may decline. A future decline in the fair value of the PSD reporting unit may result in the recognition of an impairment charge to our earnings as a result of a write-down of the value of the goodwill associated with that reporting unit. Our next annual evaluation of the goodwill by reporting unit will be performed on the first day of the fourth quarter of fiscal year 2016, or earlier if indicators of potential impairment exist. Such indicators include, but are not limited to, challenging economic conditions, such as a decline in our operating results, an unfavorable industry or macroeconomic environment, a substantial decline in our stock price, or any other adverse change in market conditions. Such conditions could have the effect of changing one of the critical assumptions or estimates we use to calculate the fair value of our reporting units, which could result in a decrease in fair value and require us to record goodwill impairment charges. In fiscal 2014, we elected to perform a qualitative analysis for impairment on goodwill rather than to perform the two-step quantitative goodwill impairment test. We assessed qualitative factors to determine whether it was necessary to perform the two-step goodwill impairment test. After assessing many qualitative factors pertinent to our Company we determined that it was more likely than not that the fair value of our reporting unit exceeds its carrying amount. In assessing the qualitative factors, we considered the impact of these key factors: 1) change in the industry and competitive environment, 2) market capitalization, 3) stock price and 4) overall financial performance. Based on the results of the testing, no goodwill impairment was recognized in fiscal 2014. In fiscal 2013, we elected to perform the two-step quantitative goodwill impairment test. Based on the results of the testing, no goodwill impairment was recognized in 2013. Fair Value of Financial Instruments: Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Our financial assets and financial liabilities that require recognition under the guidance generally include available-for-sale investments, employee deferred compensation plan and foreign currency derivatives. The guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of us. Unobservable inputs are inputs that reflect our assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. As such, fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measure. The hierarchy is broken down into three levels based on the reliability of inputs as follows: · Level 1 includes instruments for which quoted prices in active markets for identical assets or liabilities that we have the ability to access. Our financial assets utilizing Level 1 inputs include U.S. treasuries, money market funds, marketable equity securities and our employee deferred compensation plan assets with the exception of our stable value funds which are considered Level 2 instruments. · Level 2 includes instruments for which the valuations are based on quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets or liabilities. Level 2 assets consist of certain marketable debt instruments for which values are determined using inputs that are observable in the market or can be derived principally from or corroborated by observable market data. Our Level 2 instruments include certain U.S. government securities, commercial paper, corporate notes and bonds, assets held-for-sale and our employee deferred compensation plan liabilities and our stable value funds included in our deferred compensation plan assets. · Level 3 includes valuations based on inputs that are unobservable and significant to the overall fair value measurement. Consideration is given to the risk inherent in the valuation technique and the risk inherent in the inputs to the model. Financial assets utilizing Level 3 inputs primarily include auction rate securities. We do not have any financial assets or liabilities utilizing Level 3 inputs. Cash Flow Hedges: The Company enters into cash flow hedges to protect non-functional currency revenues, inventory purchases and certain other operational expenses against variability in cash flows due to foreign currency fluctuations. The Company’s foreign currency forward contracts that were designated as cash flow hedges have maturities between three and nine months. All hedging relationships are formally documented, and the hedges are designed to offset changes to future cash flows on hedged transactions at the inception of the hedge. The Company recognizes derivative instruments from hedging activities as either assets or liabilities on the balance sheet and measures them at fair value on a monthly basis. The Company records changes in the intrinsic value of its cash flow hedges in accumulated other comprehensive income on the Consolidated Balance Sheets, until the forecasted transaction occurs. Interest charges or “forward points” on the forward contracts are excluded from the assessment of hedge effectiveness and are recorded in other income (expense), net in the Consolidated Statements of Operations. When the forecasted transaction occurs, the Company reclassifies the related gain or loss on the cash flow hedge to revenue or costs, depending on the risk hedged. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the Company will reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income to other income (expense), net in its Consolidated Statements of Operations at that time. The Company evaluates hedge effectiveness at the inception of the hedge prospectively as well as retrospectively and records any ineffective portion of the hedge in other income (expense), net in its Consolidated Statements of Operations. Refer Note 11 for further details on cash flow and balance sheet hedges. Stock-Based Compensation: Under the fair value recognition provisions of the guidance, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest over the requisite service period of the awards. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including measurement of level of achievement of performance milestones, the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, our future stock-based compensation expense could be significantly different from what we have recorded. Employee Benefit Plans: In connection with the Merger, we assumed the Spansion Innovates Group Cash Balance Plan (a defined benefit pension plan) in Japan. A defined benefit pension plan is accounted for on an actuarial basis, which requires the selection of various assumptions such as turnover rates, discount rates and other factors. The discount rate assumption is determined by comparing the projected benefit payments to the Japanese corporate bonds yield curve as of end of the most recently completed fiscal year. The benefit obligation is the projected benefit obligation (PBO), which represents the actuarial present value of benefits expected to be paid upon retirement. This liability is recorded in other long term liabilities on the Consolidated Balance Sheets. Net periodic pension cost is recorded in the Consolidated Statements of Operations and includes service cost. Service cost represents the actuarial present value of participant benefits earned in the current year. Interest cost represents the time value of money associated with the passage of time on the PBO. Gains or losses resulting from a change in the PBO if actual results differ from actuarial assumptions will be accumulated and amortized over the future life of the plan participants if they exceed 10% of the PBO, being the corridor amount. If the amount of a net gain or loss does not exceed the corridor amount, it will be recorded to other comprehensive income (loss). See Note 17 for further details of the pension plans. Accounting for Income Taxes: Our global operations involve manufacturing, research and development and selling activities. Profits from non-U.S. activities are subject to local country taxes but are not subject to U.S. tax until repatriated to the U.S. United States income tax has not been provided on a portion of earnings of our non-U.S. subsidiaries to the extent that such earnings are considered to be indefinitely reinvested. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We consider historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. Should we determine that we would be able to realize deferred tax assets in the future in excess of the net recorded amount, we would record an adjustment to the deferred tax asset valuation allowance. This adjustment would increase income in the period such determination is made. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate tax assessment, a further charge to expense would result. Recent Accounting Pronouncements See “Recent Accounting Pronouncements” in Note 1 of Notes to Consolidated Financial Statements under Item 8 of this Annual Report on Form 10-K.

<s>[INST] The Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that involve risks and uncertainties, which are discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress”) delivers highperformance, highquality solutions at the heart of today’s most advanced embedded systems, from automotive, industrial and networking platforms to highly interactive consumer and mobile devices. With a broad, differentiated product portfolio that includes NOR flash memories, FRAM™ and SRAM, Traveo™ microcontrollers, the industry’s only PSoC® programmable systemonchip solutions, analog and PMIC Power Management ICs, CapSense® capacitive touchsensing controllers, and Wireless BLE Bluetooth LowEnergy and USB connectivity solutions, Cypress is committed to providing its customers worldwide with consistent innovation, bestinclass support and exceptional system value. Merger with Spansion On March 12, 2015, we completed the merger (“Merger”) with Spansion Inc. (“Spansion”) pursuant to the Agreement and Plan of Merger and Reorganization, as of December 1, 2014 (the “Merger Agreement”), for a total consideration of approximately $2.8 billion. In accordance with the terms of the Merger Agreement, Spansion shareholders received 2.457 Cypress shares for each Spansion share they owned. The Merger has been accounted for under the acquisition method of accounting in accordance with Financial Accounting Standards Board Accounting Standard Topic 805, Business Combinations, with Cypress treated as the accounting acquirer. The postMerger company is expected to realize more than $160 million in cost synergies on an annualized basis within two years, and create a leading global provider of microcontrollers and specialized memories needed in today's embedded systems. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations includes the financial results of legacy Spansion beginning March 12, 2015. The comparability of our operating results for the year ended January 3, 2016 to the same period in fiscal 2014 is significantly impacted by our Merger. In our discussion and analysis of comparative periods, we have quantified the contribution of additional revenue or expense resulting from this transaction wherever such amounts were material and identifiable. While identified amounts may provide indications of general trends, the analysis cannot completely address the effects attributable to integration efforts. Divestiture of TrueTouch® Business On August 1, 2015, we completed the sale of the TrueTouch® mobile touchscreen business, which is a business unit within our Programmable Systems Division, to Parade Technologies (“Parade”) for total cash proceeds of $98.6 million pursuant to the definitive agreement signed on June 11, 2015. Of the total cash proceeds, $10.0 million are held in an escrow account until January 2017 subject to any indemnity claims on postclosing adjustments, per the terms of the agreement. Postsale, Cypress will continue to provide TrueTouch® solutions to its automotive, industrial and home appliance customers and to its mobile customers. In connection with the transaction, we sold certain assets associated with the disposed business mostly consisting of inventory with a net book value of $10.5 million and recognized a gain of $66.5 million in the third fiscal quarter of fiscal 2015. This gain has been presented as a separate line item “Gain on divestiture of TrueTouch® mobile business” in the Consolidated Statements of Operations. Also in connection with the transaction, we entered into a Manufacturing Service Agreement (MSA) in which we agreed to sell finished wafers and devices to Parade during the oneyear period following the close of the transaction. The terms of the MSA indicated that we would sell finished products to Parade at agreedupon prices that were considered below fair market value, indicating that there was an embedded fair value that would be realized [/INST] Positive. </s>

CYPRESS SEMICONDUCTOR CORP /DE/

2017-03-01

2017-01-01

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that involve risks and uncertainties, which are discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress” or “the Company”) manufactures and sells advanced embedded system solutions for automotive, industrial, home automation and appliances, consumer electronics and medical products. Cypress’s programmable systems-on-chip, general-purpose microcontrollers, analog ICs, IoT and USB-C based connectivity solutions and memories help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. Mergers, Acquisitions and Divestitures Merger with Spansion On March 12, 2015, we completed the merger (“Merger”) with Spansion Inc. ("Spansion") pursuant to the Agreement and Plan of Merger and Reorganization, dated as of December 1, 2014 (the "Merger Agreement"), for a total consideration of approximately $2.8 billion. Acquisition of Broadcom Corporation’s Internet of Things business (“IoT business”) On July 5, 2016, we completed the acquisition of certain assets primarily related to the IoT business of Broadcom pursuant to an Asset Purchase Agreement with Broadcom Corporation, dated April 28, 2016, for a total consideration of $550 million. The following MD&A includes the financial results of the IoT business beginning July 5, 2016. The comparability of our results for the year ended January 1, 2017 to the same periods in fiscal 2015 is significantly impacted by the acquisition. To date, we have incurred approximately $8.9 million of acquisition related costs, including professional fees and other costs associated with the acquisition. The following MD&A includes the financial results of legacy Spansion beginning March 12, 2015 and the financial results of the IoT business acquired from Broadcom beginning July 5, 2016. The comparability of our results for the year ended January 1, 2017 to the same prior year periods is significantly impacted by these transactions. In our discussion and analysis of comparative periods, we have quantified the contribution of additional revenue or expense resulting from these transaction wherever such amounts were material and identifiable. While identified amounts may provide indications of general trends, the analysis cannot completely address the effects attributable to integration efforts. Divestiture of TrueTouch® Business In connection with the sale of the TrueTouch® Mobile touchscreen business to Parade Technologies (“Parade”) on August 1, 2015, we entered into a Manufacturing Service Agreement (“MSA”) in which we agreed to sell finished wafers and devices to Parade. The terms of the MSA provide that we would sell finished products to Parade at agreed-upon prices that were considered below fair market value, indicating that there was an embedded fair value that would be realized by Parade through those terms. Accordingly, we had allocated approximately $19.9 million from the $98.6 million proceeds to the fair value of the MSA based on the forecasted wafer sales to Parade for the subsequent periods. That amount was deferred on our consolidated balance sheet initially and is being amortized to revenue as we sell products to Parade. During the year ended January 1, 2017 and January 2, 2016, we recognized approximately $14.2 million and $5.7 million, respectively, of revenue from the amortization of the deferred revenue. Investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement (the "Purchase Agreement"), whereby certain third-party investors purchased 41.1% of the shares outstanding at the said date for an aggregate consideration of approximately $111.4 million. Concurrently, Deca repurchased certain of its preferred shares from us. After giving effect to the above transactions, our ownership in Deca reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to third-party new investors in the purchase agreement, including, among other things, participation on the Board of directors of Deca, approval of operating plans and approval of indebtedness, we determined that we no longer have the power to direct the activities of Deca that most significantly impacts Deca's economic performance. However, as we continue to have significant influence over Deca's financial and operating policies, effective July 29, 2016, the investment in Deca is being accounted for as an equity method investment and financial results of Deca are no longer being consolidated. The carrying value of this equity method investment was determined based on the fair value of the equity in Deca, which the Company calculated to be $142.5 million. This represents our remaining investment in Deca immediately following the investments by third-party investors. As a result of the change in the method of accounting for our investment in Deca from consolidation to the equity method of accounting, the net carrying value of the assets and liabilities related to Deca, and the adjustments related to the recognition of the initial fair value of the equity method investment resulted in a gain of $112.8 million which has been reflected as "Gain related to investment in Deca Technologies Inc." in the Consolidated Statements of Operations. Business Developments New Chief Executive Officer and Executive Chairman Effective August 10, 2016, Hassane El-Khoury was promoted to the position of President and Chief Executive Officer of the Company. Upon the effectiveness of Mr. El-Khoury’s appointment as President and Chief Executive Officer, the Office of President and Chief Executive Officer, which had been performing the duties of the President and Chief Executive Officer since April 2016, was dissolved by the Board. Mr. El-Khoury served as Executive Vice President, Microcontroller and Connectivity Division ("MCD"), from 2012 until his appointment as President and Chief Executive Officer. Effective August 10, 2016, the Board appointed H. Raymond Bingham as Executive Chairman, a newly created position pursuant to which Mr. Bingham will function as both an executive officer of the Company and as Chairman of the Board. As Executive Chairman, Mr. Bingham will report directly to the Board. Business Segments We continuously evaluate our reportable business segments in accordance with the applicable accounting guidance. Pursuant to reorganization and internal reporting structure effective fourth quarter, the Company operates under two reportable business segments: Memory Products Division ("MPD") and MCD. Prior to the fourth quarter of fiscal 2016, the Company reported under four reportable business segments: MPD, Programmable Systems Division ("PSD"), Data Communications Division ("DCD") and Emerging Technologies Division ("ETD"). The prior reportable segments of PSD and DCD have been combined and are referred to as MCD. Deca, previously included in ETD, and now accounted for as an equity method investment, has been reflected in MCD for historical results. The MPD segment comprises of substantial portion of the previous MPD segment, as well as certain portions of the previous PSD. Agiga, previously included in ETD has been combined with MPD. The prior periods herein reflect this change in segment information. RESULTS OF OPERATIONS Revenues Our total revenues increased by $315.3 million, or 19.6%, to $1,923.1 million for the year ended January 1, 2017 compared to the prior year. For the year ended January 1, 2017, $134.9 million of the increase was attributable to revenue contributions from the acquired IoT business which is included in the MCD division. Revenue for the year ended January 1, 2017 benefited from the Spansion Merger, as compared to the prior year which included such sales only for a partial period post merger, offset by the divestiture of the True Touch® business. The Company operates on a 52 or 53 week year ending on the Sunday nearest to December 31. Fiscal 2016 and 2014 were each 52 weeks and fiscal 2015 was a 53-week year, with the extra week in the fourth fiscal quarter. The additional week in fiscal 2015 did not materially affect the Company's results of operations or financial position. Consistent with our accounting policies and generally accepted accounting principles, prior to fiscal 2014 we recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty in estimating the ultimate price of these product shipments and amount of potential returns. We continually reassess our ability to reliably estimate the ultimate price of these products and, over the past several years, we have made investments in our systems and processes around our distribution channel to improve the quality of the information we receive from our distributors. Given these ongoing investments, and based on the financial framework we use for estimating potential price adjustments, in the fourth quarter of 2014, the Company began recognizing revenue on certain product families and with certain distributors (less its estimate of future price adjustments and returns) upon shipment to the distributors (also referred to as the sell-in basis of revenue recognition). As of January 1, 2017, with the exception of consignment sales, the Company is recognizing all revenue upon shipment. During the year ended January 1, 2017, we recognized an incremental $59.2 million of revenue on new product families or distributors for which we recognized revenue on a sell-in basis. This change resulted in a decrease to the net loss of $19.5 million for the year ended January 1, 2017 or $0.06 per basic and diluted share. During the year ended January 3, 2016, we recognized an incremental $40.9 million of revenue on additional product families for which revenue was previously recognized on a sell-through basis. This change resulted in a decrease to the net loss of $25.0 million for the year ended January 3, 2016 or $0.08 per basic and diluted share. The following table summarizes our consolidated revenues by segments: Memory Products Division (“MPD”): Revenues from MPD increased in fiscal 2016 by $52.1 million, or 5.9% compared to fiscal 2015. The increase was primarily due to $95.1 million of revenue contribution from the Flash memory business which grew primarily in the automotive and consumer segments. This was partially offset by $36.4 million of decrease in revenue from SRAM products. Revenues from MPD increased in fiscal 2015 by $520.1 million, or 145.9% compared to fiscal 2014. The increase was primarily due to $539.1 million of revenue contribution from the Spansion flash memory business for fiscal 2015. Excluding the impact of Spansion revenues, MPD decreased by $18.9 million or 5.3% in fiscal 2015 compared to the prior year primarily driven by sales decrease in the communication market segment. The overall average selling prices (ASP’s) of our products for MPD for the year ended January 1, 2017 was $1.25, which decreased by $0.10, compared with the prior year. The decrease is attributed to the fact that in 2016 the company saw lower ASPs in the overall memory segment, particularly in NAND and SRAM families. The overall ASP’s of our products for MPD for the year ended January 3, 2016 was $1.35, which decreased by $0.35, compared to $1.70 in prior year. The decrease in ASP is due to Spansion acquisition. Microcontroller and Connectivity Division ("MCD"): Revenues from MCD in fiscal 2016 increased by $263.2 million, or 36.0%, compared to fiscal 2015. The increase in fiscal 2016 was primarily driven by the acquisition of the IoT business from Broadcom. In fiscal 2016, revenue related to the IoT business was $134.9 million. Excluding the impact of IoT revenues, MCD increased by $128.3 million for fiscal 2016, or 17.6%, compared to the prior year, primarily due to increased revenue in the automotive segment. Revenues from MCD in fiscal 2015 increased by $362.3 million or 98.2%, compared to fiscal 2014. The increase in the 2015 MCD revenue was primarily attributable to the following factors: •Contribution from products acquired as part of the Spansion acquisition •Increase in sales of products related to automotive applications. This increase was offset by decreases related to the following factors: • Divestiture of TrueTouch® business •Weakness in demand in the mobile business and consumer end markets The overall average selling price of our products for MCD for the year ended January 1, 2017 was $1.02 which is unchanged from the prior-year. The overall average selling price of our products for MCD for the year ended January 3, 2016 was $1.02 which increased by $0.24, compared to $0.78 in fiscal 2014. The increase in ASP is due to Spansion acquisition. Cost of Revenues Our cost of revenue ratio representing cost of revenue as a percentage of revenue is significantly impacted by the mix of products we sell, which is often difficult to forecast with accuracy. Therefore, if we achieve significant revenue growth in our lower margin product lines, or if we are unable to earn as much revenue as we expect from higher margin product lines, our gross margin may be negatively impacted. Our cost of revenue ratio improved from 75.1% in fiscal 2015 to 64.4% in fiscal 2016. The primary driver of the improvement in the cost of revenue ratio was lower write downs of carrying value of inventory during fiscal 2016 as compared to the prior year and our on-going focus on gross margin expansion through cost reductions, price increases and synergies recognized from the merger. Included in the cost of revenues for fiscal 2015 was a $133.0 million write-down of carrying value of inventory assumed as a part of the Spansion Merger as well as a write down of $19.5 million of certain other inventories. In comparison, write-down of inventories during fiscal 2016 was $25.3 million. Sale of inventory that was previously written-off or written-down aggregated to $65.7 million for fiscal 2016 and $6.4 million for fiscal 2015, which favorably impacted our cost of revenues ratio in fiscal 2016. This impact was partially offset by lower fab utilization which was 56% for fiscal 2016 as compared to 62% in fiscal 2015. Our cost of revenues ratio declined to 75.1% in fiscal 2015 from 49.9% in fiscal 2014. The increase in cost of revenues for fiscal 2015 was primarily due to impact of the merger with Spansion, which historically had higher cost of revenues than Cypress, and $133.0 million of write-downs on inventory assumed as a part of the Spansion Merger. These inventory write-downs were recognized as part of our strategy to focus on high margin, profitable business as a combined company. Total charges to cost of sales for inventory writedowns aggregated to $152.5 million for fiscal 2015 and $19.8 million for fiscal 2014, unfavorably impacting our cost of revenues ratio. Sales of inventory that was previously written-off or written-down totaled $6.4 million for fiscal 2015 and $3.7 million for fiscal 2014, favorably impacting our cost of revenues ratio. Research and Development (“R&D”) R&D expenditures increased by $50.3 million in the twelve months ended January 1, 2017 compared to the same prior-year period. The increase was mainly attributable to $36.8 million of expenses due to the IoT acquisition, primarily comprised of $22.6 million of increase in labor costs due to additional headcount and increase of $14.2 million in expensed assets. The remaining increase of $13.5 million in other R&D expense was primarily due to $15.8 million of stock-compensation expense, offset by $2.3 million decrease in other R&D expenses. R&D expenditures increased by $116.8 million in fiscal 2015 compared to fiscal 2014. The increase was mainly attributable to $108.3 million of additional expenses due to the Spansion Merger, which comprised of $63.0 million of labor costs due to additional headcount, $24.0 million of building, repairs and other overhead expenses, $7.7 million of material costs on certain development projects, $8.5 million of professional services related to Information technology ("IT") and other outside services and $9.5 million of increase in stock-based compensation expense. Selling, General and Administrative (“SG&A”) SG&A expenses decreased by $6.2 million in fiscal 2016 compared to fiscal 2015. The decrease was mainly due to lower acquisition expenses of $14.1 million primarily related to merger of Spansion, a $9.0 million decrease in stock based compensation expense, offset by acquisition costs associated with the IoT acquisition of $8.9 million, and IoT operating expenses of $9.8 primarily related to labor. SG&A expenses increased by $152.8 million in fiscal 2015 compared to fiscal 2014. The increase was mainly due to $99.6 million of expenses from the Spansion Merger, primarily comprised of $50.0 million of labor costs due to additional headcount, $39.0 million of building, supplies, repairs and other overhead expenses, and $15.0 million of professional services expense related to IT, legal and finance. Additionally, we also incurred $17.4 million of costs for professional fees for legal and audit services related to the Spansion Merger integration activities, $5.0 million of termination costs on legacy Spansion patent license agreement and $30.6 million of increase in stock-based compensation expense primarily related to the 2015 PARS grants. Amortization of Acquisition-Related Intangible Assets During fiscal 2016, amortization expense increased by $66.4 million compared to fiscal 2015. The increase was mainly due to the amortization of the intangibles acquired in connection with the IoT business acquisition, Spansion Merger as well as capitalization of certain in-process research and development projects. During fiscal 2015, amortization of acquisition-related intangible assets increased by $101.7 million compared to fiscal 2014. The increase is primarily due to the amortization of the intangibles acquired in connection with the Spansion Merger. Impairment of acquisition-related intangible assets During fiscal 2016, we recognized $33.9 million of impairment charges related to two IPR&D projects that were canceled due to certain changes in our long-term product portfolio strategy during fiscal 2016. There were no impairment charges of acquisition-related intangibles during fiscal 2015 and fiscal 2014. Gain related to investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement (the "Purchase Agreement"), whereby certain third-party investors purchased 41.1% of the shares outstanding at the said date for an aggregate consideration of $111.4 million. Concurrently, Deca repurchased certain of its preferred shares from us. After giving effect to the above transactions, our ownership in Deca reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to third-party new investors in the purchase agreement, including, among other things, participation on the Board of directors of Deca, approval of operating plans, approval of indebtedness etc., we determined that we no longer have the power to direct the activities of Deca that most significantly impacts Deca's economic performance. However, as we continue to have significant influence over Deca's financial and operating policies, effective July 29, 2016, the investment in Deca is being accounted for as an equity method investment and is no longer a consolidated subsidiary. The carrying initial value of this equity method investment was determined based on the fair value of the equity in Deca, which the Company calculated to be $142.5 million. This represents our remaining investment in Deca immediately following the investments by third-party investors. As a result of the change in the method of accounting for our investment in Deca from consolidation to the equity method of accounting, the net carrying value of the assets and liabilities related to Deca, and the adjustments related to the recognition of the initial fair value of the equity method investment resulted in a gain of $112.8 million which has been reflected as "Gain related to investment in Deca Technologies Inc." in the Consolidated Statements of Operations. Impairment related to assets held for sale During fiscal 2016, we committed to a plan to sell our wafer manufacturing facility located in Bloomington, Minnesota, as well as a building in Austin, Texas, the sale of this asset is expected to be completed in fiscal 2017. On March 1, 2017, we completed the sale of our wafer fabrication facility in Minnesota. See Note 22 of the notes to the consolidated financial statements. We recorded an impairment charge of $37.2 million during fiscal 2016, to reflect the estimated fair value, net of cost to sell these assets. Goodwill impairment charge Our results for the year ended January 1, 2017 included a goodwill impairment charge of $488.5 million related to our former PSD reporting unit. The goodwill impairment charge resulted from a combination of factors including, (a) decreases in our forecasted operating results when compared with the expectations of the PSD reporting unit at the time of the Spansion Merger, primarily in consumer markets as the Company has subsequently increased its focus on the automotive and industrial end markets, (b) evaluation of business priorities due to recent changes in management at that time, and (c) certain market conditions which necessitated a quantitative impairment analysis for the carrying value of the goodwill related to PSD. There were no goodwill impairment charges recorded during fiscal 2015 and fiscal 2014. Restructuring 2016 Restructuring Plan During fiscal 2016, the Company began implementation of a reduction in workforce ("2016 Plan"), which is expected to result in elimination of approximately 430 positions worldwide across various functions. The personnel cost related to the 2016 Plan during fiscal 2016 were $26.3 million. The Company presently estimates recording approximately $2.2 million of additional restructuring costs related to the 2016 Plan through the first quarter of fiscal 2017. The Company expects that the costs incurred under the 2016 Plan will be paid out in cash through fiscal 2017. Depending on the final outcome of the pending actions related to the remaining expense to be recorded and the cash payouts maybe materially different from our current estimates. We plan to reinvest a substantial portion of the savings generated from the 2016 Restructuring Plan into certain business initiatives and opportunities. Consequently, the 2016 Restructuring Plan is not expected to result in a material reduction in our future operating expenses. Spansion Integration-Related Restructuring Plan In March 2015, we began the implementation of planned cost reduction and restructuring activities in connection with the Merger. During fiscal 2016, a release of previously estimated personnel related liability of $0.1 million was recorded. During fiscal 2015, restructuring charge of $90.1 million primarily consists of severance costs, lease termination costs and impairment of property, plant and equipment. The lease termination costs include approximately $18 million relating to the buildings Spansion had leased prior to the Merger, which we decided not to occupy in the post-Merger period. The initial term of the lease commenced on January 1, 2015 and will expire on December 31, 2026. We anticipate that the remaining restructuring liability balance will be paid out in cash through fiscal 2017 for employee terminations and over the remaining lease term through 2026 for the excess lease obligation. Gain on Divestiture of TrueTouch® Mobile Business In connection with the sale of the TrueTouch® mobile touchscreen business to Parade for total cash proceeds of $98.6 million, we sold certain assets associated with the disposed business mostly consisting of inventory with a net book value of $10.5 million and recognized a gain of $66.5 million in fiscal 2015, net of the amount of gain deferred in connection with an ongoing manufacturing service agreement we entered into with Parade in connection with the divestiture. Interest expense Interest expense for fiscal 2016 was $55.2 million and represents accretion of interest expense on 4.50% Senior Exchangeable Notes, 2.00% Senior Exchangeable Notes, interest expense incurred on our revolving line of credit, Term Loan A, Term Loan B and other debt. Interest expense for fiscal 2015 was $16.4 million and represents accretion of interest expense on 2.00% Senior Exchangeable Notes, interest expense incurred on our revolving line of credit, Term Loan A and other debt. Interest expense for fiscal 2014 was $5.8 million and represents interest expense incurred on our revolving line of credit and other term debt. Refer to Note 14 of Notes to the Consolidated Financial Statements under Item 8 for more information about our credit facilities. Other Income (expense), Net The following table summarizes the components of other income (expense), net: Employee Deferred Compensation Plan We have a deferred compensation plan, which provides certain key employees, including our executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax-deferred basis. We do not make contributions to the deferred compensation plan and we do not guarantee returns on the investments. Participant deferrals and investment gains and losses remain as our liabilities and the underlying assets are subject to claims of general creditors. In fiscal 2016, 2015 and 2014, we recognized changes in fair value of the assets under the deferred compensation plan in “Other income (expense), net” of $2.3 million of interest income, $1.4 million of interest expense, and $3.0 million of interest income, respectively. The increase or decrease in the fair value of the investments relates to the increased or decreased performance of the portfolio on a year over year basis. Refer to Note 18 of the Notes to the Consolidated Financial Statements under Item 8 for more information about our deferred compensation plan. Unrealized (realized) loss on marketable securities In the fourth quarter of fiscal 2014, the Company, through a wholly-owned subsidiary, purchased 6.9 million ordinary shares of Hua Hong Semiconductor Limited (HHSL) for an aggregate price of $10.0 million in connection with their initial public offering. HHSL is the parent company of Grace Semiconductor Manufacturing Corporation, which is one of our strategic foundry partners. We recorded an unrealized loss on our investment in HHSL’s ordinary shares of $4.7 million and $1.5 million in fiscal 2015 and 2014, respectively, as a result of the decline in the fair market value of the investment. During 2016 the Company disposed the shares of HHSL and the realized gain is immaterial to the consolidated financial statements. Equity in Net Loss of Equity Method Investees We have been making investments in Enovix Corporation ("Enovix"). We invested $28.0 million and $23.0 million in Enovix during 2015 and 2016 respectively. Our investment holding comprised of 38.7% and 46.6% of Enovix's equity at the end of fiscal 2015 and 2016, respectively. Since the fourth quarter of 2014 we have been accounting for our investment in Enovix using the equity method of accounting. In the second quarter of fiscal 2016, we changed the basis of accounting for our investment in Deca Technologies Inc. ("Deca") to the equity method of accounting. As of the end of fiscal year 2016, our investment comprised 52.5% of Deca's equity. During fiscal 2016, 2015 and 2014, we recorded $9.4 million, $7.1 million and $5.1 million respectively for our share of losses recorded by Enovix. During fiscal 2016, we recorded $8.2 million for our share of losses recorded by Deca. Income Taxes Our income tax expense was $2.6 million and $16.9 million in fiscal 2016 and fiscal 2015, respectively. Our income tax benefit was $1.2 million for fiscal 2014. The income tax expense for fiscal 2016 was primarily attributable to income taxes associated with our non-US operations, primarily offset by release of previously accrued taxes related to the lapsing of statutes of limitation. The income tax expense for fiscal 2015 was primarily a result of non-U.S. income taxes on income earned in foreign jurisdictions. The income tax benefit in fiscal 2014 was primarily attributable to a release of previously accrued taxes of approximately $8.3 million related to settlements with taxing authorities and the lapsing of statutes of limitations, primarily offset by income taxes associated with our non-U.S. operations. Our effective tax rate varies from the U.S. statutory rate primarily due to earnings of foreign subsidiaries taxed at different rates and a full valuation allowance on net operating losses incurred in the U.S. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We regularly assess our tax positions in light of legislative, bilateral tax treaty, regulatory and judicial developments in the many countries in which we and our affiliates do business. Income tax examinations of our Malaysian subsidiary for the fiscal years 2007 to 2012 and our Thailand subsidiary for fiscal year 2010 are in progress. We do not believe the ultimate outcome of these examinations will result in a material increase to our tax liability. International revenues account for a significant portion of our total revenues, such that a material portion of our pretax income is earned and taxed outside the U.S. at rates ranging from 0% to 25%. The impact on our provision for income taxes of foreign income being taxed at rates different than the U.S. federal statutory rate was an expense of approximately $36.6 million, an expense of $22.4 million, and benefit of $37.5 million in 2016, 2015 and 2014, respectively. The foreign jurisdictions with lower tax rates as compared to the U.S. statutory federal rate that had the most significant impact on our provision for foreign income taxes in the periods presented include the Cayman Islands, Malaysia, Philippines and Thailand. On July 27, 2015, in Altera Corp. v. Commissioner, the U.S. Tax Court issued an opinion related to the treatment of stock-based compensation expense in an intercompany cost-sharing arrangement. On February 19, 2016, the Internal Revenue Service appealed the decision. A final decision has yet to be issued. At this time, the U.S. Department of the Treasury has not withdrawn the requirement to include stock-based compensation from its regulations. Due to the uncertainty surrounding the status of the current regulations, questions related to the scope of potential impact, and the risk of the Tax Court’s decision being overturned upon appeal, we have not recorded any impact related to this issue as of January 1, 2017. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our consolidated cash, cash equivalents and short-term investments and working capital: Key Components of Cash Flows Fiscal 2016: Operating Activities Net cash provided by operating activities of $217.4 million during fiscal 2016 was primarily due to a net loss of $686.9 million offset by net non-cash items of $884.1 million and $20.2 million increase in cash due to changes in operating assets and liabilities. The non-cash items primarily consisted of: • depreciation and amortization of $265.9 million, • stock based compensation expense of $105.3 million, • restructuring costs and other of $27.2 million, • accretion of interest expense on Senior Exchangeable Notes and amortization of debt and financing costs on other debt of $13.1 million, • Share in net loss of equity method investees of 17.6 million, • goodwill impairment charge of $488.5 million, • gain related to investment in Deca Technologies Inc. of $112.8 million, • impairment charge related to assets held for sale of $37.2 million, and • impairment charge for acquisition-related IPR&D of $33.9 million. The increase in net cash due to changes in operating assets and liabilities during fiscal 2016 of $20.2 million, which was primarily due to the following: • an increase in accounts receivable of $41.0 million due to an increase in sales during fiscal 2016. The days sales outstanding for fiscal 2016 and fiscal 2015 were 61 days; ◦ an increase in inventories of $34.0 million as a result of the IoT acquisition; • an increase in other current and long-term assets of $12.2 million, primarily due to timing of payments for certain licenses; • an increase in accounts payable, accrued and other liabilities of $76.7 million due to timing of payments; and • a decrease in deferred income of $66.8 million due to the transition of additional product families to the sell-in basis of revenue recognition. The decrease in deferred income was offset by an increase in price adjustment reserve for sale to distributors of $97.3 million due to the change in revenue recognition for certain product families in fiscal 2016 on a sell-in basis, which required us to record a reserve for distributor price adjustments based on our estimate of historical experience rates. Investing Activities In fiscal 2016, we used approximately $613.4 million of cash in our investing activities primarily due to $550.0 million for acquisition of the IoT business, $57.4 million of cash used for property and equipment expenditures relating to purchases of certain tooling, laboratory and manufacturing facility equipment and $27.1 million cash paid for certain investments, which including $23.0 million towards our investment in Enovix. Such uses of cash were offset by sale and maturities of investments of $85.9 million. Financing Activities In fiscal 2016, we generated approximately $289.5 million of cash from financing activities, primarily from our borrowings on the 4.50% Senior Convertible Notes of $287.5 million, $450 million borrowing on our Term Loan B and proceeds of $43.9 million from employee equity awards. Such borrowings were offset by the repurchase of stock in the amount of $175.7 million, net repayments of $312.0 million on the revolving credit facility, $141.4 million dividend payments, purchase of capped call for the 4.50% Senior Exchangeable Notes of $8.2 million and repayments of capital leases and Term Loan A of $10.6 million. Fiscal 2015: Operating Activities In fiscal 2015, net cash provided by operating activities was $8.8 million compared to net cash provided by operating activities of $103.3 million in fiscal 2014. Net cash provided by operating activities in fiscal 2015 was primarily due to a net loss of $378.9 million adjusted for a net non-cash items of $293.6 million and a net cash provided by change in operating assets and liabilities of $96.4 million. The non-cash adjustments primarily consisted of depreciation and amortization of $243.8 million, stock based compensation expense of $93.5 million, non-cash restructuring charges of $8.6 million and, gain on the sale of our TrueTouch® mobile business of $66.5 million. The net cash provided by changes in operating assets and liabilities was due a decrease in inventories of $228.3 million offset by an increase in accounts receivables of $117.4 million, increase in other assets of $6.0 million, decrease in accounts payable, accrued and other liabilities of $54.3 million and a decrease in deferred income of $14.2 million. The decrease in inventory was primarily due to $133.0 million of reserves recorded to write down inventory assumed from the Merger and was recognized as part of the Company's strategy to focus on high margin, profitable business as a combined company and to move away from the production and sale of inventory associated with non-strategic businesses. Investing Activities In fiscal 2015, we used $79.1 million of cash in our investing activities compared to $42.2 million in fiscal 2014. The cash we used in investing activities in fiscal 2015 was primarily due to $105.1 million in net cash paid on the Merger as part of purchase consideration, $47.2 million of cash used for property and equipment expenditures $28.0 million cash paid for equity investments and $6.1 million paid for a cost method investment. These increases were partially offset by $17.4 million of proceeds from the sales or maturities of investments and $98.6 million of cash proceeds from the sale of our TrueTouch® Mobile business, of the total cash proceeds received from the sale of our TrueTouch® mobile business, $10.0 million are held in an Escrow account until January 2017. Financing Activities In fiscal 2015, we generated $193.2 million of cash from our financing activities compared to $43.4 million in fiscal 2014. The cash we used in our financing activities in fiscal 2015 was primarily related our net borrowings on the revolving credit facility of $537.0 million, borrowings of $97.2 million on Term Loan A, net of costs, proceeds from settlement of capped calls which were assumed as part of the Merger of $25.3 million and net proceeds from the issuance of common shares under our employee stock plans of $52.3 million. The increases were offset by $315.0 million repayment of line of credit facility, $128.0 million of dividend payments, $55.1 million of repurchase of treasury stock and $9.6 million cash used for yield enhanced structured agreements settled in common stock. Fiscal 2014: Operating Activities In fiscal 2014, net cash provided by operating activities was $103.3 million compared to $67.6 million in fiscal 2013. The increase in operating cash flows for fiscal 2014 was primarily due to an increase in net income of $66.2 million compared to fiscal 2013. Our operating cash flow for 2014 of $103.3 million was primarily due to our net income of $16.5 million, net favorable non-cash adjustments to our net income including stock-based compensation of $50.2 million and depreciation and amortization of $46.7 million, and a net change in working capital of $15.7 million. Investing Activities In fiscal 2014, net cash used in investing activities was $42.2 million compared to net cash used in investing activities of $0.3 million in fiscal 2013. The net cash used in our investing activities in fiscal 2014 was primarily due to investment purchases of $23.4 million, purchases of property and equipment of $20.9 million and investments made in other entities accounted for under the cost or equity method of accounting of $18.4 million, offset by the proceeds from sales of investments of $16.6 million. Financing Activities In fiscal 2014, net cash used in financing activities was $43.4 million compared to $45.0 million in fiscal 2013. The cash we used in our financing activities in fiscal 2014 was primarily due to payment of dividends of $69.2 million and the repayment of debt and obligations under capital leases of $6.3 million, offset by net proceeds of $32 million from the issuance of common shares under our employee stock plans. Liquidity and Contractual obligations Senior Secured Revolving Credit Facility On July 5, 2016, the Company entered into a Joinder and Amendment Agreement with the guarantors party thereto, the initial incremental term loan lenders party thereto and Morgan Stanley Senior Funding, Inc., as administrative agent and collateral agent. The Joinder Agreement supplements the Company’s existing Amended and Restated Credit and Guaranty Agreement, dated as of March 12, 2015, by and among the Company, the guarantors, the lenders, the Agent, and Morgan Stanley Bank, N.A., as issuing bank and others. The Joinder and Amendment Agreement provides for the incurrence by the Company of an incremental term loan in an aggregate principal amount of $450.0 million (“Term Loan B”). The incurrence of Term Loan B is permitted as an incremental loan under the Credit Agreement and is subject to the terms of the Credit Agreement and to additional terms set forth in the Joinder and Amendment Agreement. Term Loan B will initially bear interest at (i) an adjusted LIBOR rate loan plus an applicable margin of 5.50% or (ii) an adjusted base rate loan plus an applicable margin of 4.50%. Following the delivery of the Compliance Certificate and the financial statements for the period ending the last day of the third Fiscal Quarter of 2016, Term Loan B shall bear interest, at the Company’s option, at (i) an adjusted LIBOR rate plus an applicable margin of either 5.25% or 5.50%, or (ii) an adjusted base plus an applicable margin of either 4.25% or 4.50%, with the applicable margin in each case determined based on the Company’s total net leverage ratio for the trailing twelve month period ended as of the last day of the Company’s most recently ended fiscal quarter. The Company paid an upfront fee to the initial incremental lenders in an amount equal to 1.5% of the aggregate principal amount of the Incremental Term Loan funded. The Company is required to pay a prepayment premium of 1% of the principal amount prepaid if it prepays the Incremental Term Loan in certain circumstances prior to the date that is twelve months after the Closing Date. Term Loan B was fully funded on the Closing Date and matures on July 5, 2021.The Company incurred financing costs of $11.5 million to the lenders of Term Loan B which has been capitalized and recognized as a deduction of the Term Loan B balance in “Long-term revolving credit facility and long term debt” on the Consolidated Balance Sheet. These costs will be amortized over the life of Term Loan B and recorded in “Interest Expense” on the Consolidated Statement of Operations. The Credit Facility, as amended, provides for a $450 million revolving credit facility and generally contains the same representations and warranties, covenants, and events of default that it contained prior to the effectiveness of the Amendment. The Amendment did not change the interest rate or maturity applicable to the Credit Facility and the Credit Facility remains guaranteed by certain present and future wholly-owned material domestic subsidiaries (the “Guarantors”) and secured by a security interest in substantially all of our assets and the Guarantors. The proceeds of the Incremental Term Loan were used to finance a portion of the purchase price for the Company’s acquisition of certain assets related to the IoT business, and to pay fees and expenses incurred in connection with the acquisition. We believe that the liquidity provided by existing cash, cash equivalents and available-for-sale investments and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, should economic conditions and/or financial, business and other factors beyond our control adversely affect the estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. In addition, we may choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives (including the acquisition of other companies) and provide us with additional flexibility to take advantage of other business opportunities that arise. As of January 1, 2017, we were in compliance with all of the financial covenants under the Credit Facility. As of the filing date of this Form 10-K, $872.0 million aggregate principal amount of loans and letters of credit are outstanding under the Credit Facility. Refer to Note 14 of the Notes to the Consolidated Financial Statements under Item 8 for more information on our senior secured revolving credit facility. Contractual Obligations The following table summarizes our contractual obligations as of January 1, 2017: (1) Purchase obligations primarily include non-cancelable purchase orders for materials, services, manufacturing equipment, building improvements and supplies in the ordinary course of business. Purchase obligations are defined as enforceable agreements that are legally binding on us and that specify all significant terms, including quantity, price and timing. (2) Operating leases includes payments relating to Spansion's lease for office space in San Jose for a new headquarters entered on May 22, 2014, which is no longer required. The lease is for a period of 12 years, with two options to extend for periods of five years each after the initial lease term. The term of the lease commenced on January1, 2015 and expires on December 31, 2026. As of January 1, 2017 our unrecognized tax benefits were $24.3 million, which were classified as long-term liabilities. We believe it is possible that we may recognize approximately $0.5 million of our existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of agreements with domestic and various foreign tax authorities. Equity Investment Commitments We have committed to make additional investments of an amount of approximately $5 million in Enovix subject to the attainment of certain milestones. Capital Resources and Financial Condition Our long-term strategy is to maintain a minimum amount of cash for operational purposes and to invest the remaining amount of our cash in interest-bearing and highly liquid cash equivalents and debt securities, repayment of debt, the purchase of our stock through our stock buyback program and payments of regularly scheduled cash dividends. In addition we may use excess cash to invest in strategic investments and partnerships and pursue acquisitions. Our investment policy defines three main objectives when buying investments: security of principal, liquidity, and maximization of after-tax yield. We invest excess cash in various financial securities subject to certain requirements including security type, duration, concentration limits, and credit rating profile. As of January 1, 2017 a total cash and short-term investment position of $121.1 million is available for use in current operations. As of January 1, 2017, approximately 64.0% of our cash and cash equivalents and available-for-sale investments are held outside of the United States. While these amounts are primarily invested in U.S. dollars, a portion is held in foreign currencies. All offshore balances are exposed to local political, banking, currency control and other risks. In addition, these amounts, if repatriated may be subject to tax and other transfer restrictions. On February 17, 2017, we amended our Senior Secured Credit Facility. The amendment reduced the applicable margin on our Term Loan A from 5.11% to 3.75% and on our Term Loan B from 5.50% to 3.75% effective February 17, 2017. Additionally, the amended financial covenants include the following conditions: 1) maximum senior secured leverage ratio of 4.25 to 1.00 through December 31, 2017, 2) maximum senior secured leverage ratio of 4.00 to 1.00 through July 1, 2018 and 3.75 to 1.00 thereafter. We believe that liquidity provided by existing cash, cash equivalents and investments, our cash from operations and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, should economic conditions were to become adverse, debt covenants constraints, and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. We may also choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives including the acquisition of other companies, repurchases of shares of stock or increase our dividends or pay a special dividend and provide us with additional flexibility to take advantage of other business opportunities that arise. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K and the data used to prepare them. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and we are required to make estimates, judgments and assumptions in the course of such preparation. Note 1 of the Notes to the Consolidated Financial Statements under Item 8 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an ongoing basis, we re-evaluate our judgments and estimates including those related to revenue recognition, allowances for doubtful accounts receivable, inventory valuation, valuation of long-lived assets, goodwill and financial instruments, stock-based compensation, and settlement costs, and income taxes. We base our estimates and judgments on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies that are affected by significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements are as follows: Revenue Recognition: We generate revenues by selling products to distributors, various types of manufacturers including original equipment manufacturers (“OEMs”) and electronic manufacturing service providers (“EMSs”). We recognize revenue on sales to OEMs and EMSs provided that persuasive evidence of an arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations. Sales to certain distributors are made under agreements which provide the distributors with price protection, stock rotation and other allowances under certain circumstances. When we determine that the uncertainties associated with the rights given to these distributors, revenues and costs related to distributor sales are deferred until products are sold by the distributors to the end customers. In those circumstances, revenues are recognized upon receiving notification from the distributors that products have been sold to the end customers. In these cases, at the time of shipment to distributors, we record a trade receivable for the selling price since there is a legally enforceable right to receive payment, relieves inventory for the value of goods shipped since legal title has passed to the distributors, and defers the related margin and price adjustment as deferred income on sales to distributors on the Consolidated Balance Sheets. Any effects of distributor price adjustments are recorded as a reduction to deferred income at the time the distributors sell the products to the end customers and the distributor submits a valid claim for the price adjustment. We have prior to 2014, recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty in estimating the ultimate price of these product shipments and amount of potential returns. We continuously reassess our ability to reliably estimate the ultimate price of these products and, over the past several years, has made investments in its systems and processes around its distribution channel to improve the quality of the information it receives from its distributors. Given these ongoing investments, and based on the financial framework we use for estimating potential price adjustments, in the fourth quarter of 2014 we began recognizing revenue on certain product families and with certain distributors (less its estimate of future price adjustments and returns) upon shipment to the distributors (also referred to as the sell-in basis of revenue recognition). During fiscal 2016, we recognized approximately $59.2 million of incremental revenue from this change in revenue recognition, which resulted in a reduction of our net loss of $19.5 million for fiscal 2016, or $0.06 per basic and diluted share. We record as a reduction to revenues reserves for sales returns, price protection and allowances, based upon historical experience rates and for any specific known customer amounts. We also provide certain distributors and EMSs with volume-pricing discounts, such as rebates and incentives, which are recorded as a reduction to revenues at the time of sale. Historically these volume discounts have not been significant. Our revenue reporting is highly dependent on receiving pertinent, accurate and timely data from our distributors. Distributors provide us periodic data regarding the product, price, quantity, and end customer when products are resold as well as the quantities of our products they still have in stock. Because the data set is large and complex and because there may be errors in the reported data, we must use estimates and apply judgments to reconcile distributors’ reported inventories to their activities. Actual results could vary materially from those estimates. Business Combinations: We apply the provisions of Accounting Standards Codification 805, Business Combinations (“ASC 805”), in the accounting for acquisitions. It requires us to recognize separately from goodwill the assets acquired and the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date as well as contingent consideration, where applicable, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our Consolidated Statements of Operations. Accounting for business combinations requires the Company's management to make significant estimates and assumptions, especially at the acquisition date including our estimates for intangible assets, contractual obligations assumed, restructuring liabilities, pre-acquisition contingencies and contingent consideration, where applicable. Although we believe the assumptions and estimates it has made have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets we have acquired include but are not limited to: future expected cash flows from product sales, customer contracts and acquired technologies, expected costs to develop in-process research and development into commercially viable products and estimated cash flows from the projects when completed and discount rates. Unanticipated events and circumstances may occur that may affect the accuracy or validity of such assumptions, estimates or actual results. Valuation of Inventories: Management periodically reviews the adequacy of our inventory reserves. We record a write-down for our inventories which have become obsolete or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventories each quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans and current sales levels. Inventory reserves are not relieved until the related inventory has been sold or scrapped. Our inventories may be subject to rapid technological obsolescence and are sold in a highly competitive industry. If there were a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to record additional write-downs, and our gross margin could be adversely affected. Valuation of Long-Lived Assets: Our business requires heavy investment in manufacturing facilities and equipment that are technologically advanced but can quickly become significantly under-utilized or rendered obsolete by rapid changes in demand. In addition, we have recorded intangible assets with finite lives related to our acquisitions. We evaluate our long-lived assets, including property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors considered important that could result in an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the assets or the strategy for our business, significant negative industry or economic trends, and a significant decline in our stock price for a sustained period of time. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analysis. If there is a significant adverse change in our business in the future, we may be required to record impairment charges on our long-lived assets. Valuation of Goodwill: Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. We assess our goodwill for impairment on an annual basis and, if certain events or circumstances indicate that an impairment loss may have been incurred, on an interim basis. In accordance with ASU 2011-08, Testing Goodwill for Impairment, qualitative factors can be assessed to determine whether it is necessary to perform the current two-step test for goodwill impairment. If we believe, as a result of our qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. Cash Flow Hedges: The Company enters into cash flow hedges to protect non-functional currency revenues, inventory purchases and certain other operational expenses against variability in cash flows due to foreign currency fluctuations. The Company’s foreign currency forward contracts that were designated as cash flow hedges have maturities between three and nine months. All hedging relationships are formally documented, and the hedges are designed to offset changes to future cash flows on hedged transactions at the inception of the hedge. The Company recognizes derivative instruments from hedging activities as either assets or liabilities on the balance sheet and measures them at fair value on a monthly basis. The Company records changes in the intrinsic value of its cash flow hedges in accumulated other comprehensive income on the Consolidated Balance Sheets, until the forecasted transaction occurs. Interest charges or “forward points” on the forward contracts are excluded from the assessment of hedge effectiveness and are recorded in other income (expense), net in the Consolidated Statements of Operations. When the forecasted transaction occurs, the Company reclassifies the related gain or loss on the cash flow hedge to revenue or costs, depending on the risk hedged. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, the Company will reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income to other income (expense), net in its Consolidated Statements of Operations at that time. The Company evaluates hedge effectiveness at the inception of the hedge prospectively as well as retrospectively and records any ineffective portion of the hedge in other income (expense), net in its Consolidated Statements of Operations. Refer Note 11 of the Notes to the Consolidated Financial Statements under Item 8 for further details on cash flow and balance sheet hedges. Stock-Based Compensation: Under the fair value recognition provisions of the guidance, we recognize stock-based compensation net of an estimated forfeiture rate and only recognize compensation cost for those shares expected to vest over the requisite service period of the awards. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including measurement of level of achievement of performance milestones, the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, our future stock-based compensation expense could be significantly different from what we have recorded. Employee Benefit Plans: In connection with the Merger, we assumed the Spansion Innovates Group Cash Balance Plan (a defined benefit pension plan) in Japan. A defined benefit pension plan is accounted for on an actuarial basis, which requires the selection of various assumptions such as turnover rates, discount rates and other factors. The discount rate assumption is determined by comparing the projected benefit payments to the Japanese corporate bonds yield curve as of end of the most recently completed fiscal year. The benefit obligation is the projected benefit obligation (PBO), which represents the actuarial present value of benefits expected to be paid upon retirement. This liability is recorded in other long term liabilities on the Consolidated Balance Sheets. Net periodic pension cost is recorded in the Consolidated Statements of Operations and includes service cost. Service cost represents the actuarial present value of participant benefits earned in the current year. Interest cost represents the time value of money associated with the passage of time on the PBO. Gains or losses resulting from a change in the PBO if actual results differ from actuarial assumptions will be accumulated and amortized over the future life of the plan participants if they exceed 10% of the PBO, being the corridor amount. If the amount of a net gain or loss does not exceed the corridor amount, it will be recorded to other comprehensive income (loss). See Note 18 of the Notes to the Consolidated Financial Statements for further details of the pension plans. Accounting for Income Taxes: Our global operations involve manufacturing, research and development and selling activities. Profits from non-U.S. activities are subject to local country taxes but are not subject to U.S. tax until repatriated to the U.S. United States income tax has not been provided on a portion of earnings of our non-U.S. subsidiaries to the extent that such earnings are considered to be indefinitely reinvested. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. We consider historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. Should we determine that we would be able to realize deferred tax assets in the future in excess of the net recorded amount, we would record an adjustment to the deferred tax asset valuation allowance. This adjustment would increase income in the period such determination is made. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If payment of these amounts ultimately proves to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If the estimate of tax liabilities proves to be less than the ultimate tax assessment, a further charge to expense would result. Recent Accounting Pronouncements See “Recent Accounting Pronouncements” in Note 1 of the Notes to the Consolidated Financial Statements under Item 8 of this Annual Report on Form 10-K.

<s>[INST] EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress” or “the Company”) manufactures and sells advanced embedded system solutions for automotive, industrial, home automation and appliances, consumer electronics and medical products. Cypress’s programmable systemsonchip, generalpurpose microcontrollers, analog ICs, IoT and USBC based connectivity solutions and memories help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. Mergers, Acquisitions and Divestitures Merger with Spansion On March 12, 2015, we completed the merger (“Merger”) with Spansion Inc. ("Spansion") pursuant to the Agreement and Plan of Merger and Reorganization, dated as of December 1, 2014 (the "Merger Agreement"), for a total consideration of approximately $2.8 billion. Acquisition of Broadcom Corporation’s Internet of Things business (“IoT business”) On July 5, 2016, we completed the acquisition of certain assets primarily related to the IoT business of Broadcom pursuant to an Asset Purchase Agreement with Broadcom Corporation, dated April 28, 2016, for a total consideration of $550 million. The following MD&A includes the financial results of the IoT business beginning July 5, 2016. The comparability of our results for the year ended January 1, 2017 to the same periods in fiscal 2015 is significantly impacted by the acquisition. To date, we have incurred approximately $8.9 million of acquisition related costs, including professional fees and other costs associated with the acquisition. The following MD&A includes the financial results of legacy Spansion beginning March 12, 2015 and the financial results of the IoT business acquired from Broadcom beginning July 5, 2016. The comparability of our results for the year ended January 1, 2017 to the same prior year periods is significantly impacted by these transactions. In our discussion and analysis of comparative periods, we have quantified the contribution of additional revenue or expense resulting from these transaction wherever such amounts were material and identifiable. While identified amounts may provide indications of general trends, the analysis cannot completely address the effects attributable to integration efforts. Divestiture of TrueTouch® Business In connection with the sale of the TrueTouch® Mobile touchscreen business to Parade Technologies (“Parade”) on August 1, 2015, we entered into a Manufacturing Service Agreement (“MSA”) in which we agreed to sell finished wafers and devices to Parade. The terms of the MSA provide that we would sell finished products to Parade at agreedupon prices that were considered below fair market value, indicating that there was an embedded fair value that would be realized by Parade through those terms. Accordingly, we had allocated approximately $19.9 million from the $98.6 million proceeds to the fair value of the MSA based on the forecasted wafer sales to Parade for the subsequent periods. That amount was deferred on our consolidated balance sheet initially and is being amortized to revenue as we sell products to Parade. During the year ended January 1, 2017 and January 2, 2016, we recognized approximately $14.2 million and $5.7 million, respectively, of revenue from the amortization of the deferred revenue. Investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement (the "Purchase Agreement"), whereby certain thirdparty investors purchased 41.1% of the shares outstanding at the said date for an aggregate consideration of approximately $111.4 million. Concurrently, Deca repurchased certain of its preferred shares from us. After giving effect to the above transactions, our ownership in Deca reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to thirdparty new investors in the purchase agreement, including, among other things, participation on the Board of directors of Deca, approval of operating plans and appro [/INST] Positive. </s>

CYPRESS SEMICONDUCTOR CORP /DE/

2018-02-26

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The MD&A contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that involve risks and uncertainties, which are discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress” or “the Company”) manufactures and sells advanced embedded system solutions for automotive, industrial, home automation and appliances, consumer electronics and medical products. Cypress’ microcontrollers, analog ICs, wireless and wired connectivity solutions and memory products help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. Mergers, Acquisitions and Divestitures Merger with Spansion On March 12, 2015, we completed the merger (“Merger”) with Spansion Inc. ("Spansion") pursuant to the Agreement and Plan of Merger and Reorganization, dated as of December 1, 2014 (the "Merger Agreement"), for a total consideration of approximately $2.8 billion. Acquisition of Broadcom Corporation’s Internet of Things business (“IoT business”) On July 5, 2016, we completed the acquisition of certain assets primarily related to the IoT business of Broadcom pursuant to an Asset Purchase Agreement with Broadcom Corporation, dated April 28, 2016, for a total consideration of $550 million. The following MD&A includes the financial results of the IoT business beginning July 5, 2016. The comparability of our results for the year ended December 31, 2017, January 1, 2017 to the same periods in fiscal 2015 is significantly impacted by the acquisition. To date, we have incurred approximately $9.2 million of acquisition related costs, including professional fees and other costs associated with the acquisition. The following MD&A includes the financial results of legacy Spansion beginning March 12, 2015 and the financial results of the IoT business acquired from Broadcom beginning July 5, 2016. The comparability of our results for the year ended December 31, 2017 to the same prior year periods is significantly impacted by these transactions. In our discussion and analysis of comparative periods, we have quantified the contribution of additional revenue or expense resulting from these transactions wherever such amounts were material and identifiable. While identified amounts may provide indications of general trends, the analysis cannot completely address the effects attributable to integration efforts. Divestiture of TrueTouch® Business In connection with the sale of the TrueTouch® Mobile touchscreen business to Parade Technologies (“Parade”) on August 1, 2015, we entered into a Manufacturing Service Agreement (“MSA”) in which we agreed to sell finished wafers and devices to Parade. The terms of the MSA provide that we would sell finished products to Parade at agreed-upon prices that were considered below fair market value, indicating that there was an embedded fair value that would be realized by Parade through those terms. Accordingly, we had allocated approximately $19.9 million from the $98.6 million proceeds to the fair value of the MSA based on the forecasted wafer sales to Parade for the subsequent periods. That amount was deferred on our consolidated balance sheet initially and was amortized to revenue as we sold products to Parade. Such amount has been fully amortized in fiscal 2017. During the year ended January 1, 2017 and January 2, 2016, we recognized approximately $14.2 million and $5.7 million, respectively, of revenue from the amortization of the deferred revenue. Investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement (the "Purchase Agreement"), whereby certain third-party investors purchased 41.1% of the shares outstanding at the said date for an aggregate consideration of approximately $111.4 million. Concurrently, Deca repurchased certain of its preferred shares from us. After giving effect to the above transactions, our ownership in Deca reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to third-party new investors in the purchase agreement, including, among other things, participation on the Board of directors of Deca, approval of operating plans and approval of indebtedness, we determined that we no longer have the power to direct the activities of Deca that most significantly impacts Deca's economic performance. However, as we continue to have significant influence over Deca's financial and operating policies, effective July 29, 2016, the investment in Deca is being accounted for as an equity method investment and financial results of Deca are no longer being consolidated. The carrying value of this equity method investment was determined based on the fair value of the equity in Deca, which the Company calculated to be $142.5 million. This represents our remaining investment in Deca immediately following the investments by third-party investors. As a result of the change in the method of accounting for our investment in Deca from consolidation to the equity method of accounting, the net carrying value of the assets and liabilities related to Deca, and the adjustments related to the recognition of the initial fair value of the equity method investment resulted in a gain of $112.8 million which has been reflected as "Gain related to investment in Deca Technologies Inc." in the Consolidated Statements of Operations. Sale of CMI In fiscal 2017, we completed the sale of our wafer fabrication facility in Minnesota for gross proceeds from the sale of $30.5 million. Business Developments Business Segments We continuously evaluate our reportable business segments in accordance with the applicable accounting guidance. Pursuant to reorganization and internal reporting structure effective fourth quarter, the Company operates under two reportable business segments: MPD and MCD. Prior to the fourth quarter of fiscal 2016, the Company reported under four reportable business segments: MPD, Programmable Systems Division ("PSD"), Data Communications Division ("DCD") and Emerging Technologies Division ("ETD"). The prior reportable segments of PSD and DCD have been combined and are referred to as MCD. Deca, previously included in ETD, and now accounted for as an equity method investment, has been reflected in MCD for historical results. The MPD segment comprises a substantial portion of the previous MPD segment, as well as certain portions of the previous PSD. AgigA Tech Inc., a subsidiary previously included in ETD has been combined with MPD. The prior periods herein reflect this change in segment information. RESULTS OF OPERATIONS Revenues Our total revenues increased by $404.7 million, or 21.04%, to $2,327.8 million for the year ended December 31, 2017 compared to the prior year. For the year ended December 31, 2017, the increase was primarily attributable to increase in sales of products in our microcontroller, automotive, IoT Wireless Connectivity and Wired families included in MCD. Revenue for the year ended December 31, 2017 benefited from the acquisition of the IoT business of Broadcom, as compared to the prior year which included such sales only for a partial period post acquisition. Revenue for the year ended January 1, 2017 benefited from the Spansion Merger, as compared to the prior year which included such sales only for a partial period post merger, offset by the divestiture of the True Touch® business. The Company operates on a 52 or 53-week year ending on the Sunday nearest to December 31. Fiscal 2017 and 2016 were each 52 weeks and fiscal 2015 was a 53-week year, with the extra week in the fourth fiscal quarter. The additional week in fiscal 2015 did not materially affect the Company's results of operations or financial position. Consistent with our accounting policies and generally accepted accounting principles, prior to fiscal 2014 we recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty, at the time in estimating the ultimate price of these product shipments and amount of potential returns. In the fourth quarter of 2014, the Company began recognizing revenue on certain product families and with certain distributors (less its estimate of future price adjustments and returns) upon shipment to the distributors (also referred to as the sell-in basis of revenue recognition). During the year ended January 1, 2017, we recognized an incremental $59.2 million of revenue on new product families or distributors for which we recognized revenue on a sell-in basis. This change resulted in a decrease to the net loss of $19.5 million for the year ended January 1, 2017 or $0.06 per basic and diluted share. By the end of fiscal 2016, all our revenue from transactions with distributors was recognized on a sell-in basis of revenue recognition. During the year ended January 3, 2016, we recognized an incremental $40.9 million of revenue on additional product families for which revenue was previously recognized on a sell-through basis. This change resulted in a decrease to the net loss of $25.0 million for the year ended January 3, 2016 or $0.08 per basic and diluted share. The following table summarizes our consolidated revenues by segments: Microcontroller and Connectivity Division: Revenues recorded by MCD increased in fiscal 2017 by $414.8 million, or 41.7%, compared to fiscal 2016. We acquired the IoT business acquired from Broadcom on July 5, 2016. Consequently, fiscal 2016 revenue included only a partial period for the results from the IoT business. Additionally MCD revenues increased in fiscal 2017 as compared to fiscal 2016, due to increased revenue from our wired and wireless connectivity and PSoC products. Revenues from MCD in fiscal 2016 increased by $263.2 million or 36.0%, compared to fiscal 2015. The increase in fiscal 2016 was primarily driven by the acquisition of the IoT business from Broadcom. Additionally, MCD revenue benefited from increased revenue from the microcontrollers product family. The overall average selling price of our products for MCD for the year ended December 31, 2017 was $0.99 which decreased from the prior-year. The decrease is primarily attributed to lower ASPs for wired and wireless IoT products. The overall average selling price of our products for MCD for the year ended January 1, 2017 was $1.02 which remained unchanged as compared to fiscal 2015. Memory Products Division: Revenues recorded by MPD decreased in fiscal 2017 by $10.1 million, or 1.1% compared to fiscal 2016. The decrease was primarily due to declines in revenue from NAND products offset by strength in revenue from NOR products. Revenues from MPD increased in fiscal 2016 by $52.1 million, or 5.9% compared to fiscal 2015. The increase was primarily due to revenue contribution from the Flash memory products which grew primarily in the automotive and consumer segments. This was partially offset by a decrease in revenue from SRAM products. The overall average selling prices (ASPs) of our products for MPD for the year ended December 31, 2017 was $1.39, which increased by $0.14, compared with the prior year. The increase is primarily attributed to the higher ASPs of certain products in the Flash memory products. The overall ASPs of our products for MPD for the year ended January 1, 2017 was $1.25, which decreased by $0.10, compared to $1.35 in prior year. The decrease is primarily attributed to lower ASPs in the overall memory segment, particularly in NAND and SRAM products. Cost of Revenues Our cost of revenue ratio improved from 64.2% in fiscal 2016 to 58.9% in fiscal 2017. One of the primary drivers of the improvement in the cost of revenue ratio was lower Spansion acquisition-related expenses which declined $21.8 million as compared to the prior year. Another major contributor in the improvement in the cost of revenue ratio was higher fab utilization which increased from 56% for the year ended January 1, 2017 to 74% for the year ended December 31, 2017 and a reduction in the cost of certain products. Additionally, our cost of revenue ratio improved due to the sale of products from the acquired IoT business, which have a lower cost of revenue ratio than the company average. This was partially offset by higher write downs of carrying value of inventory during the year ended December 31, 2017 as compared to the prior year. Write-down of inventories during fiscal 2017 was $34.5 million as compared to $25.3 million in fiscal 2016. Sale of inventory that was previously written-off or written-down aggregated to $31.6 million for fiscal 2017 as compared to $65.7 million in fiscal 2016. Our cost of revenues ratio improved from 74.9% in fiscal 2015 to 64.2% in fiscal 2016. The primary driver of the improvement in the cost of revenue ratio was lower write downs of carrying value of inventory during fiscal 2016 as compared to the prior year and our on-going focus on gross margin expansion through cost reductions, price increases and synergies recognized from the merger. Included in the cost of revenues for fiscal 2015 was a $133.0 million write-down of carrying value of inventory assumed as a part of the Spansion Merger as well as a write down of $19.5 million of certain other inventories. In comparison, write-down of inventories during fiscal 2016 was $25.3 million. Sale of inventory that was previously written-off or written-down aggregated to $65.7 million for fiscal 2016 and $6.4 million for fiscal 2015, which favorably impacted our cost of revenues ratio in fiscal 2016. This impact was partially offset by lower fab utilization which was 56% for fiscal 2016 as compared to 62% in fiscal 2015. Research and Development (“R&D”) R&D expenditures increased by $25.8 million in fiscal 2017 compared to the same prior-year period. The increase was mainly attributable to $40.3 million of expenses due to the IoT business acquisition, primarily comprised of $28.2 million of increase in labor costs due to increased headcount and an increase of $12.1 million in expensed assets. The above increases were partially offset by a $1.4 million decrease in stock-based compensation expense and a $13.1 million decrease in other R&D expenses, mainly due to lower labor cost due to Cypress 3.0 restructuring and project spending. R&D expenditures increased by $56.4 million in fiscal 2016 compared to fiscal 2015. The increase was mainly attributable to $36.8 million of expenses due to the IoT acquisition, primarily comprised of $22.6 million of increase in labor costs due to additional headcount and increase of $14.2 million in expensed assets. The remaining increase of $19.6 million in other R&D expense was primarily due to $16.3 million of stock-compensation expense. Selling, General and Administrative (“SG&A”) SG&A expenses decreased by $13.7 million in fiscal 2017 compared to fiscal 2016. The decrease was mainly due to lower acquisition cost of $15.4 million related to the IoT acquisition, a $5.0 million decrease due to executive severance costs incurred in fiscal 2016, and $10.0 million decrease in non-recurring costs, offset by higher labor costs of $8.2 million, an increase of $5.4 million related to IoT operating expenses, and an increase of $3.1 million in stock-based compensation expenses. SG&A expenses decreased by $2.9 million in fiscal 2016 compared to fiscal 2015. The decrease was mainly due to lower acquisition expenses of $14.1 million primarily related to merger of Spansion, a $5.7 million decrease in stock-based compensation expenses, offset by acquisition costs associated with the IoT acquisition of $8.9 million, and IoT operating expenses of $9.8 million primarily related to labor. Amortization of Acquisition-Related Intangible Assets During fiscal 2017, amortization of acquisition-related intangible assets increased by $20.6 million compared to fiscal 2016. The increase was mainly due to the amortization of the intangibles acquired in connection with the IoT business acquisition as well as the amortization related to certain in-process research and development projects, which had reached technological feasibility and were transferred to developed technology, capitalized during 2017. During fiscal 2016, amortization of acquisition-related intangible assets increased by $66.4 million compared to fiscal 2015. The increase was mainly due to the amortization of the intangibles acquired in connection with the IoT business acquisition, Spansion Merger as well as certain in-process research and development projects capitalized during 2016. Costs and settlement charges related to shareholder matter During fiscal 2017, the Company incurred $14.3 million of shareholder litigation and proxy related expenses which includes $3.5 million in reimbursement charges incurred in connection with the cooperation and settlement agreement entered into with T.J. Rodgers. Impairment of acquisition-related intangible assets During fiscal 2016, we recognized $33.9 million of impairment charges related to two IPR&D projects that were canceled due to certain changes in our long-term product portfolio strategy during fiscal 2016. There were no impairment charges of acquisition-related intangibles during fiscal 2017 and fiscal 2015. Gain related to investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement (the "Purchase Agreement"), whereby certain third-party investors purchased 41.1% of the shares outstanding at the said date for an aggregate consideration of $111.4 million. Concurrently, Deca repurchased certain of its preferred shares previously held by Cypress. After giving effect to the above transactions, our ownership in Deca reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to third-party new investors in the purchase agreement, including, among other things, participation on the Board of directors of Deca, approval of operating plans, approval of indebtedness etc., we determined that we no longer have the power to direct the activities of Deca that most significantly impacts Deca's economic performance. However, as we continue to have significant influence over Deca's financial and operating policies, effective July 29, 2016, the investment in Deca is being accounted for as an equity method investment and Deca is no longer a consolidated subsidiary. The carrying value of this equity method investment was determined based on the fair value of the equity in Deca, which the Company calculated to be $142.5 million. This represents our remaining investment in Deca immediately following the investments by third-party investors. As a result of the change in the method of accounting for our investment in Deca from consolidation to the equity method of accounting, the net carrying value of the assets and liabilities related to Deca, and the adjustments related to the recognition of the initial fair value of the equity method investment resulted in a gain of $112.8 million which has been reflected as "Gain related to investment in Deca Technologies Inc." in the Consolidated Statements of Operations. Impairment related to assets held for sale During fiscal 2016, we committed to a plan to sell our wafer manufacturing facility located in Bloomington, Minnesota, as well as a building in Austin, Texas. The sale of these assets was completed in the first quarter of fiscal 2017. See Note 6 of the Notes to the Consolidated Financial Statements. We recorded an impairment charge of $37.2 million during fiscal 2016, to reflect the estimated fair value, net of cost to sell these assets. During fiscal 2017, we recorded a $1.2 million adjustment as a result of changes in certain estimates related to these assets, resulting in a reduction of operating expense. Goodwill impairment charge During fiscal 2016, we recorded a goodwill impairment charge of $488.5 million related to our former PSD reporting unit. The goodwill impairment charge resulted from a combination of factors including, (a) decreases in our forecasted operating results when compared with the expectations of the PSD reporting unit at the time of the Spansion Merger, primarily in consumer markets as the Company has subsequently increased its focus on the automotive and industrial end markets, (b) evaluation of business priorities due to recent changes in management at that time, and (c) certain market conditions which necessitated a quantitative impairment analysis for the carrying value of the goodwill related to PSD. There were no goodwill impairment charges recorded during fiscal 2017 and fiscal 2015. Restructuring 2017 Restructuring Plan In December 2017, the Company began implementation of a reduction in workforce ("2017 Plan") which will result in elimination of approximately 80 positions worldwide across various functions. The restructuring charge of $6.4 million during the year ended December 31, 2017 consists of personnel costs. The Company expects to incur costs and cash payments under this plan to be completed by the end of fiscal 2018. We will reinvest a substantial portion of the savings generated from the 2017 Restructuring Plan into certain business initiatives and opportunities. Consequently, we do not expect the 2017 Restructuring Plan to result in a material reduction in our operating expenses. 2016 Restructuring Plan In September 2016, the Company began implementation of a reduction in workforce ("2016 Plan") resulting in the elimination of approximately 430 positions worldwide across various functions. The restructuring charge of $2.6 million during the year ended December 31, 2017 consists of personnel costs of $1.0 million and other charges related to the write-off of certain licenses and facilities related expenses of $1.6 million The personnel costs related to the 2016 Plan during the year ended January 1, 2017 were $26.3 million. The Company expects that the costs incurred under the 2016 Plan will be paid out in cash through first quarter of fiscal 2018. We have reinvested a substantial portion of the savings generated from the 2016 Restructuring Plan into certain business initiatives and opportunities. Consequently, the 2016 Restructuring Plan did not result in a material reduction in our operating expenses. Spansion Integration-Related Restructuring Plan In March 2015, we began the implementation of planned cost reduction and restructuring activities in connection with the Merger. During fiscal 2015, restructuring charge of $90.1 million primarily consists of severance costs, lease termination costs and impairment of property, plant and equipment. The lease termination costs include approximately $18.0 million relating to the buildings Spansion had leased prior to the Merger, which we decided not to occupy in the post-Merger period. The initial term of the lease commenced on January 1, 2015 and will expire on December 31, 2026. During fiscal 2016, a release of previously estimated personnel related liability of $0.1 million was recorded. We anticipate that the remaining restructuring liability balance will be paid out over the remaining lease term through 2026 for the excess lease obligation. Gain on Divestiture of TrueTouch® Mobile Business In connection with the sale of the TrueTouch® mobile touchscreen business to Parade for total cash proceeds of $98.6 million, we sold certain assets associated with the disposed business mostly consisting of inventory with a net book value of $10.5 million and recognized a gain of $66.5 million in fiscal 2015, net of the amount of gain deferred in connection with an ongoing manufacturing service agreement we entered into with Parade in connection with the divestiture. Interest expense Interest expense for fiscal 2017 was $80.2 million and primarily represents interest payments due and amortization of debt discount and costs related to 2% 2023 Exchangeable Notes, 4.5% 2022 Senior Exchangeable Notes, 2% 2020 Spansion Exchangeable Notes, interest expense incurred on our Senior Secured Revolving Credit Facility, Term Loan B and other debt. In addition, of the $80.2 million, $7.2 million was related to the debt extinguishment for 2% 2020 Spansion Exchangeable Notes and Term Loan A. Interest expense for fiscal 2016 was $55.2 million and represents interest payments due and amortization of debt discount and costs related to 4.50% Senior Exchangeable Notes, 2% Senior Exchangeable Notes, interest expense incurred on our revolving line of credit, Term Loan A, Term Loan B and other debt. Interest expense for fiscal 2015 was 16.4 million and represents interest payments due and amortization of debt discount and costs related to 2% Senior Exchangeable Notes, interest expense incurred on our revolving line of credit, Term Loan A and other debt. Refer to Note 14 of Notes to the Consolidated Financial Statements under Item 8 for more information about our credit facilities and other debt. Other Income (expense), Net The following table summarizes the components of other income (expense), net: Employee Deferred Compensation Plan We have a deferred compensation plan, which provides certain key employees, including our executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax-deferred basis. We do not make contributions to the deferred compensation plan and we do not guarantee returns on the investments. Participant deferrals and investment gains and losses remain as our liabilities and the underlying assets are subject to claims of general creditors. In fiscal 2017, 2016 and 2015, we recognized changes in fair value of the assets under the deferred compensation plan in “Other income (expense), net” of $6.1 million, $2.3 million, and $(1.4) million, respectively. The increase or decrease in the fair value of the investments relates to the increased or decreased performance of the portfolio on a year over year basis. Refer to Note 18 of the Notes to the Consolidated Financial Statements under Item 8 for more information about our deferred compensation plan. Unrealized (realized) loss on marketable securities In the fourth quarter of fiscal 2014, the Company, through a wholly-owned subsidiary, purchased 6.9 million ordinary shares of Hua Hong Semiconductor Limited (HHSL) for an aggregate price of $10.0 million in connection with their initial public offering. HHSL is the parent company of Grace Semiconductor Manufacturing Corporation, which is one of our strategic foundry partners. We recorded an unrealized loss on our investment in HHSL’s ordinary shares of $4.7 million in fiscal 2015 as a result of the decline in the fair market value of the investment. During 2016 the Company disposed the shares of HHSL and the realized gain was immaterial to the consolidated financial statements. Share in Net Loss and Impairment of Equity Method Investees We have been making investments in Enovix Corporation ("Enovix"), a privately held development stage company. We invested $5.6 million, $23.0 million and $28.0 million in Enovix during 2017, 2016 and 2015 respectively. Our investment holding comprised of 41.2%, 46.6% and 38.7% of Enovix's equity at the end of fiscal 2017, 2016 and 2015, respectively. Since the fourth quarter of 2014 we have been accounting for our investment in Enovix using the equity method of accounting. During the fourth quarter of 2017, Enovix missed achieving certain key planned product development milestones. We considered various factors in determining whether to recognize an impairment charge, including the expectations of the investee's future cash flows and capital needs, the length of time the investee has been in a loss position, the ability to achieve milestones, and the near-term prospect of the investee and its exit strategy. Enovix’s estimated enterprise value is sensitive to its ability to achieve these milestones. Consequently, we believe our investment in Enovix has suffered an other-than-temporary impairment and we recorded a charge of $51.2 million. In the second quarter of fiscal 2016, we changed the basis of accounting for our investment in Deca Technologies Inc. ("Deca") to the equity method of accounting. As at the end of fiscal year 2017 and 2016, our investment comprised 52.5% of Deca's equity. During fiscal 2017, 2016 and 2015, we recorded $8.7 million, $9.9 million and $7.1 million respectively for our share of losses recorded by Enovix. During fiscal 2017 and 2016, we recorded $11.8 million and $8.2 million respectively for our share of losses recorded by Deca. Income Taxes Our income tax expense was $11.2 million and $2.6 million in fiscal 2017 and 2016, respectively. Our income tax expense was $16.9 million in fiscal 2015. The income tax expense for fiscal 2017 was primarily attributable to non-U.S. taxes on income earned in foreign jurisdictions, and increase in tax reserves, primarily offset by tax benefits resulting from the recently passed tax legislation, the Tax Cuts and Jobs Act of 2017 (the “Act”). Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21%, the repeal of corporate alternative minimum taxes (AMT), the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017. Based on the Act and guidance available as of the date of this filing, the Company determined a provisional estimate of the impact of the one-time transition tax on the mandatory deemed repatriation of accumulative foreign subsidiary earnings. The Company estimates that the transition tax will result in the utilization of $46.0 million of net operating loss carryforwards against which the Company maintains a corresponding valuation allowance. As a result of the reduction in the corporate income tax rate, the Company revalued its net deferred tax asset at December 31, 2017. The provisional amount related to the remeasurement of certain deferred tax liabilities, based on the rates at which they are expected to reverse in the future, was a tax benefit of $3.0 million. The provisional amount related to the repeal of corporate AMT was a tax benefit of $5.6 million as the prior year AMT credit will be refunded over 2018 - 2021. The income tax expense for fiscal 2016 was primarily attributable to income taxes associated with our non-U.S. operations, primarily offset by release of previously accrued taxes related to the lapsing of statutes of limitation. Our effective tax rate varies from the U.S. statutory rate primarily due to earnings of foreign subsidiaries taxed at different rates and a full valuation allowance on net operating losses incurred in the U.S. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We regularly assess our tax positions in light of legislative, bilateral tax treaty, regulatory and judicial developments in the many countries in which we and our affiliates do business. Income tax examinations of our Malaysian subsidiary for the fiscal years 2007 to 2012 and our Philippine subsidiary for fiscal year 2014 are in progress. We do not believe the ultimate outcome of these examinations will result in a material increase to our tax liability. International revenues account for a significant portion of our total revenues, such that a material portion of our pretax income is earned and taxed outside the U.S. at rates ranging from 0% to 25%. The impact on our provision for income taxes of foreign income being taxed at rates different than the U.S. federal statutory rate was an expense of approximately $67.7 million, an expense of $36.6 million, and expense of $22.4 million in 2017, 2016 and 2015, respectively. The foreign jurisdictions with lower tax rates as compared to the U.S. statutory federal rate that had the most significant impact on our provision for foreign income taxes in the periods presented include Malaysia, Philippines and Thailand. On July 27, 2015, in Altera Corp. v. Commissioner, the U.S. Tax Court issued an opinion related to the treatment of stock-based compensation expense in an intercompany cost-sharing arrangement. On February 19, 2016, the Internal Revenue Service appealed the decision. A final decision has yet to be issued. At this time, the U.S. Department of the Treasury has not withdrawn the requirement to include stock-based compensation from its regulations. Due to the uncertainty surrounding the status of the current regulations, questions related to the scope of potential impact, and the risk of the Tax Court’s decision being overturned upon appeal, we have not recorded any impact related to this issue as of December 31, 2017. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our consolidated cash, cash equivalents and short-term investments and working capital: Key Components of Cash Flows Fiscal 2017: Operating Activities Net cash provided by operating activities during fiscal 2017 was $403.5 million. The net loss of $80.8 million included net non-cash items of $463.2 million. Net cash provided by operating activities benefited from a $21.1 million decrease in net operating assets and liabilities. The non-cash items primarily consisted of: • depreciation and amortization of $264.9 million, • stock based compensation expense of $91.6 million, • share in net loss and impairment of equity method investees of $71.8 million, • accretion of interest expense on 2% 2023 Exchangeable Notes, 4.5% 2022 Senior Exchangeable Notes, and 2% 2020 Spansion Exchangeable Notes and amortization of debt and financing costs on other debt of $21.1 million, and • restructuring costs and other of $9.0 million, The increase in net cash due to changes in operating assets and liabilities during fiscal 2017 of $21.1 million was primarily due to the following: • a decrease in accounts payable and accrued and other liabilities of $59.0 million mainly due to timing of payments and payments related to restructuring activities; • an increase in price adjustments and other distributor related reserved of $19.1 million; • an increase in inventories of $14.3 million to support increased expected demand for IoT and other MCD products; • an increase in other current and long-term assets of $9.6 million, primarily due to timing of payments for certain licenses; and • an increase in accounts receivables of $37.0 million mainly due to an increase in revenue. Investing Activities In fiscal 2017, we used approximately $14.4 million of cash in our investing activities primarily due to: • $35.5 million of cash received on the sale of the wafer manufacturing facility located in Bloomington, Minnesota and a building in Austin, Texas, • receipt of $10.0 million of previously escrowed consideration from the divestiture of our TrueTouch® mobile touchscreen business, • $2.3 million of cash received on the sales of property and equipment • the above increases were offset by $54.3 million of cash used for property and equipment expenditures relating to purchases of certain tooling, laboratory and manufacturing facility equipment and $9.3 million related to our equity method and cost method investments. Financing Activities In fiscal 2017, we used approximately $357.6 million of cash in our financing activities, primarily related to: • $144.7 million dividend payments, • net repayments of $242.0 million on the Senior Secured Revolving Credit Facility, • $128.0 million repayment of 2% 2020 Spansion Exchangeable Notes, and • $118.7 million repayment of Term Loan A and Term Loan B. • the above payments were offset by $91.3 million of borrowings under Term Loan B and $150.0 million of borrowing under 2% 2023 Exchangeable Notes. Fiscal 2016: Operating Activities Net cash provided by operating activities of $217.4 million during fiscal 2016 was primarily due to a net loss of $683.9 million offset by net non-cash items of $877.3 million and a $24.0 million increase in cash due to changes in operating assets and liabilities. The non-cash items primarily consisted of: • depreciation and amortization of $265.9 million, • stock based compensation expense of $98.5 million, • restructuring costs and other of $27.2 million • accretion of interest expense on Senior Exchangeable Notes and amortization of debt and financing costs on other debt of $13.1 million, • Share in net loss of equity method investees of $17.6 million, • goodwill impairment charge of $488.5 million, • gain related to investment in Deca Technologies Inc. of $112.8 million, • impairment charge related to assets held for sale of $37.2 million, and • impairment charge for acquisition-related IPR&D of $33.9 million. The increase in net cash due to changes in operating assets and liabilities during fiscal 2016 of $24.0 million, was primarily due to the following: • an increase in accounts receivable of $41.0 million due to an increase in sales during fiscal 2016. The days sales outstanding for fiscal 2016 and fiscal 2015 were 61 days; • an increase in inventories of $33.7 million primarily as a result of the IoT acquisition; • an increase in other current and long-term assets of $12.2 million, primarily due to timing of payments for certain licenses; • an increase in accounts payable, accrued and other liabilities of $79.5 million due to timing of payments; and • a decrease in deferred income of $69.0 million due to the transition of additional product families to the sell-in basis of revenue recognition. The decrease in deferred income was offset by an increase in price adjustment reserve for sale to distributors of $100.4 million due to the change in revenue recognition for certain product families in fiscal 2016 on a sell-in basis, which required us to record a reserve for distributor price adjustments based on our estimate of historical experience rates. Investing Activities In fiscal 2016, we used approximately $613.4 million of cash in our investing activities primarily due to: • $550.0 million for the acquisition of the IoT business, • $57.4 million of cash used for property and equipment expenditures relating to purchases of certain tooling, laboratory and manufacturing facility equipment and • $27.1 million cash paid for certain investments, which included $23.0 million towards our investment in Enovix. • such uses of cash were offset by sale and maturities of investments of $85.9 million. Financing Activities In fiscal 2016, we generated approximately $289.5 million of cash from financing activities, primarily from • our borrowings on the 4.50% Senior Exchangeable Notes of $287.5 million, • $450.0 million borrowing on our Term Loan B and • proceeds of $43.9 million from employee equity awards. The above borrowings were offset by • the repurchase of stock in the amount of $175.7 million, • net repayments of $312.0 million on the Senior secured revolving credit facility, • $141.4 million dividend payments, • purchase of capped call for the 4.50% Senior Exchangeable Notes of $8.2 million and • repayments of capital leases and Term Loan A of $10.6 million. Liquidity and Contractual Obligations Summary of our debt balances is included below: Of the total principal amount outstanding, $27.3 million related to the total Term Loan B is classified as current liabilities as of December 31, 2017. Of the total principal amount outstanding, $22.5 million related to Term Loan B, $7.5 million related to Term Loan A, $0.1 million related to Equipment loans, and $40 thousand related to Capital lease obligation, were classified as current liabilities as of January 1, 2017. The Senior Secured Revolving Credit Facility, as amended, provides for a $540 million Senior Secured Revolving Credit Facility of which $450 million was undrawn as at December 31, 2017. We believe that the liquidity provided by existing cash, cash equivalents and available-for-sale investments and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, should economic conditions and/or financial, business and other factors beyond our control adversely affect the estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. In addition, we may choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives (including the acquisition of other companies) and provide us with additional flexibility to take advantage of other business opportunities that arise. As of December 31, 2017, we were in compliance with all of the financial covenants under the Senior Secured Revolving Credit Facility. Refer to Note 14 of the Notes to the Consolidated Financial Statements under Item 8 for more information on our debt obligations. Contractual Obligations The following table summarizes our contractual obligations as of December 31, 2017: (1) Purchase obligations primarily include non-cancelable purchase orders for materials, services, manufacturing equipment, building improvements and supplies in the ordinary course of business. Purchase obligations are defined as enforceable agreements that are legally binding on us and that specify all significant terms, including quantity, price and timing, that have remaining terms in excess of one year. (2) Operating leases includes payments relating to Spansion's lease for office space in San Jose entered on May 22, 2014, which is no longer required. The lease is for a period of 12 years, with two options to extend for periods of five years each after the initial lease term. The term of the lease commenced on January 1, 2015 and expires on December 31, 2026. We do not plan to exercise the option to extend the lease beyond 2026. As of December 31, 2017, our unrecognized tax benefits were $28.9 million, which were classified as long-term liabilities. We believe it is possible that we may recognize approximately $0.2 million of our existing unrecognized tax benefits within the next twelve months as a result of the lapse of statutes of limitations and the resolution of agreements with domestic and various foreign tax authorities. As of December 31, 2017, we had long-term pension and other employee related liabilities of $16.8 million, which were classified as long-term liabilities. Capital Resources and Financial Condition Our long-term strategy is to maintain a minimum amount of cash for operational purposes and to invest the remaining amount of our cash in interest-bearing and highly liquid cash equivalents and debt securities, repayment of debt, the purchase of our stock through our stock buyback program and payments of regularly scheduled cash dividends. In addition we may use excess cash to invest in strategic investments and partnerships and pursue acquisitions. Our investment policy defines three main objectives when buying investments: security of principal, liquidity, and maximization of after-tax yield. We invest excess cash in various financial securities subject to certain requirements including security type, duration, concentration limits, and credit rating profile. As of December 31, 2017, a total cash and short-term investment position of $151.6 million is available for use in current operations. As of December 31, 2017, approximately 20% of our cash and cash equivalents and available-for-sale investments are held outside of the United States. While these amounts are primarily invested in U.S. dollars, a portion is held in foreign currencies. All offshore balances are exposed to local political, banking, currency control and other risks. In addition, these amounts, if repatriated may be subject to tax and other transfer restrictions. On February 17, 2017, we amended our Credit Facility which includes the Senior Secured Revolving Credit Facility and the Term Loans. The amendment reduced the applicable margins on the Term Loan B and Term Loan A from 5.50% and 5.11%, respectively, to 3.75% effective February 17, 2017. Additionally, the amended financial covenants include the following conditions: 1) maximum total leverage ratio of 4.25 to 1.00 through December 31, 2017 and 2) maximum total leverage ratio of 4.00 to 1.00 through July 1, 2018 and 3.75 to 1.00 thereafter. We incurred financing costs of $5.9 million to lenders of the Term Loans which were capitalized and recognized as a reduction of the Term Loan A and Term Loan B balances in “Credit Facility and long-term debt” on the Consolidated Balance Sheets. These costs will be amortized over the life of the Term Loans and are recorded in “Interest Expense” on the Consolidated Statements of Operations. On April 7, 2017, we further amended our Credit Facility. The amendment reduced the applicable margins on our Term Loan A from 3.75% to 2.75% effective April 7, 2017. We incurred financing costs of $0.4 million to lenders of Term Loan A which were recognized as a reduction of the Term Loan A balance in “Long-term credit facility and long-term debt” on the Consolidated Balance Sheet. On August 18, 2017, we amended our Credit Facility. As a result of the amendment, Term Loan A borrowing of $91.3 million was extinguished as a separate borrowing. Term Loan B was increased by $91.3 million to replace Term Loan A (the "Additional Incremental Term Loan"). Previously unamortized debt issuance costs of $3.0 million related to Term Loan A were written off and recorded as "Interest expense" in the Consolidated Statements of Operations during fiscal 2017. The additional incremental term loan is subject to the terms of the Credit Agreement and the additional terms set forth in the amendment. The amendment also reduced the applicable margins on Term Loan B from 3.75% to 2.75% effective August 18, 2017. We incurred financing costs of $0.6 million to the lenders of the Term Loans which have been capitalized and recognized as a reduction of the Term Loan B balances in “Credit facility and long-term debt” on the Consolidated Balance Sheet. These costs will be amortized over the life of the Term Loans and are recorded in “Interest Expense” on the Consolidated Statements of Operations. On November 6, 2017, the Company entered into an indenture (the “Indenture”), by and between the Company and U.S. Bank National Association, as trustee (the “Trustee”), pursuant to which the Company issued a total of $150.0 million aggregate principal amount of Notes. The Notes bear interest at a rate of 2.00% per year, payable in cash on February 1 and August 1 of each year, commencing on February 1, 2018. The Notes will mature on February 1, 2023, unless earlier repurchased or converted. In December 2017, we entered into fixed-for-floating interest rate forward swap agreements (expiring July 2021) with two counterparties starting from April 2018, to swap variable interest payments on our debt for fixed interest payments. The aggregate notional amount of these interest rate swaps was $300 million. On November 17, 2017, the Company entered into a privately negotiated agreement to induce the extinguishment of a portion of the Spansion Notes. The Company paid the holders of the Spansion Notes cash in the aggregate principal of $128 million and delivered 17.3 million shares of common stock for the conversion spread. The Company recorded $4.3 million in loss on extinguishment, which included $1.2 million paid in cash as an inducement premium and a reduction in additional paid-in capital of $290.6 million towards the deemed repurchase of the equity component of the notes. As of December 31, 2017, the remaining principal amount was $22.0 million. The Notes will mature on September 1, 2020 unless earlier repurchased or converted. We believe that liquidity provided by existing cash, cash equivalents and investments, our cash from operations and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, if economic conditions deteriorate, debt covenants unexpectedly impact our business, and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. We may also choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives including the acquisition of other companies, repurchase shares of our stock, increase our dividends or pay a special dividend and provide us with additional flexibility to take advantage of other business opportunities that arise. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K and the data used to prepare them. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and we are required to make estimates, judgments and assumptions in the course of such preparation. Note 1 of the Notes to the Consolidated Financial Statements under Item 8 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an ongoing basis, we re-evaluate our judgments and estimates including those related to revenue recognition, allowances for doubtful accounts receivable, inventory valuation, valuation of long-lived assets, goodwill and financial instruments, stock-based compensation, and settlement costs, and income taxes. We base our estimates and judgments on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies that are affected by significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements are as follows: Revenue Recognition: We generate revenues by selling products to distributors, various types of manufacturers including original equipment manufacturers (“OEMs”) and electronic manufacturing service providers (“EMSs”). We recognize revenue on sales to OEMs and EMSs provided that persuasive evidence of an arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, there are no customer acceptance requirements, and there are no remaining significant obligations. Sales to certain distributors are made under agreements which provide the distributors with price protection, stock rotation and other allowances under certain circumstances. The Company typically recognizes revenue from sales of its products to distributors upon shipment. An allowance for estimated distributor credits covering price adjustments is recorded based on historical experience rates as well as economic conditions and contractual terms. Any effects of change in estimates related to distributor price adjustments are recorded as an adjustment to revenue. Prior to 2014, we had recognized a significant portion of revenue through distributors at the time the distributor resold the product to its end customer (also referred to as the sell-through basis of revenue recognition) given the difficulty, at the time, in estimating the ultimate price of these product shipments and amount of potential returns. We continuously reassess our ability to reliably estimate the ultimate price of these products and, over the past several years, have made investments in our systems and processes around its distribution channel to improve the quality of the information it receives from its distributors. Given these ongoing investments, and based on the financial framework we use for estimating potential price adjustments, in the fourth quarter of 2014 we began recognizing revenue on certain product families and with certain distributors (less its estimate of future price adjustments and returns) upon shipment to the distributors (also referred to as the sell-in basis of revenue recognition). During fiscal 2015, we recognized $40.9 million of incremental revenue from this change, which resulted in a decrease in net loss of $25.0 million or $0.08 per basic and diluted shares. During fiscal 2016, we recognized approximately $59.2 million of incremental revenue from this change in revenue recognition, which resulted in a reduction of our net loss of $19.5 million for fiscal 2016, or $0.06 per basic and diluted share. By the end of fiscal 2016, the Company had transitioned all revenue from distributions from sell-through to the sell-in basis of revenue recognition. We record as a reduction to revenues reserves for sales returns, price protection and allowances, based upon historical experience rates and for any specific known customer amounts. We also provide certain distributors and EMSs with volume-pricing discounts, such as rebates and incentives, which are recorded as a reduction to revenues at the time of sale. Historically these volume discounts have not been significant. Our revenue reporting is dependent on receiving pertinent, accurate and timely data from our distributors. Distributors provide us periodic data regarding the product, price, quantity, and end customer when products are resold as well as the quantities of our products they still have in stock. Because the data set is large and complex and because there may be errors in the reported data, we must use estimates and apply judgments to reconcile distributors’ reported inventories to their activities. Actual results could vary materially from those estimates. Business Combinations: We apply the provisions of Accounting Standards Codification 805, Business Combinations (“ASC 805”), in the accounting for acquisitions. It requires us to recognize separately from goodwill the assets acquired and the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date as well as contingent consideration, where applicable, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our Consolidated Statements of Operations. Accounting for business combinations requires the Company's management to make significant estimates and assumptions, especially at the acquisition date including our estimates for intangible assets, contractual obligations assumed, restructuring liabilities, pre-acquisition contingencies and contingent consideration, where applicable. Although we believe the assumptions and estimates it has made have been reasonable and appropriate, they are based in part on historical experience and information obtained from the management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets we have acquired include but are not limited to: future expected cash flows from product sales, customer contracts and acquired technologies, expected costs to develop in-process research and development into commercially viable products and estimated cash flows from the projects when completed and discount rates. Unanticipated events and circumstances may occur that may affect the accuracy or validity of such assumptions, estimates or actual results. Valuation of Inventories: Management periodically reviews the adequacy of our inventory reserves. We record a write-down for our inventories which have become obsolete or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventories each quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans and current sales levels. Inventory reserves are not relieved until the related inventory has been sold or scrapped. Our inventories may be subject to rapid technological obsolescence and are sold in a highly competitive industry. If there were a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to record additional write-downs, and our gross margin could be adversely affected. Valuation of Long-Lived Assets: Our business requires heavy investment in manufacturing facilities and equipment that are technologically advanced but can quickly become significantly under-utilized or rendered obsolete by rapid changes in demand. In addition, we have recorded intangible assets with finite lives related to our acquisitions. We evaluate our long-lived assets, including property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors considered important that could result in an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the assets or the strategy for our business, significant negative industry or economic trends, and a significant decline in our stock price for a sustained period of time. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analysis. If there is a significant adverse change in our business in the future, we may be required to record impairment charges on our long-lived assets. Valuation of Goodwill: Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. We assess our goodwill for impairment on an annual basis. Additionally, if certain events or circumstances indicate that an impairment loss may have been incurred, we will also perform an impairment assessment on an interim basis. In accordance with ASU 2011-08, Testing Goodwill for Impairment, qualitative factors can be assessed to determine whether it is necessary to perform the current two-step test for goodwill impairment. If we believe, as a result of our qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. Cash Flow Hedges: We recognize derivative instruments from hedging activities as either assets or liabilities on the balance sheet and measure them at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting. To receive hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedge, and the hedges must be highly effective in offsetting changes to future cash flows on hedged transactions. We record changes in the intrinsic value of these cash flow hedges in accumulated other comprehensive loss on the Consolidated Balance Sheets, until the forecasted transaction occurs. When the forecasted transaction occurs, we reclassify the related gain or loss on the cash flow hedge to the appropriate revenue or expense line of the Consolidated Statements of Operations. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, we will reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive loss to other income (expense), net in our Consolidated Statements of Operations at that time. The Company enters into cash flow hedges to protect non-functional currency revenues, inventory purchases and certain other operational expenses against variability in cash flows due to foreign currency fluctuations. The Company’s foreign currency forward contracts that were designated as cash flow hedges have maturities between three and twelve months. The Company evaluates hedge effectiveness at the inception of the hedge prospectively as well as retrospectively and records any ineffective portion of the hedge in other income (expense), net in its Consolidated Statements of Operations. The Company enters into interest rate swaps to manage the variability in cash flow due to interest rate fluctuations. The Company evaluates hedge effectiveness at the inception of the hedge prospectively as well as retrospectively and records any ineffective portion of the hedge in other income (expense), net in its Consolidated Statements of Operations. Changes in the fair value of interest rate swaps that have been designated as hedging instruments will be recognized in accumulated other comprehensive income. Refer Note 11 of the Notes to the Consolidated Financial Statements under Item 8 for further details on cash flow and balance sheet hedges. Share-Based Compensation: Under the fair value recognition provisions of the guidance, the Company recognizes share-based compensation based on the grant date fair value of the award and is recognized over the service period, which is usually the vesting period. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including measurement of the level of achievement of performance milestones, the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. Through fiscal 2016, we estimated the expected forfeiture rate and only recognized the expense for those shares expected to vest. Beginning fiscal 2017, with the adoption of ASU 2016-09, "Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting," the Company elected to recognize forfeitures as they occurred and adopted these changes using a modified retrospective approach, with a cumulative adjustment recorded to opening accumulative deficit. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future. Employee Benefit Plans: In connection with the Merger, we assumed the Spansion Innovates Group Cash Balance Plan (a defined benefit pension plan) in Japan. A defined benefit pension plan is accounted for on an actuarial basis, which requires the selection of various assumptions such as turnover rates, discount rates and other factors. The discount rate assumption is determined by comparing the projected benefit payments to the Japanese corporate bonds yield curve as of the end of the most recently completed fiscal year. The benefit obligation is the projected benefit obligation (PBO), which represents the actuarial present value of benefits expected to be paid upon retirement. This liability is recorded in other long-term liabilities on the Consolidated Balance Sheets. Net periodic pension cost is recorded in the Consolidated Statements of Operations and includes service cost. Service cost represents the actuarial present value of participant benefits earned in the current year. Interest cost represents the time value of money associated with the passage of time on the PBO. Gains or losses resulting from a change in the PBO if actual results differ from actuarial assumptions will be accumulated and amortized over the future life of the plan participants if they exceed 10% of the PBO, being the corridor amount. If the amount of a net gain or loss does not exceed the corridor amount, it will be recorded to other comprehensive income (loss). See Note 18 of the Notes to the Consolidated Financial Statements for further details of the pension plans. Accounting for Income Taxes: On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (the “Act”) was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a federal corporate tax rate decrease from 35% to 21% for tax years beginning after December 31, 2017, the repeal of corporate AMT for tax years, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings. We have computed our provision for income taxes in accordance with the Act and guidance available as of the date of this filing and as a result have recorded a tax benefit of $8.6 million in the fourth quarter of 2017, the period in which the legislation was enacted. The provisional amount related to the remeasurement of certain deferred tax liabilities, based on the rates at which they are expected to reverse in the future, was a tax benefit of $3.0 million. The provisional amount related to the repeal of corporate AMT was a tax benefit of $5.6 million as the prior year AMT credit will be refunded over 2018 - 2021. Based on the Act and guidance available as of the date of this filing, the Company determined a provisional estimate of the impact of the one-time transition tax on the mandatory deemed repatriation of accumulative foreign subsidiary earnings. The Company estimates that the transition tax will result in the utilization of $46.0 million of net operating loss carryforwards against which the Company maintains a corresponding valuation allowance. As a result of the reduction in the corporate income tax rate, the Company revalued its net deferred tax asset at December 31, 2017, which resulted in a decrease of the net deferred tax balance and corresponding valuation allowance balance of $158.7 million. On December 22, 2017, Staff Accounting Bulletin No. 118 ("SAB 118") was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Act. In accordance with SAB 118, we have determined that there is no additional current tax expense required to be recorded in connection with the transition tax on the mandatory deemed repatriation of cumulative foreign earnings and a reasonable estimate at December 31, 2017 as we believe we have sufficient tax attributes such as NOL and tax credits to offset any tax imposed on this income. Additional work is necessary for a more detailed analysis of our historical foreign earnings as well as potential correlative adjustments. Any subsequent adjustment to these amounts will be recorded to current tax expense upon completion of the analysis during the subsequent quarters of 2018. Recent Accounting Pronouncements See “Recent Accounting Pronouncements” in Note 1 of the Notes to the Consolidated Financial Statements under Item 8 of this Annual Report on Form 10-K.

<s>[INST] EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (“Cypress” or “the Company”) manufactures and sells advanced embedded system solutions for automotive, industrial, home automation and appliances, consumer electronics and medical products. Cypress’ microcontrollers, analog ICs, wireless and wired connectivity solutions and memory products help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. Mergers, Acquisitions and Divestitures Merger with Spansion On March 12, 2015, we completed the merger (“Merger”) with Spansion Inc. ("Spansion") pursuant to the Agreement and Plan of Merger and Reorganization, dated as of December 1, 2014 (the "Merger Agreement"), for a total consideration of approximately $2.8 billion. Acquisition of Broadcom Corporation’s Internet of Things business (“IoT business”) On July 5, 2016, we completed the acquisition of certain assets primarily related to the IoT business of Broadcom pursuant to an Asset Purchase Agreement with Broadcom Corporation, dated April 28, 2016, for a total consideration of $550 million. The following MD&A includes the financial results of the IoT business beginning July 5, 2016. The comparability of our results for the year ended December 31, 2017, January 1, 2017 to the same periods in fiscal 2015 is significantly impacted by the acquisition. To date, we have incurred approximately $9.2 million of acquisition related costs, including professional fees and other costs associated with the acquisition. The following MD&A includes the financial results of legacy Spansion beginning March 12, 2015 and the financial results of the IoT business acquired from Broadcom beginning July 5, 2016. The comparability of our results for the year ended December 31, 2017 to the same prior year periods is significantly impacted by these transactions. In our discussion and analysis of comparative periods, we have quantified the contribution of additional revenue or expense resulting from these transactions wherever such amounts were material and identifiable. While identified amounts may provide indications of general trends, the analysis cannot completely address the effects attributable to integration efforts. Divestiture of TrueTouch® Business In connection with the sale of the TrueTouch® Mobile touchscreen business to Parade Technologies (“Parade”) on August 1, 2015, we entered into a Manufacturing Service Agreement (“MSA”) in which we agreed to sell finished wafers and devices to Parade. The terms of the MSA provide that we would sell finished products to Parade at agreedupon prices that were considered below fair market value, indicating that there was an embedded fair value that would be realized by Parade through those terms. Accordingly, we had allocated approximately $19.9 million from the $98.6 million proceeds to the fair value of the MSA based on the forecasted wafer sales to Parade for the subsequent periods. That amount was deferred on our consolidated balance sheet initially and was amortized to revenue as we sold products to Parade. Such amount has been fully amortized in fiscal 2017. During the year ended January 1, 2017 and January 2, 2016, we recognized approximately $14.2 million and $5.7 million, respectively, of revenue from the amortization of the deferred revenue. Investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement (the "Purchase Agreement"), whereby certain thirdparty investors purchased 41.1% of the shares outstanding at the said date for an aggregate consideration of approximately $111.4 million. Concurrently, Deca repurchased certain of its preferred shares from us. After giving effect to the above transactions, our ownership in Deca reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to thirdparty new investors in the purchase agreement, including, among other things, participation on the Board of [/INST] Positive. </s>

CYPRESS SEMICONDUCTOR CORP /DE/

2019-02-27

2018-12-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The MD&A contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that involve risks and uncertainties, which are discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (together with its consolidated subsidiaries, "Cypress", "the Company", "we" or "us") manufactures and sells advanced embedded system solutions for automotive, industrial, consumer and enterprise end markets. Cypress’ microcontroller, analog ICs, wireless and wired connectivity solutions and memory products help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. The Company operates on a 52 or 53-week fiscal year ending on the Sunday nearest to December 31. Fiscal years 2018, 2017 and 2016 each contained 52 weeks. Mergers, Acquisitions and Divestitures Joint Venture with SK hynix system ic Inc. ("SKHS") On October 23, 2018, we entered into an agreement whereby we will transfer our NAND business to a JV with SKHS. The transaction is subject to customary closing conditions and regulatory approvals. We presently expect that the transaction will be completed in the first quarter of fiscal 2019. In addition to our NAND Flash business, we will contribute $2.4 million in cash towards the equity of the JV. We will own 40% of the JV’s common stock. The NAND business is presently reported as part of the MPD segment. We recognized $167.3 million, $168.1 million and $180.5 million in revenue from the NAND business for the years ended December 30, 2018, December 31, 2017 and January 1, 2017. Sale of Cypress Minnesota Incorporated In fiscal 2017, we completed the sale of our wafer fabrication facility in Minnesota for gross proceeds of $30.5 million. Investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement, whereby certain third-party investors purchased 41.1% of the shares outstanding at that time for an aggregate consideration of approximately $111.4 million. Concurrently, Deca repurchased certain of its preferred shares from us. After giving effect to the above transactions, our ownership in Deca was reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to third-party new investors in the share purchase agreement, including, among other things, participation on the Board of directors of Deca, approval of operating plans and approval of indebtedness, we determined that we no longer have the power to direct the activities of Deca that most significantly impact Deca's economic performance. However, as we continue to have significant influence over Deca's financial and operating policies, effective July 29, 2016, our investment in Deca is being accounted for as an equity method investment and financial results of Deca are no longer being consolidated. Acquisition of Broadcom Corporation’s Internet of Things business (“wireless IoT business”) On July 5, 2016, we completed the acquisition of certain assets primarily related to the wireless IoT business of Broadcom pursuant to an Asset Purchase Agreement with Broadcom Corporation, dated April 28, 2016, for a total consideration of $550 million. Our consolidated financial statements include the financial results of the wireless IoT business acquired from Broadcom beginning July 5, 2016. The comparability of our results for the years ended December 30, 2018 and December 31, 2017 to the prior year is significantly impacted by this transaction. Business Developments Business Segments We continuously evaluate our reportable business segments in accordance with the applicable accounting guidance. Consistent with the year ended December 31, 2017, the Company operates under two reportable business segments, MPD and MCD, for the year ended December 30, 2018. RESULTS OF OPERATIONS Revenues Our total revenues increased by $156.1 million, or 6.7%, to $2,483.8 million for the year ended December 30, 2018 compared to the prior fiscal year. For the year ended December 30, 2018, the increase was primarily driven by strength in automotive and wireless connectivity, microcontrollers, and memory products. Revenue for the year ended December 31, 2017 benefited from our acquisition of the IoT business of Broadcom, as compared to the prior year which included such sales only for a partial period post acquisition. The following table summarizes our consolidated revenues by segments: Microcontroller and Connectivity Division: Revenues recorded by MCD increased in fiscal 2018 by $65.2 million, or 4.6%, compared to fiscal 2017. The increase was primarily driven by growth in our microcontrollers, wired and wireless connectivity and automotive products. MCD revenue during fiscal 2018 benefited from volume increases as a result of new program ramps at certain customers. Revenues recorded by MCD increased in fiscal 2017 by $414.8 million, or 41.7%, compared to fiscal 2016. We acquired the wireless IoT business acquired from Broadcom on July 5, 2016. Consequently, fiscal 2016 revenue included the results of the wireless IoT business for only a partial year. Additionally, MCD revenues increased in fiscal 2017 as compared to fiscal 2016, due to increased revenue from our wired and wireless connectivity and microcontrollers products. Memory Products Division: Revenues recorded by MPD increased in fiscal 2018 by $90.9 million, or 9.9% compared to fiscal 2017. The increase was primarily due to growth in revenue from the Flash memory products. MPD revenue increased over fiscal 2017 primarily due to a shift in product mix towards high density NOR products, as well as an increase in revenue on NAND products. Revenues recorded by MPD decreased in fiscal 2017 by $10.1 million, or 1.1% compared to fiscal 2016. The decrease was primarily due to declines in revenue from memory products. MPD revenue decreased over fiscal 2016 due to a decline in revenue from NAND products offset by strength in revenue from NOR products. Gross Profit & Margin Our gross margin improved from 33.6% in fiscal 2017 to 37.5% in fiscal 2018. The primary drivers of the improvement in gross margin were higher fab utilization, which increased from 74.2% for the year ended December 31, 2017 to 81.2% for the year ended December 30, 2018; a reduction in the cost of certain products; a shift in the product mix towards higher density memory products and a decrease in commoditized products; and ramping of new products at favorable margins. Additionally, there was a reduction in write-downs of carrying value of inventory for the year ended December 30, 2018 as compared to the prior year. Write-down of inventories for the year ended December 30, 2018 was $22.3 million as compared to $34.5 million for the year ended December 31, 2017. Write-down of inventories unfavorably impacted our gross margin by 0.9% and 1.5% for the year ended December 30, 2018 and for the year ended December 31, 2017, respectively. Sale of inventory that was previously written off or written down aggregated to $19.5 million and $31.6 million in fiscal 2018 and fiscal 2017, respectively, which favorably impacted our gross margin by 0.8% and 1.4%, respectively. Included in the cost of revenues are restructuring costs of $3.3 million and $0.6 million for fiscal 2018 and fiscal 2017, respectively. The increase in restructuring costs is primarily due to the 2018 Plan (as defined below), which we began implementing in the first quarter of 2018. Included in cost of revenues is the amortization of intangible assets of $196.0 million and $175.0 million for fiscal 2018 and fiscal 2017, respectively. The increase of the amortization of intangible assets is mainly due to the increase of in-process research and development ("IPR&D") projects capitalized during the year. Included in cost of revenues in fiscal 2018 is the impairment of assets held for sale of $10.9 million as a result of entering into a definitive agreement to divest the NAND products business to a joint venture with SKHS in October 2018. Our gross margin improved from 23.8% in fiscal 2016 to 33.6% in fiscal 2017. The primary drivers of the improvement in gross margin were sales from the acquired wireless IoT business, which were accretive to our gross margin in 2017, higher fab utilization, which increased from 56.0% for the year ended January 1, 2017 to 74.2% for the year ended December 31, 2017, and a reduction in the cost of certain products and ramping of new products at accretive margins. This was partially offset by higher write downs of carrying value of inventory during the year ended December 31, 2017 as compared to the same prior year period. Write-down of inventories for the year ended December 31, 2017 was $34.5 million as compared to $25.3 million for the year ended January 1, 2017. Write-down of inventories unfavorably impacted our gross margin by 1.5% and 1.3% for the year ended December 31, 2017 and for the year ended January 1, 2017, respectively. Sale of inventory that was previously written off or written down aggregated to $31.6 million and $65.7 million in fiscal 2017 and fiscal 2016, respectively, which favorably impacted our gross margin by 1.4% and 3.4%, respectively. Included in the cost of revenues are restructuring costs of $0.5 million and $1.4 million for the fiscal 2017 and fiscal 2016, respectively. During fiscal 2016, we recognized $33.9 million of impairment charges related to two IPR&D projects that were canceled due to certain changes in our long-term product portfolio strategy during fiscal 2016. In addition, we recorded an impairment charge of $37.2 million related to the sale of our wafer manufacturing facility located in Bloomington, Minnesota, as well as a building in Austin, Texas during fiscal 2016, to reflect the estimated fair value, net of cost to sell these assets. During fiscal 2017, we recorded a $1.2 million adjustment as a result of changes in certain estimates related to these assets, resulting in a reduction of operating expense. Research and Development ("R&D") Our R&D efforts are focused on the development and design of new semiconductor products and design methodologies, as well as the continued development of advanced software platforms. Our R&D organization works with our manufacturing facilities, suppliers and customers to improve our semiconductor designs and lower our manufacturing costs. Our R&D groups conduct ongoing efforts to reduce design cycle time and increase first pass yield through structured re-use of intellectual property blocks from a controlled intellectual property library, development of computer-aided design tools and improved design business processes. Design and related software development work primarily occurs at design centers located in the United States, Ukraine, Ireland, Germany, Israel, India, Japan and China. R&D expenditures increased by $1.1 million in fiscal 2018 compared to the prior year. The increase was mainly attributable to $5.4 million in increased labor costs mainly due to employee-related compensation expenses, $3.6 million increase in depreciation, and $1.8 million in licensing payments to certain vendors, partially offset by a $4.1 million in lower restructuring costs, $3.8 million decrease in deferred compensation expenses, and a $1.7 million decrease in stock-based compensation expenses. R&D expenditures increased by $15.8 million in fiscal 2017 compared to fiscal 2016. The increase was mainly attributable to $40.3 million of expenses due to the wireless IoT business acquisition which was primarily comprised of $28.2 million of increase in labor costs due to increased headcount and an increase of $12.1 million in expensed assets. The above increases were partially offset by a $1.4 million decrease in stock-based compensation expense and a $23.1 million decrease in other R&D expenses, mainly due to reduction in labor costs due to Cypress 3.0 restructuring initiatives. Selling, General and Administrative ("SG&A") SG&A expenses increased by $62.1 million in fiscal 2018 compared to fiscal 2017. The increase was mainly due to an impairment of goodwill attributable to NAND of $65.7 million, a $9.1 million increase in restructuring costs, a $5.1 million increase in stock-based compensation, a $3.8 million increase in higher professional fee, a $3.4 million increase in advertising expenses and a $2.5 million increase in facilities expenses, partially offset by a $14.3 million decrease in shareholder litigation, a $7.9 million decrease in labor expenses, and a $5.0 million decrease in deferred compensation expenses. SG&A expenses decreased by $379.2 million in fiscal 2017 compared to fiscal 2016. The decrease was mainly due to a goodwill impairment charge of $488.5 million related to our former PSD reporting unit, a $15.4 million decrease in acquisition cost related to the wireless IoT acquisition, a $6.1 million decrease in restructuring cost, a $5.0 million decrease in executive severance costs and a $10.0 million decrease in non-recurring costs, partially offset by a $112.8 million decrease in gain related to Deca Technologies (the gain was recorded in 2016), a $14.3 million increase in shareholder litigation and proxy related expenses, a $8.2 million increase in labor costs, a $5.4 million increase in wireless IoT business operating expenses, and an increase of $3.1 million in stock-based compensation expenses. Interest expense Interest expense for fiscal 2018 was $65.3 million and primarily represents interest payments due and amortization of debt discount and costs related to our 2% 2023 Exchangeable Notes, 4.5% 2022 Senior Exchangeable Notes, 2% 2020 Spansion Exchangeable Notes, and interest expense incurred on our Revolving Credit Facility, Term Loan B and other debt. In addition, of the $65.3 million, $5.2 million was related to the refinancing and write-off of debt issuance costs upon the debt amendment for Term Loan B and the extinguishment for the 2% 2020 Spansion Exchangeable Notes. Interest expense for fiscal 2017 was $80.2 million and primarily represents interest payments due and amortization of debt discount and costs related to our 2% 2023 Exchangeable Notes, 4.5% 2022 Senior Exchangeable Notes, and 2% 2020 Spansion Exchangeable Notes, and interest expense incurred on our Revolving Credit Facility, Term Loan B and other debt. In addition, of the $80.2 million, $7.2 million was related to the debt extinguishment of the 2% 2020 Spansion Exchangeable Notes and Term Loan A. Interest expense for fiscal 2016 was $55.2 million and represents interest payments due and amortization of debt discount and costs related to our 4.50% Senior Exchangeable Notes and 2% Senior Exchangeable Notes, and interest expense incurred on our revolving line of credit, Term Loan A, Term Loan B and other debt. Refer to Note 15 of the Notes to Consolidated Financial Statements under Item 8 for more information about our credit facility and other debt. Other Income (expense), Net The following table summarizes the components of other income (expense), net: Employee Deferred Compensation Plan We have a deferred compensation plan, which provides certain key employees, including our executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax-deferred basis. We do not make contributions to the deferred compensation plan and we do not guarantee returns on the investments. Participant deferrals and investment gains and losses remain as our liabilities and the underlying assets are subject to claims of general creditors. In fiscal 2018, 2017 and 2016, we recognized changes in fair value of the assets under the deferred compensation plan in "Other income (expense), net" of $(2.9) million, $6.1 million, and $2.3 million, respectively. The increase or decrease in the fair value of the investments relates to the increased or decreased performance of the portfolio on a year over year basis. Refer to Note 19 of the Notes to Consolidated Financial Statements under Item 8 for more information about our deferred compensation plan. Share in Net Loss and Impairment of Equity Method Investees We have been making investments in Enovix Corporation ("Enovix"), a privately held development stage company. Our investment holding comprised 24.8%, 41.2% and 46.6% of Enovix's equity at the end of fiscal 2018, 2017 and 2016, respectively. Since the fourth quarter of 2014 we have been accounting for our investment in Enovix using the equity method of accounting. During the fourth quarter of 2017, Enovix missed achieving certain key planned product development milestones. We considered various factors in determining whether to recognize an impairment charge, including the expectations of the investee's future cash flows and capital needs, the length of time the investee has been in a loss position, the ability to achieve milestones, and the near-term prospect of the investee and its exit strategy. Enovix’s estimated enterprise value is sensitive to its ability to achieve these milestones. Consequently, we concluded that our investment in Enovix had suffered an other-than-temporary impairment and we recorded a charge of $51.2 million. In fiscal 2018, we did not record any share of losses recorded by Enovix. During fiscal 2017 and 2016, we recorded $8.7 million and $9.9 million, respectively, for our share of losses recorded by Enovix. In the second quarter of fiscal 2016, we changed the basis of accounting for our investment in Deca Technologies Inc. ("Deca") to the equity method of accounting. As at the end of fiscal years 2018 and 2017, our investment comprised 52.5% of Deca's equity. During the fourth quarter of fiscal 2018, the Company determined that its investment in Deca, which is accounted for as an equity method investment, was other-than temporarily impaired due to to failure to achieve significant product development and testing milestones. We considered various factors in determining whether to recognize an impairment charge, including the expectations of the investee's future cash flows and capital needs, the length of time the investee has been in a loss position, the ability to achieve milestones, and the near-term prospect of the investee and its exit strategy. Deca’s estimated enterprise value is sensitive to its ability to achieve these milestones. Consequently, we recognized a charge of $41.5 million in order to write down the carrying amount of the investment to the estimated fair value of $65.1 million as at end of fiscal 2018. This write down was recorded in "Selling, general and administrative expenses" in the Consolidated Statements of Operations. During fiscal 2018 and 2017, we recorded $15.8 million and $11.8 million, respectively, for our share of losses recorded by Deca. Income Taxes We recorded an income tax benefit of $315.6 million in fiscal 2018, and income tax provisions of $11.2 million and $2.6 million in fiscal 2017 and 2016, respectively. The income tax benefit for 2018 was primarily due to a release of our valuation allowance previously maintained against certain deferred tax assets of $343.3 million, as discussed further below. The income tax expenses for fiscal 2017 and 2016 were primarily attributable to income taxes associated with our non-U.S. operations, partially offset by release of previously accrued taxes related to the lapsing of statutes of limitation. A valuation allowance is established or maintained when, based on currently available information and other factors, it is more likely than not that all or a portion of the deferred tax assets will not be realized. We regularly assess our valuation allowance against deferred tax assets on a jurisdiction by jurisdiction basis. We consider all available positive and negative evidence, including future reversals of temporary differences, projected future taxable income, tax planning strategies and recent financial results. During the fourth quarter of 2018, the Company emerged from a cumulative loss position over the previous three years. The cumulative three-year pre-tax income is considered positive evidence which is objective and verifiable and thus received significant weighting. The continued pattern of income before tax, recent global restructuring executed in fiscal 2018 and projected future operating income in the U.S. was additional positive evidence. As a result, the Company released $343.3 million of the valuation allowance attributable to certain U.S. deferred tax assets during 2018. Our effective tax rate varies from the U.S. statutory rate primarily due to a release of valuation allowance and earnings of foreign subsidiaries taxed at different rates. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We regularly assess our tax positions in light of legislative, bilateral tax treaties, and regulatory and judicial developments in the many countries in which we and our affiliates do business. LIQUIDITY AND CAPITAL RESOURCES Our Revolving Credit Facility has a capacity of $540 million. As of December 30, 2018, the Revolving Credit Facility was undrawn and provided a guarantee for one outstanding letter of credit for $1 million. The following table summarizes our consolidated cash, cash equivalents and short-term investments and working capital: Key Components of Cash Flows Fiscal 2018: Operating Activities Net cash provided by operating activities during fiscal 2018 was $471.7 million consisted of (in millions): The decrease in net cash due to changes in operating assets and liabilities during fiscal 2018 of $103.9 million was primarily due to the following: • an increase in accounts receivables of $23.8 million mainly due to an increase in revenue, • an increase in inventories of $20.8 million, • an increase in other current and long-term assets of $5.4 million, • a decrease in accounts payable and accrued and other liabilities of $36.7 million mainly due to timing of payments and payments related to restructuring activities, • a decrease in price adjustments and other distributor related reserved of $14.5 million, and • an increase in assets held for sale related inventories of $13.5 million due to the sale of NAND business. Investing Activities In fiscal 2018, we used approximately $49.7 million of cash in our investing activities primarily due to: • $68.9 million of cash used for property and equipment expenditures relating to purchases of certain laboratory and manufacturing facility equipment, partially offset by: • $5.8 million of cash received on the sales of property and equipment, and • $18.5 million of cash received related to our investments in privately held equity interests. Financing Activities In fiscal 2018, we used approximately $287.9 million of cash in our financing activities, primarily related to: • $157.4 million dividend payments, • net repayments of $90.0 million on the Senior Secured Revolving Credit Facility, • $35.6 million repayment of Term Loan B. • $35.0 million for stock repurchase, • $10.0 million repayment of 2% 2020 Spansion Exchangeable Notes, and • The above payments were partially offset by $40.7 million due to issuance of common stock. Fiscal 2017: Operating Activities Net cash provided by operating activities during fiscal 2017 was $403.5 million consisted of (in millions): The increase in net cash due to changes in operating assets and liabilities during fiscal 2016 of $21.1 million was primarily due to the following: • a decrease in accounts payable and accrued and other liabilities of $59.0 million mainly due to timing of payments and payments related to restructuring activities, • an increase in price adjustments and other distributor related reserves of $19.1 million, • an increase in inventories of $14.3 million to support increased expected demand for IoT and other MCD products, • an increase in other current and long-term assets of $9.6 million, primarily due to timing of payments for certain licenses, and • an increase in accounts receivables of $37.0 million mainly due to an increase in revenue. Investing Activities In fiscal 2017, we used approximately $14.4 million of cash in our investing activities primarily due to: • $54.3 million of cash used for property and equipment expenditures relating to purchases of certain laboratory and manufacturing facility equipment and $9.3 million related to our equity method and cost method investments, partially offset by: • $35.5 million of cash received on the sale of the wafer manufacturing facility located in Bloomington, Minnesota and a building in Austin, Texas, • receipt of $10.0 million of previously escrowed consideration from the divestiture of our TrueTouch® mobile touchscreen business, and • $2.3 million of cash received on the sales of property and equipment. Financing Activities In fiscal 2017, we used approximately $357.6 million of cash in financing activities, primarily from: • $144.7 million in dividend payments, • net repayments of $242.0 million on the Revolving Credit Facility, • $128.0 million repayment of 2% 2020 Spansion Exchangeable Notes, and • $118.7 million repayment of Term Loan A and Term Loan B. • The above payments were partially offset by $91.3 million of borrowings under Term Loan B and $150.0 million of borrowing under 2% 2023 Exchangeable Notes. Liquidity and Contractual Obligations Summary of our debt balances is included below: Of the total principal amount outstanding, $6.9 million related to Term Loan B and capital lease obligation is classified in current liabilities as of December 30, 2018. Of the total principal amount outstanding, $27.3 million related to Term Loan B was classified in current liabilities as of December 31, 2017. On March 12, 2015, we entered into an Amended and Restated Credit and Guaranty Agreement with Morgan Stanley Bank, N.A., as issuing bank, and other lenders (as amended, the "Credit Agreement"). The Credit Agreement establishes a credit facility (the "Credit Facility" or "Senior Secured Credit Facility") that includes a revolving loan facility (the "Revolving Credit Facility") and provides for the possibility of term loans. The Revolving Credit Facility provides for $540 million of borrowing capacity, of which $450 million was available at December 31, 2017 and $540 million was available at December 31, 2018. We believe that the liquidity provided by existing cash, cash equivalents and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, should economic conditions and/or financial, business and other factors beyond our control adversely affect the estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. In addition, we may choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives (including the acquisition of other companies) and provide us with additional flexibility to take advantage of other business opportunities that arise. As of December 30, 2018, we were in compliance with all of the financial covenants under the Senior Secured Credit Facility. Refer to Note 15 of the Notes to Consolidated Financial Statements under Item 8 for more information on our debt obligations. Contractual Obligations The following table summarizes our contractual obligations as of December 30, 2018: (1) Purchase obligations primarily include non-cancelable purchase orders for materials, services, manufacturing equipment, building improvements and supplies in the ordinary course of business. Purchase obligations are defined as enforceable agreements that are legally binding on us and that specify all significant terms, including quantity, price and timing, that have remaining terms in excess of one year. (2) Operating leases include payments in 2019 relating to Spansion's lease for which the Company has signed a termination agreement, see Note 11. (3) Interest and commitment fees due on variable debt is based on the effective interest rates as of December 30, 2018. Capital Resources and Financial Condition Our long-term strategy is to minimize the amount of cash required for operational purposes and to utilize the remaining amount of our cash investing in interest-bearing and highly liquid cash equivalents and debt securities, repayment of debt, the purchase of our stock through our stock buyback program and payments of regularly scheduled cash dividends. In addition, we may use excess cash to invest in strategic investments and partnerships and pursue acquisitions. Our investment policy defines three main objectives when buying investments: security of principal, liquidity, and maximization of after-tax yield. We invest excess cash in various financial securities subject to certain requirements including security type, duration, concentration limits, and credit rating profile. As of December 30, 2018, a total cash and cash equivalents position of $285.7 million is available for use in current operations. As of December 30, 2018, approximately 23.8% of our cash and cash equivalents are held outside of the United States. While these amounts are primarily invested in U.S. dollars, a portion is held in foreign currencies. All offshore balances are exposed to local political, banking, currency control and other risks. In addition, these amounts, if repatriated may be subject to tax and other transfer restrictions. In December 2017, we entered into fixed-for-floating interest rate forward swap agreements (expiring July 2021) with two counterparties starting from April 2018, to swap variable interest payments on our debt for fixed interest payments. The aggregate notional amount of these interest rate swaps was $300 million. The interest rate on the variable debt was fixed in December 2017 and became effective in April 2017. On March 7, 2018, we entered into a privately negotiated agreement to induce the extinguishment of $10 million of the remaining $22 million of Spansion Notes outstanding. We paid the holders of the Spansion Notes cash for the aggregate principal of $10 million and delivered 1.4 million shares of common stock for the value in excess of the principal amount. On March 12, 2018, we amended our Credit Agreement. The amendment reduces the applicable margins on the Revolving Credit Facility and Term Loan B. After giving effect to the amendment, the Term Loan B bore interest, at our option, at the base rate plus an applicable margin of 1.25% or the Eurodollar rate plus an applicable margin of 2.25%; and the Revolving Credit Facility bore interest, at our option, at the base rate plus an applicable margin of either 0.75% or 1.00%, depending on our secured leverage ratio, or the Eurodollar rate plus an applicable margin of 1.75% or 2.00%, depending on the Company's secured leverage ratio. The amendment removed the fixed charge coverage ratio financial covenants. In addition, for Term Loan B, the amendment removed the total leverage ratio covenant, changed the required amortization payments to 1% per annum, and waived the excess cash flow mandatory repayment for fiscal 2017. On September 13, 2018, we again amended our Credit Agreement. The amendment reduces the applicable margin for Term Loan B. After giving effect to the amendment, Term Loan B will bear interest, at our option, at the base rate plus an applicable margin of 1.00% or the Eurodollar rate plus an applicable margin of 2.00%. In addition, for Term Loan B, the amendment waived the excess cash flow mandatory repayment for fiscal 2018. As part of the transaction we repaid $25.0 million of outstanding Term Loan B principal. In October 2018, we entered into fixed-for-floating interest rate forward swap agreements starting in July 2021 with two counterparties to swap variable interest payments on expected future debt for fixed interest payments; these agreements will expire in December 2024. The aggregate notional amount of these interest rate swaps is $300 million. We believe that liquidity provided by existing cash, cash equivalents and investments, our cash from operations and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, if economic conditions deteriorate, debt covenants unexpectedly impact our business, and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements, we could be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all. We may also choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives including the acquisition of other companies, repurchase shares of our stock, increase our dividends or pay a special dividend and provide us with additional flexibility to take advantage of other business opportunities that arise. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements included in this Annual Report on Form 10-K and the data used to prepare them. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and we are required to make estimates, judgments and assumptions in the course of such preparation. Note 1 of the Notes to Consolidated Financial Statements under Item 8 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an ongoing basis, we re-evaluate our judgments and estimates including those related to revenue recognition, allowances for doubtful accounts receivable, inventory valuation, valuation of long-lived assets, goodwill and financial instruments, stock-based compensation, and settlement costs, and income taxes. We base our estimates and judgments on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies that are affected by significant estimates, assumptions and judgments used in the preparation of our consolidated financial statements are as follows: Revenue Recognition: On January 1, 2018, the Company adopted ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)." This standard update outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. We adopted using the modified retrospective method applied to all contracts that were not completed contracts at the date of initial application (i.e., January 1, 2018). Results for reporting periods after January 1, 2018 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with the Company's historic accounting under Topic 605. Revenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. Sales of products with alternative use account for the majority of the Company's revenue and are recognized at a point in time. Sales to certain distributors are made under arrangements that provide the distributors with price adjustments, price protection, stock rotation and other allowances under certain circumstances. These adjustments and allowances are accounted for as variable consideration. The Company estimates these amounts based on the expected amount to be provided to customers and reduce revenue recognized. The Company believes that there will not be significant changes to its estimates of variable consideration. If the arrangement includes variable contingent consideration, the Company recognizes revenue over time if management can reasonably measure its progress or is capable of providing reliable information as required to apply an appropriate method of measuring progress. Business Combinations: We apply the provisions of Accounting Standards Codification 805, Business Combinations ("ASC 805"), in the accounting for acquisitions. It requires us to recognize separately from goodwill the assets acquired and the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date as well as contingent consideration, where applicable, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our Consolidated Statements of Operations. Accounting for business combinations requires our management to make significant estimates and assumptions, especially at the acquisition date including our estimates for intangible assets, contractual obligations assumed, restructuring liabilities, pre-acquisition contingencies and contingent consideration, where applicable. Although we believe the assumptions and estimates we have made have been reasonable and appropriate, they are based in part on historical experience and information obtained from our management of the acquired companies and are inherently uncertain. Critical estimates in valuing certain of the intangible assets we have acquired include but are not limited to: future expected cash flows from product sales, customer contracts and acquired technologies, expected costs to develop in-process research and development into commercially viable products and estimated cash flows from the projects when completed and discount rates. Unanticipated events and circumstances may occur that may affect the accuracy or validity of such assumptions, estimates or actual results. Valuation of Inventories: Management periodically reviews the adequacy of our inventory reserves. We record a write-down for our inventories which have become obsolete or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventories each quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans and current sales levels. Inventory reserves are not released until the related inventory has been sold or scrapped. Our inventories may be subject to rapid technological obsolescence and are sold in a highly competitive industry. If there were a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to record additional write-downs, and our gross margin could be adversely affected. Valuation of Long-Lived Assets: Our business requires heavy investment in manufacturing facilities and equipment that are technologically advanced but can quickly become significantly under-utilized or rendered obsolete by rapid changes in demand. In addition, we have recorded intangible assets with finite lives related to our acquisitions. We evaluate our long-lived assets, including property, plant and equipment and purchased intangible assets with finite lives, for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Factors considered important that could result in an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the assets or the strategy for our business, significant negative industry or economic trends, and a significant decline in our stock price for a sustained period of time. Impairments are recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analysis. If there is a significant adverse change in our business in the future, we may be required to record impairment charges on our long-lived assets. Valuation of Goodwill: Goodwill represents the excess of the purchase price over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. We assess our goodwill for impairment on an annual basis. Additionally, if certain events or circumstances indicate that an impairment loss may have been incurred, we will also perform an impairment assessment on an interim basis. In accordance with ASU 2011-08, Testing Goodwill for Impairment, qualitative factors can be assessed to determine whether it is necessary to perform the current two-step test for goodwill impairment. If we believe, as a result of our qualitative assessment, that it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, the quantitative impairment test is required. Otherwise, no further testing is required. Investments in equity interests Investments in the stock of entities in which we exercise significant influence but do not own a majority equity interest or otherwise control are accounted for using the equity method and are included as equity method investments in our consolidated balance sheets. We record our share of the results of those companies within share in net loss and impairment of equity method investees in our consolidated statements of operations. Investments in privately held equity interests in which we do not exercise significant influence are accounted for using the cost method of accounting and are included in other long-term assets in our consolidated balance sheets. We review our investments for other-than-temporary impairment whenever events or changes in business circumstances indicate that the carrying value of the investment may not be fully recoverable. Investments identified as having an indication of impairment are subject to further analysis to determine if the impairment is other-than-temporary and this analysis requires estimating the fair value of the investment. The determination of fair value of the investment involves considering factors such as current economic and market conditions, the operating performance of the entities including current earnings trends and forecasted cash flows, and other company and industry specific information. Cash Flow Hedges: We recognize derivative instruments from hedging activities as either assets or liabilities on the balance sheet and measure them at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting. To receive hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedge, and the hedges must be highly effective in offsetting changes to future cash flows on hedged transactions. We record changes in the intrinsic value of these cash flow hedges in accumulated other comprehensive loss on the Consolidated Balance Sheets, until the forecasted transaction occurs. When the forecasted transaction occurs, we reclassify the related gain or loss on the cash flow hedge to the appropriate revenue or expense line of the Consolidated Statements of Operations. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, we will reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive loss to other income (expense), net in our Consolidated Statements of Operations at that time. We enter into cash flow hedges to protect non-functional currency revenues, inventory purchases and certain other operational expenses against variability in cash flows due to foreign currency fluctuations. Our foreign currency forward contracts that were designated as cash flow hedges have maturities between three and thirteen months. We evaluate hedge effectiveness at the inception of the hedge prospectively as well as retrospectively and record any ineffective portion of the hedge in other income (expense), net in the Consolidated Statements of Operations. We enter into interest rate swaps to manage the variability in cash flow due to interest rate fluctuations. We evaluate hedge effectiveness at the inception of the hedge prospectively as well as retrospectively and record any ineffective portion of the hedge in other income (expense), net in our Consolidated Statements of Operations. Changes in the fair value of interest rate swaps that have been designated as hedging instruments are recognized in accumulated other comprehensive income (loss). Refer to Note 12 of the Notes to Consolidated Financial Statements under Item 8 for further details on cash flow and balance sheet hedges. Share-Based Compensation: Under the fair value recognition provisions of the guidance, we recognize share-based compensation based on the grant date fair value of the award and recognize share-based compensation over the service period, which is usually the vesting period. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including measurement of the level of achievement of performance milestones, the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. Through fiscal 2016, we estimated the expected forfeiture rate and only recognized the expense for those shares expected to vest. Beginning fiscal 2017, with the adoption of ASU 2016-09, "Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting," we elected to recognize forfeitures as they occurred and adopted these changes using a modified retrospective approach, with a cumulative adjustment recorded to opening accumulative deficit. As a result, if factors change and we use different assumptions, our share-based compensation expense could be materially different in the future. Employee Benefit Plans: In connection with the merger with Spansion, we assumed the Spansion Innovates Group Cash Balance Plan (a defined benefit pension plan) in Japan. A defined benefit pension plan is accounted for on an actuarial basis, which requires the selection of various assumptions such as turnover rates, discount rates and other factors. The discount rate assumption is determined by comparing the projected benefit payments to the Japanese corporate bonds yield curve as of the end of the most recently completed fiscal year. The benefit obligation is the projected benefit obligation (PBO), which represents the actuarial present value of benefits expected to be paid upon retirement. This liability is recorded in other long-term liabilities on the Consolidated Balance Sheets. Net periodic pension cost is recorded in the Consolidated Statements of Operations and includes service cost. Service cost represents the actuarial present value of participant benefits earned in the current year. Interest cost represents the time value of money associated with the passage of time on the PBO. Gains or losses resulting from a change in the PBO if actual results differ from actuarial assumptions will be accumulated and amortized over the future life of the plan participants if they exceed 10% of the PBO, being the corridor amount. If the amount of a net gain or loss does not exceed the corridor amount, it will be recorded to other comprehensive income (loss). See Note 19 of the Notes to Consolidated Financial Statements for further details of the pension plans. Accounting for Income Taxes: A valuation allowance is established or maintained when, based on currently available information and other factors, it is more likely than not that all or a portion of the deferred tax assets will not be realized. We regularly assess our valuation allowance against deferred tax assets on a jurisdiction by jurisdiction basis. We consider all available positive and negative evidence, including future reversals of temporary differences, projected future taxable income, tax planning strategies and recent financial results. During the fourth quarter of 2018, the Company emerged from a cumulative loss position over the previous three years. The cumulative three-year pre-tax income is considered positive evidence which is objective and verifiable and thus received significant weighting. The continued pattern of income before tax, recent global restructuring executed in fiscal 2018 and projected future operating income in the U.S. was additional positive evidence. As a result, the Company released $343.3 million of the valuation allowance attributable to certain U.S. deferred tax assets during 2018. Recent Accounting Pronouncements See "Recent Accounting Pronouncements" in Note 1 of the Notes to Consolidated Financial Statements under Item 8 of this Annual Report on Form 10-K.

<s>[INST] EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (together with its consolidated subsidiaries, "Cypress", "the Company", "we" or "us") manufactures and sells advanced embedded system solutions for automotive, industrial, consumer and enterprise end markets. Cypress’ microcontroller, analog ICs, wireless and wired connectivity solutions and memory products help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. The Company operates on a 52 or 53week fiscal year ending on the Sunday nearest to December 31. Fiscal years 2018, 2017 and 2016 each contained 52 weeks. Mergers, Acquisitions and Divestitures Joint Venture with SK hynix system ic Inc. ("SKHS") On October 23, 2018, we entered into an agreement whereby we will transfer our NAND business to a JV with SKHS. The transaction is subject to customary closing conditions and regulatory approvals. We presently expect that the transaction will be completed in the first quarter of fiscal 2019. In addition to our NAND Flash business, we will contribute $2.4 million in cash towards the equity of the JV. We will own 40% of the JV’s common stock. The NAND business is presently reported as part of the MPD segment. We recognized $167.3 million, $168.1 million and $180.5 million in revenue from the NAND business for the years ended December 30, 2018, December 31, 2017 and January 1, 2017. Sale of Cypress Minnesota Incorporated In fiscal 2017, we completed the sale of our wafer fabrication facility in Minnesota for gross proceeds of $30.5 million. Investment in Deca Technologies Inc. On July 29, 2016, Deca Technologies Inc. ("Deca"), our majority owned subsidiary entered into a share purchase agreement, whereby certain thirdparty investors purchased 41.1% of the shares outstanding at that time for an aggregate consideration of approximately $111.4 million. Concurrently, Deca repurchased certain of its preferred shares from us. After giving effect to the above transactions, our ownership in Deca was reduced to 52.2% as at July 29, 2016. As a consequence of the substantive rights afforded to thirdparty new investors in the share purchase agreement, including, among other things, participation on the Board of directors of Deca, approval of operating plans and approval of indebtedness, we determined that we no longer have the power to direct the activities of Deca that most significantly impact Deca's economic performance. However, as we continue to have significant influence over Deca's financial and operating policies, effective July 29, 2016, our investment in Deca is being accounted for as an equity method investment and financial results of Deca are no longer being consolidated. Acquisition of Broadcom Corporation’s Internet of Things business (“wireless IoT business”) On July 5, 2016, we completed the acquisition of certain assets primarily related to the wireless IoT business of Broadcom pursuant to an Asset Purchase Agreement with Broadcom Corporation, dated April 28, 2016, for a total consideration of $550 million. Our consolidated financial statements include the financial results of the wireless IoT business acquired from Broadcom beginning July 5, 2016. The comparability of our results for the years ended December 30, 2018 and December 31, 2017 to the prior year is significantly impacted by this transaction. Business Developments Business Segments We continuously evaluate our reportable business segments in accordance with the applicable accounting guidance. Consistent with the year ended December 31, 2017, the Company operates under two reportable business segments, MPD and MCD, for the year ended December 30, 2018. RESULTS OF OPERATIONS Revenues Our total revenues increased by $156.1 million, [/INST] Negative. </s>

CYPRESS SEMICONDUCTOR CORP /DE/

2020-02-21

2019-12-29

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") should be read in conjunction with the financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. The MD&A contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended that involve risks and uncertainties, including those discussed under Item 1A. EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (together with its consolidated subsidiaries, "Cypress", "the Company", "we" or "us") manufactures and sells advanced embedded system solutions for Internet of Things (or "IoT"), automotive, industrial, and consumer applications. Cypress’ microcontroller, analog integrated circuits ("ICs"), wireless and wired connectivity solutions and memories help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. The Company operates on a 52 or 53-week fiscal year ending on the Sunday nearest to December 31. Fiscal years 2019, 2018 and 2017 each contained 52 weeks. Pending Acquisition by Infineon In June 2019, we entered into a definitive Agreement and Plan of Merger (the "Merger Agreement") with Infineon Technologies AG, a stock corporation (Aktiengesellschaft) organized under the laws of the Federal Republic of Germany ("Infineon") and IFX Merger Sub Inc., a Delaware corporation and a wholly owned subsidiary of Infineon ("Merger Sub"). Subject to approval by the relevant regulatory bodies as well as other customary closing conditions, the Merger Agreement provides for Merger Sub to merge with and into Cypress, with Cypress continuing as the surviving corporation in the Merger and as a wholly owned subsidiary of Infineon. Refer to Note 2, Merger Agreement, of the Notes to Consolidated Financial Statements under Part II, Item 8 for more information. Mergers, Acquisitions and Divestitures Acquisition of the Noncontrolling Interest in AgigA Tech, Inc. ("AgigA") In September 2019, we acquired the minority shareholders' noncontrolling interest in AgigA for total cash consideration of $3.9 million, making AgigA a wholly-owned subsidiary of Cypress. Joint Venture with SK hynix system ic Inc. ("SKHS") In April 2019, we closed the transfer of our NAND flash business to a newly-formed joint venture between Cypress and SKHS. The joint venture entity is named SkyHigh Memory Limited ("SkyHigh") and its headquarters are in Hong Kong, China. SkyHigh is 60-percent-owned by SKHS and 40-percent-owned by us. The NAND business was reported as part of our MPD segment prior to the close of the transfer. We recognized $31.1 million, $167.3 million and $168.1 million in revenue from the NAND business for the years ended December 29, 2019, December 30, 2018 and December 31, 2017. Acquisition of a software business In August 2018, we acquired an embedded software company focused on the Internet of things market for cash consideration of $3.0 million. The purchased assets were primarily developed technology. Pro forma results of operations of this acquired company are not presented because the effect of the acquisition was not material. Sale of Cypress Minnesota Incorporated In March 2017, we completed the sale of our wafer fabrication facility in Minnesota for gross proceeds of $30.5 million. Business Segments We continuously evaluate our reportable business segments in accordance with the applicable accounting guidance. Consistent with the year ended December 30, 2018, we operated under two reportable business segments, MPD and MCD, for the year ended December 29, 2019. RESULTS OF OPERATIONS Revenues Our total revenues decreased by $278.5 million, or 11.2%, to $2,205.3 million for the year ended December 29, 2019 compared to the prior fiscal year. The decrease was attributable in part to the divestiture of our NAND flash business, which was completed on April 1, 2019. Revenue from the NAND flash business decreased by $136.2 million to $31.1 million in fiscal 2019 compared to the prior fiscal year. The remainder of the decrease was primarily due to demand softening across our NOR flash, microcontroller and wireless connectivity businesses. Our total revenues increased by $156.1 million, or 6.7%, to $2,483.8 million for the year ended December 30, 2018 compared to the prior fiscal year. For the year ended December 30, 2018, the increase was primarily driven by strength in automotive and wireless connectivity, microcontrollers, and memory products. The following table summarizes our consolidated revenues by segments: Microcontroller and Connectivity Division: Revenues recorded by MCD increased in fiscal 2019 by $2.2 million, or 0.2%, compared to fiscal 2018. The increase was primarily due to a growth in automotive and wired connectivity products, partially offset by a decline in demand for microcontrollers and wireless connectivity products. Revenues recorded by MCD increased in fiscal 2018 by $65.2 million, or 4.6%, compared to fiscal 2017. The increase was primarily driven by growth in our microcontrollers, wired and wireless connectivity and automotive products. MCD revenue during fiscal 2018 benefited from volume increases as a result of new program ramps at certain customers. Memory Products Division: Revenues recorded by MPD decreased in fiscal 2019 by $280.7 million, or 27.8% compared to fiscal 2018. The decrease was primarily due to a decline in demand for NOR flash products, and the divestiture of our NAND flash business, which was completed on April 1, 2019. Revenue from the NAND flash business decreased by $136.2 million to $31.1 million in fiscal 2019 compared to the prior fiscal year. The decrease was partially offset by the manufacturing services revenue of approximately $10.5 million generated from SkyHigh in fiscal 2019. Revenues recorded by MPD increased in fiscal 2018 by $90.9 million, or 9.9% compared to fiscal 2017. MPD revenue increased over fiscal 2017 primarily due to a shift in product mix towards high density NOR products, as well as an increase in revenue on NAND products. Gross Profit & Margin Our gross margin remained relatively constant at 37.6% in fiscal 2019 as compared to 37.5% in fiscal 2018. Improvements to gross margin were offset by items having an unfavorable impact to gross margin. Favorable items included a shift in the product mix toward higher density memory products, a decrease in sales of commoditized products, which was due in part to the divestiture of the NAND business effective the second quarter of fiscal 2019. Additionally, a loss from sale of assets related to planned sale of the NAND business in the amount of $1.9 million and $10.9 million was recorded in the cost of goods sold in fiscal 2019 and 2018 respectively. A primary unfavorable item was the decrease in revenue in fiscal 2019 compared to fiscal 2018 causing an increase in amortization expense from intangible assets as a percentage of revenue. Amortization of intangible assets included in cost of revenue was $187.5 million or 8.5% of revenues in fiscal 2019 compared to $196.0 million or 7.9% of revenues in fiscal 2018. Our gross margin improved from 33.6% in fiscal 2017 to 37.5% in fiscal 2018. The primary drivers of the improvement in gross margin were higher fab utilization, which increased from 74.2% for the year ended December 31, 2017 to 81.2% for the year ended December 30, 2018; a reduction in the cost of certain products; a shift in the product mix towards higher density memory products and away from commoditized products; and ramping of new products at favorable margins. Additionally, there was a reduction in write-downs of carrying value of inventory for the year ended December 30, 2018 as compared to the prior year. Write-down of inventories for the year ended December 30, 2018 was $22.3 million as compared to $34.5 million for the year ended December 31, 2017. Write-down of inventories unfavorably impacted our gross margin by 0.9% and 1.5% for the year ended December 30, 2018 and for the year ended December 31, 2017, respectively. Sale of inventory that was previously written off or written down aggregated to $19.5 million and $31.6 million in fiscal 2018 and fiscal 2017, respectively, which favorably impacted our gross margin by 0.8% and 1.4%, respectively. Included in the cost of revenues are restructuring costs of $3.3 million and $0.6 million for fiscal 2018 and fiscal 2017, respectively. The increase in restructuring costs is primarily due to the 2018 Plan (as defined below), which we began implementing in the first quarter of 2018. Included in cost of revenues is the amortization of intangible assets of $196.0 million and $175.0 million for fiscal 2018 and fiscal 2017, respectively. The increase of the amortization of intangible assets is mainly due to the capitalization of in-process research and development ("IPR&D") projects. Included in cost of revenues in fiscal 2018 is the impairment of assets held for sale of $10.9 million as a result of entering into a definitive agreement to divest the NAND products business to a joint venture with SKHS in October 2018. Research and Development ("R&D") Our R&D efforts are focused on the development and design of new semiconductor products and design methodologies, as well as the continued development of advanced software platforms. Our R&D organization works with our manufacturing facilities, suppliers and customers to improve our semiconductor designs and lower our manufacturing costs. Our R&D groups conduct ongoing efforts to reduce design cycle time and increase first pass yield through structured re-use of intellectual property blocks from a controlled intellectual property library, development of computer-aided design tools and improved design business processes. Design and related software development work primarily occurs at design centers located in the United States, Ukraine, Ireland, Germany, Israel, India, Japan, China and Malaysia. R&D expenditures decreased by $1.3 million in fiscal 2019 compared to the prior year. The decrease was mainly attributable to a $14.7 million decrease in labor costs due to reductions in variable compensation expenses and a $1.4 million decrease in stock-based compensation. These decreases were partially offset by $6.7 million increase in outside services, $5.1 million increase in other compensation, $2.9 million increase in software expenses and $0.1 million increase in other expenses. R&D expenditures increased by $1.1 million in fiscal 2018 compared to the fiscal 2017. The increase was mainly attributable to $5.4 million in increased labor costs mainly due to employee-related compensation expenses, a $3.6 million increase in depreciation, and $1.8 million in licensing payments to certain vendors, partially offset by $4.1 million in lower restructuring costs, a $3.8 million decrease in deferred compensation expenses, and a $1.7 million decrease in stock-based compensation expenses. Selling, General and Administrative ("SG&A") SG&A expenses decreased by $59.0 million in fiscal 2019 compared to fiscal 2018. The decrease was mainly due to a loss from sale of assets related to planned sale of the NAND business of $65.7 million recognized in fiscal 2018, as well as a decrease of $17.2 million in professional fee and a decrease of $10.9 million in restructuring charges. These decreases were partially offset by an increase of $12.3 million in merger-related expenses, a $12.5 million increase in stock-based compensation expense, a $8.2 million increase in labor expenses and an increase of $1.8 million in facility-related expenses. SG&A expenses increased by $62.1 million in fiscal 2018 compared to fiscal 2017. The increase was mainly due to a loss from sale of assets related to planned sale of the NAND business of $65.7 million, a $9.1 million increase in restructuring costs, a $5.1 million increase in stock-based compensation, a $3.8 million increase in professional fees, a $3.4 million increase in advertising expenses and a $2.5 million increase in facilities expenses, partially offset by a $14.3 million decrease in shareholder litigation, a $7.9 million decrease in labor expenses, and a $5.0 million decrease in deferred compensation expenses. Interest Expense Interest expense for fiscal 2019 was $58.7 million and primarily represents interest payments due and amortization of debt discount and costs related to our 2% Convertible Senior Notes due 2023, 4.5% Convertible Senior Notes due 2022, 2% Exchangeable Senior Notes due 2020, and interest expense incurred on our Revolving Credit Facility, Term Loan B and other debt. In addition, of the $58.7 million, $6.4 million was related to the loss on extinguishment of Term Loan B. Interest expense for fiscal 2018 was $65.3 million and primarily represents interest payments due and amortization of debt discount and costs related to our 2% 2023 Exchangeable Notes, 4.5% 2022 Senior Exchangeable Notes, 2% 2020 Spansion Exchangeable Notes, and interest expense incurred on our Revolving Credit Facility, Term Loan B and other debt. In addition, of the $65.3 million, $5.2 million was related to the refinancing and write-off of debt issuance costs upon the debt amendment for Term Loan B and the extinguishment of the 2% 2020 Spansion Exchangeable Notes. Interest expense for fiscal 2017 was $80.2 million and primarily represents interest payments due and amortization of debt discount and costs related to our 2% 2023 Exchangeable Notes, 4.5% 2022 Senior Exchangeable Notes, and 2% 2020 Spansion Exchangeable Notes, and interest expense incurred on our Revolving Credit Facility, Term Loan B and other debt. In addition, of the $80.2 million, $7.2 million was related to the debt extinguishment of the 2% 2020 Spansion Exchangeable Notes and Term Loan A. Refer to Note 16, Debt, of the Notes to Consolidated Financial Statements under Part II, Item 8 for more information about our credit facility and other debt. Other Income (Expense), Net The following table summarizes the components of other income (expense), net: Employee Deferred Compensation Plan We have a deferred compensation plan, which provides certain key employees, including our executive management, with the ability to defer the receipt of compensation in order to accumulate funds for retirement on a tax-deferred basis. We do not make contributions to the deferred compensation plan and we do not guarantee returns on the investments. Participant deferrals and investment gains and losses remain as our liabilities and the underlying assets are subject to claims of general creditors. In fiscal 2019, 2018 and 2017, we recognized changes in fair value of the assets under the deferred compensation plan in "Other income (expense), net" of $8.0 million, $(2.9) million, and $6.1 million, respectively. The increase or decrease in the fair value of the investments relates to the increased or decreased performance of the portfolio on a year over year basis. Refer to Note 21, Employee Benefit Plans, of the Notes to Consolidated Financial Statements under Part II, Item 8 for more information about our deferred compensation plan. Share in Gain/Loss, Net and Impairment of Equity Method Investees Deca Technologies Inc. ("Deca") Cypress held 52.4% and 52.5% of Deca's outstanding voting shares as of December 29, 2019 and December 30, 2018, respectively. Our investment in Deca is accounted for as an equity method investment. During the fourth quarter of fiscal 2018, we determined that our investment in Deca was other-than-temporarily impaired due to Deca's failure to achieve significant product development and testing milestones. As a result, we recognized a charge of $41.5 million in order to write down the carrying amount of the investment to the estimated fair value as of the end of fiscal 2018. During the second quarter of fiscal 2019, certain key customers notified Deca management of their intention to significantly reduce their previously estimated orders from Deca for 2019. Additionally, preliminary conversations between Deca and certain potential investors during the second quarter of fiscal 2019 had indicated that the enterprise value of Deca was lower than Cypress’s previous estimates. As a result, we recognized a charge of $29.5 million in order to write down the carrying amount of the investment to the estimated fair value as of the end of the second quarter of fiscal 2019. During fiscal 2019 and 2018, we recorded $10.5 million and $15.8 million, respectively, for our share of losses recorded by Deca. On October 1, 2019, Deca reached a definitive agreement with nepes Corporation (“nepes”) to sell Deca’s Philippines manufacturing facility to nepes, subject to receipt of regulatory approvals and other customary closing conditions. As part of the agreement, nepes has licensed certain Deca technologies, and nepes will purchase a limited number of Deca’s shares from certain existing shareholders which may include Cypress. The agreement provides for milestone-based payments from nepes to Deca both for the Philippines manufacturing facility purchase and the technology license, which milestones are currently expected to be achieved in 2020. The transfer of Deca's manufacturing facility to nepes closed on January 1, 2020. Following the closing, Deca's remaining assets primarily consist of intellectual property and its new business model will focus on monetizing its intellectual property portfolio as well as providing engineering services. Given the factors described above, there continues to be a substantial risk that the carrying value of our investment in Deca may be further impaired in the future. Conditions that may have a material adverse effect on Deca’s business, results of operations and financial condition or on its enterprise value include: • any delays of failure to complete product or intellectual property development milestones-similar to those previously experienced; • any inability of Deca to raise sufficient funding, if needed, for continuing its operations; and • any inability of Deca to monetize its intellectual property assets. We may be required to record further impairments resulting in partial or full write down of the carrying value of our investment in Deca if any of the conditions described above were to materialize. SkyHigh On April 1, 2019, we closed the transfer of our NAND business to a newly-formed joint venture between Cypress and SK hynix system ic Inc. ("SKHS"). The joint venture entity is named SkyHigh Memory Limited ("SkyHigh") and its headquarters are in Hong Kong, China. SkyHigh is 60-percent-owned by SKHS and 40-percent-owned by Cypress. We paid $2.4 million in cash as our capital contribution in SkyHigh upon close of the transaction. Our investment in SkyHigh is accounted for as an equity method investment. During fiscal 2019, we recorded $4.1 million for our share of income recorded by SkyHigh. Enovix Corporation ("Enovix") We held 23.2% and 24.8% of Enovix's outstanding equity at the end of fiscal 2019 and 2018, respectively. During the fourth quarter of fiscal 2017, Enovix missed achieving certain key planned product development milestones. Consequently, we concluded that our investment in Enovix was other-than-temporarily impaired and recorded a charge of $51.2 million to write down the carrying amount of the investment to zero. During fiscal 2017, we recorded $8.7 million for our share of losses recorded by Enovix. No further share in losses of Enovix have been recorded since the full impairment of the carrying value of our investment in Enovix in the fourth quarter of fiscal 2017 as described above. Income Taxes We recorded income tax provision of $2.4 million and income tax benefit of $315.6 million in fiscal 2019 and 2018, respectively, and an income tax provision of $11.2 million in fiscal 2017. The income tax provision for 2019 was primarily due to income taxes associated with our non-U.S. operation, partially offset by tax credits and excess tax benefits from stock-based compensation. The income tax benefit for 2018 was primarily due to a release of our valuation allowance previously maintained against certain deferred tax assets of $343.3 million, as discussed further below. The income tax expense for fiscal 2017 was primarily attributable to income taxes associated with our non-U.S. operations, partially offset by release of previously accrued taxes related to the lapsing of statutes of limitation. A valuation allowance is established or maintained when, based on currently available information and other factors, it is more likely than not that all or a portion of the deferred tax assets will not be realized. We regularly assess our valuation allowance against deferred tax assets on a jurisdiction by jurisdiction basis. We consider all available positive and negative evidence, including future reversals of temporary differences, projected future taxable income, tax planning strategies and recent financial results. During the fourth quarter of 2018, we released $343.3 million of the valuation allowance attributable to certain U.S. deferred tax assets. As of December 29, 2019, for certain federal and state attributes, a valuation allowance of $176.0 million has been recorded for the portion that is not more likely than not to be realized. We will continue to evaluate all evidence in future periods to determine if a further release of the valuation allowance is warranted. Our effective tax rate varies from the U.S. statutory rate primarily due to earnings of foreign subsidiaries taxed at different rates. The calculation of tax liabilities involves dealing with uncertainties in the application of complex global tax regulations. We regularly assess our tax positions in light of legislative, bilateral tax treaties, and regulatory and judicial developments in the many countries in which we and our affiliates do business. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes information regarding our cash and cash equivalents and working capital: Key Components of Cash Flows Fiscal 2019: Operating Activities Net cash provided by operating activities during fiscal 2019 of $478.9 million consisted of (in millions): The decrease in net cash due to changes in operating assets and liabilities during fiscal 2019 of $17.3 million was primarily due to a decrease in accounts payable and accrued and other liabilities of $101.0 million mainly due to timing of payments to vendors. This was partially offset by an increase of $67.5 million in price adjustments and other revenue reserves for sales to distributors (the "DPA Reserve") mainly due to a transition of business between distributors in Japan during the third quarter of fiscal 2019. Other changes that impacted the operating assets and liabilities included the following: • $56.0 million in operating lease right-of-use assets recorded due to the adoption of ASU No. 2016-02, "Leases (ASC Topic 842)," partially offset by $44.6 million of operating lease liability; • a decrease in accounts receivable of $23.4 million due to timing of invoicing and collections; and • an increase in inventories of $3.0 million primarily due to inventory builds to support certain supplier transitions. Investing Activities In fiscal 2019, we used approximately $27.3 million of cash in our investing activities primarily due to: • property and equipment expenditures of $41.2 million relating to purchases of manufacturing facility equipment; • cash paid for purchase of noncontrolling interest in AgigA of $3.7 million; and • cash paid for equity method investments of $2.4 million. These cash outflows were partially offset by proceeds of $13.6 million from our sale of the NAND business to a joint venture and $5.8 million in net distributions for the deferred compensation plan. Financing Activities In fiscal 2019, we used approximately $321.9 million of cash in our financing activities, primarily related to: • payments of $476.3 million on Term Loan B; • dividend payments of $160.9 million; • payments of $147.0 million on our Revolving Credit Facility; • payments of $19.4 million on net shares settlement of restricted stock units; and • payments of $1.7 million on finance lease liabilities. These payments were partially offset by proceeds of $447.0 million from draws on our Revolving Credit Facility and proceeds of $38.6 million from employee equity awards. Fiscal 2018: Operating Activities Net cash provided by operating activities during fiscal 2018 of $471.7 million consisted of (in millions): The decrease in net cash due to changes in operating assets and liabilities during fiscal 2018 of $101.1 million was primarily due to the following: • an increase in accounts receivable of $23.8 million mainly due to an increase in revenue; • an increase in inventories of $20.8 million; • an increase in other current and long-term assets of $5.4 million; • a decrease in accounts payable and accrued and other liabilities of $33.9 million mainly due to timing of payments and payments related to restructuring activities; • a decrease in price adjustments and other distributor related reserves of $14.5 million; and • an increase in assets held for sale related inventories of $13.5 million due to the sale of NAND business. Investing Activities In fiscal 2018, we used approximately $49.7 million of cash in our investing activities primarily due to: • $68.9 million of cash used for property and equipment expenditures relating to purchases of certain laboratory and manufacturing facility equipment. These cash outflows were partially offset by $5.8 million of cash received on the sales of property and equipment, and $18.5 million of cash received related to our investments in privately held equity interests. Financing Activities In fiscal 2018, we used approximately $287.9 million of cash in our financing activities, primarily related to: • $157.4 million for dividend payments; • net repayments of $90.0 million on the Senior Secured Revolving Credit Facility; • $35.6 million for repayment of Term Loan B; • $35.0 million for stock repurchase; and • $10.0 million for repayment of 2% 2020 Spansion Exchangeable Notes. The above payments were partially offset by proceeds of $40.7 million from employee equity awards. Liquidity and Contractual Obligations Summary of our debt balances is included below: Of the net carrying value outstanding, $11.8 million related to 2% Exchangeable Senior Notes due 2020 and $1.9 million related to finance lease obligations were classified as current liabilities as of December 29, 2019. Of the net carrying value outstanding, $6.9 million related to Term Loan B and finance lease obligation was classified as current liabilities as of December 30, 2018. On March 12, 2015, we entered into an Amended and Restated Credit and Guaranty Agreement with Morgan Stanley Bank, N.A., as issuing bank, and other lenders (as amended, the "Credit Agreement"). The Credit Agreement establishes a credit facility (the "Credit Facility" or the "Senior Secured Credit Facility") that includes a revolving loan facility (the "Revolving Credit Facility") and provides for the possibility of term loans. The Revolving Credit Facility, as amended, provides for $700 million of borrowing capacity, of which $400.0 million was undrawn as of December 29, 2019. As of December 29, 2019, we were in compliance with all of the financial covenants under all of our debt facilities. Refer to Note 16, Debt, of the Notes to Consolidated Financial Statements under Part II, Item 8 for more information on our debt obligations. Contractual Obligations The following table summarizes our contractual obligations as of December 29, 2019: (1) Purchase obligations primarily include commitments under "take or pay" arrangements, non-cancelable purchase orders for materials, services, manufacturing equipment, building improvements and supplies in the ordinary course of business. Purchase obligations are defined as enforceable agreements that are legally binding on us and that specify all significant terms, including quantity, price and timing. (2) The notes are presented based on scheduled payment due dates and had become exchangeable or convertible (as applicable) at the holders' options during the third and fourth quarters of fiscal 2019. (3) Interest and commitment fees due on variable debt is based on the effective interest rates as of December 29, 2019. (4) Total contractual obligations do not include transaction fees of approximately $63 million which are contingently payable upon the completion of the proposed Merger with Infineon. If the proposed Merger does not close under circumstances in which we receive a reverse break-up fee, transaction fees of approximately $22.2 million are contingently payable by us. Additionally, the contractual obligations do not include $10.2 million in retention bonuses awarded to certain employees, 50% of which are payable upon the closing of the Merger, and the remaining 50% of which are potentially payable six months after the closing of the Merger. Capital Resources and Financial Condition Our long-term strategy is to minimize the amount of cash required for operational purposes and to utilize the remaining amount of our cash for investments in interest-bearing and highly liquid cash equivalents and debt securities, repayment of debt, the purchase of our stock through our stock buyback program and payments of regularly scheduled cash dividends. In addition, we may use excess cash to invest in strategic investments and partnerships and pursue acquisitions. Our investment policy defines three main objectives when making investments: security of principal, liquidity, and maximization of after-tax yield. We invest excess cash in various financial securities subject to certain requirements including security type, duration, concentration limits, and credit rating profile. As of December 29, 2019, a total cash and cash equivalents position of $415.5 million is available for use in current operations. As of December 29, 2019, approximately 12.2% of our cash and cash equivalents were held by our non-U.S. subsidiaries. While these amounts are primarily invested in U.S. dollars, a portion is held in foreign currencies. All offshore balances are exposed to local political, banking, currency control and other risks. In addition, these amounts, if repatriated may be subject to tax and other transfer restrictions. On July 31, 2019, we amended the Revolving Credit Facility to increase the available amount from $540 million to $700 million and extend its maturity from March 12, 2020 to January 31, 2021. We may, at our sole discretion, extend the maturity for another six months to July 31, 2021. The financial covenants were amended to increase the maximum total leverage ratio from 3.75 to 4.0. Subject to the terms and conditions set forth in the amended Revolving Credit Facility, the completion of the Merger will trigger the change of control provision of the Revolving Credit Facility causing the debt to become payable immediately. We borrowed $447 million under the amended Revolving Credit Facility and repaid the entire outstanding Term Loan B principal balance of approximately $448 million in July 2019, resulting in an extinguishment of Term Loan B, which was scheduled to mature on July 5, 2021. As a result, we recorded a debt extinguishment loss of $6.4 million in connection with the write-off of unamortized debt discount and issuance costs, which was recorded in "Interest expense" in the Consolidated Statements of Operations. Subsequently, we repaid $147.0 million of the outstanding amended Revolving Credit Facility during fiscal 2019. We believe that liquidity provided by existing cash, cash equivalents, our cash from operations and our borrowing arrangements will provide sufficient capital to meet our requirements for at least the next twelve months. However, if economic conditions deteriorate, debt covenants unexpectedly impact our ability to borrow and other factors beyond our control adversely affect our estimates of our future cash requirements, we could be required to fund our cash requirements using alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us if at all. We may also choose at any time to raise additional capital or debt to strengthen our financial position, facilitate growth, enter into strategic initiatives including the acquisition of other companies, repurchase shares of our stock, increase our dividends and/or provide us with additional liquidity to take advantage of other business opportunities that arise. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements included in this Annual Report on Form 10-K and the data used to prepare them. Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. Note 1, Description of Business and Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements under Part II, Item 8 describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. We are required to make estimates, judgments and assumptions in the course of preparing our financial statements. We base our estimates, judgments and assumptions on historical experience, knowledge of current conditions and our beliefs of what could occur in the future considering available information. While we believe that our estimates, judgments and assumptions are reasonable, actual results may differ from these estimates under different assumptions or conditions. Our critical accounting estimates and policies are as follows: Revenue Recognition: estimates related to (i) distributor price adjustments and stock rotation, which are primarily determined based on our analysis of historical trends experienced for similar revenue transactions; and (ii) determining whether reliable information related to an arrangement with a customer that includes variable contingent consideration is available. Valuation of Inventories: estimates related to write-down of our inventories that have become obsolete or are in excess of anticipated demand or net realizable value. Primary factors used in making this estimate include historical sales levels, demand forecast, backlog and age of the inventory items. Share-Based Compensation: estimates related to measuring the level of achievement of performance milestones, based on forecasted operating results. Accounting for Income Taxes: estimating reserves needed against uncertain tax positions. Such reserves are recorded primarily based on judgmental assessment of tax regulations and case law. Recent Accounting Pronouncements See "Recent Accounting Pronouncements" in Note 1, Description of Business and Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements under Part II, Item 8 of this Annual Report on Form 10-K.

<s>[INST] EXECUTIVE SUMMARY General Cypress Semiconductor Corporation (together with its consolidated subsidiaries, "Cypress", "the Company", "we" or "us") manufactures and sells advanced embedded system solutions for Internet of Things (or "IoT"), automotive, industrial, and consumer applications. Cypress’ microcontroller, analog integrated circuits ("ICs"), wireless and wired connectivity solutions and memories help engineers design differentiated products and help with speed to market. Cypress is committed to providing customers with quality support and engineering resources. The Company operates on a 52 or 53week fiscal year ending on the Sunday nearest to December 31. Fiscal years 2019, 2018 and 2017 each contained 52 weeks. Pending Acquisition by Infineon In June 2019, we entered into a definitive Agreement and Plan of Merger (the "Merger Agreement") with Infineon Technologies AG, a stock corporation (Aktiengesellschaft) organized under the laws of the Federal Republic of Germany ("Infineon") and IFX Merger Sub Inc., a Delaware corporation and a wholly owned subsidiary of Infineon ("Merger Sub"). Subject to approval by the relevant regulatory bodies as well as other customary closing conditions, the Merger Agreement provides for Merger Sub to merge with and into Cypress, with Cypress continuing as the surviving corporation in the Merger and as a wholly owned subsidiary of Infineon. Refer to Note 2, Merger Agreement, of the Notes to Consolidated Financial Statements under Part II, Item 8 for more information. Mergers, Acquisitions and Divestitures Acquisition of the Noncontrolling Interest in AgigA Tech, Inc. ("AgigA") In September 2019, we acquired the minority shareholders' noncontrolling interest in AgigA for total cash consideration of $3.9 million, making AgigA a whollyowned subsidiary of Cypress. Joint Venture with SK hynix system ic Inc. ("SKHS") In April 2019, we closed the transfer of our NAND flash business to a newlyformed joint venture between Cypress and SKHS. The joint venture entity is named SkyHigh Memory Limited ("SkyHigh") and its headquarters are in Hong Kong, China. SkyHigh is 60percentowned by SKHS and 40percentowned by us. The NAND business was reported as part of our MPD segment prior to the close of the transfer. We recognized $31.1 million, $167.3 million and $168.1 million in revenue from the NAND business for the years ended December 29, 2019, December 30, 2018 and December 31, 2017. Acquisition of a software business In August 2018, we acquired an embedded software company focused on the Internet of things market for cash consideration of $3.0 million. The purchased assets were primarily developed technology. Pro forma results of operations of this acquired company are not presented because the effect of the acquisition was not material. Sale of Cypress Minnesota Incorporated In March 2017, we completed the sale of our wafer fabrication facility in Minnesota for gross proceeds of $30.5 million. Business Segments We continuously evaluate our reportable business segments in accordance with the applicable accounting guidance. Consistent with the year ended December 30, 2018, we operated under two reportable business segments, MPD and MCD, for the year ended December 29, 2019. RESULTS OF OPERATIONS Revenues Our total revenues decreased by $278.5 million, or 11.2%, to $2,205.3 million for the year ended December 29, 2019 compared to the prior fiscal year. The decrease was attributable in part to the divestiture of our NAND flash business, which was completed on April 1, 2019. Revenue from the NAND flash business decreased by $136.2 million to $31.1 million in fiscal 2019 compared to the prior fiscal year. The remainder of the decrease was primarily due to [/INST] Positive. </s>

THERMO FISHER SCIENTIFIC INC.

2015-02-26

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions such as its 2014 acquisition of Life Technologies. On February 3, 2014, the company completed the acquisition of Life Technologies Corporation for a total purchase price of $15.30 billion, net of cash acquired, including the assumption of $2.28 billion of debt. The company issued debt and common stock in late 2013 and early 2014 to partially fund the acquisition discussed below under the caption “Liquidity and Capital Resources”. Life Technologies was integrated into the Life Sciences Solutions segment and provides innovative products and services to customers conducting scientific research and genetic analysis, as well as those in applied markets, such as forensics and food safety testing. Life Technologies’ revenues totaled $3.87 billion in 2013. On March 21, 2014, the company sold its legacy sera and media, gene modulation and magnetic beads businesses to GE Healthcare for $1.06 billion, net of cash divested. The sale of these businesses resulted in a pre-tax gain of approximately $761 million included in restructuring and other costs (income), net. The businesses fell principally in the Life Sciences Solutions segment. Divestiture of these businesses was a condition to obtaining antitrust approval for the Life Technologies acquisition. Revenues and operating income of the businesses sold were approximately $250 million and $64 million, respectively, for the year ended December 31, 2013 and $61 million and $12 million, respectively, in 2014 through the date of sale. On August 15, 2014, the company sold its Cole-Parmer specialty channel business, part of the Laboratory Products and Services segment, for $480 million in cash, net of cash divested. The sale of this business resulted in a pre-tax gain of approximately $134 million, included in restructuring and other costs (income), net. Revenues and operating income of the business sold were approximately $232 million and $43 million, respectively, for the year ended December 31, 2013 and $149 million and $28 million, respectively, in 2014 through the date of sale. Overview of Results of Operations and Liquidity Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) Sales in 2014 were $16.89 billion, an increase of $3.80 billion from 2013. Sales increased $3.31 billion due to acquisitions, net of divestitures. The unfavorable effects of currency translation resulted in a decrease in revenues of $60 million in 2014. Aside from the effects of currency translation and acquisitions/divestitures, revenues increased $549 million (4%) primarily due to increased demand. Demand from biopharma customers remained strong. Sales to customers in healthcare and industrial markets grew moderately while sales to academic and government markets grew modestly in 2014. Sales growth was strong in Europe and moderate in North America and Asia. Revenues and operating income of the company’s non-U.S. operations are translated into U.S. dollars to report consolidated results. Based on weakening of currency exchange rates against the U.S. dollar that occurred in late 2014 and early 2015, the company currently expects that there will be a significant adverse effect on reported amounts of revenues and operating income in 2015 as a result of the stronger U.S. dollar. In 2014, total company operating income and operating income margin were $2.50 billion and 14.8%, respectively, compared with $1.61 billion and 12.3%, respectively, in 2013. The increase in operating income and operating income margin was primarily due to net gains of $895 million on the sale of businesses, inclusion of Life Technologies’ results from the date of acquisition and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by $450 million of charges associated with the acquisition, as discussed below, as well as $569 million of higher amortization expenses, also primarily related to the acquisition. The company’s references throughout this discussion to productivity improvements generally refer to improved cost efficiencies from its Practical Process Improvement (PPI) business system, reduced costs resulting from global sourcing initiatives, a lower cost structure following restructuring actions, including headcount reductions and consolidation of facilities, and low cost region manufacturing. The company’s effective tax rates were 9.2% and 3.1% in 2014 and 2013, respectively. The 2014 provision for income taxes includes $390 million related to gains on the sales of businesses. Aside from the discrete tax on the gains, the company had a benefit from income taxes primarily due to restructuring and other costs associated with the acquisition of Life Technologies as well as an increase in the expected benefit from foreign tax credits. In 2014, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $172 million, offset in part by additional U.S. income taxes of $55 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $117 million and reduced the company’s effective tax rate by 5.6 percentage points in 2014. The federal tax credit for 2014 research and development activities favorably affected the tax provision in 2014 by $20.1 million, or 1.0 percentage point. In 2014, the company recognized a discrete tax benefit of $15.4 million, or 0.7 percentage points, attributable to tax rulings related to non-U.S. subsidiaries. Due primarily to the non-deductibility of intangible asset amortization, the company’s cash payments (net of refunds) for income taxes were higher than its income tax expense for financial reporting purposes and totaled $586 million and $230 million in 2014 and 2013, respectively. The effective tax rate in both periods was also affected by relatively significant earnings in lower tax jurisdictions. The tax provision in the 2014 period was favorably affected by $5.5 million, or 0.3 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates. The U.S. Congress has not extended the tax credit for research and development activities in 2015 as of February 26, 2015. In 2013, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $160 million offset by additional U.S. income taxes of $56 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $104 million and reduced the company’s effective tax rate by 7.9 percentage points in 2013. In addition, the effective tax rate in 2013 was also reduced by the U.S. Congress’ renewal in January 2013 of a tax credit for research and development activities for 2012 and 2013 and, to a lesser extent, financing costs associated with the acquisition of Life Technologies that are deductible in the U.S. The federal tax credit for 2012 and 2013 research and development activities favorably affected the tax provision in 2013 by $15.4 million, or 1.2 percentage points. The tax provision in the 2013 period was unfavorably affected by $5.4 million, or 0.4 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates and audit settlements. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) The company expects its effective tax rate in 2015 will be less than 3% based on currently forecasted rates of profitability in the countries in which the company conducts business. Income from continuing operations increased to $1.90 billion in 2014, from $1.28 billion in 2013. The increase in operating income in the 2014 period (discussed above) was offset in part by an increase in the income tax provision in the 2014 period (discussed above) and an increase in interest expense of $218 million as a result of debt issued and assumed in connection with the acquisition of Life Technologies. During 2014, the company’s cash flow from operations totaled $2.62 billion compared with $2.01 billion for 2013. The increase resulted from cash flow from the acquired Life Technologies operations and a lower investment in working capital items, principally due to income tax refunds and the timing of tax payments, offset in part by cash disbursements totaling $325 million related to the acquisition of Life Technologies, including severance obligations, third-party transaction/integration costs and monetizing certain equity awards held by Life Technologies employees at the date of acquisition. As of December 31, 2014, the company’s short-term debt totaled $2.21 billion, including $1.21 billion of senior notes, due in the first half of 2015 and $1.00 billion of minimum payments due in the next twelve months on the company’s term loan. The company has a revolving credit facility with a bank group that provides unsecured multi-currency revolving credit. In February 2015, the maximum capacity of this facility was increased from $1.50 billion to $2.00 billion. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2014, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $59 million as a result of outstanding letters of credit. The company believes that its existing cash and short-term investments of $1.35 billion as of December 31, 2014 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Critical Accounting Policies and Estimates The company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent liabilities. On an on-going basis, management evaluates its estimates, including those related to bad debts, inventories, business combinations, intangible assets and goodwill, equity investments, sales returns, warranty obligations, income taxes, contingencies and litigation, pension costs and stock-based compensation. Management believes the most complex and sensitive judgments, because of their significance to the consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Management bases its estimates on historical experience, current market and economic conditions and other assumptions that management believes are reasonable. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities where the values are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) The company believes the following represent its critical accounting policies and estimates used in the preparation of its financial statements: (a) Accounts Receivable The company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to pay amounts due. Such allowances totaled $74 million at December 31, 2014. The company estimates the amount of customer receivables that are uncollectible based on the age of the receivable, the creditworthiness of the customer and any other information that is relevant to the judgment. If the financial condition of the company’s customers were to deteriorate, reducing their ability to make payments, additional allowances would be required. (b) Inventories The company writes down its inventories for estimated excess quantities and obsolescence based on differences between the cost and estimated net realizable value taking into consideration usage in the preceding 12 months, expected demand and any other information that is relevant to the judgment. If ultimate usage or demand varies significantly from expected usage or demand, additional writedowns may be required. (c) Intangible Assets and Goodwill The company uses assumptions and estimates in determining the fair value of assets acquired and liabilities assumed in a business combination. The determination of the fair value of intangible assets, which represent a significant portion of the purchase price in many of the company’s acquisitions, requires the use of significant judgment with regard to (i) the fair value; and (ii) whether such intangibles are amortizable or non-amortizable and, if the former, the period and the method by which the intangible asset will be amortized. The company estimates the fair value of acquisition-related intangible assets principally based on projections of cash flows that will arise from identifiable intangible assets of acquired businesses. The projected cash flows are discounted to determine the present value of the assets at the dates of acquisition. Definite-lived intangible assets totaled $12.81 billion at December 31, 2014. The company reviews definite-lived intangible assets for impairment when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Actual cash flows arising from a particular intangible asset could vary from projected cash flows which could imply different carrying values from those established at the dates of acquisition and which could result in impairment of such asset. The company evaluates goodwill and indefinite-lived intangible assets for impairment annually and when events occur or circumstances change that may reduce the fair value of the asset below its carrying amount. Events or circumstances that might require an interim evaluation include unexpected adverse business conditions, economic factors, unanticipated technological changes or competitive activities, loss of key personnel and acts by governments and courts. Goodwill and indefinite-lived intangible assets totaled $18.84 billion and $1.30 billion, respectively, at December 31, 2014. Estimates of future cash flows require assumptions related to revenue and operating income growth, asset-related expenditures, working capital levels and other factors. Different assumptions from those made in the company’s analysis could materially affect projected cash flows and the company’s evaluation of goodwill and indefinite-lived intangible assets for impairment. Projections of profitability for 2015 and thereafter and indicated fair values based on peer revenues and earnings trading multiples were sufficient to conclude that no impairment of goodwill or indefinite-lived intangible assets existed at the end of the tenth fiscal month of 2014, the date of the company’s impairment testing. There can be no assurance, however, that an economic downturn will not materially adversely affect peer trading multiples and the company’s businesses such that they do not achieve their forecasted profitability and these assets become impaired. Should the fair value of the company’s goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines, or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment may be necessary. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) With the completion of the Life Technologies acquisition in February 2014, the company established a new segment and reporting unit called Life Sciences Solutions. This new segment consists of the majority of the former Life Technologies businesses and the remaining Thermo Fisher biosciences businesses following anti-trust required divestitures in March 2014. Because this segment consists primarily of the acquired business, the book value of which equaled its fair value as of the acquisition date, the company believes minimal cushion of fair value over book value existed at that date. During its 2014 goodwill impairment testing, the company determined that the Life Sciences Solutions segment’s cushion of fair value over book value had increased to 9% as of October 31, 2014. Despite this favorable increase, given that the fair value is not substantially in excess of the book value, relatively small decreases in future cash flows from forecasted results or changes in discount rates or other assumptions could result in impairment of goodwill. The key variables that drive the cash flows of the reporting unit are levels of profitability and terminal value growth rate assumptions, as well as the weighted average cost of capital (WACC) rate applied. The estimates used for these assumptions represent management's best estimates, which the company believes are reasonable. These assumptions, however, are subject to uncertainty, including the degree to which the acquired business will grow revenue and profitability levels. The Life Sciences Solutions segment had $7.25 billion of goodwill, and had an overall carrying value of $14.75 billion as of December 31, 2014. (d) Other Long-lived Assets The company reviews other long-lived assets for impairment when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Other long-lived assets totaled $3.36 billion at December 31, 2014, including $2.43 billion of fixed assets. In testing a long-lived asset for impairment, assumptions are made concerning projected cash flows associated with the asset. Estimates of future cash flows require assumptions related to revenue and operating income growth and asset-related expenditures associated with the asset being reviewed for impairment. Should future cash flows decline significantly from estimated amounts, charges for impairment of other long-lived assets may be necessary. (e) Revenues In instances where the company sells equipment with a related installation obligation, the company generally recognizes revenue related to the equipment when title passes. The company recognizes revenue related to the installation when it performs the installation. The allocation of revenue between the equipment and the installation is based on relative selling price at the time of sale. Should the relative value of either the equipment or the installation change, the company’s revenue recognition would be affected. In instances where the company sells equipment with customer-specified acceptance criteria, the company must assess whether it can demonstrate adherence to the acceptance criteria prior to the customer’s acceptance testing to determine the timing of revenue recognition. If the nature of customer-specified acceptance criteria were to change or grow in complexity such that the company could not demonstrate adherence, the company would be required to defer additional revenues upon shipment of its products until completion of customer acceptance testing. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) The company’s software license agreements generally include multiple products and services, or “elements.” The company recognizes software license revenue based on the residual method after all elements have either been delivered or vendor specific objective evidence (VSOE) of fair value exists for any undelivered elements. In the event VSOE is not available for any undelivered element, revenue for all elements is deferred until delivery of all elements other than post-contract support is completed. Revenues from software maintenance and support contracts are recognized on a straight-line basis over the term of the contract. VSOE of fair value of software maintenance and support is determined based on the price charged for the maintenance and support when sold separately. Revenues from training and consulting services are recognized as services are performed, based on VSOE, which is determined by reference to the price customers pay when the services are sold separately. The company records reductions to revenue for estimated product returns by customers. Should a greater or lesser number of products be returned, additional adjustments to revenue may be required. (f) Warranty Obligations At the time the company recognizes revenue, it provides for the estimated cost of standard product warranties in cost of product revenues based primarily on historical experience and knowledge of any specific warranty problems that indicate projected warranty costs may vary from historical patterns. The liability for standard warranty obligations of the company’s continuing operations totaled $58 million at December 31, 2014. Should product failure rates or the actual cost of correcting product failures vary from estimates, revisions to the estimated warranty liability would be necessary. (g) Income Taxes In the ordinary course of business there is inherent uncertainty in quantifying the company’s income tax positions. The company assesses income tax positions and records tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, the company has recorded the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. The company’s reserve for these matters totaled $214 million at December 31, 2014. Where applicable, associated interest expense has also been recognized as a component of the provision for income taxes. The company operates in numerous countries under many legal forms and, as a result, is subject to the jurisdiction of numerous domestic and non-U.S. tax authorities, as well as to tax agreements and treaties among these governments. Determination of taxable income in any jurisdiction requires the interpretation of the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions, permissible revenue recognition methods under the tax law and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, currency exchange restrictions or the company’s level of operations or profitability in each taxing jurisdiction could have an impact upon the amount of current and deferred tax balances and hence the company’s net income. The company estimates the degree to which tax assets and loss carryforwards will result in a benefit based on expected profitability by tax jurisdiction, and provides a valuation allowance for tax assets and loss carryforwards that it believes will more likely than not go unused. If it becomes more likely than not that a tax asset or loss carryforward will be used, the company reverses the related valuation allowance. Any such reversals are recorded as a reduction of the company’s tax provision. The company’s tax valuation allowance totaled $116 million at December 31, 2014. Should the company’s actual future taxable income by tax jurisdiction vary from estimates, additional allowances or reversals thereof may be necessary. The company provides a liability for future income tax payments in the worldwide tax jurisdictions in which it operates. Should tax return positions that the company expects are sustainable not be sustained upon audit, the company could be required to record an incremental tax provision for such taxes. Should previously unrecognized tax benefits ultimately be sustained, a reduction in the company’s tax provision would result. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) (h) Contingencies and Litigation The company records accruals for various contingencies, including legal proceedings, environmental, workers’ compensation, product, general and auto liabilities, and other claims that arise in the normal course of business. The accruals are based on management’s judgment, historical claims experience, the probability of losses and, where applicable, the consideration of opinions of internal and or external legal counsel and actuarial estimates. Accruals of acquired businesses, including product liability and environmental accruals, were initially recorded at fair value and discounted to their net present value. Additionally, the company records receivables from third-party insurers when recovery has been determined to be probable. (i) Pension and Other Retiree Benefits Several of the company’s U.S. and non-U.S. subsidiaries sponsor defined benefit pension and other retiree benefit plans. The cost and obligations of these arrangements are calculated using many assumptions to estimate the benefits that the employee earns while working, the amount of which cannot be completely determined until the benefit payments cease. Major assumptions used in the accounting for these employee benefit plans include the discount rate, expected return on plan assets and rate of increase in employee compensation levels. Assumptions are determined based on company data and appropriate market indicators in consultation with third-party actuaries, and are evaluated each year as of the plans’ measurement date. Net periodic pension costs for the company’s pension and other postretirement benefit plans totaled $56 million in 2014. The company’s unfunded benefit obligation totaled $540 million at year-end 2014 (including plan obligations assumed in the acquisition of Life Technologies) compared with $301 million at year-end 2013. Should any of these assumptions change, they would have an effect on net periodic pension costs and the unfunded benefit obligation. For example, a 10% decrease in the discount rate would result in an annual increase in pension and other postretirement benefit expense of approximately $1 million and an increase in the benefit obligation of approximately $108 million. As of December 31, 2014, the company expects to contribute between $40 and $60 million to its existing defined benefit pension plans in 2015. (j) Stock-based Compensation The fair value of most stock options granted by the company is estimated using the Black-Scholes option pricing model. For option grants and restricted stock units that require achievement of both service and market conditions, a lattice model is used to estimate fair value. Use of a valuation model requires management to make certain assumptions with respect to selected model inputs. Management estimates expected volatility based on the historical volatility of the company’s stock. Historical data on exercise patterns is the basis for determining the expected life of an option. The risk-free interest rate is based on U.S. Treasury zero-coupon issues with a remaining term which approximates the expected life assumed at the date of grant. The dividend yield is based on the company’s most recent quarterly dividend rate. Changes in these input variables would affect the amount of expense associated with stock-based compensation. The compensation expense recognized for all stock-based awards is net of estimated forfeitures. The company estimates forfeiture rates based on historical analysis of option forfeitures. If actual forfeitures should vary from estimated forfeitures, adjustments to compensation expense may be required. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations 2014 Compared With 2013 Continuing Operations Sales in 2014 were $16.89 billion, an increase of $3.80 billion from 2013. Sales increased $3.31 billion due to acquisitions, net of divestitures. The unfavorable effects of currency translation resulted in a decrease in revenues of $60 million in 2014. Aside from the effects of currency translation and acquisitions/divestitures, revenues increased $549 million (4%) primarily due to increased demand. Demand from biopharma customers remained strong. Sales to customers in healthcare and industrial markets grew moderately while sales to academic and government markets grew modestly in 2014. Sales growth was strong in Europe and moderate in North America and Asia. Revenues and operating income of the company’s non-U.S. operations are translated into U.S. dollars to report consolidated results. Based on weakening of currency exchange rates against the U.S. dollar that occurred in late 2014 and early 2015, the company currently expects that there will be a significant adverse effect on reported amounts of revenues and operating income in 2015 as a result of the stronger U.S. dollar. In 2014, total company operating income and operating income margin were $2.50 billion and 14.8%, respectively, compared with $1.61 billion and 12.3%, respectively, in 2013. The increase in operating income and operating income margin was primarily due to net gains of $895 million on the sale of businesses, inclusion of Life Technologies’ results from the date of acquisition and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by $450 million of charges associated with the acquisition, as discussed below, as well as $569 million of higher amortization expenses, also primarily related to the acquisition. The company’s references throughout this discussion to productivity improvements generally refer to improved cost efficiencies from its Practical Process Improvement (PPI) business system, reduced costs resulting from global sourcing initiatives, a lower cost structure following restructuring actions, including headcount reductions and consolidation of facilities, and low cost region manufacturing. In 2014, the company recorded restructuring and other income, net, of $140 million, including net gains on the sale of businesses and real estate of $895 million and $15 million, respectively, offset in part by $328 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition; $131 million of charges to selling, general and administrative expenses primarily for transaction costs related to the acquisition of Life Technologies; and $29 million of charges for pension settlements. The company incurred $268 million of cash restructuring costs primarily associated with the Life Technologies acquisition including cash compensation to monetize certain equity awards held by Life Technologies employees at the date of acquisition and severance obligations to former executives and employees of Life Technologies. In addition, the company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia (see Note 14). Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) In 2013, the company recorded restructuring and other costs, net, of $180 million, including $29 million of charges to cost of revenues primarily related to the sale of inventories revalued at the date of acquisition and, to a lesser extent, accelerated depreciation on manufacturing assets to be abandoned due to facility consolidations and $74 million of charges to selling, general and administrative expenses primarily consisting of transaction costs related to the acquisition of Life Technologies, changes in estimates of contingent consideration for an acquisition and a charge associated with product liability litigation. The company incurred $78 million of cash restructuring costs primarily for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that were being consolidated. The cash costs also included $4 million of transaction expenses related to the agreement to sell its sera and media, gene modulation and magnetic beads businesses (see Note 2). As of February 26, 2015, the company has identified restructuring actions that will result in additional charges of approximately $70 million in 2015 and expects to identify additional actions during 2015 which will be recorded when specified criteria are met, such as abandonment of leased facilities. Approximately half of the additional charges will be incurred in the Life Sciences Solutions segment, with the remainder incurred across the company’s remaining segments. The restructuring projects for which charges were incurred in 2014 are expected to result in annual cost savings of approximately $120 million beginning in part in 2014 and, to a greater extent, in 2015, including $80 million in the Life Sciences Solutions segment, $10 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $20 million in the Laboratory Products and Services segment. The restructuring actions for which charges were incurred in 2013 resulted in annual cost savings of approximately $80 million beginning in part in 2013 and to a greater extent in 2014, including $5 million in the Life Sciences Solutions segment, $30 million in the Analytical Instruments segment, $20 million in the Specialty Diagnostics segment and $25 million in the Laboratory Products and Services segment. Segment Results The company’s management evaluates segment operating performance using operating income before certain charges/credits to cost of revenues and selling, general and administrative expenses, principally associated with acquisition-related activities; restructuring and other costs/income including costs arising from facility consolidations such as severance and abandoned lease expense and gains and losses from the sale of real estate and product lines; and amortization of acquisition-related intangible assets. The company also refers to this measure as adjusted operating income. The company uses this measure because it helps management understand and evaluate the segments’ core operating results and facilitate comparison of performance for determining compensation (Note 3). Accordingly, the following segment data is reported on this basis. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Income from the company’s reportable segments increased 45% to $3.69 billion in 2014 due primarily to the acquisition of Life Technologies and to a lesser extent, productivity improvements, net of inflationary costs increases, offset in part by strategic growth investments. Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $3.48 billion to $4.20 billion in 2014 primarily due to the acquisition of Life Technologies, net of divestitures. Had the acquisition of Life Technologies been completed at the beginning of 2013, pro forma revenues for the 2014 period would have decreased $38 million compared to pro forma 2013 revenues, including a decrease of $151 million due to dispositions, net of other acquisitions and a decrease of $45 million due to the unfavorable effects of currency translation, offset in part by an increase of $158 million (4%) due to higher revenues at existing businesses. The increase in pro forma revenue at existing businesses was primarily due to increased demand for biosciences and bioprocess production products, offset in part by lower licensing revenues. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Operating income margin was 29.0% in 2014 compared to 23.8% in 2013. The increase resulted primarily from higher operating margins in Life Technologies’ businesses relative to the segment’s legacy operations and, to a lesser extent, productivity improvements, net of inflationary cost increases. The company expects the segment’s operating income margin in the first quarter of 2015 will be lower than the 29.3% reported in the first quarter of 2014. This is due to excluding the results of Life Technologies prior to the February 3, 2014 acquisition date. Results for January commonly have a lower margin rate than results for the balance of the quarter, due to the phasing of revenue and costs. Analytical Instruments Sales in the Analytical Instruments segment increased $98 million to $3.25 billion in 2014. Sales increased $113 million (4%) due to higher revenues at existing businesses and $15 million due to acquisitions, offset in part by a decrease of $30 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for chromatography and mass spectrometry instruments and, to a lesser extent, environmental instruments. These increases were offset in part by modestly lower sales of chemical analysis products due primarily to softness in certain commodity markets such as minerals. Operating income margin was 17.9% in 2014 compared to 17.7% in 2013. The increase resulted primarily from productivity improvements, net of inflationary cost increases and, to a lesser extent, profit from favorable sales mix. The increases were offset in part by strategic growth investments. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $152 million to $3.34 billion in 2014. Sales increased $154 million (5%) due to higher revenues at existing businesses and $10 million due to an acquisition net of a divestiture, offset in part by a decrease of $12 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for immunodiagnostics products, products sold through the segment’s healthcare market channel and, to a lesser extent, clinical diagnostics products. Operating income margin was 27.4% in 2014 and 27.1% in 2013. The increase resulted primarily from favorable sales mix and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by strategic growth investments. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $203 million to $6.60 billion in 2014. Sales increased $312 million (5%) due to higher revenues at existing businesses. The increase was offset in part by a decrease of $93 million due to dispositions and $17 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for laboratory products and, to a lesser extent, clinical trial logistics services. Operating income margin was 14.9% in 2014 and 15.0% in 2013. The decrease resulted primarily from strategic growth investments offset in part by productivity improvements, net of inflationary cost increases. Other Expense, Net The company reported other expense, net, of $416 million and $290 million in 2014 and 2013, respectively (Note 4). Interest expense increased $218 million primarily due to the debt issued and assumed in connection with the acquisition of Life Technologies. In 2014, the company realized net gains of $9 million from equity and available-for-sale investments. In 2013, the company recorded $74 million of charges related to amortization of fees paid to obtain bridge financing commitments related to the acquisition of Life Technologies. Also in 2013, the company irrevocably contributed appreciated available-for-sale investments that had a fair value of $27 million to two of its U.K. defined benefit plans, resulting in realization of a previously unrecognized gain of $11 million. Provision for Income Taxes The company’s effective tax rates were 9.2% and 3.1% in 2014 and 2013, respectively. The 2014 provision for income taxes includes $390 million related to gains on the sales of businesses. Aside from the discrete tax on the gains, the company had a benefit from income taxes primarily due to restructuring and other costs associated with the acquisition of Life Technologies as well as an increase in the expected benefit from foreign tax credits. In 2014, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $172 million, offset in part by additional U.S. income taxes of $55 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $117 million and reduced the company’s effective tax rate by 5.6 percentage points in 2014. The federal tax credit for 2014 research and development activities favorably affected the tax provision in 2014 by $20.1 million, or 1.0 percentage point. In 2014, the company recognized a discrete tax benefit of $15.4 million, or 0.7 percentage points, attributable to tax rulings related to non-U.S. subsidiaries. Due primarily to the non-deductibility of intangible asset amortization, the company’s cash payments (net of refunds) for income taxes were higher than its income tax expense for financial reporting purposes and totaled $586 million and $230 million in 2014 and 2013, respectively. The effective tax rate in both periods was also affected by relatively significant earnings in lower tax jurisdictions. The tax provision in the 2014 period was favorably affected by $5.5 million, or 0.3 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates. The U.S. Congress has not extended the tax credit for research and development activities in 2015 as of February 26, 2015. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) In 2013, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $160 million offset by additional U.S. income taxes of $56 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $104 million and reduced the company’s effective tax rate by 7.9 percentage points in 2013. In addition, the effective tax rate in 2013 was also reduced by the U.S. Congress’ renewal in January 2013 of a tax credit for research and development activities for 2012 and 2013 and, to a lesser extent, financing costs associated with the acquisition of Life Technologies that are deductible in the U.S. The federal tax credit for 2012 and 2013 research and development activities favorably affected the tax provision in 2013 by $15.4 million, or 1.2 percentage points. The tax provision in the 2013 period was unfavorably affected by $5.4 million, or 0.4 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates and audit settlements. The company expects its effective tax rate in 2015 will be less than 3% based on currently forecasted rates of profitability in the countries in which the company conducts business. The company has operations and a taxable presence in approximately 50 countries outside the U.S. All of these countries except one have a lower tax rate than the U.S. The countries in which the company has a material presence that have significantly lower tax rates than the U.S. include Germany, the Netherlands, Singapore, Sweden, Switzerland and the United Kingdom. The company’s ability to obtain a benefit from lower tax rates outside the U.S. is dependent on its relative levels of income in countries outside the U.S. and on the statutory tax rates in those countries. Based on the dispersion of the company’s non-U.S. income tax provision among many countries, the company believes that a change in the statutory tax rate in any individual country is not likely to materially affect the company’s income tax provision or net income, aside from any resulting one-time adjustment to the company’s deferred tax balances to reflect a new rate. Discontinued Operations In June 2012, in an effort to exit a non-core business, the company pursued a sale of its laboratory workstations business, part of the Laboratory Products and Services segment. The company completed the sale in October 2012 for nominal proceeds. In 2013, the company recorded an after-tax charge of $4.2 million for the estimated cost to raze certain abandoned facilities of the discontinued operations prior to the planned sale of the land. Recent Accounting Pronouncements In January 2015, the FASB issued new guidance to simplify income statement classification by removing the concept of extraordinary items from U.S. GAAP. As a result, items that are both unusual and infrequent will no longer be separately reported net of tax after continuing operations. The company adopted this guidance effective January 2015. The adoption of this standard in 2015 is not expected to have a material impact on the company’s consolidated financial statements. In May 2014, the FASB issued new revenue recognition guidance which provides a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and will supersede most current revenue recognition guidance. The new standard also requires significantly expanded disclosures regarding the qualitative and quantitative information of an entity's nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The guidance is effective for the company in 2017. Early adoption is not permitted. The company is currently evaluating the impact the standard will have on its consolidated financial statements. In April 2014, the FASB issued new guidance on reporting discontinued operations and disclosures of disposals. Under the new guidance, only disposals representing a strategic shift in operations will be presented as discontinued operations. The new guidance also requires disclosure of the pre-tax income attributable to a disposal of a significant part of the company that does not qualify for discontinued operations reporting. The company adopted this guidance effective January 2015. The adoption of this standard in 2015 is not expected to have a material impact on the company’s consolidated financial statements. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Contingent Liabilities The company is contingently liable with respect to certain legal proceedings and related matters. An unfavorable outcome that differs materially from current accrual estimates, if any, for one or more of the matters described under the headings “Product Liability, Workers Compensation and Other Personal Injury Matters” and “Intellectual Property Matters” in Note 10 could have a material adverse effect on the company’s financial position as well as its results of operations and cash flows. 2013 Compared With 2012 Continuing Operations Sales in 2013 were $13.09 billion, an increase of $580 million from 2012. Sales increased $188 million due to acquisitions. The unfavorable effects of currency translation resulted in a decrease in revenues of $36 million in 2013. Aside from the effects of currency translation and acquisitions, revenues increased $429 million (3%) primarily due to increased demand offset in part by modestly lower sales to customers in academic and government markets which the company believes was due in part to uncertainty in government funding expectations in the U.S. Sales remained strong to customers in pharmaceutical and biotech industries while sales growth was modest to customers in industrial markets. Sales growth was strong in Asia and modest in Europe and North America. In 2013, total company operating income and operating income margin were $1.61 billion and 12.3%, respectively, compared with $1.48 billion and 11.8%, respectively, in 2012. The increase in operating income and operating income margin was primarily due to productivity improvements, net of inflationary cost increases, and, to a lesser extent, profit on incremental sales from acquisitions. The increase was offset in part by strategic growth investments, unfavorable foreign currency exchange and, to a lesser extent, $24 million of higher acquisition-related charges in 2013, an increase in amortization expense of $16 million in 2013 primarily related to the acquisitions of One Lambda and Doe & Ingalls and imposition of a medical device excise tax in 2013. In 2013, the company recorded restructuring and other costs, net, of $180 million, including $29 million of charges to cost of revenues related primarily for the sale of inventories revalued at the date of acquisition and, to a lesser extent, accelerated depreciation on manufacturing assets to be abandoned due to facility consolidations and $74 million of charges to selling, general and administrative expenses consisting primarily of transaction costs related to the acquisition of Life Technologies, revisions of estimated contingent consideration for an acquisition and a charge associated with product liability litigation. The company incurred $78 million of cash restructuring costs primarily for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, such as the consolidation of several facilities in the U.S. and Europe (see Note 14). The cash costs also included $4 million of transaction expenses related to the agreement to sell its sera and media, gene modulation and magnetic beads businesses (see Note 2). Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) In 2012, the company recorded restructuring and other costs, net, of $150 million, including $56 million of charges to cost of revenues primarily related to the sale of inventories revalued at the date of acquisition and $13 million of charges to selling, general and administrative expenses primarily consisting of transaction costs related to the acquisition of One Lambda. The company incurred $67 million of cash restructuring costs primarily for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated. The company also recorded $15 million of non-cash expense, net, primarily for the impairment of intangible asset at several small business units and, to a lesser extent, real estate writedowns related to facility consolidations partially offset by a $6 million gain from the settlement of pre-acquisition litigation. The restructuring actions for which charges were incurred in 2012 resulted in annual cost savings of approximately $85 million beginning in part in 2012 and to a greater extent in 2013, including $10 million in the Life Sciences Solutions segment, $25 million in the Analytical Instruments segment, $20 million in the Specialty Diagnostics segment and $30 million in the Laboratory Products and Services segment. Segment Results Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Income from the company’s reportable segments increased 7% to $2.55 billion in 2013 due primarily to productivity improvements, net of inflationary costs increases, and, to a lesser extent, profit on incremental sales from acquisitions, offset in part by strategic growth investments and unfavorable foreign currency exchange. Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $54 million to $713 million in 2013. Sales increased $55 million (8%) due to higher revenues at existing businesses offset in part by a decrease of $1 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for bioscience products. Operating income margin was 23.8% in 2013 compared to 23.5% in 2012. Operating margin was favorably affected by productivity improvements, net of inflationary cost increases, offset in part by strategic growth investments. Analytical Instruments Sales in the Analytical Instruments segment increased $40 million to $3.15 billion in 2013. Sales increased $53 million (2%) due to higher revenues at existing businesses and $9 million due to acquisitions. These increases were offset in part by a decrease of $23 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for chromatography and mass spectrometry instruments, offset in part by lower sales of chemical analysis products which the company believes were affected by macro economic conditions facing customers in industrial markets. Operating income margin was 17.7% in 2013 compared to 17.8% in 2012. Operating margin was unfavorably affected by strategic growth investments and, to a lesser extent, unfavorable foreign currency exchange, offset in part by productivity improvements, net of inflationary cost increases. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $230 million to $3.19 billion in 2013. Sales increased $143 million due to an acquisition and $93 million (3%) due to higher revenues at existing businesses. These increases were offset in part by a decrease of $5 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand, particularly for clinical diagnostics products and, to a lesser extent, microbiology and allergy products in part as a result of strong flu and pollen seasons, partially offset by weakness from reduced healthcare utilization and lower sales of instruments to diagnostic laboratories due in part to lower healthcare reimbursement rates in the U.S. for anatomical pathology tests. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Operating income margin was 27.1% in 2013 and 25.6% in 2012. The increase resulted from profit on incremental sales from an acquisition and, to a lesser extent, at existing businesses as well as productivity improvements, net of inflationary cost increases. The increases were offset in part by strategic growth investments and imposition of the medical device excise tax in 2013. Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $296 million to $6.40 billion in 2013. Sales increased $266 million (4%) due to higher revenues at existing businesses and $36 million due to an acquisition. The unfavorable effects of currency translation resulted in a decrease in revenues of $6 million in 2013. The increase in revenue at existing businesses was primarily due to increased demand for laboratory products and clinical trial logistics services. Sales of laboratory equipment increased only modestly due to weakness in demand from customers in academic and government markets. Operating income margin was 15.0% in both 2013 and 2012. Productivity improvements, net of inflationary cost increases and, to a lesser extent, price increases were offset by strategic growth investments and unfavorable sales mix. Other Expense, Net The company reported other expense, net, of $290 million and $213 million in 2013 and 2012, respectively (Note 4). In the first quarter of 2013, the company irrevocably contributed appreciated available-for-sale investments that had a fair value of $27 million to two of its U.K. defined benefit plans, resulting in realization of a previously unrecognized gain of $11 million. In 2013, other items, net also includes $74 million of charges related to amortization of fees paid to obtain bridge financing commitments related to the Life Technologies Acquisition, offset in part by gains totaling $5 million from sales of equity investments. Interest expense increased $21 million primarily due to the debt issued to fund the One Lambda and Life Technologies acquisitions. Provision for Income Taxes The company’s effective tax rates were 3.1% and 0.9% in 2013 and 2012, respectively. Due primarily to the non-deductibility of intangible asset amortization, the company’s cash payments (net of refunds) for income taxes for its continuing operations were higher than its income tax expense for financial reporting purposes and totaled $230 million and $331 million in 2013 and 2012, respectively. Tax payments decreased in 2013 due primarily to refunds of taxes paid in 2012. In 2013, non-U.S. subsidiaries of the company made cash and deemed distributions to the U.S. which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $160 million offset by additional U.S. income taxes of $56 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $104 million and reduced the company’s effective tax rate by 7.9 percentage points in 2013. In addition, the effective tax rate in 2013 was also reduced by the U.S. Congress’ renewal in January 2013 of a tax credit for research and development activities for 2012 and 2013 and, to a lesser extent, increased earnings in lower tax jurisdictions and financing costs associated with the acquisition of Life Technologies that are deductible in the U.S. The tax credit for 2012 and 2013 research and development activities favorably affected the tax provision in 2013 by $15.4 million, or 1.2 percentage points. The tax provision in the 2013 period was unfavorably affected by $5.4 million, or 0.4 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates and audit settlements. The tax provision in 2012 was favorably affected by $53 million, or 4.1 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates, particularly a lower tax rate in Sweden. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Discontinued Operations The company completed the sale of its laboratory workstations business in October 2012 for nominal proceeds. The business was included in the Laboratory Products and Services segment prior to being reclassified to discontinued operations for all periods presented in June 2012. Revenues of the laboratory workstations business were $147 million in the 2012 period prior to the sale. The business incurred a pre-tax loss of $30 million in 2012 in part due to inventory write-offs, higher manufacturing costs and restructuring and other transition costs associated with relocation of the business. In 2012, the company recorded after-tax charges aggregating $63 million as the loss on the divestiture. The loss in 2013 for discontinued operations primarily represents a charge for the cost of razing abandoned facilities of the business prior to sale of the land. Liquidity and Capital Resources Consolidated working capital was $1.19 billion at December 31, 2014, compared with $6.75 billion at December 31, 2013. Included in working capital were cash, cash equivalents and short-term investments of $1.35 billion at December 31, 2014 and $5.83 billion at December 31, 2013. The decrease in working capital is primarily due to the cash used to fund the Life Technologies acquisition and an increase in short-term debt of $1.2 billion, also principally due to the acquisition. Cash provided by operating activities was $2.62 billion during 2014, primarily from the company’s earnings. Increases in accounts receivable and inventories used cash of $145 million and $110 million, respectively, primarily to support growth in sales. Other assets decreased by $163 million primarily due to collection of tax refunds including those related to legacy Life Technologies’ operations. Other liabilities increased by $308 million primarily due to the timing of payments for incentive compensation and income taxes. In 2014, the company made cash payments including severance obligations, third-party transaction/integration costs and monetizing certain equity awards totaling $325 million related to the acquisition of Life Technologies. The company made cash contributions to its pension and postretirement benefit plans totaling $50 million during 2014. Cash payments for income taxes increased to $586 million during 2014, compared with $230 million in 2013, in part due to taxes on the gains from the sale of businesses. During 2014, the company’s investing activities used $11.78 billion of cash, principally for the acquisition of Life Technologies. Acquisitions used cash of $13.06 billion. Proceeds from the sale of businesses provided $1.52 billion. The company’s investing activities also included the purchase of $428 million of property, plant and equipment. In February 2015, the company completed an acquisition for approximately $300 million in cash (Note 17). The company’s financing activities provided $4.80 billion of cash during 2014. To partially fund the acquisition of Life Technologies, the company borrowed $5.00 billion under an unsecured term loan (Note 9) and issued 34.9 million shares of its common stock for net proceeds of $2.94 billion in cash (Note 11). Other long-term borrowings totaled $1.59 billion. Repayments of long-term debt, principally the term loan, totaled $4.43 billion. A decrease in commercial paper obligations used cash of $250 million. The company’s financing activities also included $155 million of proceeds from employee stock option exercises offset by the payment of $235 million in cash dividends. On November 8, 2012, the Board of Directors authorized the repurchase of up to $1.00 billion of the company’s common stock beginning January 1, 2013. At December 31, 2014, $910 million was available for future repurchases of the company’s common stock under this authorization. In the first quarter of 2015 through February 26, 2015, the company repurchased $500 million of its common stock under this authorization. In February 2015, the company notified holders of its 5.00% Senior Notes due June 2015 that it will redeem all $250 million principal amount outstanding on March 6, 2015. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) As of December 31, 2014, the company’s short-term debt totaled $2.21 billion, including $1.21 billion of senior notes, due in the first half of 2015 and $1.00 billion of minimum payments due in the next twelve months on the company’s term loan. The company has a revolving credit facility with a bank group that provides unsecured multi-currency revolving credit. In February 2015, the maximum capacity of this facility was increased from $1.50 billion to $2.00 billion. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2014, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $59 million as a result of outstanding letters of credit. Approximately half of the company’s cash balances and cash flows from operations are from outside the U.S. The company uses its non-U.S. cash for needs outside of the U.S. including acquisitions and repayment of acquisition-related intercompany debt to the U.S. In addition, the company also transfers cash to the U.S. using non-taxable returns of capital as well as dividends where the related U.S. foreign tax credit equals or exceeds any tax cost arising from the dividends. As a result of using such means of transferring cash to the U.S., the company does not expect any material adverse liquidity effects from its significant non-U.S. cash balances for the foreseeable future. The company believes that its existing cash and short-term investments of $1.35 billion as of December 31, 2014 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Cash provided by operating activities was $2.01 billion during 2013, primarily from the company’s earnings. Increases in accounts receivable and inventories used cash of $148 million and $72 million, respectively, primarily to support growth in sales. A decrease in other assets provided cash of $169 million primarily due to timing of income tax refunds. An increase in accounts payable provided cash of $47 million, primarily due to higher inventory purchases. An increase in other liabilities provided cash of $163 million primarily due to the timing of payments for income taxes and incentive compensation. In the 2013, the company paid fees to obtain bridge financing commitments and other transaction costs totaling $108 million related to the acquisition of Life Technologies. The company made cash contributions to its pension and postretirement benefit plans totaling $38 million during 2013. Cash payments for income taxes of continuing operations totaled $230 million. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $69 million during 2013. During 2013, the company’s primary investing activity was the purchase of $282 million of property, plant and equipment. The company’s financing activities provided $3.31 billion of cash during 2013. To partially fund the acquisition of Life Technologies, the company issued $3.20 billion of senior notes. The company’s financing activities also included the receipt of $230 million of proceeds from employee stock option exercises offset by the repurchase of $90 million of the company’s common stock and the payment of $216 million in cash dividends. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) Cash provided by operating activities was $2.04 billion during 2012, primarily from the company’s earnings. An increase in inventories used cash of $60 million, primarily to support growth in sales. An increase in other assets used cash of $100 million primarily related to the timing of tax refunds. An increase in other liabilities provided cash of $127 million, primarily due to the timing of payments for incentive compensation and income taxes. Cash payments for income taxes of continuing operations totaled $331 million during 2012. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $64 million during 2012. During 2012, the company’s primary investing activities included acquisitions and the purchase of property, plant and equipment. The company expended $1.08 billion for acquisitions and $315 million for purchases of property, plant and equipment. The company’s investing activities also included a $45 million increase in restricted cash to collateralize short-term borrowings in Asia. The company’s discontinued operations provided $59 million of cash, primarily tax benefits from the loss on sale of the laboratory workstations business and receipt of escrowed proceeds from the 2011 sale of Lancaster Laboratories. The company’s financing activities used $918 million of cash during 2012, principally for the repurchase of $1.15 billion of the company’s common stock and to reduce commercial paper obligations by $849 million, offset in part by the issuance of $1.3 billion in senior notes. The company’s financing activities in 2012 also included the repayment of $355 million of long-term debt and the receipt of $254 million of proceeds from employee stock option exercises. Cash dividend payments totaled $142 million during 2012. Off-Balance Sheet Arrangements The company did not use special purpose entities or other off-balance-sheet financing arrangements in 2012 - 2014 except for letters of credit, bank guarantees, a build-to-suit lease arrangement entered in 2012, surety bonds and other guarantees disclosed in the table or discussed below. Of the amounts disclosed in the table below for letters of credit, bank guarantees, surety bonds and other guarantees, $32.1 million relates to guarantees of the performance of third parties, principally in connection with businesses that were sold. The balance relates to guarantees of the company’s own performance, primarily in the ordinary course of business. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) Contractual Obligations and Other Commercial Commitments The table below summarizes, by period due or expiration of commitment, the company’s contractual obligations and other commercial commitments as of December 31, 2014. (a) Amounts represent the expected cash payments for debt and do not include any deferred issuance costs. (b) Unconditional purchase obligations include agreements to purchase goods, services or fixed assets that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable at any time without penalty. (c) Obligation represents funding commitments pursuant to investments held by the company. Reserves for unrecognized tax benefits of $214 million have not been included in the above table due to the inability to predict the timing of tax audit resolutions. The company has no material commitments for purchases of property, plant and equipment, other than those included in the above table, but expects that for 2015, such expenditures will approximate $450 to $470 million. A guarantee of residual value under a build-to-suit lease arrangement for a facility that was leased upon completion of construction has not been included in the above table due to the inability to predict if and when the guarantee may require payment. Upon completion of construction in 2014, a five-year lease commenced with options to purchase the facility or renew the lease for up to three 5-year terms. The residual value guarantee becomes operative at the end of the lease for up to a maximum of $58 million. Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) A guarantee of pension plan obligations of a divested business has not been included in the preceding table due to the inability to predict if and when the guarantee may require payment. The purchaser of the divested business has agreed to pay for the pension benefits, however the company was required to guarantee payment of these pension benefits should the purchaser fail to do so. The amount of the guarantee at December 31, 2014 was $49 million. In disposing of assets or businesses, the company often provides representations, warranties and/or indemnities to cover various risks including, for example, unknown damage to the assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste facilities, and unidentified tax liabilities and related legal fees. The company does not have the ability to estimate the potential liability from such indemnities because they relate to unknown conditions. However, the company has no reason to believe that these uncertainties would have a material adverse effect on its financial position, annual results of operations or cash flows. The company has recorded liabilities for known indemnifications included as part of environmental liabilities. See Item 1. Business - Environmental Matters for a discussion of these liabilities.

<s>[INST] Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions such as its 2014 acquisition of Life Technologies. On February 3, 2014, the company completed the acquisition of Life Technologies Corporation for a total purchase price of $15.30 billion, net of cash acquired, including the assumption of $2.28 billion of debt. The company issued debt and common stock in late 2013 and early 2014 to partially fund the acquisition discussed below under the caption “Liquidity and Capital Resources”. Life Technologies was integrated into the Life Sciences Solutions segment and provides innovative products and services to customers conducting scientific research and genetic analysis, as well as those in applied markets, such as forensics and food safety testing. Life Technologies’ revenues totaled $3.87 billion in 2013. On March 21, 2014, the company sold its legacy sera and media, gene modulation and magnetic beads businesses to GE Healthcare for $1.06 billion, net of cash divested. The sale of these businesses resulted in a pretax gain of approximately $761 million included in restructuring and other costs (income), net. The businesses fell principally in the Life Sciences Solutions segment. Divestiture of these businesses was a condition to obtaining antitrust approval for the Life Technologies acquisition. Revenues and operating income of the businesses sold were approximately $250 million and $64 million, respectively, for the year ended December 31, 2013 and $61 million and $12 million, respectively, in 2014 through the date of sale. On August 15, 2014, the company sold its ColeParmer specialty channel business, part of the Laboratory Products and Services segment, for $480 million in cash, net of cash divested. The sale of this business resulted in a pretax gain of approximately $134 million, included in restructuring and other costs (income), net. Revenues and operating income of the business sold were approximately $232 million and $43 million, respectively, for the year ended December 31, 2013 and $149 million and $28 million, respectively, in 2014 through the date of sale. Overview of Results of Operations and Liquidity Financial Statement Index THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) Sales in 2014 were $16.89 billion, an increase of $3.80 billion from 2013. Sales increased $3.31 billion due to acquisitions, net of divestitures. The unfavorable effects of currency translation resulted in a decrease in revenues of $60 million in 2014. Aside from the effects of currency translation and acquisitions/divestitures, revenues increased $549 million (4%) primarily due to increased demand. Demand from biopharma customers remained strong. Sales to customers in healthcare and industrial markets grew moderately while sales to academic and government markets grew modestly in 2014. Sales growth was strong in Europe and moderate in North America and Asia. Revenues and operating income of the company’s nonU.S. operations are translated into U.S. dollars to report consolidated results. Based on weakening of currency exchange rates against the U.S. dollar that occurred in late 2014 and early 2015, the company currently expects that there will be a significant adverse effect on reported amounts of revenues and operating income in 2 [/INST] Negative. </s>

THERMO FISHER SCIENTIFIC INC.

2016-02-25

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions and divestitures are described below. On February 3, 2014, the company completed the acquisition of Life Technologies Corporation for a total purchase price of $15.30 billion, net of cash acquired, including the assumption of $2.28 billion of debt. The company issued debt and common stock in late 2013 and early 2014 to partially fund the acquisition discussed below under the caption “Liquidity and Capital Resources”. Life Technologies was integrated into the Life Sciences Solutions segment and provides innovative products and services to customers conducting scientific research and genetic analysis, as well as those in applied markets, such as forensics and food safety testing. Life Technologies’ revenues totaled $3.87 billion in 2013. On March 21, 2014, the company sold its legacy sera and media, gene modulation and magnetic beads businesses to GE Healthcare for $1.06 billion, net of cash divested. The sale of these businesses resulted in a pre-tax gain of approximately $761 million included in restructuring and other costs (income), net. The businesses fell principally in the Life Sciences Solutions segment. Divestiture of these businesses was a condition to obtaining antitrust approval for the Life Technologies acquisition. Revenues and operating income of the businesses sold were approximately $250 million and $64 million, respectively, for the year ended December 31, 2013 and $61 million and $12 million, respectively, in 2014 through the date of sale. On August 15, 2014, the company sold its Cole-Parmer specialty channel business, part of the Laboratory Products and Services segment, for $480 million in cash, net of cash divested. The sale of this business resulted in a pre-tax gain of approximately $134 million, included in restructuring and other costs (income), net. Revenues and operating income of the business sold were approximately $232 million and $43 million, respectively, for the year ended December 31, 2013 and $149 million and $28 million, respectively, in 2014 through the date of sale. On February 4, 2015, the company acquired Advanced Scientifics, Inc., a North America-based global provider of single-use technologies for customized bioprocessing solutions, for approximately $289 million. Advanced Scientifics was integrated into the Life Sciences Solutions segment and expands the company’s bioprocessing offerings. Revenues of Advanced Scientifics were approximately $80 million in 2014. On September 30, 2015, the company acquired, within the Laboratory Products and Services segment, Alfa Aesar, a U.K.-based global manufacturer of research chemicals from Johnson Matthey Plc, for £257 million ($392 million) in cash. The acquisition expands the company’s existing portfolio of chemicals, solvents and reagents. Revenues of Alfa Aesar were approximately £78 million in 2014. In January 2016, the company signed an agreement to acquire, within the Life Sciences Solutions segment, Affymetrix, Inc., a North America-based provider of cellular and genetic analysis products, for approximately $1.3 billion in cash. The acquisition will expand the company's existing portfolio of antibodies and assays for high-growth flow cytometry and single-cell biology applications. Revenues of Affymetrix were $360 million in 2015. The transaction, which is expected to close by the end of the second quarter of 2016, is subject to the approval of Affymetrix shareholders and the satisfaction of customary closing conditions, including regulatory approvals. The company expects to issue debt in advance of closing the acquisition of Affymetrix to partially fund the acquisition. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity Sales in 2015 were $16.97 billion, an increase of $76 million from 2014. The unfavorable effects of currency translation resulted in a decrease in revenues of $938 million in 2015. Sales increased $212 million due to acquisitions, net of divestitures. Aside from the effects of currency translation, acquisitions and divestitures, revenues increased $803 million (5%) primarily due to increased demand. Sales to customers in the company’s primary end markets grew. Demand from customers in pharmaceutical and biotech industries was particularly strong, while sales to industrial markets and academic and government markets grew modestly in 2015. Sales growth was moderate in North America and Europe and strong in Asia. Revenues and operating income of the company’s non-U.S. operations are translated into U.S. dollars to report consolidated results. Based on weakening of currency exchange rates against the U.S. dollar that occurred in 2015 and early 2016, the company currently expects that there will be a continued adverse effect on reported amounts of revenues and operating income in 2016 as a result of the stronger U.S. dollar. In 2015, total company operating income and operating income margin were $2.34 billion and 13.8%, respectively, compared with $2.50 billion and 14.8%, respectively, in 2014. The decrease in operating income and operating income margin was primarily due to net gains of $895 million on the sale of businesses in 2014, offset in part by $450 million of charges in 2014 associated with the February 2014 acquisition of Life Technologies. The unfavorable impact of foreign currency exchange also contributed to the decrease in profitability. These factors that reduced operating income in 2015 were offset in part by productivity improvements, net of inflationary cost increases and, to a lesser extent, profit on higher sales in local currencies. The company’s references throughout this discussion to productivity improvements generally refer to improved cost efficiencies from its Practical Process Improvement (PPI) business system, reduced costs resulting from global sourcing initiatives, a lower cost structure following restructuring actions, including headcount reductions and consolidation of facilities, and low cost region manufacturing. The company recorded a benefit from income taxes in 2015. In 2015, the company implemented tax planning initiatives related to non-U.S. subsidiaries. These initiatives resulted in additional foreign tax credits of $111 million, offset in part by additional U.S. income taxes of $46 million on the related foreign income (net benefit of $66 million), which reduced the company’s effective rate by 3.4 percentage points. The company also implemented foreign tax credit planning in Sweden which resulted in $80 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded tax benefits totaling $54 million, or 2.8 percentage points, related to additional prior year foreign tax and other credits as well as restructuring and other costs associated with the 2014 acquisition of Life Technologies. The tax provision in the 2015 period was favorably affected by $37 million, or 1.9 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates. The effective tax rate in both 2015 and 2014 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $477 million and $586 million in 2015 and 2014, respectively. The company’s effective tax rate was 9.2% in 2014. The 2014 provision for income taxes included $390 million related to gains on the sales of businesses. Aside from the discrete tax on the gains, the company had a benefit from income taxes primarily due to restructuring and other costs associated with the acquisition of Life Technologies as well as an increase in the expected benefit from foreign tax credits. In 2014, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $172 million, offset in part by additional U.S. income taxes of $55 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $117 million and reduced the company’s effective tax rate by 5.6 percentage points in 2014. The federal tax credit for 2014 research and development activities favorably affected the tax provision in 2014 by $20 million, or 1.0 percentage point. In 2014, the company recognized a discrete THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) tax benefit of $15 million, or 0.7 percentage points, attributable to tax rulings related to non-U.S. subsidiaries. The tax provision in the 2014 period was favorably affected by $5.5 million, or 0.3 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates. The company expects its effective tax rate in 2016 will be less than 3% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. Income from continuing operations increased to $1.98 billion in 2015, from $1.90 billion in 2014. The decrease in operating income in the 2015 period (discussed above) was more than offset by an increase in the income tax benefit in the 2015 period (discussed above) and a decrease in interest expense of $65 million primarily due to a reduction in outstanding debt and effective interest rates. During 2015, the company’s cash flow from operations totaled $2.82 billion compared with $2.62 billion for 2014. The increase resulted from cash disbursements in the 2014 period totaling $325 million related to the acquisition of Life Technologies, including severance obligations, third-party transaction/integration costs and monetizing certain equity awards held by Life Technologies employees at the date of acquisition, offset in part by lower payments in 2014 for incentive compensation as a result of Life Technologies having paid its annual incentive compensation prior to the acquisition. As of December 31, 2015, the company’s short-term debt totaled $1.05 billion, including $1.00 billion of senior notes, due in the next twelve months and $50 million of commercial paper obligations. The company has a revolving credit facility with a bank group that provides up to $2.00 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2015, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $65 million as a result of outstanding letters of credit. The company believes that its existing cash and cash equivalents of $452 million as of December 31, 2015 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Critical Accounting Policies and Estimates The company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent liabilities. On an on-going basis, management evaluates its estimates, including those related to bad debts, inventories, business combinations, intangible assets and goodwill, sales returns, income taxes, contingencies and litigation, and pension costs. Management believes the most complex and sensitive judgments, because of their significance to the consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Management bases its estimates on historical experience, current market and economic conditions and other assumptions that management believes are reasonable. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities where the values are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The company believes the following represent its critical accounting policies and estimates used in the preparation of its financial statements: (a) Accounts Receivable The company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to pay amounts due. Such allowances totaled $70 million at December 31, 2015. The company estimates the amount of customer receivables that are uncollectible based on the age of the receivable, the creditworthiness of the customer and any other information that is relevant to the judgment. If the financial condition of the company’s customers were to deteriorate, reducing their ability to make payments, additional allowances would be required. (b) Inventories The company writes down its inventories for estimated excess quantities and obsolescence based on differences between the cost and estimated net realizable value taking into consideration usage in the preceding 12 months, THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) expected demand and any other information that is relevant to the judgment. If ultimate usage or demand varies significantly from expected usage or demand, additional writedowns may be required. (c) Intangible Assets and Goodwill The company uses assumptions and estimates in determining the fair value of assets acquired and liabilities assumed in a business combination. The determination of the fair value of intangible assets, which represent a significant portion of the purchase price in many of the company’s acquisitions, requires the use of significant judgment with regard to (i) the fair value; and (ii) whether such intangibles are amortizable or non-amortizable and, if the former, the period and the method by which the intangible asset will be amortized. The company estimates the fair value of acquisition-related intangible assets principally based on projections of cash flows that will arise from identifiable intangible assets of acquired businesses. The projected cash flows are discounted to determine the present value of the assets at the dates of acquisition. Definite-lived intangible assets totaled $11.51 billion at December 31, 2015. The company reviews definite-lived intangible assets for impairment when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Actual cash flows arising from a particular intangible asset could vary from projected cash flows which could imply different carrying values from those established at the dates of acquisition and which could result in impairment of such asset. The company evaluates goodwill and indefinite-lived intangible assets for impairment annually and when events occur or circumstances change that may reduce the fair value of the asset below its carrying amount. Events or circumstances that might require an interim evaluation include unexpected adverse business conditions, economic factors, unanticipated technological changes or competitive activities, loss of key personnel and acts by governments and courts. Goodwill and indefinite-lived intangible assets totaled $18.83 billion and $1.25 billion, respectively, at December 31, 2015. Estimates of future cash flows require assumptions related to revenue and operating income growth, asset-related expenditures, working capital levels and other factors. Different assumptions from those made in the company’s analysis could materially affect projected cash flows and the company’s evaluation of goodwill and indefinite-lived intangible assets for impairment. Projections of profitability for 2016 and thereafter and indicated fair values based on peer revenues and earnings trading multiples were sufficient to conclude that no impairment of goodwill or indefinite-lived intangible assets existed at the end of the tenth fiscal month of 2015, the date of the company’s impairment testing. There can be no assurance, however, that an economic downturn will not materially adversely affect peer trading multiples and the company’s businesses such that they do not achieve their forecasted profitability and these assets become impaired. Should the fair value of the company’s goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines, or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment may be necessary. (d) Revenues In instances where the company sells equipment with a related installation obligation, the company generally recognizes revenue related to the equipment when title passes. The company recognizes revenue related to the installation when it performs the installation. The allocation of revenue between the equipment and the installation is based on relative selling price at the time of sale. Should the relative value of either the equipment or the installation change, the company’s revenue recognition would be affected. In instances where the company sells equipment with customer-specified acceptance criteria, the company must assess whether it can demonstrate adherence to the acceptance criteria prior to the customer’s acceptance testing to determine the timing of revenue recognition. If the nature of customer-specified acceptance criteria were to change or grow in complexity such that the company could not demonstrate adherence, the company would be required to defer additional revenues upon shipment of its products until completion of customer acceptance testing. The company records reductions to revenue for estimated product returns by customers. Should a greater or lesser number of products be returned, additional adjustments to revenue may be required. (e) Income Taxes In the ordinary course of business there is inherent uncertainty in quantifying the company’s income tax positions. The company assesses income tax positions and records tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, the company has recorded the largest THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. The company’s reserve for these matters totaled $350 million at December 31, 2015. Where applicable, associated interest expense has also been recognized as a component of the provision for income taxes. The company operates in numerous countries under many legal forms and, as a result, is subject to the jurisdiction of numerous domestic and non-U.S. tax authorities, as well as to tax agreements and treaties among these governments. Determination of taxable income in any jurisdiction requires the interpretation of the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions, permissible revenue recognition methods under the tax law and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, currency exchange restrictions or the company’s level of operations or profitability in each taxing jurisdiction could have an impact upon the amount of current and deferred tax balances and hence the company’s net income. The company estimates the degree to which tax assets and loss carryforwards will result in a benefit, based on expected profitability by tax jurisdiction, and provides a valuation allowance for tax assets and loss carryforwards that it believes will more likely than not go unused. If it becomes more likely than not that a tax asset or loss carryforward will be used, the company reverses the related valuation allowance. Any such reversals are recorded as a reduction of the company’s tax provision. The company’s tax valuation allowance totaled $109 million at December 31, 2015. Should the company’s actual future taxable income by tax jurisdiction vary from estimates, additional allowances or reversals thereof may be necessary. The company provides a liability for future income tax payments in the worldwide tax jurisdictions in which it operates. Should tax return positions that the company expects are sustainable not be sustained upon audit, the company could be required to record an incremental tax provision for such taxes. Should previously unrecognized tax benefits ultimately be sustained, a reduction in the company’s tax provision would result. (f) Contingencies and Litigation The company records accruals for various contingencies, including legal proceedings, environmental, workers’ compensation, product, general and auto liabilities, and other claims that arise in the normal course of business. The accruals are based on management’s judgment, historical claims experience, the probability of losses and, where applicable, the consideration of opinions of internal and or external legal counsel and actuarial estimates. Accruals of acquired businesses, including product liability and environmental accruals, were initially recorded at fair value and discounted to their net present value. Additionally, the company records receivables from third-party insurers when recovery has been determined to be probable. (g) Pension and Other Retiree Benefits Several of the company’s U.S. and non-U.S. subsidiaries sponsor defined benefit pension and other retiree benefit plans. The cost and obligations of these arrangements are calculated using many assumptions to estimate the benefits that the employee earns while working, the amount of which cannot be completely determined until the benefit payments cease. Major assumptions used in the accounting for these employee benefit plans include the discount rate, expected return on plan assets and rate of increase in employee compensation levels. Assumptions are determined based on company data and appropriate market indicators in consultation with third-party actuaries, and are evaluated each year as of the plans’ measurement date. Net periodic pension costs for the company’s pension and other postretirement benefit plans totaled $29 million in 2015. The company’s unfunded benefit obligation totaled $528 million at year-end 2015 compared with $540 million at year-end 2014. Should any of these assumptions change, they would have an effect on net periodic pension costs and the unfunded benefit obligation. For example, a 10% decrease in the discount rate would result in an annual increase in pension and other postretirement benefit expense of approximately $2 million and an increase in the benefit obligation of approximately $102 million. As of December 31, 2015, the company expects to contribute between $30 and $50 million to its existing defined benefit pension plans in 2016. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations 2015 Compared With 2014 Continuing Operations Sales in 2015 were $16.97 billion, an increase of $76 million from 2014. The unfavorable effects of currency translation resulted in a decrease in revenues of $938 million in 2015. Sales increased $212 million due to acquisitions, principally Life Technologies, net of divestitures. Aside from the effects of currency translation and acquisitions/divestitures, revenues increased $803 million (5%) primarily due to increased demand. Sales to customers in the company’s primary end markets grew. Demand from customers in pharmaceutical and biotech industries was particularly strong. Sales growth was moderate in North America and Europe and strong in Asia. In 2015, total company operating income and operating income margin were $2.34 billion and 13.8%, respectively, compared with $2.50 billion and 14.8%, respectively, in 2014. The decrease in operating income and operating income margin was primarily due to net gains of $895 million on the sale of businesses in 2014, offset in part by $450 million of charges in 2014 associated with the February 2014 acquisition of Life Technologies. The unfavorable impact of foreign currency exchange also contributed to the decrease in profitability. These factors that reduced operating income in 2015 were offset in part by productivity improvements, net of inflationary cost increases and, to a lesser extent, profit on higher sales in local currencies. In 2015, the company recorded restructuring and other costs, net, of $171 million, including $9 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and, to a lesser extent, accelerated depreciation at facilities closing due to real estate consolidation; $46 million of charges to selling, general and administrative expenses primarily for charges associated with product liability litigation, third-party transaction and integration costs primarily related to the acquisitions of Life Technologies and Alfa Aesar, and accelerated depreciation at facilities closing due to real estate consolidation. In addition, the company recorded $82 million of cash restructuring costs primarily for actions to achieve synergies from the Life Technologies acquisition and for abandoned facilities costs associated with a manufacturing facility in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia. The company also recorded charges for litigation-related matters associated with acquired businesses and impairment of acquired technology in development. These costs were partially offset by gains on the sale of a small product line and real estate (see Note 14). In 2014, the company recorded restructuring and other income, net, of $140 million, including net gains on the sale of businesses and real estate of $895 million and $15 million, respectively, offset in part by $328 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition; $131 million of charges to selling, general and administrative expenses primarily for transaction costs related to the acquisition of Life Technologies; and $29 million of charges for pension settlements. The company incurred $268 million of cash restructuring costs primarily associated with the Life Technologies acquisition including cash compensation to monetize certain equity awards held by Life Technologies employees at the date of acquisition and severance obligations to former executives and employees of Life Technologies. In addition, the company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia. As of February 25, 2016, the company has identified restructuring actions that will result in additional charges of approximately $55 million in 2016 and expects to identify additional actions during 2016 which will be recorded when specified criteria are met, such as abandonment of leased facilities. Approximately 70% of the additional charges will be incurred in the Life Sciences Solutions segment, with the remainder incurred across the company’s remaining segments. The restructuring projects for which charges were incurred in 2015 are expected to result in annual cost savings of approximately $100 million beginning in part in 2015 and, to a greater extent, in 2016, including $50 million in the Life Sciences Solutions segment, $25 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $15 million in the Laboratory Products and Services segment. The restructuring actions for which charges were incurred in 2014 resulted in annual cost savings of approximately $120 million beginning in part in 2014 and to a greater extent in 2015, including $80 million in the Life Sciences Solutions segment, $10 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $20 million in the Laboratory Products and Services segment. Segment Results The company’s management evaluates segment operating performance using operating income before certain charges/credits to cost of revenues and selling, general and administrative expenses, principally associated with acquisition-related activities; restructuring and other costs/income including costs arising from facility consolidations such as severance and abandoned lease expense and gains and losses from the sale of real estate and product lines; and amortization of acquisition-related intangible assets. The company also refers to this measure as adjusted operating income. The company uses this measure because it helps management understand and evaluate the segments’ core operating results and facilitate comparison of performance for determining compensation (Note 3). Accordingly, the following segment data is reported on this basis. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Income from the company’s reportable segments increased 3% to $3.82 billion in 2015 due primarily to productivity improvements, net of inflationary costs increases and, to a lesser extent, profit on higher sales in local currencies, offset in part by the unfavorable impact of foreign exchange and strategic growth investments. Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $244 million to $4.44 billion in 2015 primarily due to the acquisition of Life Technologies, net of divestitures. Had the acquisition of Life Technologies been completed at the beginning of 2013, revenues for the 2015 period would have decreased $25 million compared to pro forma 2014 revenues, including a decrease of $278 million due to the unfavorable effects of currency translation, offset in part by an increase of $213 million (5%) due to higher revenues at existing businesses and an increase of $40 million due to other acquisitions, net of dispositions. The increase in pro forma revenue at existing businesses was primarily due to increased demand for bioprocess production products as well as biosciences products. Operating income margin was 30.1% in 2015 compared to 29.0% in 2014. The increase resulted primarily from productivity improvements (including acquisition cost synergies), net of inflationary cost increases and favorable sales mix. These increases were offset in part by the unfavorable impact of foreign currency exchange and, to a lesser extent, by exclusion in 2014 of January’s lower margin results for Life Technologies. Results for January commonly have a lower margin rate than results for the balance of the quarter, due to the phasing of revenue and costs. Analytical Instruments Sales in the Analytical Instruments segment decreased $44 million to $3.21 billion in 2015. Sales decreased $189 million due to the unfavorable effects of currency translation, offset in part by increases of $141 million (4%) due to higher revenues at existing businesses and $4 million due to acquisitions. The increase in revenue at existing businesses was primarily due to increased demand for chromatography products and, to a lesser extent, sales of service offerings and increased demand for mass spectrometry instruments. These increases were offset in part by modestly lower sales of chemical analysis products due primarily to softness in certain commodity materials markets. Operating income margin was 19.1% in 2015 compared to 17.9% in 2014. The increase resulted primarily from productivity improvements, net of inflationary cost increases and profit on incremental sales in local currencies, offset in part by strategic growth investments and the impact of unfavorable foreign currency exchange. Specialty Diagnostics Sales in the Specialty Diagnostics segment decreased $100 million to $3.24 billion in 2015. Sales decreased $197 million due to the unfavorable effects of currency translation offset in part by $86 million (3%) due to higher revenues at existing businesses and $11 million due to an acquisition net of a divestiture. The increase in revenue at existing businesses was primarily due to increased demand for clinical diagnostics products, products sold through the segment’s healthcare market THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) channel and immunodiagnostics products. These increases were offset in part by lower sales due to the expiration, in late 2014, of an OEM contract following the acquisition of the customer by a competitor. Operating income margin was 26.9% in 2015 and 27.4% in 2014. The decrease resulted primarily from strategic growth investments and unfavorable foreign currency exchange, offset in part by productivity improvements, net of inflationary cost increases. Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $60 million to $6.66 billion in 2015. Sales increased $465 million (7%) due to higher revenues at existing businesses. This increase was offset in part by $303 million due to the unfavorable effects of currency translation and $102 million due to a disposition, net of an acquisition. The increase in revenue at existing businesses was primarily due to increased demand for products in each of the segment’s principal businesses. Operating income margin was 15.0% in 2015 and 14.9% in 2014. The increase was primarily due to productivity improvements, net of inflationary cost increases as well as profit on incremental sales in local currencies offset in part by unfavorable sales mix and strategic growth investments. Other Expense, Net The company reported other expense, net, of $400 million and $416 million in 2015 and 2014, respectively (Note 4). Interest expense decreased $65 million primarily due to a reduction in outstanding debt and effective interest rates. In 2015, other items, net includes losses of $12 million on the early extinguishment of debt and costs of $7.5 million associated with entering into interest rate swap arrangements. In 2014, other items, net includes net gains of $9 million on the sale of investments. Provision for Income Taxes The company recorded a benefit from income taxes in 2015. In 2015, the company implemented tax planning initiatives related to non-U.S. subsidiaries. These initiatives resulted in additional foreign tax credits of $111 million, offset in part by additional U.S. income taxes of $46 million on the related foreign income (net benefit of $66 million), which reduced the company’s effective rate by 3.4 percentage points. The company also implemented foreign tax credit planning in Sweden which resulted in $80 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded tax benefits totaling $54 million, or 2.8 percentage points, related to additional prior year foreign tax and other credits as well as restructuring and other costs associated with the 2014 acquisition of Life Technologies. The tax provision in the 2015 period was favorably affected by $37 million, or 1.9 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates. The effective tax rate in both 2015 and 2014 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $477 million and $586 million in 2015 and 2014, respectively. The company’s effective tax rate was 9.2% in 2014. The 2014 provision for income taxes included $390 million related to gains on the sales of businesses. Aside from the discrete tax on the gains, the company had a benefit from income taxes primarily due to restructuring and other costs associated with the acquisition of Life Technologies as well as an increase in the expected benefit from foreign tax credits. In 2014, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $172 million, offset in part by additional U.S. income taxes of $55 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $117 million and reduced the company’s effective tax rate by 5.6 percentage points in 2014. The federal tax credit for 2014 research and development activities favorably affected the tax provision in 2014 by $20 million, or 1.0 percentage point. In 2014, the company recognized a discrete tax benefit of $15 million, or 0.7 percentage points, attributable to tax rulings related to non-U.S. subsidiaries. The tax provision in the 2014 period was favorably affected by $5.5 million, or 0.3 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) The company expects its effective tax rate in 2016 will be less than 3% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The company has operations and a taxable presence in approximately 50 countries outside the U.S. All of these countries except one have a lower tax rate than the U.S. The countries in which the company has a material presence that have significantly lower tax rates than the U.S. include Germany, the Netherlands, Singapore, Sweden, Switzerland and the United Kingdom. The company’s ability to obtain a benefit from lower tax rates outside the U.S. is dependent on its relative levels of income in countries outside the U.S. and on the statutory tax rates in those countries. Based on the dispersion of the company’s non-U.S. income tax provision among many countries, the company believes that a change in the statutory tax rate in any individual country is not likely to materially affect the company’s income tax provision or net income, aside from any resulting one-time adjustment to the company’s deferred tax balances to reflect a new rate. Recent Accounting Pronouncements A description of recently issued accounting standards is included under the heading “Recent Accounting Pronouncements” in Note 1. Contingent Liabilities The company is contingently liable with respect to certain legal proceedings and related matters. An unfavorable outcome that differs materially from current accrual estimates, if any, for one or more of the matters described under the headings “Product Liability, Workers Compensation and Other Personal Injury Matters" and "Intellectual Property Matters" in Note 10 could have a material adverse effect on the company’s financial position as well as its results of operations and cash flows. 2014 Compared With 2013 Continuing Operations Sales in 2014 were $16.89 billion, an increase of $3.80 billion from 2013. Sales increased $3.31 billion due to acquisitions, net of divestitures. The unfavorable effects of currency translation resulted in a decrease in revenues of $60 million in 2014. Aside from the effects of currency translation and acquisitions/divestitures, revenues increased $549 million (4%) primarily due to increased demand. Demand from biopharma customers remained strong. Sales to customers in healthcare and industrial markets grew moderately while sales to academic and government markets grew modestly in 2014. Sales growth was strong in Europe and moderate in North America and Asia. In 2014, total company operating income and operating income margin were $2.50 billion and 14.8%, respectively, compared with $1.61 billion and 12.3%, respectively, in 2013. The increase in operating income and operating income margin was primarily due to net gains of $895 million on the sale of businesses, inclusion of Life Technologies’ results from the date of acquisition and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by $450 million of charges associated with the acquisition, as discussed below, as well as $569 million of higher amortization expenses, also primarily related to the acquisition. In 2014, the company recorded restructuring and other income, net, of $140 million, including net gains on the sale of businesses and real estate of $895 million and $15 million, respectively, offset in part by $328 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition; $131 million of charges to selling, general and administrative expenses primarily for transaction costs related to the acquisition of Life Technologies; and $29 million of charges for pension settlements. The company incurred $268 million of cash restructuring costs primarily associated with the THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Life Technologies acquisition including cash compensation to monetize certain equity awards held by Life Technologies employees at the date of acquisition and severance obligations to former executives and employees of Life Technologies. In addition, the company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia (see Note 14). In 2013, the company recorded restructuring and other costs, net, of $180 million, including $29 million of charges to cost of revenues primarily related to the sale of inventories revalued at the date of acquisition and, to a lesser extent, accelerated depreciation on manufacturing assets to be abandoned due to facility consolidations and $74 million of charges to selling, general and administrative expenses primarily consisting of transaction costs related to the acquisition of Life Technologies, changes in estimates of contingent consideration for an acquisition and a charge associated with product liability litigation. The company incurred $78 million of cash restructuring costs primarily for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that were being consolidated. The cash costs also included $4 million of transaction expenses related to the agreement to sell its sera and media, gene modulation and magnetic beads businesses (see Note 2). The restructuring actions for which charges were incurred in 2013 resulted in annual cost savings of approximately $80 million beginning in part in 2013 and to a greater extent in 2014, including $5 million in the Life Sciences Solutions segment, $30 million in the Analytical Instruments segment, $20 million in the Specialty Diagnostics segment and $25 million in the Laboratory Products and Services segment. Segment Results THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Income from the company’s reportable segments increased 45% to $3.69 billion in 2014 due primarily to the acquisition of Life Technologies and to a lesser extent, productivity improvements, net of inflationary costs increases, offset in part by strategic growth investments. Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $3.48 billion to $4.20 billion in 2014 primarily due to the acquisition of Life Technologies, net of divestitures. Had the acquisition of Life Technologies been completed at the beginning of 2013, pro forma revenues for the 2014 period would have decreased $38 million compared to pro forma 2013 revenues, including a decrease of $151 million due to dispositions, net of other acquisitions and a decrease of $45 million due to the unfavorable effects of currency translation, offset in part by an increase of $158 million (4%) due to higher revenues at existing businesses. The increase in pro forma revenue at existing businesses was primarily due to increased demand for biosciences and bioprocess production products, offset in part by lower licensing revenues. Operating income margin was 29.0% in 2014 compared to 23.8% in 2013. The increase resulted primarily from higher operating margins in Life Technologies’ businesses relative to the segment’s legacy operations and, to a lesser extent, productivity improvements, net of inflationary cost increases. Analytical Instruments Sales in the Analytical Instruments segment increased $98 million to $3.25 billion in 2014. Sales increased $113 million (4%) due to higher revenues at existing businesses and $15 million due to acquisitions, offset in part by a decrease of $30 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for chromatography and mass spectrometry instruments and, to a lesser extent, environmental instruments. These increases were offset in part by modestly lower sales of chemical analysis products due primarily to softness in certain commodity markets such as minerals. Operating income margin was 17.9% in 2014 compared to 17.7% in 2013. The increase resulted primarily from productivity improvements, net of inflationary cost increases and, to a lesser extent, profit from favorable sales mix. The increases were offset in part by strategic growth investments. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $152 million to $3.34 billion in 2014. Sales increased $154 million (5%) due to higher revenues at existing businesses and $10 million due to an acquisition net of a divestiture, offset in part by a decrease of $12 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for immunodiagnostics products, products sold through the segment’s healthcare market channel and, to a lesser extent, clinical diagnostics products. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Operating income margin was 27.4% in 2014 and 27.1% in 2013. The increase resulted primarily from favorable sales mix and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by strategic growth investments. Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $203 million to $6.60 billion in 2014. Sales increased $312 million (5%) due to higher revenues at existing businesses. The increase was offset in part by a decrease of $93 million due to dispositions and $17 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for laboratory products and, to a lesser extent, clinical trial logistics services. Operating income margin was 14.9% in 2014 and 15.0% in 2013. The decrease resulted primarily from strategic growth investments offset in part by productivity improvements, net of inflationary cost increases. Other Expense, Net The company reported other expense, net, of $416 million and $290 million in 2014 and 2013, respectively (Note 4). Interest expense increased $218 million primarily due to the debt issued and assumed in connection with the acquisition of Life Technologies. In 2014, the company realized net gains of $9 million from equity and available-for-sale investments. In 2013, the company recorded $74 million of charges related to amortization of fees paid to obtain bridge financing commitments related to the acquisition of Life Technologies. Also in 2013, the company irrevocably contributed appreciated available-for-sale investments that had a fair value of $27 million to two of its U.K. defined benefit plans, resulting in realization of a previously unrecognized gain of $11 million. Provision for Income Taxes The company’s effective tax rates were 9.2% and 3.1% in 2014 and 2013, respectively. The 2014 provision for income taxes includes $390 million related to gains on the sales of businesses. Aside from the discrete tax on the gains, the company had a benefit from income taxes primarily due to restructuring and other costs associated with the acquisition of Life Technologies as well as an increase in the expected benefit from foreign tax credits. In 2014, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $172 million, offset in part by additional U.S. income taxes of $55 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $117 million and reduced the company’s effective tax rate by 5.6 percentage points in 2014. The federal tax credit for 2014 research and development activities favorably affected the tax provision in 2014 by $20 million, or 1.0 percentage point. In 2014, the company recognized a discrete tax benefit of $15 million, or 0.7 percentage points, attributable to tax rulings related to non-U.S. subsidiaries. Due primarily to the non-deductibility of intangible asset amortization, the company’s cash payments (net of refunds) for income taxes were higher than its income tax expense for financial reporting purposes and totaled $586 million and $230 million in 2014 and 2013, respectively. The effective tax rate in both periods was also affected by relatively significant earnings in lower tax jurisdictions. The tax provision in the 2014 period was favorably affected by $5.5 million, or 0.3 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates. In 2013, non-U.S. subsidiaries of the company made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company generated U.S. foreign tax credits of $160 million offset by additional U.S. income taxes of $56 million on the related foreign income. The net result of these transactions favorably affected the income tax provision by $104 million and reduced the company’s effective tax rate by 7.9 percentage points in 2013. In addition, the effective tax rate in 2013 was also reduced by the U.S. Congress’ renewal in January 2013 of a tax credit for research and development activities for 2012 and 2013 and, to a lesser extent, financing costs associated with the acquisition of Life Technologies that are deductible in the U.S. The federal tax credit for 2012 and 2013 research and development activities favorably affected the tax provision in 2013 by $15 million, or 1.2 percentage points. The tax provision in the 2013 period was unfavorably affected by $5 million, or 0.4 percentage points, as a result of adjustments to deferred tax balances due to changes in tax rates and audit settlements. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Consolidated working capital was $1.59 billion at December 31, 2015, compared with $1.19 billion at December 31, 2014. Included in working capital were cash and cash equivalents of $452 million at December 31, 2015 and $1.34 billion at December 31, 2014. The increase in working capital is primarily due to a decrease in current debt offset in part by lower cash balances. Cash provided by operating activities was $2.82 billion during 2015. Increases in accounts receivable and inventories used cash of $149 million and $141 million, respectively, primarily to support growth in sales in local currencies. An increase in other assets used cash of $254 million primarily related to the timing of tax payments/refunds. An increase in other liabilities provided cash of $148 million primarily due to the timing of payments for income taxes and incentive compensation. Cash payments for income taxes decreased to $477 million during 2015, compared with $586 million in 2014 that included taxes associated with gains on divestitures. The company made cash contributions to its pension and postretirement benefit plans totaling $38 million during 2015. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $97 million during 2015. During 2015, the company’s investing activities used $1.09 billion of cash. Acquisitions used cash of $695 million. The company’s investing activities also included the purchase of $423 million of property, plant and equipment. In January 2016, the company announced an agreement to acquire Affymetrix for approximately $1.3 billion in cash. The transaction, which is expected to be completed by the end of the second quarter of 2016, is subject to the approval of Affymetrix shareholders and the satisfaction of customary closing conditions, including applicable regulatory approvals. The company expects to issue debt in advance of closing the acquisition of Affymetrix to partially fund the acquisition. The company’s financing activities used $2.49 billion of cash during 2015. Repayments of long-term debt totaled $3.78 billion. Issuance of senior notes provided cash of $1.80 billion and an increase in commercial paper obligations provided cash of $50 million. The company’s financing activities also included the repurchase of $500 million of the company’s common stock and the payment of $241 million in cash dividends, offset in part by $124 million of proceeds from employee stock option exercises. On November 12, 2015, the Board of Directors replaced the existing repurchase authorization with a new authorization to repurchase up to $1.00 billion of the company’s common stock. At December 31, 2015, $1.00 billion was available for future repurchases of the company’s common stock under this authorization. In the first quarter of 2016 through February 25, 2016, the company repurchased $500 million of its common stock under this authorization. As of December 31, 2015, the company’s short-term debt totaled $1.05 billion, including $1.00 billion of senior notes, due in the next twelve months and $50 million of commercial paper obligations. The company has a revolving credit facility with a bank group that provides up to $2.00 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2015, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $65 million as a result of outstanding letters of credit. Approximately half of the company’s cash balances and cash flows from operations are from outside the U.S. The company uses its non-U.S. cash for needs outside of the U.S. including acquisitions and repayment of acquisition-related intercompany debt to the U.S. In addition, the company also transfers cash to the U.S. using non-taxable returns of capital as well as dividends where the related U.S. foreign tax credit equals or exceeds any tax cost arising from the dividends. As a result of using such means of transferring cash to the U.S., the company does not expect any material adverse liquidity effects from its significant non-U.S. cash balances for the foreseeable future. The company believes that its existing cash and cash equivalents of $452 million as of December 31, 2015 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Cash provided by operating activities was $2.62 billion during 2014 primarily from the company’s earnings. Increases in accounts receivable and inventories used cash of $145 million and $110 million, respectively, primarily to support growth in sales. Other assets decreased by $163 million primarily due to collection of tax refunds including those related to legacy Life Technologies’ operations. Other liabilities increased by $308 million primarily due to the timing of payments for incentive compensation and income taxes. In 2014, the company made cash payments including monetizing certain equity awards, THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) severance obligations and transaction costs totaling $325 million related to the acquisition of Life Technologies. The company made cash contributions to its pension and postretirement benefit plans totaling $50 million during 2014. Cash payments for income taxes totaled $586 million. During 2014, the company’s investing activities used $11.78 billion of cash, principally for the acquisition of Life Technologies. Acquisitions used cash of $13.06 billion. Proceeds from the sale of businesses provided $1.52 billion. The company’s investing activities also included the purchase of $428 million of property, plant and equipment. The company’s financing activities provided $4.80 billion of cash during 2014. To partially fund the acquisition of Life Technologies, the company borrowed $5.00 billion under an unsecured term loan and issued 34.9 million shares of its common stock for net proceeds of $2.94 billion in cash (Note 11). Other long-term borrowings totaled $1.59 billion. Repayments of long-term debt, principally the term loan, totaled $4.43 billion. A decrease in commercial paper obligations used cash of $250 million. The company’s financing activities also included the receipt of $155 million of proceeds from employee stock option exercises offset by the payment of $235 million in cash dividends. Cash provided by operating activities was $2.01 billion during 2013, primarily from the company’s earnings. Increases in accounts receivable and inventories used cash of $148 million and $72 million, respectively, primarily to support growth in sales. A decrease in other assets provided cash of $169 million primarily due to timing of income tax refunds. An increase in accounts payable provided cash of $47 million, primarily due to higher inventory purchases. An increase in other liabilities provided cash of $163 million primarily due to the timing of payments for income taxes and incentive compensation. In the 2013, the company paid fees to obtain bridge financing commitments and other transaction costs totaling $108 million related to the acquisition of Life Technologies. The company made cash contributions to its pension and postretirement benefit plans totaling $38 million during 2013. Cash payments for income taxes of continuing operations totaled $230 million. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $69 million during 2013. During 2013, the company’s primary investing activity was the purchase of $282 million of property, plant and equipment. The company’s financing activities provided $3.31 billion of cash during 2013. To partially fund the acquisition of Life Technologies, the company issued $3.20 billion of senior notes. The company’s financing activities also included the receipt of $230 million of proceeds from employee stock option exercises offset by the repurchase of $90 million of the company’s common stock and the payment of $216 million in cash dividends. Off-Balance Sheet Arrangements The company did not use special purpose entities or other off-balance-sheet financing arrangements in 2013 - 2015 except for letters of credit, bank guarantees, residual value guarantees under two lease agreements, surety bonds and other guarantees disclosed in the table or discussed below. Of the amounts disclosed in the table below for letters of credit, bank guarantees, surety bonds and other guarantees, $18 million relates to guarantees of the performance of third parties, principally in connection with businesses that were sold. The balance relates to guarantees of the company’s own performance, primarily in the ordinary course of business. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) Contractual Obligations and Other Commercial Commitments The table below summarizes, by period due or expiration of commitment, the company’s contractual obligations and other commercial commitments as of December 31, 2015. (a) Amounts represent the expected cash payments for debt and do not include any deferred issuance costs. (b) Unconditional purchase obligations include agreements to purchase goods, services or fixed assets that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable at any time without penalty. (c) Obligation represents funding commitments pursuant to investments held by the company. Reserves for unrecognized tax benefits of $350 million have not been included in the above table due to the inability to predict the timing of tax audit resolutions. The company has no material commitments for purchases of property, plant and equipment, other than those included in the above table, but expects that for 2016, such expenditures will approximate $415 to $430 million. Guarantees of residual value under lease arrangements for two facilities have not been included in the above table due to the inability to predict if and when the guarantees may require payment (see Note 10). The residual value guarantees become operative at the end of the leases for up to a maximum of $111 million. The initial terms of these leases end in 2019 and 2020, although renewal options exist for each. A guarantee of pension plan obligations of a divested business has not been included in the preceding table due to the inability to predict if and when the guarantee may require payment. The purchaser of the divested business has agreed to pay for the pension benefits, however the company was required to guarantee payment of these pension benefits should the purchaser fail to do so. The amount of the guarantee at December 31, 2015 was $41 million. In January 2016, the company committed to acquire Affymetrix for approximately $1.3 billion (see Note 16). In disposing of assets or businesses, the company often provides representations, warranties and/or indemnities to cover various risks including, for example, unknown damage to the assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste facilities, and unidentified tax liabilities and related legal fees. The company does not have the ability to estimate the potential liability from such indemnities because they relate to THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) unknown conditions. However, the company has no reason to believe that these uncertainties would have a material adverse effect on its financial position, annual results of operations or cash flows. The company has recorded liabilities for known indemnifications included as part of environmental liabilities. See Item 1. Business - Environmental Matters for a discussion of these liabilities.

<s>[INST] Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions and divestitures are described below. On February 3, 2014, the company completed the acquisition of Life Technologies Corporation for a total purchase price of $15.30 billion, net of cash acquired, including the assumption of $2.28 billion of debt. The company issued debt and common stock in late 2013 and early 2014 to partially fund the acquisition discussed below under the caption “Liquidity and Capital Resources”. Life Technologies was integrated into the Life Sciences Solutions segment and provides innovative products and services to customers conducting scientific research and genetic analysis, as well as those in applied markets, such as forensics and food safety testing. Life Technologies’ revenues totaled $3.87 billion in 2013. On March 21, 2014, the company sold its legacy sera and media, gene modulation and magnetic beads businesses to GE Healthcare for $1.06 billion, net of cash divested. The sale of these businesses resulted in a pretax gain of approximately $761 million included in restructuring and other costs (income), net. The businesses fell principally in the Life Sciences Solutions segment. Divestiture of these businesses was a condition to obtaining antitrust approval for the Life Technologies acquisition. Revenues and operating income of the businesses sold were approximately $250 million and $64 million, respectively, for the year ended December 31, 2013 and $61 million and $12 million, respectively, in 2014 through the date of sale. On August 15, 2014, the company sold its ColeParmer specialty channel business, part of the Laboratory Products and Services segment, for $480 million in cash, net of cash divested. The sale of this business resulted in a pretax gain of approximately $134 million, included in restructuring and other costs (income), net. Revenues and operating income of the business sold were approximately $232 million and $43 million, respectively, for the year ended December 31, 2013 and $149 million and $28 million, respectively, in 2014 through the date of sale. On February 4, 2015, the company acquired Advanced Scientifics, Inc., a North Americabased global provider of singleuse technologies for customized bioprocessing solutions, for approximately $289 million. Advanced Scientifics was integrated into the Life Sciences Solutions segment and expands the company’s bioprocessing offerings. Revenues of Advanced Scientifics were approximately $80 million in 2014. On September 30, 2015, the company acquired, within the Laboratory Products and Services segment, Alfa Aesar, a U.K.based global manufacturer of research chemicals from Johnson Matthey Plc, for £257 million ($392 million) in cash. The acquisition expands the company’s existing portfolio of chemicals, solvents and reagents. Revenues of Alfa Aesar were approximately £78 million in 2014. In January 2016, the company signed an agreement to acquire, within the Life Sciences Solutions segment, Affymetrix, Inc., a North Americabased provider of cellular and genetic analysis products, for approximately $1.3 billion in cash. The acquisition will expand the company's existing portfolio of antibodies and assays for highgrowth flow cytometry [/INST] Negative. </s>

THERMO FISHER SCIENTIFIC INC.

2017-02-28

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions and divestitures are described below. On February 3, 2014, the company completed the acquisition of Life Technologies Corporation for a total purchase price of $15.30 billion, net of cash acquired, including the assumption of $2.28 billion of debt. The company issued debt and common stock in late 2013 and early 2014 to partially fund the acquisition discussed below under the caption “Liquidity and Capital Resources”. Life Technologies was integrated into the Life Sciences Solutions segment and provides innovative products and services to customers conducting scientific research and genetic analysis, as well as those in applied markets, such as forensics and food safety testing. Life Technologies’ revenues totaled $3.87 billion in 2013. On March 21, 2014, the company sold its legacy sera and media, gene modulation and magnetic beads businesses to GE Healthcare for $1.06 billion, net of cash divested. The sale of these businesses resulted in a pre-tax gain of approximately $761 million included in restructuring and other costs (income), net. The businesses fell principally in the Life Sciences Solutions segment. Divestiture of these businesses was a condition to obtaining antitrust approval for the Life Technologies acquisition. Revenues and operating income of the businesses sold were approximately $250 million and $64 million, respectively, for the year ended December 31, 2013 and $61 million and $12 million, respectively, in 2014 through the date of sale. On August 15, 2014, the company sold its Cole-Parmer specialty channel business, part of the Laboratory Products and Services segment, for $480 million in cash, net of cash divested. The sale of this business resulted in a pre-tax gain of approximately $134 million, included in restructuring and other costs (income), net. Revenues and operating income of the business sold were approximately $232 million and $43 million, respectively, for the year ended December 31, 2013 and $149 million and $28 million, respectively, in 2014 through the date of sale. In February 2015, the company acquired, within the Life Sciences Solutions segment, Advanced Scientifics, Inc., a North America-based global provider of single-use systems and process equipment for bioprocess production, for approximately $289 million. The acquisition expanded the company’s bioprocessing offerings. Revenues of Advanced Scientifics were approximately $80 million in 2014. On September 30, 2015, the company acquired, within the Laboratory Products and Services segment, Alfa Aesar, a U.K.-based global manufacturer of research chemicals from Johnson Matthey Plc, for £257 million ($393 million) in cash. The acquisition expanded the company’s existing portfolio of chemicals, solvents and reagents. Revenues of Alfa Aesar were approximately £78 million in 2014. On March 31, 2016, the company acquired, within the Life Sciences Solutions segment, Affymetrix, Inc., a North America-based provider of cellular and genetic analysis products, for a total purchase price of $1.34 billion, net of cash acquired, including the assumption of $254 million of debt. The acquisition expanded the company's existing portfolio of antibodies and assays for flow cytometry and single-cell biology applications. Additionally, the acquisition expanded the company's genetic analysis portfolio through the addition of microarrays. Revenues of Affymetrix were $360 million in 2015. On September 19, 2016, the company acquired, within the Analytical Instruments segment, FEI Company, a North America-based provider of high-performance electron microscopy, for a total purchase price of $4.08 billion, net of cash acquired. The acquisition strengthened the company's analytical instrument portfolio with the addition of high-end electron microscopes. Revenues of FEI were $930 million in 2015. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity Sales in 2016 were $18.27 billion, an increase of $1.31 billion from 2015. Sales increased $733 million due to acquisitions. The unfavorable effects of currency translation resulted in a decrease in revenues of $145 million in 2016. Aside from the effects of currency translation and acquisitions, revenues increased $721 million (4%) primarily due to increased demand. Sales to customers in the company’s primary end markets grew. Demand from customers in pharmaceutical and biotech industries was particularly strong. Sales growth was strong in Asia, moderate in Europe and modest in North America. Based on the weakening of currency exchange rates against the U.S. dollar that occurred in 2016, the company currently expects that there will be a continued adverse effect on reported amounts of revenue and operating income in 2017 as a result of the stronger U.S. dollar. In 2016, total company operating income and operating income margin were $2.45 billion and 13.4%, respectively, compared with $2.34 billion and 13.8%, respectively, in 2015. The increase in operating income was primarily due to profit on higher sales in local currencies, productivity improvements, net of inflationary cost increases, and, to a lesser extent, acquisitions. These increases were offset in part by higher restructuring and acquisition-related charges in the 2016 period, strategic growth investments and unfavorable sales mix. The company’s references to strategic growth investments generally refer to targeted spending for enhancing commercial capabilities, including expansion of geographic sales reach and e-commerce platforms, marketing initiatives, focused research projects and other expenditures to enhance the customer experience. The company’s references throughout this discussion to productivity improvements generally refer to improved cost efficiencies from its Practical Process Improvement (PPI) business system, reduced costs resulting from global sourcing initiatives, a lower cost structure following restructuring actions, including headcount reductions and consolidation of facilities, and low cost region manufacturing. The company recorded a benefit from income taxes in 2016. In 2016, the company continued to implement tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $91 million, offset in part by additional U.S. taxes of $37 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2016) for a net benefit of $54 million. The foreign tax credits are the result of foreign earnings remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company intends to make similar types of distributions from non-U.S. subsidiaries when they can be made at no net tax cost. The ability of the company to make distributions in future periods of similar type and magnitude will depend on the level of earnings and cash flow in various foreign jurisdictions and on the applicable tax laws in effect at that time. Accordingly, the impact of foreign tax credits on the company’s effective tax rate in future periods is likely to vary. The company also implemented foreign tax credit planning in Sweden which resulted in $100 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits in 2016 totaling $39 million related to prior year tax filings and net charges of $12 million related to tax audits. The company recorded a benefit from income taxes in 2015. In 2015, the company implemented tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $111 million, offset in part by additional U.S. taxes of $46 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2015) for a net benefit of $66 million. The foreign tax credits are the result of foreign earnings remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company also implemented foreign tax credit planning in Sweden which resulted in $80 million of foreign tax credits, with no related THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) incremental U.S. income tax expense. In addition, the company recorded discrete benefits totaling $54 million related to additional prior year foreign tax and other credits as well as restructuring and other costs associated with the 2014 acquisition of Life Technologies. The tax provision in the 2015 period was favorably affected by $37 million as a result of adjustments to deferred tax balances due to changes in tax rates. The effective tax rate in both 2016 and 2015 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $663 million and $477 million in 2016 and 2015, respectively. The company expects its effective tax rate in 2017 will be less than 3% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. Income from continuing operations increased to $2.03 billion in 2016, from $1.98 billion in 2015. The increase in operating income in the 2016 period (discussed above) was offset in part by an increase in interest expense of $55 million primarily due to increases in outstanding debt to fund acquisitions and a lower tax benefit from income taxes in 2016. During 2016, the company’s cash flow from operations totaled $3.16 billion compared with $2.82 billion for 2015. The increase primarily resulted from lower investments in working capital and higher income before amortization and depreciation in the 2016 period. As of December 31, 2016, the company’s short-term debt totaled $1.26 billion, including $300 million due within the next twelve months under a 3-year term loan agreement and $953 million of commercial paper obligations. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2016, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $72 million as a result of outstanding letters of credit. The company believes that its existing cash and cash equivalents of $786 million as of December 31, 2016 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Critical Accounting Policies and Estimates The company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent liabilities. On an on-going basis, management evaluates its estimates, including those related to bad debts, inventories, business combinations, intangible assets and goodwill, sales returns, income taxes, contingencies and litigation, and pension costs. Management believes the most complex and sensitive judgments, because of their significance to the consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Management bases its estimates on historical experience, current market and economic conditions and other assumptions that management believes are reasonable. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities where the values are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The company believes the following represent its critical accounting policies and estimates used in the preparation of its financial statements: (a) Accounts Receivable The company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to pay amounts due. Such allowances totaled $77 million at December 31, 2016. The company estimates the amount of customer receivables that are uncollectible based on the age of the receivable, the creditworthiness of the customer and any other information that is relevant to the judgment. If the financial condition of the company’s customers were to deteriorate, reducing their ability to make payments, additional allowances would be required. (b) Inventories The company writes down its inventories for estimated excess quantities and obsolescence based on differences between the cost and estimated net realizable value taking into consideration usage in the preceding 12 months, THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) expected demand and any other information that is relevant to the judgment. If ultimate usage or demand varies significantly from expected usage or demand, additional writedowns may be required. (c) Intangible Assets and Goodwill The company uses assumptions and estimates in determining the fair value of assets acquired and liabilities assumed in a business combination. The determination of the fair value of intangible assets, which represent a significant portion of the purchase price in many of the company’s acquisitions, requires the use of significant judgment with regard to (i) the fair value; and (ii) whether such intangibles are amortizable or non-amortizable and, if the former, the period and the method by which the intangible asset will be amortized. The company estimates the fair value of acquisition-related intangible assets principally based on projections of cash flows that will arise from identifiable intangible assets of acquired businesses. The projected cash flows are discounted to determine the present value of the assets at the dates of acquisition. Definite-lived intangible assets totaled $12.63 billion at December 31, 2016. The company reviews definite-lived intangible assets for impairment when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Actual cash flows arising from a particular intangible asset could vary from projected cash flows which could imply different carrying values from those established at the dates of acquisition and which could result in impairment of such asset. The company evaluates goodwill and indefinite-lived intangible assets for impairment annually and when events occur or circumstances change that may reduce the fair value of the asset below its carrying amount. Events or circumstances that might require an interim evaluation include unexpected adverse business conditions, economic factors, unanticipated technological changes or competitive activities, loss of key personnel and acts by governments and courts. Goodwill and indefinite-lived intangible assets totaled $21.33 billion and $1.34 billion, respectively, at December 31, 2016. Estimates of future cash flows require assumptions related to revenue and operating income growth, asset-related expenditures, working capital levels and other factors. Different assumptions from those made in the company’s analysis could materially affect projected cash flows and the company’s evaluation of goodwill and indefinite-lived intangible assets for impairment. Indications of fair value based on projections of profitability for 2017 and thereafter and on peer revenues and earnings trading multiples were sufficient to conclude that no impairment of goodwill or indefinite-lived intangible assets existed at the end of the tenth fiscal month of 2016, the date of the company’s impairment testing. There can be no assurance, however, that an economic downturn will not materially adversely affect peer trading multiples and the company’s businesses such that they do not achieve their forecasted profitability and these assets become impaired. Should the fair value of the company’s goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines, or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment may be necessary. With the completion of the FEI acquisition in September 2016, the company established a new reporting unit called Materials and Structural Analysis, which consists of the former FEI business. Because this reporting unit consists solely of the acquired business, the book value of which equaled its fair value as of the acquisition date, no cushion of fair value over book value existed at the acquisition date. During its 2016 goodwill impairment testing, the company determined that the Materials and Structural Analysis reporting unit’s cushion of fair value over book value was nominal as of November 5, 2016. Given that the fair value is not substantially in excess of the book value, relatively small decreases in future cash flows from forecasted results or changes in discount rates or other assumptions could result in impairment of goodwill. The key variables that drive the cash flows of the reporting unit are levels of profitability and terminal value growth rate assumptions, as well as the weighted average cost of capital (WACC) rate applied. The estimates used for these assumptions represent management's best estimates, which the company believes are reasonable. These assumptions, however, are subject to uncertainty, including the degree to which the acquired business will grow revenue and profitability levels. The Materials and Structural Analysis reporting unit had $1.99 billion of goodwill, and had an overall carrying value of $3.93 billion as of December 31, 2016. (d) Revenues In instances where the company sells equipment with a related installation obligation, the company generally recognizes revenue related to the equipment when title passes. The company recognizes revenue related to the installation when it performs the installation. The allocation of revenue between the equipment and the installation is based on relative selling price at the time of sale. Should the relative value of either the equipment or the installation change, the company’s revenue recognition would be affected. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) In instances where the company sells equipment with customer-specified acceptance criteria, the company must assess whether it can demonstrate adherence to the acceptance criteria prior to the customer’s acceptance testing to determine the timing of revenue recognition. If the nature of customer-specified acceptance criteria were to change or grow in complexity such that the company could not demonstrate adherence, the company would be required to defer additional revenues upon shipment of its products until completion of customer acceptance testing. The company records reductions to revenue for estimated product returns by customers. Should a greater or lesser number of products be returned, additional adjustments to revenue may be required. (e) Income Taxes In the ordinary course of business there is inherent uncertainty in quantifying the company’s income tax positions. The company assesses income tax positions and records tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, the company has recorded the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. The company’s reserve for these matters totaled $802 million at December 31, 2016. Where applicable, associated interest expense has also been recognized as a component of the provision for income taxes. The company operates in numerous countries under many legal forms and, as a result, is subject to the jurisdiction of numerous domestic and non-U.S. tax authorities, as well as to tax agreements and treaties among these governments. Determination of taxable income in any jurisdiction requires the interpretation of the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions, permissible revenue recognition methods under the tax law and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, currency exchange restrictions or the company’s level of operations or profitability in each taxing jurisdiction could have an impact upon the amount of current and deferred tax balances and hence the company’s net income. The company estimates the degree to which tax assets and loss carryforwards will result in a benefit, based on expected profitability by tax jurisdiction, and provides a valuation allowance for tax assets and loss carryforwards that it believes will more likely than not go unused. If it becomes more likely than not that a tax asset or loss carryforward will be used, the company reverses the related valuation allowance. Any such reversals are recorded as a reduction of the company’s tax provision. The company’s tax valuation allowance totaled $113 million at December 31, 2016. Should the company’s actual future taxable income by tax jurisdiction vary from estimates, additional allowances or reversals thereof may be necessary. The company provides a liability for future income tax payments in the worldwide tax jurisdictions in which it operates. Should tax return positions that the company expects are sustainable not be sustained upon audit, the company could be required to record an incremental tax provision for such taxes. Should previously unrecognized tax benefits ultimately be sustained, a reduction in the company’s tax provision would result. The company operates in various jurisdictions around the world. With the exception of its Affymetrix Singapore subsidiary, the company has not provided income taxes on the undistributed earnings of its non-U.S. subsidiaries due to its intention to permanently reinvest such earnings unless the company can remit such earnings to the U.S. without associated net tax cost. The company recorded a deferred tax liability of $156 million in acquisition accounting for the outside basis difference of Affymetrix Singapore as the company intends to integrate it with the company’s existing Singapore operations within the next twelve months. Aside from this plan, the company’s intent is to only make distributions from non-U.S. subsidiaries in the future when they can be made at no net tax cost. (f) Contingencies and Litigation The company records accruals for various contingencies, including legal proceedings, environmental, workers’ compensation, product, general and auto liabilities, and other claims that arise in the normal course of business. The accruals are based on management’s judgment, historical claims experience, the probability of losses and, where applicable, the consideration of opinions of internal and or external legal counsel and actuarial estimates. Accruals of acquired businesses, including product liability and environmental accruals, were initially recorded at fair value and THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) discounted to their net present value. Additionally, the company records receivables from third-party insurers when recovery has been determined to be probable. (g) Pension and Other Retiree Benefits Several of the company’s U.S. and non-U.S. subsidiaries sponsor defined benefit pension and other retiree benefit plans. The cost and obligations of these arrangements are calculated using many assumptions to estimate the benefits that the employee earns while working, the amount of which cannot be completely determined until the benefit payments cease. Major assumptions used in the accounting for these employee benefit plans include the discount rate, expected return on plan assets and rate of increase in employee compensation levels. Assumptions are determined based on company data and appropriate market indicators in consultation with third-party actuaries, and are evaluated each year as of the plans’ measurement date. Net periodic pension costs for the company’s pension and other postretirement benefit plans totaled $34 million in 2016. The company’s unfunded benefit obligation totaled $610 million at year-end 2016 compared with $528 million at year-end 2015. Should any of these assumptions change, they would have an effect on net periodic pension costs and the unfunded benefit obligation. For example, a 10% decrease in the discount rate would result in an annual increase in pension and other postretirement benefit expense of approximately $2 million and an increase in the benefit obligation of approximately $93 million. As of December 31, 2016, the company expects to contribute between $215 and $235 million to its existing defined benefit pension plans in 2017. As of January 1, 2017, the company changed the method it uses to estimate the service and interest components of net periodic benefit cost for pension and other retiree benefit plans. Historically, the company estimated these service and interest cost components utilizing the single weighted-average discount rate used to measure each plan's benefit obligation at the beginning of the year. Beginning in 2017, the company will utilize a full yield curve approach in the estimation of these components by applying the specific spot-rates along the yield curve used in the determination of the benefit obligation to the relevant projected cash flows. The company has made this change to provide a more precise measurement of the service and interest costs by improving the correlation between projected benefit cash flows to the corresponding spot yield curve rates. The company has accounted for this change as a change in accounting estimate and will account for it prospectively starting in January 2017. The reduction in service and interest costs for 2017 associated with this change in estimate will be approximately $10 million. Results of Operations 2016 Compared With 2015 Sales in 2016 were $18.27 billion, an increase of $1.31 billion from 2015. The unfavorable effects of currency translation resulted in a decrease in revenues of $145 million in 2016. Sales increased $733 million due to acquisitions. Aside from the effects of currency translation and acquisitions, revenues increased $721 million (4%) primarily due to increased demand. Sales to customers in the company’s primary end markets grew. Demand from customers in pharmaceutical and biotech industries was particularly strong. Sales growth was strong in Asia, moderate in Europe and modest in North America. In 2016, total company operating income and operating income margin were $2.45 billion and 13.4%, respectively, compared with $2.34 billion and 13.8%, respectively, in 2015. The increase in operating income was primarily due to profit on higher sales in local currencies, productivity improvements, net of inflationary cost increases, and, to a lesser extent, THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) acquisitions. These increases were offset in part by higher restructuring and acquisition-related charges in the 2016 period, strategic growth investments and unfavorable sales mix. In 2016, the company recorded restructuring and other costs, net, of $395 million, including $102 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and to conform the accounting policies of FEI and Affymetrix with the company's accounting policies; $104 million of charges to selling, general and administrative expenses primarily for third-party transaction and integration costs related to the acquisitions of FEI and Affymetrix. In addition, the company recorded $164 million of cash restructuring costs, primarily to achieve acquisition synergies, including severance and abandoned facilities costs associated with the closure and consolidation of facilities in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S., Europe and Asia (see Note 14). The company also recorded charges for litigation and environmental remediation matters. These costs were partially offset by gains on the sales of real estate. In 2015, the company recorded restructuring and other costs, net, of $171 million, including $9 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and, to a lesser extent, accelerated depreciation at facilities closing due to real estate consolidation; $46 million of charges to selling, general and administrative expenses primarily for charges associated with product liability litigation, third-party transaction and integration costs primarily related to the acquisitions of Life Technologies and Alfa Aesar, and accelerated depreciation at facilities closing due to real estate consolidation. In addition, the company recorded $82 million of cash restructuring costs primarily for actions to achieve synergies from the Life Technologies acquisition and for abandoned facilities costs associated with a manufacturing facility in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia. The company also recorded charges for litigation-related matters associated with acquired businesses and impairment of acquired technology in development. These costs were partially offset by gains on the sale of a small product line and real estate. As of February 28, 2017, the company has identified restructuring actions that will result in additional charges of approximately $85 million in 2017 and expects to identify additional actions during 2017 which will be recorded when specified criteria are met, such as communication of benefit arrangements and abandonment of leased facilities. Approximately 45% of the additional charges will be incurred in the Life Sciences Solutions segment, 35% in the Analytical Instruments segment, with the remainder incurred across the company's remaining segments. The restructuring projects for which charges were incurred in 2016 are expected to result in annual cost savings of approximately $100 million beginning in part in 2016 and, to a greater extent, in 2017, including $60 million in the Life Sciences Solutions segment, $25 million in the Analytical Instruments segment, $5 million in the Specialty Diagnostics segment and $10 million in the Laboratory Products and Services segment. The restructuring actions for which charges were incurred in 2015 resulted in annual cost savings of approximately $100 million beginning in part in 2015 and to a greater extent in 2016, including $50 million in the Life Sciences Solutions segment, $25 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $15 million in the Laboratory Products and Services segment. Segment Results The company’s management evaluates segment operating performance using operating income before certain charges/credits to cost of revenues and selling, general and administrative expenses, principally associated with acquisition-related activities; restructuring and other costs/income including costs arising from facility consolidations such as severance and abandoned lease expense and gains and losses from the sale of real estate and product lines; and amortization of acquisition-related intangible assets. The company uses this measure because it helps management understand and evaluate the segments’ core operating results and facilitate comparison of performance for determining compensation (Note 3). Accordingly, the following segment data is reported on this basis. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Income from the company’s reportable segments increased 10% to $4.22 billion in 2016 due primarily to profit on higher sales in local currencies and productivity improvements, net of inflationary cost increases. These increases were offset in part by strategic growth investments and unfavorable sales mix. Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $539 million to $4.98 billion in 2016. Sales increased $315 million (7%) due to higher revenues at existing businesses and $261 million due to acquisitions, offset in part by a decrease of $38 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for biosciences products and bioprocess production products and, to a lesser extent, next generation sequencing products. Operating income margin was 30.4% in 2016 compared to 30.1% in 2015. The increase in operating margin resulted from productivity improvements, net of inflationary cost increases, profit on higher sales in local currencies and, to a lesser extent, price increases. These increases were offset in part by unfavorable sales mix, acquisition dilution and strategic growth investments. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Analytical Instruments Sales in the Analytical Instruments segment increased $460 million to $3.67 billion in 2016. Sales increased $387 million due to acquisitions and $100 million (3%) due to higher revenues at existing businesses, offset in part by a decrease of $27 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products sold by the segment's chromatography and mass spectrometry business and, to a lesser extent, sales of environmental instruments. These increases were offset in part by lower sales of chemical analysis products due primarily to softness in certain industrial end markets. Operating income margin was 20.3% in 2016 compared to 19.1% in 2015. The increase resulted primarily from productivity improvements, net of inflationary cost increases, profit on higher sales in local currencies and, to a lesser extent, favorable foreign currency exchange. These increases were offset in part by unfavorable sales mix and strategic growth investments. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $95 million to $3.34 billion in 2016. Sales increased $115 million (4%) due to higher revenues at existing businesses, offset in part by a decrease of $20 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products in each of the segment's principal businesses with particular strength in the segment’s healthcare market channel and sales of immunodiagnostics products and clinical diagnostics products. Operating income margin was 27.2% in 2016 and 26.9% in 2015. The increase resulted primarily from productivity improvements, net of inflationary cost increases, and profit on higher sales in local currencies, offset in part by strategic growth investments. Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $369 million to $7.03 billion in 2016. Sales increased $354 million (5%) due to higher revenues at existing businesses and $90 million due to an acquisition. These increases were offset in part by $76 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products in each of the segment’s principal businesses. Operating income margin was 15.0% in both 2016 and 2015. Increases due to productivity improvements, net of inflationary cost increases, and profit on higher sales in local currencies, were offset by strategic growth investments and unfavorable sales mix. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Other Expense, Net The company reported other expense, net, of $425 million and $400 million in 2016 and 2015, respectively (Note 4). Interest expense increased $55 million primarily due to an increase in outstanding debt. In 2016, other items, net includes $22 million of charges related to the amortization of fees paid to obtain bridge financing commitments for the acquisition of FEI and $9 million of losses on the early extinguishment of debt, offset in part by $12.5 million of gains on investments. In 2015, other items, net includes losses of $12 million on the early extinguishment of debt and costs of $7.5 million associated with entering into interest rate swap arrangements. Provision for Income Taxes The company recorded a benefit from income taxes in 2016. In 2016, the company continued to implement tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $91 million, offset in part by additional U.S. taxes of $37 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2016) for a net benefit of $54 million. The foreign tax credits are the result of foreign earnings remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company intends to make similar types of distributions from non-U.S. subsidiaries when they can be made at no net tax cost. The ability of the company to make distributions in future periods of similar type and magnitude will depend on the level of earnings and cash flow in various foreign jurisdictions and on the applicable tax laws in effect at that time. Accordingly, the impact of foreign tax credits on the company’s effective tax rate in future periods is likely to vary. The company also implemented foreign tax credit planning in Sweden which resulted in $100 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits in 2016 totaling $39 million related to prior year tax filings and net charges of $12 million related to tax audits. The company recorded a benefit from income taxes in 2015. In 2015, the company implemented tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $111 million, offset in part by additional U.S. taxes of $46 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2015) for a net benefit of $66 million. The foreign tax credits are the result of foreign earnings remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company also implemented foreign tax credit planning in Sweden which resulted in $80 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits totaling $54 million related to additional prior year foreign tax and other credits as well as restructuring and other costs associated with the 2014 acquisition of Life Technologies. The tax provision in the 2015 period was favorably affected by $37 million as a result of adjustments to deferred tax balances due to changes in tax rates. The effective tax rate in both 2016 and 2015 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $663 million and $477 million in 2016 and 2015, respectively. The company expects its effective tax rate in 2017 will be less than 3% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The company has operations and a taxable presence in approximately 50 countries outside the U.S. All of these countries except one have a lower tax rate than the U.S. The countries in which the company has a material presence that have significantly lower tax rates than the U.S. include Germany, the Netherlands, Singapore, Sweden, Switzerland and the United Kingdom. The company’s ability to obtain a benefit from lower tax rates outside the U.S. is dependent on its relative levels of income in countries outside the U.S. and on the statutory tax rates in those countries. Based on the dispersion of the company’s non-U.S. income tax provision among many countries, the company believes that a change in the statutory tax rate in any individual country is not likely to materially affect the company’s income tax provision or net income, aside from any resulting one-time adjustment to the company’s deferred tax balances to reflect a new rate. Recent Accounting Pronouncements A description of recently issued accounting standards is included under the heading “Recent Accounting Pronouncements” in Note 1. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Contingent Liabilities The company is contingently liable with respect to certain legal proceedings and related matters. An unfavorable outcome that differs materially from current accrual estimates, if any, for one or more of the matters described under the headings “Product Liability, Workers Compensation and Other Personal Injury Matters," "Intellectual Property Matters" and "Commercial Matters" in Note 10 could have a material adverse effect on the company’s financial position as well as its results of operations and cash flows. 2015 Compared With 2014 Sales in 2015 were $16.97 billion, an increase of $76 million from 2014. The unfavorable effects of currency translation resulted in a decrease in revenues of $938 million in 2015. Sales increased $212 million due to acquisitions, principally Life Technologies, net of divestitures. Aside from the effects of currency translation and acquisitions/divestitures, revenues increased $803 million (5%) primarily due to increased demand. Sales to customers in the company’s primary end markets grew. Demand from customers in pharmaceutical and biotech industries was particularly strong. Sales growth was moderate in North America and Europe and strong in Asia. In 2015, total company operating income and operating income margin were $2.34 billion and 13.8%, respectively, compared with $2.50 billion and 14.8%, respectively, in 2014. The decrease in operating income and operating income margin was primarily due to net gains of $895 million on the sale of businesses in 2014, offset in part by $450 million of charges in 2014 associated with the February 2014 acquisition of Life Technologies. The unfavorable impact of foreign currency exchange also contributed to the decrease in profitability. These factors that reduced operating income in 2015 were offset in part by productivity improvements, net of inflationary cost increases and, to a lesser extent, profit on higher sales in local currencies. In 2015, the company recorded restructuring and other costs, net, of $171 million, including $9 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and, to a lesser extent, accelerated depreciation at facilities closing due to real estate consolidation; $46 million of charges to selling, general and administrative expenses primarily for charges associated with product liability litigation, third-party transaction and integration costs primarily related to the acquisitions of Life Technologies and Alfa Aesar, and accelerated depreciation at facilities closing due to real estate consolidation. In addition, the company recorded $82 million of cash restructuring costs primarily for actions to achieve synergies from the Life Technologies acquisition and for abandoned facilities costs associated with a manufacturing facility in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia. The company also recorded charges for litigation-related matters associated with acquired businesses and impairment of acquired technology in development. These costs were partially offset by gains on the sale of a small product line and real estate (see Note 14). In 2014, the company recorded restructuring and other income, net, of $140 million, including net gains on the sale of businesses and real estate of $895 million and $15 million, respectively, offset in part by $328 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition; $131 million of charges to selling, general and administrative expenses primarily for transaction costs related to the acquisition of Life Technologies; and $29 million of charges for pension settlements. The company incurred $268 million of cash restructuring costs primarily associated with the Life Technologies acquisition including cash compensation to monetize certain equity awards held by Life Technologies THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) employees at the date of acquisition and severance obligations to former executives and employees of Life Technologies. In addition, the company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia. The restructuring actions for which charges were incurred in 2014 resulted in annual cost savings of approximately $120 million beginning in part in 2014 and to a greater extent in 2015, including $80 million in the Life Sciences Solutions segment, $10 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $20 million in the Laboratory Products and Services segment. Segment Results Income from the company’s reportable segments increased 3% to $3.82 billion in 2015 due primarily to productivity improvements, net of inflationary cost increases, and, to a lesser extent, profit on higher sales in local currencies, offset in part by the unfavorable impact of foreign currency exchange and strategic growth investments. Life Sciences Solutions THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Sales in the Life Sciences Solutions segment increased $244 million to $4.44 billion in 2015 primarily due to the acquisition of Life Technologies, net of divestitures. Had the acquisition of Life Technologies been completed at the beginning of 2013, revenues for the 2015 period would have decreased $25 million compared to pro forma 2014 revenues, including a decrease of $278 million due to the unfavorable effects of currency translation, offset in part by an increase of $213 million (5%) due to higher revenues at existing businesses and an increase of $40 million due to other acquisitions, net of dispositions. The increase in pro forma revenue at existing businesses was primarily due to increased demand for bioprocess production products as well as biosciences products. Operating income margin was 30.1% in 2015 compared to 29.0% in 2014. The increase resulted primarily from productivity improvements (including acquisition cost synergies), net of inflationary cost increases and favorable sales mix. These increases were offset in part by the unfavorable impact of foreign currency exchange and, to a lesser extent, by exclusion in 2014 of January’s lower margin results for Life Technologies. Results for January commonly have a lower margin rate than results for the balance of the quarter, due to the phasing of revenue and costs. Analytical Instruments Sales in the Analytical Instruments segment decreased $44 million to $3.21 billion in 2015. Sales decreased $189 million due to the unfavorable effects of currency translation, offset in part by increases of $141 million (4%) due to higher revenues at existing businesses and $4 million due to acquisitions. The increase in revenue at existing businesses was primarily due to increased demand for chromatography products and, to a lesser extent, sales of service offerings and increased demand for mass spectrometry instruments. These increases were offset in part by modestly lower sales of chemical analysis products due primarily to softness in certain commodity materials markets. Operating income margin was 19.1% in 2015 compared to 17.9% in 2014. The increase resulted primarily from productivity improvements, net of inflationary cost increases and profit on incremental sales in local currencies, offset in part by strategic growth investments and the impact of unfavorable foreign currency exchange. Specialty Diagnostics Sales in the Specialty Diagnostics segment decreased $100 million to $3.24 billion in 2015. Sales decreased $197 million due to the unfavorable effects of currency translation offset in part by $86 million (3%) due to higher revenues at existing businesses and $11 million due to an acquisition net of a divestiture. The increase in revenue at existing businesses was primarily due to increased demand for clinical diagnostics products, products sold through the segment’s healthcare market channel and immunodiagnostics products. These increases were offset in part by lower sales due to the expiration, in late 2014, of an OEM contract following the acquisition of the customer by a competitor. Operating income margin was 26.9% in 2015 and 27.4% in 2014. The decrease resulted primarily from strategic growth investments and unfavorable foreign currency exchange, offset in part by productivity improvements, net of inflationary cost increases. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $60 million to $6.66 billion in 2015. Sales increased $465 million (7%) due to higher revenues at existing businesses. This increase was offset in part by $303 million due to the unfavorable effects of currency translation and $102 million due to a disposition, net of an acquisition. The increase in revenue at existing businesses was primarily due to increased demand for products in each of the segment’s principal businesses. Operating income margin was 15.0% in 2015 and 14.9% in 2014. The increase was primarily due to productivity improvements, net of inflationary cost increases as well as profit on incremental sales in local currencies offset in part by unfavorable sales mix and strategic growth investments. Other Expense, Net The company reported other expense, net, of $400 million and $416 million in 2015 and 2014, respectively (Note 4). Interest expense decreased $65 million primarily due to a reduction in outstanding debt and effective interest rates. In 2015, other items, net includes losses of $12 million on the early extinguishment of debt and costs of $7.5 million associated with entering into interest rate swap arrangements. In 2014, other items, net includes net gains of $9 million on the sale of investments. Provision for Income Taxes The company recorded a benefit from income taxes in 2015. In 2015, the company implemented tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $111 million, offset in part by additional U.S. taxes of $46 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2015) for a net benefit of $66 million. The foreign tax credits are the result of foreign earnings remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company also implemented foreign tax credit planning in Sweden which resulted in $80 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits totaling $54 million related to additional prior year foreign tax and other credits as well as restructuring and other costs associated with the 2014 acquisition of Life Technologies. The tax provision in the 2015 period was favorably affected by $37 million as a result of adjustments to deferred tax balances due to changes in tax rates. The company’s effective tax rate was 9.2% in 2014. The 2014 provision for income taxes included $390 million related to gains on the sales of businesses. Aside from the discrete tax on the gains, the company had a benefit from income taxes primarily due to restructuring and other costs associated with the acquisition of Life Technologies as well as an increase in the expected benefit from foreign tax credits. In 2014, the company implemented tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $172 million, offset in part by additional U.S. taxes of $55 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2014) for a net benefit of $117 million. The foreign tax credits are the result of foreign earnings remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The federal tax credit for 2014 research and development activities favorably affected the tax provision in 2014 by $20 million. In 2014, the company recognized a discrete tax benefit of $15 million attributable to tax rulings related to non-U.S. subsidiaries. The tax provision in the 2014 period was favorably affected by $5.5 million as a result of adjustments to deferred tax balances due to changes in tax rates. The effective tax rate in both 2015 and 2014 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $477 million and $586 million in 2015 and 2014, respectively. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Consolidated working capital was $2.16 billion at December 31, 2016, compared with $1.59 billion at December 31, 2015. Included in working capital were cash and cash equivalents of $786 million at December 31, 2016 and $452 million at December 31, 2015. Cash provided by operating activities was $3.16 billion during 2016. An increase in accounts receivable used cash of $352 million primarily to support growth in sales in local currencies and due to the mid-month timing of the acquisition of FEI when receivables are commonly lower than at quarter-end. Inventories provided cash of $98 million due to a reduction associated with fourth quarter 2016 sales. An increase in other assets used cash of $153 million primarily due to the timing of payments. An increase in other liabilities provided cash of $168 million primarily due to the timing of payments for income taxes and incentive compensation. Cash payments for income taxes increased to $663 million during 2016, compared with $477 million in 2015. The company made cash contributions to its pension and postretirement benefit plans totaling $43 million during 2016. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $122 million during 2016. During 2016, the company’s investing activities used $5.53 billion of cash. Acquisitions used cash of $5.19 billion. The company’s investing activities also included the purchase of $444 million of property, plant and equipment. In February 2017, the company completed an acquisition for approximately $225 million in cash (Note 16). The company’s financing activities provided $2.86 billion of cash during 2016. Issuance of senior notes and borrowings under term loans provided cash of $7.60 billion and an increase in commercial paper obligations provided cash of $904 million. Repayment of senior notes, the 364-day term loan and acquired debt used cash of $4.33 billion. The company’s financing activities also included the repurchase of $1.25 billion of the company’s common stock and the payment of $238 million in cash dividends, offset in part by $135 million of proceeds from employee stock option exercises. On July 7, 2016, the Board of Directors authorized the repurchase of up to $1.50 billion of the company’s common stock. At December 31, 2016, $1.25 billion was available for future repurchases of the company’s common stock under this authorization. Early in the first quarter of 2017, the company repurchased $500 million of the company's common stock which reduced the availability under this authorization to $750 million as of February 28, 2017. As of December 31, 2016, the company’s short-term debt totaled $1.26 billion, including $300 million due within the next twelve months under a 3-year term loan agreement and $953 million of commercial paper obligations. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2016, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $72 million as a result of outstanding letters of credit. Approximately half of the company’s cash balances and cash flows from operations are from outside the U.S. The company uses its non-U.S. cash for needs outside of the U.S. including acquisitions and repayment of acquisition-related intercompany debt to the U.S. In addition, the company also transfers cash to the U.S. using non-taxable returns of capital as well as dividends where the related U.S. foreign tax credit equals or exceeds any tax cost arising from the dividends. As a result of using such means of transferring cash to the U.S., the company does not expect any material adverse liquidity effects from its significant non-U.S. cash balances for the foreseeable future. The company believes that its existing cash and cash equivalents of $786 million as of December 31, 2016 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Cash provided by operating activities was $2.82 billion during 2015. Increases in accounts receivable and inventories used cash of $149 million and $141 million, respectively, primarily to support growth in sales in local currencies. An increase in other assets used cash of $254 million primarily related to the timing of tax payments/refunds. An increase in other liabilities provided cash of $148 million primarily due to the timing of payments for income taxes and incentive compensation. Cash payments for income taxes decreased to $477 million during 2015, compared with $586 million in 2014 that included taxes associated with gains on divestitures. The company made cash contributions to its pension and postretirement benefit plans THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) totaling $38 million during 2015. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $97 million during 2015. During 2015, the company’s investing activities used $1.09 billion of cash. Acquisitions used cash of $695 million. The company’s investing activities also included the purchase of $423 million of property, plant and equipment. The company’s financing activities used $2.49 billion of cash during 2015. Repayments of long-term debt totaled $3.78 billion. Issuance of senior notes provided cash of $1.80 billion and an increase in commercial paper obligations provided cash of $50 million. The company’s financing activities also included the repurchase of $500 million of the company’s common stock and the payment of $241 million in cash dividends, offset in part by $124 million of proceeds from employee stock option exercises. Cash provided by operating activities was $2.62 billion during 2014 primarily from the company’s earnings. Increases in accounts receivable and inventories used cash of $145 million and $110 million, respectively, primarily to support growth in sales. Other assets decreased by $163 million primarily due to collection of tax refunds including those related to legacy Life Technologies’ operations. Other liabilities increased by $308 million primarily due to the timing of payments for incentive compensation and income taxes. In 2014, the company made cash payments including monetizing certain equity awards, severance obligations and transaction costs totaling $325 million related to the acquisition of Life Technologies. The company made cash contributions to its pension and postretirement benefit plans totaling $50 million during 2014. Cash payments for income taxes totaled $586 million. During 2014, the company’s investing activities used $11.78 billion of cash, principally for the acquisition of Life Technologies. Acquisitions used cash of $13.06 billion. Proceeds from the sale of businesses provided $1.52 billion. The company’s investing activities also included the purchase of $428 million of property, plant and equipment. The company’s financing activities provided $4.80 billion of cash during 2014. To partially fund the acquisition of Life Technologies, the company borrowed $5.00 billion under an unsecured term loan and issued 34.9 million shares of its common stock for net proceeds of $2.94 billion in cash (Note 11). Other long-term borrowings totaled $1.59 billion. Repayments of long-term debt, principally the term loan, totaled $4.43 billion. A decrease in commercial paper obligations used cash of $250 million. The company’s financing activities also included the receipt of $155 million of proceeds from employee stock option exercises offset by the payment of $235 million in cash dividends. Off-Balance Sheet Arrangements The company did not use special purpose entities or other off-balance-sheet financing arrangements in 2014, 2015 or 2016, except for letters of credit, bank guarantees, residual value guarantees under three lease agreements, surety bonds and other guarantees disclosed in the table or discussed below. The amounts disclosed in the table below for letters of credit, bank guarantees, surety bonds and other guarantees relate to guarantees of the company’s performance, primarily in the ordinary course of business. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) Contractual Obligations and Other Commercial Commitments The table below summarizes, by period due or expiration of commitment, the company’s contractual obligations and other commercial commitments as of December 31, 2016. (a) Amounts represent the expected cash payments for debt and do not include any deferred issuance costs. (b) Unconditional purchase obligations include agreements to purchase goods, services or fixed assets that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable at any time without penalty. (c) Obligation represents funding commitments pursuant to investments held by the company. Reserves for unrecognized tax benefits of $802 million have not been included in the above table due to the inability to predict the timing of tax audit resolutions. The company has no material commitments for purchases of property, plant and equipment, other than those included in the above table, but expects that for 2017, such expenditures will approximate $500 million. Guarantees of residual value under lease arrangements for three facilities have not been included in the above table due to the inability to predict if and when the guarantees may require payment (see Note 10). The residual value guarantees become operative at the end of the leases for up to a maximum of $155 million. The initial terms of these leases end in 2019, 2020 and 2022, although renewal options exist for each. A guarantee of pension plan obligations of a divested business has not been included in the preceding table due to the inability to predict if and when the guarantee may require payment. The purchaser of the divested business has agreed to pay for the pension benefits, however the company was required to guarantee payment of these pension benefits should the purchaser fail to do so. The amount of the guarantee at December 31, 2016 was $40 million. In disposing of assets or businesses, the company often provides representations, warranties and/or indemnities to cover various risks including, for example, unknown damage to the assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste facilities, and unidentified tax liabilities and related legal fees. The company does not have the ability to estimate the potential liability from such indemnities because they relate to unknown conditions. However, the company has no reason to believe that these uncertainties would have a material adverse effect on its financial position, annual results of operations or cash flows. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) The company has recorded liabilities for known indemnifications included as part of environmental liabilities. See Item 1. Business - Environmental Matters for a discussion of these liabilities.

<s>[INST] Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions and divestitures are described below. On February 3, 2014, the company completed the acquisition of Life Technologies Corporation for a total purchase price of $15.30 billion, net of cash acquired, including the assumption of $2.28 billion of debt. The company issued debt and common stock in late 2013 and early 2014 to partially fund the acquisition discussed below under the caption “Liquidity and Capital Resources”. Life Technologies was integrated into the Life Sciences Solutions segment and provides innovative products and services to customers conducting scientific research and genetic analysis, as well as those in applied markets, such as forensics and food safety testing. Life Technologies’ revenues totaled $3.87 billion in 2013. On March 21, 2014, the company sold its legacy sera and media, gene modulation and magnetic beads businesses to GE Healthcare for $1.06 billion, net of cash divested. The sale of these businesses resulted in a pretax gain of approximately $761 million included in restructuring and other costs (income), net. The businesses fell principally in the Life Sciences Solutions segment. Divestiture of these businesses was a condition to obtaining antitrust approval for the Life Technologies acquisition. Revenues and operating income of the businesses sold were approximately $250 million and $64 million, respectively, for the year ended December 31, 2013 and $61 million and $12 million, respectively, in 2014 through the date of sale. On August 15, 2014, the company sold its ColeParmer specialty channel business, part of the Laboratory Products and Services segment, for $480 million in cash, net of cash divested. The sale of this business resulted in a pretax gain of approximately $134 million, included in restructuring and other costs (income), net. Revenues and operating income of the business sold were approximately $232 million and $43 million, respectively, for the year ended December 31, 2013 and $149 million and $28 million, respectively, in 2014 through the date of sale. In February 2015, the company acquired, within the Life Sciences Solutions segment, Advanced Scientifics, Inc., a North Americabased global provider of singleuse systems and process equipment for bioprocess production, for approximately $289 million. The acquisition expanded the company’s bioprocessing offerings. Revenues of Advanced Scientifics were approximately $80 million in 2014. On September 30, 2015, the company acquired, within the Laboratory Products and Services segment, Alfa Aesar, a U.K.based global manufacturer of research chemicals from Johnson Matthey Plc, for £257 million ($393 million) in cash. The acquisition expanded the company’s existing portfolio of chemicals, solvents and reagents. Revenues of Alfa Aesar were approximately £78 million in 2014. On March 31, 2016, the company acquired, within the Life Sciences Solutions segment, Affymetrix, Inc., a North Americabased provider of cellular and genetic analysis products, for a total purchase price of $1.34 billion, net of cash acquired, including the assumption of $254 million of debt. The acquisition expanded the company's existing portfolio of antibodies and [/INST] Negative. </s>

THERMO FISHER SCIENTIFIC INC.

2018-02-28

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions are described below. In February 2015, the company acquired, within the Life Sciences Solutions segment, Advanced Scientifics, Inc., a North America-based global provider of single-use systems and process equipment for bioprocess production, for approximately $289 million. The acquisition expanded the company’s bioprocessing offerings. Revenues of Advanced Scientifics were approximately $80 million in 2014. On September 30, 2015, the company acquired, within the Laboratory Products and Services segment, Alfa Aesar, a U.K.-based global manufacturer of research chemicals from Johnson Matthey Plc, for £257 million ($393 million) in cash. The acquisition expanded the company’s existing portfolio of chemicals, solvents and reagents. Revenues of Alfa Aesar were approximately £78 million in 2014. On March 31, 2016, the company acquired, primarily within the Life Sciences Solutions segment, Affymetrix, Inc., a North America-based provider of cellular and genetic analysis products, for a total purchase price of $1.34 billion, net of cash acquired, including the assumption of $254 million of debt. The acquisition expanded the company's existing portfolio of antibodies and assays for flow cytometry and single-cell biology applications. Additionally, the acquisition expanded the company's genetic analysis portfolio through the addition of microarrays. Revenues of Affymetrix were $360 million in 2015. On September 19, 2016, the company acquired, within the Analytical Instruments segment, FEI Company, a North America-based provider of high-performance electron microscopy, for a total purchase price of $4.08 billion, net of cash acquired. The acquisition strengthened the company's analytical instrument portfolio with the addition of high-end electron microscopes. Revenues of FEI were $930 million in 2015. On February 14, 2017, the company acquired, within the Life Sciences Solutions segment, Finesse Solutions, Inc., a North America-based developer of scalable control automation systems and software for bioproduction, for a total purchase price of $221 million, net of cash acquired. The acquisition expanded the company's bioproduction offerings. Revenues of Finesse Solutions were approximately $50 million in 2016. On March 2, 2017, the company acquired, within the Analytical Instruments segment, Core Informatics, a North America-based provider of cloud-based platforms supporting scientific data management, for a total purchase price of $94 million, net of cash acquired. The acquisition enhanced the company's existing informatics solutions. Revenues of Core Informatics were approximately $10 million in 2016. On August 29, 2017, the company acquired, within the Laboratory Products and Services segment, substantially all of the issued and outstanding shares of Patheon N.V., a leading global provider of high-quality drug development and delivery solutions to the pharmaceutical and biopharma sectors, for $35.00 per share in cash, or $7.36 billion, including the assumption of net debt. The company financed the purchase price, including the repayment of indebtedness of Patheon, with issuances of debt and equity. Patheon provides comprehensive, integrated and highly customizable solutions as well as the expertise to help biopharmaceutical companies of all sizes satisfy complex development and manufacturing needs. The acquisition provided entry into the pharmaceutical contract development and manufacturing organization market and added a complementary service to the company's existing pharmaceutical services portfolio. Patheon's revenues totaled $1.87 billion for the year ended October 31, 2016. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity Sales in 2017 were $20.92 billion, an increase of $2.64 billion from 2016. Sales increased $1.63 billion due to acquisitions. The favorable effects of currency translation resulted in an increase in revenues of $70 million in 2017. Aside from the effects of acquisitions and currency translation, revenues increased $949 million (5%) primarily due to increased demand. Sales to customers in each of the company's primary end markets grew. Sales growth was moderate in North America and Europe and particularly strong in Asia. In 2017, total company operating income and operating income margin were $2.97 billion and 14.2%, respectively, compared with $2.45 billion and 13.4%, respectively, in 2016. The increase in operating income was primarily due to profit on higher sales in local currencies, the effects of acquisitions and productivity improvements, net of inflationary cost increases, offset in part by an increase in amortization of acquisition-related intangible assets, due to recent acquisitions, and strategic growth investments. The company’s references to strategic growth investments generally refer to targeted spending for enhancing commercial capabilities, including expansion of geographic sales reach and e-commerce platforms, marketing initiatives, focused research projects and other expenditures to enhance the customer experience. The company’s references throughout this discussion to productivity improvements generally refer to improved cost efficiencies from its Practical Process Improvement (PPI) business system, reduced costs resulting from global sourcing initiatives, a lower cost structure following restructuring actions, including headcount reductions and consolidation of facilities, and low cost region manufacturing. The increase in our effective tax rate in 2017 was principally due to a net provision of $204 million from the effects of the Tax Cuts and Jobs Act of 2017 (the Tax Act), consisting primarily of a one-time transition tax on deemed repatriated earnings and profits of foreign subsidiaries, net of a benefit from adjusting the deferred tax balances for the U.S. statutory tax rate reduction. Although the net $204 million charge represents what the company believes is a reasonable estimate of the impact of the Tax Act, the components of the net charge are provisional and may change as discussed in Note 7. In 2017, the company refinanced certain long term inter-company debt which resulted in an income tax benefit of $237 million related to a foreign exchange loss recognized for income tax purposes. In addition, in 2017 the company recorded a $65 million favorable adjustment to deferred tax balances due to extension of a tax holiday agreement in Singapore and $65 million of benefit associated with new required accounting for tax benefits from equity awards, as discussed in Note 1. The company continued to implement tax planning initiatives related to non-U.S. subsidiaries in 2017. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $86 million, offset in part by additional U.S. income taxes of $53 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2017) for a net benefit of $33 million. The foreign tax credits are the result of foreign earnings and profits remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company intends to make similar types of distributions from non-U.S. subsidiaries when they can be made at no net tax cost. The ability of the company to make distributions in future periods of similar type and magnitude will depend on the level of earnings and cash flow in various foreign jurisdictions and on the applicable tax laws in effect at that time. Accordingly, the impact of foreign tax credits on the company’s effective tax rate in future periods is likely to vary. The company also implemented foreign tax credit planning in Sweden which resulted in $20 million of foreign tax credits, with no related incremental U.S. income tax expense. The company recorded a benefit from income taxes in 2016. In 2016, the company continued to implement tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $91 million, offset in part by additional U.S. taxes of $37 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2016) for a net benefit of $54 million. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) The company also implemented foreign tax credit planning in Sweden which resulted in $100 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits in 2016 totaling $39 million related to prior year tax filings and net charges of $12 million related to tax audits. The effective tax rate in both 2017 and 2016 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $479 million and $663 million in 2017 and 2016, respectively. The company expects its effective tax rate in 2018 will be between 6% and 9% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The effective tax rate can vary significantly from period to period as a result of discrete income tax factors and events. Income from continuing operations increased to $2.23 billion in 2017, from $2.03 billion in 2016. The increase in operating income in 2017 (discussed above) was offset in part by an increase in interest expense of $123 million primarily due to increases in outstanding debt to fund acquisitions and the increase in the tax provision in 2017 (discussed above). During 2017, the company’s cash flow from operations totaled $4.01 billion compared with $3.26 billion for 2016. The increase primarily resulted from higher income before amortization and depreciation in the 2017 period and lower investment in working capital in 2017. As of December 31, 2017, the company’s short-term debt totaled $2.14 billion, including $0.96 billion of commercial paper obligations and $1.17 billion of senior notes due within the next twelve months. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2017, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $77 million as a result of outstanding letters of credit. The company believes that its existing cash and cash equivalents of $1.34 billion as of December 31, 2017 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Critical Accounting Policies and Estimates The company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent liabilities. On an on-going basis, management evaluates its estimates, including those related to bad debts, inventories, business combinations, intangible assets and goodwill, sales returns, income taxes, contingencies and litigation, and pension costs. Management believes the most complex and sensitive judgments, because of their significance to the consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Management bases its estimates on historical experience, current market and economic conditions and other assumptions that management believes are reasonable. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities where the values are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The company believes the following represent its critical accounting policies and estimates used in the preparation of its financial statements: (a) Intangible Assets and Goodwill The company uses assumptions and estimates in determining the fair value of assets acquired and liabilities assumed in a business combination. The determination of the fair value of intangible assets, which represent a significant portion of the purchase price in many of the company’s acquisitions, requires the use of significant judgment with regard to (i) the fair value; and (ii) whether such intangibles are amortizable or non-amortizable and, if the former, the period and the method by which the intangible asset will be amortized. The company estimates the fair value of acquisition-related intangible assets principally based on projections of cash flows that will arise from identifiable intangible assets of acquired businesses. The projected cash flows are discounted to determine the present value of the assets at THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) the dates of acquisition. Definite-lived intangible assets totaled $15.41 billion at December 31, 2017. The company reviews definite-lived intangible assets for impairment when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Actual cash flows arising from a particular intangible asset could vary from projected cash flows which could imply different carrying values from those established at the dates of acquisition and which could result in impairment of such asset. The company evaluates goodwill and indefinite-lived intangible assets for impairment annually and when events occur or circumstances change that would more-likely-than-not reduce the fair value of the asset below its carrying amount. Events or circumstances that might require an interim evaluation include unexpected adverse business conditions, economic factors, unanticipated technological changes or competitive activities, loss of key personnel and acts by governments and courts. Goodwill and indefinite-lived intangible assets totaled $25.29 billion and $1.27 billion, respectively, at December 31, 2017. Estimates of future cash flows require assumptions related to revenue and operating income growth, asset-related expenditures, working capital levels and other factors. Different assumptions from those made in the company’s analysis could materially affect projected cash flows and the company’s evaluation of goodwill and indefinite-lived intangible assets for impairment. For reporting units where the company performed the quantitative goodwill impairment test, indications of fair value based on projections of profitability for 2018 and thereafter and on peer revenues and earnings trading multiples were sufficient to conclude that no impairment of goodwill or indefinite-lived intangible assets existed at the end of the tenth fiscal month of 2017, the date of the company’s impairment testing. There can be no assurance, however, that an economic downturn will not materially adversely affect peer trading multiples and the company’s businesses such that they do not achieve their forecasted profitability and these assets become impaired. Should the fair value of the company’s goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines, or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment may be necessary. With the completion of the Patheon acquisition in August 2017, the company established a new reporting unit which solely consists of the legacy Patheon business, the book carrying value of which equaled its fair value as of the acquisition date. During its annual 2017 goodwill impairment assessment, the company performed a qualitative assessment of this reporting unit and determined that no events had occurred and no circumstances had changed that would more-likely-than-not reduce the fair value of the reporting unit below its carrying amount. As a result, the company did not perform the quantitative goodwill impairment test for this reporting unit. Given that the fair value of the reporting unit was not substantially in excess of its carrying value as of the annual 2017 assessment date, relatively small decreases in future cash flows from anticipated results could result in impairment of goodwill. The key variables that will drive the cash flows of the reporting unit will be levels of profitability and terminal value growth rate assumptions, as well as the weighted average cost of capital rate applied. The business unit consisting of the legacy Patheon business had $3.25 billion of goodwill, and an overall carrying value of $7.33 billion as of December 31, 2017. (b) Income Taxes In the ordinary course of business there is inherent uncertainty in quantifying the company’s income tax positions. The company assesses income tax positions and records tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, the company has recorded the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. Should tax return positions that the company expects are sustainable not be sustained upon audit, the company could be required to record an incremental tax provision for such taxes. The company’s reserve for these matters totaled $1.41 billion at December 31, 2017. The company operates in numerous countries under many legal forms and, as a result, is subject to the jurisdiction of numerous domestic and non-U.S. tax authorities, as well as to tax agreements and treaties among these governments. Determination of taxable income in any jurisdiction requires the interpretation of the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions, permissible revenue recognition methods under the tax law and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, currency exchange restrictions or the company’s THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) level of operations or profitability in each taxing jurisdiction could have an impact upon the amount of current and deferred tax balances and hence the company’s net income. The company estimates the degree to which tax assets and loss carryforwards will result in a benefit, after consideration of all positive and negative evidence, and provides a valuation allowance for tax assets and loss carryforwards that it believes will more likely than not go unused. In situations in which the company has been able to conclude that its deferred tax assets will be realized, it has generally relied on future reversals of taxable temporary differences, expected future taxable income where such estimates have historically been reliable, and other factors. If it becomes more likely than not that a tax asset or loss carryforward will be used, the company reverses the related valuation allowance. Any such reversals are recorded as a reduction of the company’s tax provision. The company’s tax valuation allowance totaled $256 million at December 31, 2017. Should the company’s actual future taxable income by tax jurisdiction vary from estimates, additional allowances or reversals thereof may be necessary. The company has not provided state income or foreign withholding taxes on certain of its non-U.S. subsidiaries’ undistributed earnings, as such amounts are intended to be reinvested outside the United States indefinitely in the respective jurisdictions based on specific business plans and tax strategies. These business plans and tax strategies consider: short-term and long-term forecasts and budgets of the U.S. parent and non-U.S. subsidiaries; working capital and other needs in locations where earnings are generated; the company’s past practices regarding non-U.S. subsidiary dividends; sources of financing by the U.S. parent, such as issuing debt or equity; and uses of cash by the U.S. parent that are more discretionary in nature, such as business combinations and share repurchase programs. However, should the company change its business plans and tax strategies in the future and decide to repatriate a portion of these earnings to one of its U.S. subsidiaries, including cash maintained by these non-U.S. subsidiaries, the company would recognize additional U.S. tax liabilities. It is not practicable to estimate the amount of additional state and foreign withholding tax liabilities that the company would incur. (c) Contingencies and Litigation The company records accruals for various contingencies, including legal proceedings, environmental, workers’ compensation, product, general and auto liabilities, and other claims that arise in the normal course of business. The accruals are based on management’s judgment, historical claims experience, the probability of losses and, where applicable, the consideration of opinions of internal and or external legal counsel and actuarial estimates. Accruals of acquired businesses, including product liability and environmental accruals, were initially recorded at fair value and discounted to their net present value. Additionally, the company records receivables from third-party insurers when recovery has been determined to be probable. (d) Pension and Other Retiree Benefits Several of the company’s U.S. and non-U.S. subsidiaries sponsor defined benefit pension and other retiree benefit plans. The cost and obligations of these arrangements are calculated using many assumptions to estimate the benefits that the employee earns while working, the amount of which cannot be completely determined until the benefit payments cease. Major assumptions used in the accounting for these employee benefit plans include the discount rate, expected return on plan assets and rate of increase in employee compensation levels. Assumptions are determined based on company data and appropriate market indicators in consultation with third-party actuaries, and are evaluated each year as of the plans’ measurement date. Net periodic pension costs for the company’s pension and other postretirement benefit plans totaled $25 million in 2017. The company’s unfunded benefit obligation totaled $486 million at year-end 2017 compared with $610 million at year-end 2016. Should any of these assumptions change, they would have an effect on net periodic pension costs and the unfunded benefit obligation. For example, a 10% decrease in the discount rate would result in an annual increase in pension and other postretirement benefit expense of approximately $2 million and an increase in the benefit obligation of approximately $95 million. As of December 31, 2017, the company expects to contribute between $35 and $65 million to its existing defined benefit pension plans in 2018. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations 2017 Compared With 2016 Sales in 2017 were $20.92 billion, an increase of $2.64 billion from 2016. Sales increased $1.63 billion due to acquisitions. The favorable effects of currency translation resulted in an increase in revenues of $70 million in 2017. Aside from the effects of acquisitions and currency translation, revenues increased $949 million (5%) primarily due to increased demand. Sales to customers in each of the company's primary end markets grew. Sales growth was moderate in North America and Europe and particularly strong in Asia. In 2017, total company operating income and operating income margin were $2.97 billion and 14.2%, respectively, compared with $2.45 billion and 13.4%, respectively, in 2016. The increase in operating income was primarily due to profit on higher sales in local currencies, the effects of acquisitions and productivity improvements, net of inflationary cost increases, offset in part by an increase in amortization of acquisition-related intangible assets, due to recent acquisitions, and strategic growth investments. In 2017, the company recorded restructuring and other costs, net, of $298 million, including $123 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition, and, to a lesser extent, to conform the accounting policies of Patheon to the company's accounting policies. The company recorded $78 million of charges to selling, general and administrative expenses, primarily for third-party transaction and integration costs associated with recent acquisitions and changes in estimates of acquisition contingent consideration. In addition, the company recorded $97 million of cash restructuring costs, primarily to achieve acquisition synergies, including severance and abandoned facilities costs associated with the closure and consolidation of facilities in the U.S and Europe. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S., Europe and Asia. The company also recorded $27 million of net credits for litigation-related matters, which were mostly offset by compensation due at Patheon on the date of the acquisition, hurricane response/impairment costs, and net charges for the settlement/curtailment of retirement plans (see Note 14). In 2016, the company recorded restructuring and other costs, net, of $395 million, including $102 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and to conform the accounting policies of FEI and Affymetrix to the company's accounting policies; $104 million of charges to selling, general and administrative expenses primarily for third-party transaction and integration costs related to the acquisitions of FEI and Affymetrix. In addition, the company recorded $164 million of cash restructuring costs, primarily to achieve acquisition synergies, including severance and abandoned facilities costs associated with the closure and consolidation of facilities in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S., Europe and Asia. The company also recorded charges for litigation and environmental remediation matters. These costs were partially offset by gains on the sales of real estate. As of February 28, 2018, the company has identified restructuring actions that will result in additional charges of approximately $105 million, primarily in 2018, and expects to identify additional actions during 2018 which will be recorded when specified criteria are met, such as communication of benefit arrangements and abandonment of leased facilities. Approximately 35% of the additional charges will be incurred in the Life Sciences Solutions segment, 25% in the Analytical THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Instruments segment, 30% in the Laboratory Products and Services segment, and 10% in the Specialty Diagnostics segment. The restructuring projects for which charges were incurred in 2017 are expected to result in annual cost savings of approximately $90 million beginning in part in 2017 and, to a greater extent, in 2018, including $50 million in the Life Sciences Solutions segment, $20 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $10 million in the Laboratory Products and Services segment. The restructuring actions for which charges were incurred in 2016 resulted in annual cost savings of approximately $100 million beginning in part in 2016 and to a greater extent in 2017, including $60 million in the Life Sciences Solutions segment, $25 million in the Analytical Instruments segment, $5 million in the Specialty Diagnostics segment and $10 million in the Laboratory Products and Services segment. Segment Results The company’s management evaluates segment operating performance using operating income before certain charges/credits to cost of revenues and selling, general and administrative expenses, principally associated with acquisition-related activities; restructuring and other costs/income including costs arising from facility consolidations such as severance and abandoned lease expense and gains and losses from the sale of real estate and product lines; and amortization of acquisition-related intangible assets. The company uses this measure because it helps management understand and evaluate the segments’ core operating results and facilitate comparison of performance for determining compensation (Note 3). Accordingly, the following segment data is reported on this basis. Income from the company’s reportable segments increased 15% to $4.86 billion in 2017 due primarily to profit on higher sales in local currencies, the effects of acquisitions and productivity improvements, net of inflationary cost increases, offset in part by strategic growth investments. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $411 million to $5.73 billion in 2017. Sales increased $300 million (6%) due to higher revenues at existing businesses, $99 million due to acquisitions and $12 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for biosciences products and, to a lesser extent, bioprocess production products as well as genetic sciences products. Operating income margin was 33.1% in 2017 compared to 30.0% in 2016. The increase in operating margin resulted primarily from productivity improvements, net of inflationary cost increases, and, to a lesser extent, profit on higher sales in local currencies and price increases. These increases were offset in part by strategic growth investments and acquisition dilution. Analytical Instruments Sales in the Analytical Instruments segment increased $1.15 billion to $4.82 billion in 2017. Sales increased $794 million due to acquisitions, $330 million (9%) due to higher revenues at existing businesses and $29 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand in each of the segment's primary businesses particularly products sold by the segment's chromatography and mass spectrometry business and materials and structural analysis business. Operating income margin was 21.3% in 2017 compared to 20.3% in 2016. The increase resulted primarily from profit on higher sales in local currencies, productivity improvements, net of inflationary cost increases and, to a lesser extent, the effect of acquisitions, offset in part by strategic growth investments and, to a lesser extent, unfavorable foreign currency exchange and unfavorable sales mix. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $147 million to $3.49 billion in 2017. Sales increased $126 million (4%) due to higher revenues at existing businesses, $12 million due to the favorable effects of currency translation and $9 million due to acquisitions. The increase in revenue at existing businesses was primarily due to higher demand for products sold through the segment's healthcare market channel as well as clinical diagnostics products and immunodiagnostics products. Operating income margin was 26.7% in 2017 and 27.2% in 2016. The decrease resulted primarily from strategic growth investments and, to a lesser extent, unfavorable sales mix, offset in part by profit on higher sales in local currencies and productivity improvements, net of inflationary cost increases. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $1.10 billion to $7.83 billion in 2017. Sales increased $727 million due to acquisitions, $361 million (5%) due to higher revenues at existing businesses and $13 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products sold through the segment's channel business and, to a lesser extent, laboratory equipment and consumables. Operating income margin was 12.9% in 2017 compared to 14.4% in 2016. The decrease was primarily due to unfavorable sales mix and strategic growth investments offset in part by profit on higher sales in local currencies and, to a lesser extent, the effect of acquisitions. Other Expense, Net The company reported other expense, net, of $539 million and $425 million in 2017 and 2016, respectively (Note 4). Interest expense increased $123 million primarily due to an increase in outstanding debt. Provision for Income Taxes The increase in our effective tax rate in 2017 was principally due to a net provision of $204 million from the effects of the Tax Cuts and Jobs Act of 2017, consisting primarily of a one-time transition tax on deemed repatriated earnings and profits of foreign subsidiaries, net of a benefit from adjusting the deferred tax balances for the U.S. statutory tax rate reduction. Although the net $204 million charge represents what the company believes is a reasonable estimate of the impact of the Tax Act, the components of the net charge are provisional and may change as discussed in Note 7. In 2017, the company refinanced certain long term inter-company debt which resulted in an income tax benefit of $237 million related to a foreign exchange loss recognized for income tax purposes. In addition, in 2017 the company recorded a $65 million favorable adjustment to deferred tax balances due to extension of a tax holiday agreement in Singapore and $65 million of benefit associated with new required accounting for tax benefits from equity awards, as discussed in Note 1. The company continued to implement tax planning initiatives related to non-U.S. subsidiaries in 2017. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $86 million, offset in part by additional U.S. income taxes of $53 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2017) for a net benefit of $33 million. The foreign tax credits are the result of foreign earnings and profits remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company intends to make similar types of distributions from non-U.S. subsidiaries when they can be made at no net tax cost. The ability of the company to make distributions in future periods of similar type and magnitude will depend on the level of earnings and cash flow in various foreign jurisdictions and on the applicable tax laws in effect at that time. Accordingly, the impact of foreign tax credits on the company’s effective tax rate in future periods is likely to vary. The company also implemented foreign tax credit planning in Sweden which resulted in $20 million of foreign tax credits, with no related incremental U.S. income tax expense. The company recorded a benefit from income taxes in 2016. In 2016, the company continued to implement tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $91 million, offset in part by additional U.S. taxes of $37 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2016) for a net benefit of $54 million. The company also implemented foreign tax credit planning in Sweden which resulted in $100 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits in 2016 totaling $39 million related to prior year tax filings and net charges of $12 million related to tax audits. The effective tax rate in both 2017 and 2016 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) income taxes were higher than its income tax expense for financial reporting purposes and totaled $479 million and $663 million in 2017 and 2016, respectively. The company expects its effective tax rate in 2018 will be between 6% and 9% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The effective tax rate can vary significantly from period to period as a result of discrete income tax factors and events. The company has operations and a taxable presence in approximately 50 countries outside the U.S. Some of these countries have lower tax rates than the U.S. The company’s ability to obtain a benefit from lower tax rates outside the U.S. is dependent on its relative levels of income in countries outside the U.S. and on the statutory tax rates in those countries. Based on the dispersion of the company’s non-U.S. income tax provision among many countries, the company believes that a change in the statutory tax rate in any individual country is not likely to materially affect the company’s income tax provision or net income, aside from any resulting one-time adjustment to the company’s deferred tax balances to reflect a new rate. Recent Accounting Pronouncements A description of recently issued accounting standards is included under the heading "Recent Accounting Pronouncements" in Note 1. Contingent Liabilities The company is contingently liable with respect to certain legal proceedings and related matters. An unfavorable outcome that differs materially from current accrual estimates, if any, for one or more of the matters described under the headings "Product Liability, Workers Compensation and Other Personal Injury Matters," "Intellectual Property Matters" and "Commercial Matters" in Note 10 could have a material adverse effect on the company’s financial position as well as its results of operations and cash flows. 2016 Compared With 2015 Sales in 2016 were $18.27 billion, an increase of $1.31 billion from 2015. The unfavorable effects of currency translation resulted in a decrease in revenues of $145 million in 2016. Sales increased $733 million due to acquisitions. Aside from the effects of currency translation and acquisitions, revenues increased $721 million (4%) primarily due to increased demand. Sales to customers in the company’s primary end markets grew. Demand from customers in pharmaceutical and biotech industries was particularly strong. Sales growth was strong in Asia, moderate in Europe and modest in North America. In 2016, total company operating income and operating income margin were $2.45 billion and 13.4%, respectively, compared with $2.34 billion and 13.8%, respectively, in 2015. The increase in operating income was primarily due to profit on higher sales in local currencies, productivity improvements, net of inflationary cost increases, and, to a lesser extent, acquisitions. These increases were offset in part by higher restructuring and acquisition-related charges in the 2016 period, strategic growth investments and unfavorable sales mix. In 2016, the company recorded restructuring and other costs, net, of $395 million, including $102 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and to conform the accounting policies of FEI and Affymetrix to the company's accounting policies; $104 million of charges to selling, general and administrative expenses primarily for third-party transaction and integration costs related to the acquisitions of FEI and Affymetrix. In addition, the company recorded $164 million of cash restructuring costs, primarily to achieve acquisition synergies, including severance and THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) abandoned facilities costs associated with the closure and consolidation of facilities in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S., Europe and Asia (see Note 14). The company also recorded charges for litigation and environmental remediation matters. These costs were partially offset by gains on the sales of real estate. In 2015, the company recorded restructuring and other costs, net, of $171 million, including $9 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and, to a lesser extent, accelerated depreciation at facilities closing due to real estate consolidation; $46 million of charges to selling, general and administrative expenses primarily for charges associated with product liability litigation, third-party transaction and integration costs primarily related to the acquisitions of Life Technologies and Alfa Aesar, and accelerated depreciation at facilities closing due to real estate consolidation. In addition, the company recorded $82 million of cash restructuring costs primarily for actions to achieve synergies from the Life Technologies acquisition and for abandoned facilities costs associated with a manufacturing facility in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated, including the consolidation of operations within several facilities in the U.S., Europe and Asia. The company also recorded charges for litigation-related matters associated with acquired businesses and impairment of acquired technology in development. These costs were partially offset by gains on the sale of a small product line and real estate. The restructuring actions for which charges were incurred in 2015 resulted in annual cost savings of approximately $100 million beginning in part in 2015 and to a greater extent in 2016, including $50 million in the Life Sciences Solutions segment, $25 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $15 million in the Laboratory Products and Services segment. Segment Results THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Income from the company’s reportable segments increased 10% to $4.22 billion in 2016 due primarily to profit on higher sales in local currencies and productivity improvements, net of inflationary cost increases. These increases were offset in part by strategic growth investments and unfavorable sales mix. Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $543 million to $5.32 billion in 2016. Sales increased $326 million (7%) due to higher revenues at existing businesses and $255 million due to acquisitions, offset in part by a decrease of $38 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for biosciences products and bioprocess production products and, to a lesser extent, next generation sequencing products. Operating income margin was 30.0% in 2016 compared to 29.6% in 2015. The increase in operating margin resulted from productivity improvements, net of inflationary cost increases, profit on higher sales in local currencies and, to a lesser extent, price increases. These increases were offset in part by unfavorable sales mix, acquisition dilution and strategic growth investments. Analytical Instruments Sales in the Analytical Instruments segment increased $460 million to $3.67 billion in 2016. Sales increased $387 million due to acquisitions and $100 million (3%) due to higher revenues at existing businesses, offset in part by a decrease of $27 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products sold by the segment's chromatography and mass spectrometry business and, to a lesser extent, sales of environmental instruments. These increases were offset in part by lower sales of chemical analysis products due primarily to softness in certain industrial end markets. Operating income margin was 20.3% in 2016 compared to 19.1% in 2015. The increase resulted primarily from productivity improvements, net of inflationary cost increases, profit on higher sales in local currencies and, to a lesser extent, favorable foreign currency exchange. These increases were offset in part by unfavorable sales mix and strategic growth investments. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $95 million to $3.34 billion in 2016. Sales increased $115 million (4%) due to higher revenues at existing businesses, offset in part by a decrease of $20 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products in each of the segment's principal businesses with particular strength in the segment’s healthcare market channel and sales of immunodiagnostics products and clinical diagnostics products. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Operating income margin was 27.2% in 2016 and 26.9% in 2015. The increase resulted primarily from productivity improvements, net of inflationary cost increases, and profit on higher sales in local currencies, offset in part by strategic growth investments. Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $352 million to $6.72 billion in 2016. Sales increased $331 million (5%) due to higher revenues at existing businesses and $96 million due to an acquisition. These increases were offset in part by $75 million due to the unfavorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products in each of the segment’s principal businesses. Operating income margin was 14.4% in 2016 compared to 14.5% in 2015. Decreases due to strategic growth investments and unfavorable sales mix were offset in part by productivity improvements, net of inflationary cost increases, and profit on higher sales in local currencies. Other Expense, Net The company reported other expense, net, of $425 million and $400 million in 2016 and 2015, respectively (Note 4). Interest expense increased $55 million primarily due to an increase in outstanding debt. In 2016, other items, net includes $22 million of charges related to the amortization of fees paid to obtain bridge financing commitments for the acquisition of FEI and $9 million of losses on the early extinguishment of debt, offset in part by $12.5 million of gains on investments. In 2015, other items, net includes losses of $12 million on the early extinguishment of debt and costs of $7.5 million associated with entering into interest rate swap arrangements. Provision for Income Taxes The company recorded a benefit from income taxes in 2016. In 2016, the company continued to implement tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $91 million, offset in part by additional U.S. taxes of $37 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2016) for a net benefit of $54 million. The company also implemented foreign tax credit planning in Sweden which resulted in $100 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits in 2016 totaling $39 million related to prior year tax filings and net charges of $12 million related to tax audits. The company recorded a benefit from income taxes in 2015. In 2015, the company implemented tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $111 million, offset in part by additional U.S. taxes of $46 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2015) for a net benefit of $66 million. The foreign tax credits are the result of foreign earnings and profits remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company also implemented foreign tax credit planning in Sweden which resulted in $80 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits totaling $54 million related to additional prior year foreign tax and other credits as well as restructuring and other costs associated with the 2014 acquisition of Life Technologies. The tax provision in the 2015 period was favorably affected by $37 million as a result of adjustments to deferred tax balances due to changes in tax rates. The effective tax rate in both 2016 and 2015 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $663 million and $477 million in 2016 and 2015, respectively. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Consolidated working capital was $2.37 billion at December 31, 2017, compared with $2.16 billion at December 31, 2016. Included in working capital were cash and cash equivalents of $1.34 billion at December 31, 2017 and $786 million at December 31, 2016. Cash provided by operating activities was $4.01 billion during 2017. An increase in other liabilities provided cash of $1.02 billion primarily due to the Tax Act's one-time transition tax on deemed repatriated earnings and profits of foreign subsidiaries. Given the availability of foreign tax credits, the company does not expect the transition tax to result in significant cash requirements. An increase in accounts payable provided cash of $274 million due to the timing of payments. Increases in accounts receivable and inventories used cash of $362 million and $81 million, respectively, primarily to support growth in sales in local currencies. An increase in other assets used cash of $153 million primarily due to the timing of income tax refunds. Cash payments for income taxes decreased to $479 million during 2017, compared with $663 million in 2016. The company made cash contributions to its pension and postretirement benefit plans totaling $200 million during 2017. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $93 million during 2017. During 2017, the company’s investing activities used $7.73 billion of cash. Acquisitions used cash of $7.23 billion. The company’s investing activities also included the purchase of $508 million of property, plant and equipment. The company’s financing activities provided $3.85 billion of cash during 2017. Issuance of senior notes and borrowings under a term loan provided cash of $6.46 billion. The company also issued 10 million shares of its common stock for net proceeds of $1.69 billion. Repayment of senior notes and term loans used cash of $3.30 billion and a net decrease in commercial paper obligations used cash of $134 million. The company’s financing activities also included the repurchase of $750 million of the company’s common stock and the payment of $237 million in cash dividends, offset in part by $128 million of net proceeds from employee stock option exercises. On July 7, 2016, the Board of Directors authorized the repurchase of up to $1.50 billion of the company’s common stock. At February 28, 2018, $500 million was available for future repurchases of the company’s common stock under this authorization. In January 2018, the company issued additional commercial paper obligations and used the proceeds and cash on hand to repay the $450 million principal balance of the 2.15% Senior Notes due 2018. As of December 31, 2017, the company’s short-term debt totaled $2.14 billion, including $960 million of commercial paper obligations and $1.17 billion of senior notes due within the next twelve months. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2017, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $77 million as a result of outstanding letters of credit. Approximately half of the company’s cash balances and cash flows from operations are from outside the U.S. A portion of these foreign cash balances are associated with earnings that are permanently reinvested and which the company plans to use to support continued growth plans outside of the U.S. through funding operations and other investment and growth opportunities. The majority of these funds are only available for use by the company's U.S. operations if they are repatriated into the U.S. The funds repatriated would be subject to additional state and foreign withholding taxes upon repatriation; however, it is not practicable to estimate the amount of additional tax liabilities that would be incurred. The company currently has no plans to repatriate these funds held by its non-U.S. subsidiaries. The company believes that its existing cash and cash equivalents of $1.34 billion as of December 31, 2017 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Cash provided by operating activities was $3.26 billion during 2016. An increase in accounts receivable used cash of $352 million primarily to support growth in sales in local currencies and due to the mid-month timing of the acquisition of FEI when receivables are commonly lower than at quarter-end. Inventories provided cash of $98 million due to a reduction associated with fourth quarter 2016 sales. An increase in other assets used cash of $153 million primarily due to the timing of payments. An increase in other liabilities provided cash of $216 million primarily due to the timing of payments for income taxes and THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) incentive compensation. Cash payments for income taxes increased to $663 million during 2016, compared with $477 million in 2015. The company made cash contributions to its pension and postretirement benefit plans totaling $43 million during 2016. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $122 million during 2016. During 2016, the company’s investing activities used $5.52 billion of cash. Acquisitions used cash of $5.18 billion. The company’s investing activities also included the purchase of $444 million of property, plant and equipment. The company’s financing activities provided $2.76 billion of cash during 2016. Issuance of senior notes and borrowings under term loans provided cash of $7.60 billion and an increase in commercial paper obligations provided cash of $904 million. Repayment of senior notes, the 364-day term loan and acquired debt used cash of $4.33 billion. The company’s financing activities also included the repurchase of $1.25 billion of the company’s common stock and the payment of $238 million in cash dividends, offset in part by $87 million of proceeds from employee stock option exercises. Cash provided by operating activities was $2.94 billion during 2015. Increases in accounts receivable and inventories used cash of $149 million and $141 million, respectively, primarily to support growth in sales in local currencies. An increase in other assets used cash of $254 million primarily related to the timing of tax payments/refunds. An increase in other liabilities provided cash of $200 million primarily due to the timing of payments for income taxes and incentive compensation. Cash payments for income taxes decreased to $477 million during 2015, compared with $586 million in 2014 that included taxes associated with gains on divestitures. The company made cash contributions to its pension and postretirement benefit plans totaling $38 million during 2015. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $97 million during 2015. During 2015, the company’s investing activities used $1.09 billion of cash. Acquisitions used cash of $695 million. The company’s investing activities also included the purchase of $423 million of property, plant and equipment. The company’s financing activities used $2.62 billion of cash during 2015. Repayments of long-term debt totaled $3.79 billion. Issuance of senior notes provided cash of $1.80 billion and an increase in commercial paper obligations provided cash of $50 million. The company’s financing activities also included the repurchase of $500 million of the company’s common stock and the payment of $241 million in cash dividends, offset in part by $72 million of proceeds from employee stock option exercises. Off-Balance Sheet Arrangements The company did not use special purpose entities or other off-balance-sheet financing arrangements in 2015, 2016 or 2017, except for letters of credit, bank guarantees, residual value guarantees under three lease agreements, surety bonds and other guarantees disclosed in the table or discussed below. The amounts disclosed in the table below for letters of credit, bank guarantees, surety bonds and other guarantees relate to guarantees of the company’s performance, primarily in the ordinary course of business. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) Contractual Obligations and Other Commercial Commitments The table below summarizes, by period due or expiration of commitment, the company’s contractual obligations and other commercial commitments as of December 31, 2017. (a) Amounts represent the expected cash payments for debt and do not include any deferred issuance costs. (b) Unconditional purchase obligations include agreements to purchase goods, services or fixed assets that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable at any time without penalty. (c) Obligation represents funding commitments pursuant to investments held by the company. Reserves for unrecognized tax benefits of $1.41 billion have not been included in the above table due to the inability to predict the timing of tax audit resolutions. The company has no material commitments for purchases of property, plant and equipment, other than those included in the above table, but expects that for 2018, such expenditures will be between $700 and $730 million. Guarantees of residual value under lease arrangements for three facilities have not been included in the above table due to the inability to predict if and when the guarantees may require payment (see Note 10). The residual value guarantees become operative at the end of the leases for up to a maximum of $155 million. The initial terms of these leases end in 2019, 2020 and 2022, although renewal options exist for each. A guarantee of pension plan obligations of a divested business has not been included in the preceding table due to the inability to predict if and when the guarantee may require payment. The purchaser of the divested business has agreed to pay for the pension benefits, however the company was required to guarantee payment of these pension benefits should the purchaser fail to do so. The amount of the guarantee at December 31, 2017 was $43 million. In disposing of assets or businesses, the company often provides representations, warranties and/or indemnities to cover various risks including, for example, unknown damage to the assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste facilities, and unidentified tax liabilities and related legal fees. The company does not have the ability to estimate the potential liability from such indemnities because they relate to unknown conditions. However, the company has no reason to believe that these uncertainties would have a material adverse effect on its financial position, annual results of operations or cash flows. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) The company has recorded liabilities for known indemnifications included as part of environmental liabilities. See Item 1. Business - Environmental Matters for a discussion of these liabilities.

<s>[INST] Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 3): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestitures The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions are described below. In February 2015, the company acquired, within the Life Sciences Solutions segment, Advanced Scientifics, Inc., a North Americabased global provider of singleuse systems and process equipment for bioprocess production, for approximately $289 million. The acquisition expanded the company’s bioprocessing offerings. Revenues of Advanced Scientifics were approximately $80 million in 2014. On September 30, 2015, the company acquired, within the Laboratory Products and Services segment, Alfa Aesar, a U.K.based global manufacturer of research chemicals from Johnson Matthey Plc, for £257 million ($393 million) in cash. The acquisition expanded the company’s existing portfolio of chemicals, solvents and reagents. Revenues of Alfa Aesar were approximately £78 million in 2014. On March 31, 2016, the company acquired, primarily within the Life Sciences Solutions segment, Affymetrix, Inc., a North Americabased provider of cellular and genetic analysis products, for a total purchase price of $1.34 billion, net of cash acquired, including the assumption of $254 million of debt. The acquisition expanded the company's existing portfolio of antibodies and assays for flow cytometry and singlecell biology applications. Additionally, the acquisition expanded the company's genetic analysis portfolio through the addition of microarrays. Revenues of Affymetrix were $360 million in 2015. On September 19, 2016, the company acquired, within the Analytical Instruments segment, FEI Company, a North Americabased provider of highperformance electron microscopy, for a total purchase price of $4.08 billion, net of cash acquired. The acquisition strengthened the company's analytical instrument portfolio with the addition of highend electron microscopes. Revenues of FEI were $930 million in 2015. On February 14, 2017, the company acquired, within the Life Sciences Solutions segment, Finesse Solutions, Inc., a North Americabased developer of scalable control automation systems and software for bioproduction, for a total purchase price of $221 million, net of cash acquired. The acquisition expanded the company's bioproduction offerings. Revenues of Finesse Solutions were approximately $50 million in 2016. On March 2, 2017, the company acquired, within the Analytical Instruments segment, Core Informatics, a North Americabased provider of cloudbased platforms supporting scientific data management, for a total purchase price of $94 million, net of cash acquired. The acquisition enhanced the company's existing informatics solutions. Revenues of Core Informatics were approximately $10 million in 2016. On August 29, 2017, the company acquired, within the Laboratory Products and Services segment, substantially all of the issued and outstanding shares of Patheon N.V., a leading global provider of highquality drug development and delivery solutions to the pharmaceutical and biopharma sectors, for $35.00 per share in cash, or $7.36 billion, including the assumption of net debt. The company financed the purchase price, including the repayment of indebtedness of Patheon, with issuances of debt and equity. [/INST] Negative. </s>

THERMO FISHER SCIENTIFIC INC.

2019-02-27

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 4): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions are described below. On March 31, 2016, the company acquired, primarily within the Life Sciences Solutions segment, Affymetrix, Inc., a North America-based provider of cellular and genetic analysis products, for a total purchase price of $1.34 billion, net of cash acquired, including the assumption of $254 million of debt. The acquisition expanded the company's existing portfolio of antibodies and assays for flow cytometry and single-cell biology applications. Additionally, the acquisition expanded the company's genetic analysis portfolio through the addition of microarrays. Revenues of Affymetrix were $360 million in 2015. On September 19, 2016, the company acquired, within the Analytical Instruments segment, FEI Company, a North America-based provider of high-performance electron microscopy, for a total purchase price of $4.08 billion, net of cash acquired. The acquisition strengthened the company's analytical instrument portfolio with the addition of high-end electron microscopes. Revenues of FEI were $930 million in 2015. On February 14, 2017, the company acquired, within the Life Sciences Solutions segment, Finesse Solutions, Inc., a North America-based developer of scalable control automation systems and software for bioproduction, for a total purchase price of $221 million, net of cash acquired. The acquisition expanded the company's bioproduction offerings. Revenues of Finesse Solutions were approximately $50 million in 2016. On March 2, 2017, the company acquired, within the Analytical Instruments segment, Core Informatics, a North America-based provider of cloud-based platforms supporting scientific data management, for a total purchase price of $94 million, net of cash acquired. The acquisition enhanced the company's existing informatics solutions. Revenues of Core Informatics were approximately $10 million in 2016. On August 29, 2017, the company acquired, within the Laboratory Products and Services segment, Patheon N.V., a leading global provider of high-quality drug development and delivery solutions to the pharmaceutical and biopharma sectors, for $35.00 per share in cash, or $7.36 billion, including the assumption of net debt. The company financed the purchase price, including the repayment of indebtedness of Patheon, with issuances of debt and equity. Patheon provides comprehensive, integrated and highly customizable solutions as well as the expertise to help biopharmaceutical companies of all sizes satisfy complex development and manufacturing needs. The acquisition provided entry into the pharmaceutical contract development and manufacturing organization market and added a complementary service to the company's existing pharmaceutical services portfolio. Patheon's revenues totaled $1.87 billion for the year ended October 31, 2016. On October 25, 2018, the company acquired, within the Life Sciences Solutions segment, Becton Dickinson and Company's Advanced Bioprocessing business for $477 million in cash. This North America-based business adds complementary cell culture products that expand the segment's bioproduction offerings to help customers increase yield during production of biologic drugs. Revenues of the Advanced Bioprocessing business were $100 million in 2017. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity Sales in 2018 were $24.36 billion, an increase of $3.44 billion from 2017. Sales increased $1.53 billion due to acquisitions. The favorable effects of currency translation resulted in an increase in revenues of $173 million in 2018. Aside from the effects of acquisitions and currency translation, revenues increased $1.74 billion (8%) primarily due to increased demand. Sales to customers in each of the company's primary end markets grew. Sales growth was strong in each of the company's primary geographic areas, particularly Asia. In 2018, total company operating income and operating income margin were $3.78 billion and 15.5%, respectively, compared with $2.96 billion and 14.2%, respectively, in 2017. The increase in operating income was primarily due to profit on higher sales and, to a lesser extent, the effects of acquisitions and productivity improvements, net of inflationary cost increases, offset in part by an increase in strategic growth investments, unfavorable sales mix and amortization of acquisition-related intangible assets, due to recent acquisitions. The company’s references to strategic growth investments generally refer to targeted spending for enhancing commercial capabilities, including expansion of geographic sales reach and e-commerce platforms, marketing initiatives, expanded service and operational infrastructure, focused research projects and other expenditures to enhance the customer experience. The company’s references throughout this discussion to productivity improvements generally refer to improved cost efficiencies from its Practical Process Improvement (PPI) business system, reduced costs resulting from global sourcing initiatives, a lower cost structure following restructuring actions, including headcount reductions and consolidation of facilities, and low cost region manufacturing. The company recorded a provision for income taxes in 2018 including a net provision of $68 million to adjust the estimated initial effects of the Tax Cuts and Jobs Act of 2017 (the Tax Act) recorded in 2017, consisting of an incremental provision of $117 million offset in part by a $49 million reduction of related unrecognized tax benefits established in 2017. These adjustments were required based on new U.S. Treasury guidance and further analysis of available tax accounting methods and elections, legislative updates, regulations, earnings and profit computations and foreign taxes. In 2018, the provision for income taxes also included a $71 million charge to establish a valuation allowance against net operating losses that will not be utilized as a result of the planned sale of the Anatomical Pathology business (Note 2). The company recorded a provision for income taxes in 2017 principally due to a net provision of $204 million from the effects of the Tax Act consisting primarily of a one-time transition tax on deemed repatriated earnings and profits of foreign subsidiaries, net of a benefit from adjusting the deferred tax balances for the U.S. statutory tax rate reduction. In 2017, the company refinanced certain long term inter-company debt which resulted in an income tax benefit of $237 million related to a foreign exchange loss recognized for income tax purposes. In addition, in 2017 the company recorded a $65 million favorable adjustment to deferred tax balances due to extension of a tax holiday agreement in Singapore. The company continued to implement tax planning initiatives related to non-U.S. subsidiaries in 2017. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $86 million, offset in part by additional U.S. income taxes of $53 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2017) for a net benefit of $33 million. The foreign tax credits are the result of foreign earnings and profits remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company also implemented foreign tax credit planning in Sweden which resulted in $20 million of foreign tax credits, with no related incremental U.S. income tax expense., The effective tax rate in both 2018 and 2017 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) income taxes were higher than its income tax expense for financial reporting purposes and totaled $591 million and $479 million in 2018 and 2017, respectively. The company expects its effective tax rate in 2019 will be between 7% and 10% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The effective tax rate can vary significantly from period to period as a result of discrete income tax factors and events. Income from continuing operations increased to $2.94 billion in 2018, from $2.23 billion in 2017 principally due to increase in operating income in 2018 (discussed above). During 2018, the company’s cash flow from operations totaled $4.54 billion compared with $4.01 billion for 2017. The increase primarily resulted from higher income before amortization and depreciation in the 2018 period, offset in part by higher investment in working capital to support sales growth. As of December 31, 2018, the company’s short-term debt totaled $1.27 billion, including $693 million of commercial paper obligations and $573 million of senior notes due within the next twelve months. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2018, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $82 million as a result of outstanding letters of credit. The company expects to fund the acquisition of Gatan Inc. with a combination of existing cash balances and short-term borrowings. The company believes that its existing cash and cash equivalents of $2.10 billion as of December 31, 2018 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Critical Accounting Policies and Estimates The company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent liabilities. On an on-going basis, management evaluates its estimates, including those related to intangible assets and goodwill, income taxes, contingencies and litigation, and pension costs. Management believes the most complex and sensitive judgments, because of their significance to the consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Management bases its estimates on historical experience, current market and economic conditions and other assumptions that management believes are reasonable. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities where the values are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The company believes the following represent its critical accounting policies and estimates used in the preparation of its financial statements: (a) Intangible Assets and Goodwill The company uses assumptions and estimates in determining the fair value of assets acquired and liabilities assumed in a business combination. The determination of the fair value of intangible assets, which represent a significant portion of the purchase price in many of the company’s acquisitions, requires the use of significant judgment with regard to (i) the fair value; and (ii) whether such intangibles are amortizable or non-amortizable and, if the former, the period and the method by which the intangible asset will be amortized. The company estimates the fair value of acquisition-related intangible assets principally based on projections of cash flows that will arise from identifiable intangible assets of acquired businesses. The projected cash flows are discounted to determine the present value of the assets at the dates of acquisition. Definite-lived intangible assets totaled $13.71 billion at December 31, 2018. The company reviews definite-lived intangible assets for impairment when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Actual cash flows arising from a particular intangible asset could vary from projected cash flows which could imply different carrying values from those established at the dates of acquisition and which could result in impairment of such asset. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) The company evaluates goodwill and indefinite-lived intangible assets for impairment annually and when events occur or circumstances change that would more-likely-than-not reduce the fair value of the asset below its carrying amount. Events or circumstances that might require an interim evaluation include unexpected adverse business conditions, economic factors, unanticipated technological changes or competitive activities, loss of key personnel and acts by governments and courts. Goodwill and indefinite-lived intangible assets totaled $25.35 billion and $1.27 billion, respectively, at December 31, 2018. Estimates of discounted future cash flows require assumptions related to revenue and operating income growth, discount rates and other factors. For the goodwill impairment tests, the company considers peer revenues and earnings trading multiples from companies that have operational and financial characteristics that are similar to the respective reporting units and estimated weighted average costs of capital. Different assumptions from those made in the company’s analysis could materially affect projected cash flows and the company’s evaluation of goodwill and indefinite-lived intangible assets for impairment. For reporting units where the company performed the quantitative goodwill impairment test, indications of fair value based on projections of profitability for 2019 and thereafter and on peer revenues and earnings trading multiples were sufficient to conclude that no impairment of goodwill or indefinite-lived intangible assets existed at the end of the tenth fiscal month of 2018, the date of the company’s impairment testing. There can be no assurance, however, that an economic downturn will not materially adversely affect peer trading multiples and the company’s businesses such that they do not achieve their forecasted profitability and these assets become impaired. Should the fair value of the company’s goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines, or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment may be necessary. With the completion of the Patheon acquisition in August 2017, the company established a new reporting unit, called Pharma Services, which solely consists of the legacy Patheon business, the book carrying value of which equaled its fair value as of the acquisition date. During its annual 2018 goodwill impairment assessment, the company determined that the Pharma Services reporting unit's cushion of fair value over book value had increased to 5%. Despite this favorable increase, given that the fair value of the reporting unit was not substantially in excess of its carrying value, relatively small decreases in future cash flows from anticipated results could result in impairment of goodwill. The key variables that drive the valuation of the reporting unit are revenue and operating income growth rate assumptions, peer revenue and earnings trading multiples, as well as the weighted average cost of capital rate applied. The estimates used for these assumptions represent management's best estimates, which the company believes are reasonable. These assumptions, however are subject to variability and uncertainty, including the degree to which the reporting unit will grow revenue and profitability levels. The Pharma Services reporting unit had $3.37 billion of goodwill, and an overall carrying value of $7.70 billion as of December 31, 2018. (b) Income Taxes In the ordinary course of business there is inherent uncertainty in quantifying the company’s income tax positions. The company assesses income tax positions and records tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, the company has recorded the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. Should tax return positions that the company expects are sustainable not be sustained upon audit, the company could be required to record an incremental tax provision for such taxes. The company’s liability for these unrecognized tax benefits totaled $1.44 billion at December 31, 2018. The company operates in numerous countries under many legal forms and, as a result, is subject to the jurisdiction of numerous domestic and non-U.S. tax authorities, as well as to tax agreements and treaties among these governments. Determination of taxable income in any jurisdiction requires the interpretation of the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions, permissible revenue recognition methods under the tax law and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, currency exchange restrictions or the company’s level of operations or profitability in each taxing jurisdiction could have an impact upon the amount of current and deferred tax balances and hence the company’s net income. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) The company estimates the degree to which tax assets and loss carryforwards will result in a benefit, after consideration of all positive and negative evidence, and provides a valuation allowance for tax assets and loss carryforwards that it believes will more likely than not go unused. In situations in which the company has been able to conclude that its deferred tax assets will be realized, it has generally relied on future reversals of taxable temporary differences, expected future taxable income where such estimates have historically been reliable, and other factors. If it becomes more likely than not that a tax asset or loss carryforward will be used, the company reverses the related valuation allowance. Any such reversals are recorded as a reduction of the company’s tax provision. The company’s tax valuation allowance totaled $471 million at December 31, 2018. Should the company’s actual future taxable income by tax jurisdiction vary from estimates, additional allowances or reversals thereof may be necessary. The company has not provided state income or foreign withholding taxes on certain of its non-U.S. subsidiaries’ undistributed earnings, as such amounts are intended to be reinvested outside the United States indefinitely in the respective jurisdictions based on specific business plans and tax strategies. These business plans and tax strategies consider: short-term and long-term forecasts and budgets of the U.S. parent and non-U.S. subsidiaries; working capital and other needs in locations where earnings are generated; the company’s past practices regarding non-U.S. subsidiary dividends; sources of financing by the U.S. parent, such as issuing debt or equity; and uses of cash by the U.S. parent that are more discretionary in nature, such as business combinations and share repurchase programs. However, should the company change its business plans and tax strategies in the future and decide to repatriate a portion of these earnings to one of its U.S. subsidiaries, including cash maintained by these non-U.S. subsidiaries, the company would recognize additional tax liabilities. It is not practicable to estimate the amount of additional state and foreign withholding tax liabilities that the company would incur. The company’s intent is to only make distributions from non-U.S. subsidiaries in the future when they can be made at no net tax costs. (c) Contingencies and Litigation The company records accruals for various contingencies, including legal proceedings, environmental, workers’ compensation, product, general and auto liabilities, and other claims that arise in the normal course of business. The accruals are based on management’s judgment, historical claims experience, the probability of losses and, where applicable, the consideration of opinions of internal and or external legal counsel and actuarial estimates. Accruals of acquired businesses, including product liability and environmental accruals, were initially recorded at fair value and discounted to their net present value. Additionally, the company records receivables from third-party insurers when recovery has been determined to be probable. (d) Pension and Other Retiree Benefits Several of the company’s U.S. and non-U.S. subsidiaries sponsor defined benefit pension and other retiree benefit plans. The cost and obligations of these arrangements are calculated using many assumptions to estimate the benefits that the employee earns while working, the amount of which cannot be completely determined until the benefit payments cease. Major assumptions used in the accounting for these employee benefit plans include the discount rate, expected return on plan assets and rate of increase in employee compensation levels. Assumptions are determined based on company data and appropriate market indicators in consultation with third-party actuaries, and are evaluated each year as of the plans’ measurement date. Net periodic pension costs for the company’s pension and other postretirement benefit plans totaled $22 million in 2018. The company’s unfunded benefit obligation totaled $391 million at year-end 2018 compared with $486 million at year-end 2017. Should any of these assumptions change, they would have an effect on net periodic pension costs and the unfunded benefit obligation. For example, a 10% decrease in the discount rate would result in an annual increase in pension and other postretirement benefit expense of approximately $2 million and an increase in the benefit obligation of approximately $93 million. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations 2018 Compared With 2017 Sales in 2018 were $24.36 billion, an increase of $3.44 billion from 2017. Sales increased $1.53 billion due to acquisitions. The favorable effects of currency translation resulted in an increase in revenues of $173 million in 2018. Aside from the effects of acquisitions and currency translation, revenues increased $1.74 billion (8%) primarily due to increased demand. Sales to customers in each of the company's primary end markets grew. Sales growth was strong in each of the company's primary geographic areas, particularly Asia. In 2018, total company operating income and operating income margin were $3.78 billion and 15.5%, respectively, compared with $2.96 billion and 14.2%, respectively, in 2017. The increase in operating income was primarily due to profit on higher sales and, to a lesser extent, the effects of acquisitions and productivity improvements, net of inflationary cost increases, offset in part by an increase in strategic growth investments, unfavorable sales mix and amortization of acquisition-related intangible assets, due to recent acquisitions. In 2018, the company recorded restructuring and other costs, net, of $91 million, including $12 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition. The company recorded $29 million of net charges to selling, general and administrative expenses, principally third-party transaction and integration costs associated with recent and pending acquisitions, offset in part by income from the favorable results of product liability litigation. In addition, the company recorded $88 million of cash restructuring costs in its continuing effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S. and Europe. The company also recorded $38 million of other income, net, principally for resolution of a litigation matter (see Note 15). In 2017, the company recorded restructuring and other costs, net, of $298 million, including $123 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition and, to a lesser extent, to conform the accounting policies of Patheon to the company's accounting policies; $78 million of charges to selling, general and administrative expenses primarily for third-party transaction and integration costs associated with recent acquisitions and changes in estimates of acquisition contingent consideration. In addition, the company recorded $97 million of cash restructuring costs, primarily to achieve acquisition synergies, including severance and abandoned facilities costs associated with the closure and consolidation of facilities in the U.S. and Europe. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S., Europe and Asia. The company also recorded $27 million of net credits for litigation-related matters, which were mostly offset by compensation due at Patheon on the date of acquisition, hurricane response/impairment costs, and net charges for the settlement/curtailment of retirement plans. As of February 27, 2019, the company has identified restructuring actions that will result in additional charges of approximately $65 million, primarily in 2019, and expects to identify additional actions during 2019 which will be recorded when specified criteria are met, such as communication of benefit arrangements and abandonment of leased facilities. Approximately 40% of the additional charges will be incurred in the Life Sciences Solutions segment, 25% in the Analytical Instruments segment, 30% in the Laboratory Products and Services segment, and 5% in the Specialty Diagnostics segment. The restructuring projects for which charges were incurred in 2018 are expected to result in annual cost savings of approximately THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) $65 million beginning in part in 2018 and, to a greater extent, in 2019, including $20 million in the Life Sciences Solutions segment, $10 million in the Analytical Instruments segment, $5 million in the Specialty Diagnostics segment and $30 million in the Laboratory Products and Services segment. The restructuring actions for which charges were incurred in 2017 resulted in annual cost savings of approximately $90 million beginning in part in 2017 and to a greater extent in 2018, including $50 million in the Life Sciences Solutions segment, $20 million in the Analytical Instruments segment, $10 million in the Specialty Diagnostics segment and $10 million in the Laboratory Products and Services segment. Segment Results The company’s management evaluates segment operating performance using operating income before certain charges/credits to cost of revenues and selling, general and administrative expenses, principally associated with acquisition-related activities; restructuring and other costs/income including costs arising from facility consolidations such as severance and abandoned lease expense and gains and losses from the sale of real estate and product lines; and amortization of acquisition-related intangible assets. The company uses this measure because it helps management understand and evaluate the segments’ core operating results and facilitate comparison of performance for determining compensation (Note 4). Accordingly, the following segment data is reported on this basis. Income from the company’s reportable segments increased 16% to $5.62 billion in 2018 due primarily to profit on higher sales and, to a lesser extent, the effects of acquisitions, and productivity improvements, net of inflationary cost increases, offset in part by strategic growth investments and unfavorable sales mix. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $541 million to $6.27 billion in 2018. Sales increased $464 million (8%) due to higher revenues at existing businesses, $49 million due to the favorable effects of currency translation and $28 million due to acquisitions. The increase in revenue at existing businesses was primarily due to increased demand at each of the segment's primary businesses, with particular strength from sales of biosciences products and bioprocess production products. Operating income margin was 34.4% in 2018 compared to 33.1% in 2017. The increase in operating margin resulted primarily from profit on higher sales and productivity improvements, net of inflationary cost increases. These increases were offset in part by unfavorable sales mix, and strategic growth investments. Analytical Instruments Sales in the Analytical Instruments segment increased $648 million to $5.47 billion in 2018. Sales increased $562 million (12%) due to higher revenues at existing businesses, $45 million due to acquisitions and $41 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand at each of the segment's primary businesses. Operating income margin was 22.8% in 2018 compared to 21.3% in 2017. The increase resulted primarily from profit on higher sales and, to a lesser extent, productivity improvements, net of inflationary cost increases, offset in part by strategic growth investments. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $238 million to $3.72 billion in 2018. Sales increased $189 million (5%) due to higher revenues at existing businesses, $41 million due to the favorable effects of currency translation and $8 million due to an acquisition. The increase in revenue at existing businesses was due to broad based higher demand in each of the segment's primary businesses with particular strength in sales of products sold through the segment’s healthcare market channel. Operating income margin was 25.6% in 2018 and 26.6% in 2017. The decrease resulted primarily from strategic growth investments and, to a lesser extent, unfavorable sales mix, offset in part by profit on higher sales and, to a lesser extent, favorable foreign currency exchange. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $2.21 billion to $10.04 billion in 2018. Sales increased $1.47 billion due to an acquisition, $694 million (9%) due to higher revenues at existing businesses and $50 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand in each of the segment's principal businesses with particular strength in its research and safety market channel business and its clinical trials business. Operating income margin was 12.5% in 2018 compared to 12.8% in 2017. The decrease was primarily due to unfavorable sales mix and, to a lesser extent, strategic growth investments, offset in part by profit on higher sales. Other Expense, Net The company reported other expense, net, of $521 million and $531 million in 2018 and 2017, respectively (Note 5). An increase in interest expense of $75 million was offset in part by an increase in interest income of $56 million in 2018. In 2017, other expense, net included $32 million of charges related to the amortization of fees paid to obtain bridge financing commitments related to the acquisition of Patheon. Provision for Income Taxes The company recorded a provision for income taxes in 2018 including a net provision of $68 million to adjust the estimated initial effects of the Tax Cuts and Jobs Act of 2017 recorded in 2017, consisting of an incremental provision of $117 million offset in part by a $49 million reduction of related unrecognized tax benefits established in 2017. These adjustments were required based on new U.S. Treasury guidance and further analysis of available tax accounting methods and elections, legislative updates, regulations, earnings and profit computations and foreign taxes. In 2018, the provision for income taxes also included a $71 million charge to establish a valuation allowance against net operating losses that will not be utilized as a result of the planned sale of the Anatomical Pathology business (Note 2). The company recorded a provision for income taxes in 2017 principally due to a net provision of $204 million from the effects of the Tax Act consisting primarily of a one-time transition tax on deemed repatriated earnings and profits of foreign subsidiaries, net of a benefit from adjusting the deferred tax balances for the U.S. statutory tax rate reduction. In 2017, the company refinanced certain long term inter-company debt which resulted in an income tax benefit of $237 million related to a foreign exchange loss recognized for income tax purposes. In addition, in 2017 the company recorded a $65 million favorable adjustment to deferred tax balances due to extension of a tax holiday agreement in Singapore. The company continued to implement tax planning initiatives related to non-U.S. subsidiaries in 2017. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $86 million, offset in part by additional U.S. income taxes of $53 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2017) for a net benefit of $33 million. The foreign tax credits are the result of foreign earnings and profits remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company also implemented foreign tax credit planning in Sweden which resulted in $20 million of foreign tax credits, with no related incremental U.S. income tax expense. The effective tax rate in both 2018 and 2017 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $591 million and $479 million in 2018 and 2017, respectively. The company expects its effective tax rate in 2019 will be between 7% and 10% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The effective tax rate can vary significantly from period to period as a result of discrete income tax factors and events. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) The company has operations and a taxable presence in approximately 50 countries outside the U.S. Some of these countries have lower tax rates than the U.S. The company’s ability to obtain a benefit from lower tax rates outside the U.S. is dependent on its relative levels of income in countries outside the U.S. and on the statutory tax rates in those countries. Based on the dispersion of the company’s non-U.S. income tax provision among many countries, the company believes that a change in the statutory tax rate in any individual country is not likely to materially affect the company’s income tax provision or net income, aside from any resulting one-time adjustment to the company’s deferred tax balances to reflect a new rate. Recent Accounting Pronouncements A description of recently issued accounting standards is included under the heading "Recent Accounting Pronouncements" in Note 1. Contingent Liabilities The company is contingently liable with respect to certain legal proceedings and related matters. An unfavorable outcome that differs materially from current accrual estimates, if any, for one or more of the matters described under the headings "Product Liability, Workers Compensation and Other Personal Injury Matters," and "Intellectual Property Matters" in Note 11 could have a material adverse effect on the company’s financial position as well as its results of operations and cash flows. 2017 Compared With 2016 Sales in 2017 were $20.92 billion, an increase of $2.64 billion from 2016. Sales increased $1.63 billion due to acquisitions. The favorable effects of currency translation resulted in an increase in revenues of $70 million in 2017. Aside from the effects of acquisitions and currency translation, revenues increased $949 million (5%) primarily due to increased demand. Sales to customers in each of the company's primary end markets grew. Sales growth was moderate in North America and Europe and particularly strong in Asia. In 2017, total company operating income and operating income margin were $2.96 billion and 14.2%, respectively, compared with $2.46 billion and 13.5%, respectively, in 2016. The increase in operating income was primarily due to profit on higher sales in local currencies, the effects of acquisitions and productivity improvements, net of inflationary cost increases, offset in part by an increase in amortization of acquisition-related intangible assets, due to recent acquisitions, and strategic growth investments. In 2017, the company recorded restructuring and other costs, net, of $298 million, including $123 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition, and, to a lesser extent, to conform the accounting policies of Patheon to the company's accounting policies. The company recorded $78 million of charges to selling, general and administrative expenses, primarily for third-party transaction and integration costs associated with recent acquisitions and changes in estimates of acquisition contingent consideration. In addition, the company recorded $97 million of cash restructuring costs, primarily to achieve acquisition synergies, including severance and abandoned facilities costs associated with the closure and consolidation of facilities in the U.S and Europe. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S., Europe and Asia. The company also recorded $27 million of net credits for litigation-related matters, which were mostly offset by compensation due at Patheon on the date of the acquisition, hurricane response/impairment costs, and net charges for the settlement/curtailment of retirement plans (see Note 15). THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) In 2016, the company recorded restructuring and other costs, net, of $395 million, including $102 million of charges to cost of revenues for the sale of inventories revalued at the date of acquisition and to conform the accounting policies of FEI and Affymetrix to the company's accounting policies; $104 million of charges to selling, general and administrative expenses primarily for third-party transaction and integration costs related to the acquisitions of FEI and Affymetrix. In addition, the company recorded $164 million of cash restructuring costs, primarily to achieve acquisition synergies, including severance and abandoned facilities costs associated with the closure and consolidation of facilities in the U.S. The company’s other businesses incurred costs for continued headcount reductions and facility consolidations in an effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S., Europe and Asia. The company also recorded charges for litigation and environmental remediation matters. These costs were partially offset by gains on the sales of real estate. The restructuring actions for which charges were incurred in 2016 resulted in annual cost savings of approximately $100 million beginning in part in 2016 and to a greater extent in 2017, including $60 million in the Life Sciences Solutions segment, $25 million in the Analytical Instruments segment, $5 million in the Specialty Diagnostics segment and $10 million in the Laboratory Products and Services segment. Segment Results Income from the company’s reportable segments increased 15% to $4.85 billion in 2017 due primarily to profit on higher sales in local currencies, the effects of acquisitions and productivity improvements, net of inflationary cost increases, offset in part by strategic growth investments. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Life Sciences Solutions Sales in the Life Sciences Solutions segment increased $411 million to $5.73 billion in 2017. Sales increased $300 million (6%) due to higher revenues at existing businesses, $99 million due to acquisitions and $12 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for biosciences products and, to a lesser extent, bioprocess production products as well as genetic sciences products. Operating income margin was 33.1% in 2017 compared to 30.1% in 2016. The increase in operating margin resulted primarily from productivity improvements, net of inflationary cost increases, and, to a lesser extent, profit on higher sales in local currencies and price increases. These increases were offset in part by strategic growth investments and acquisition dilution. Analytical Instruments Sales in the Analytical Instruments segment increased $1.15 billion to $4.82 billion in 2017. Sales increased $794 million due to acquisitions, $330 million (9%) due to higher revenues at existing businesses and $29 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand in each of the segment's primary businesses particularly products sold by the segment's chromatography and mass spectrometry business and materials and structural analysis business. Operating income margin was 21.3% in 2017 compared to 20.4% in 2016. The increase resulted primarily from profit on higher sales in local currencies, productivity improvements, net of inflationary cost increases and, to a lesser extent, the effect of acquisitions, offset in part by strategic growth investments and, to a lesser extent, unfavorable foreign currency exchange and unfavorable sales mix. Specialty Diagnostics Sales in the Specialty Diagnostics segment increased $147 million to $3.49 billion in 2017. Sales increased $126 million (4%) due to higher revenues at existing businesses, $12 million due to the favorable effects of currency translation and $9 million due to acquisitions. The increase in revenue at existing businesses was primarily due to higher demand for products sold through the segment's healthcare market channel as well as clinical diagnostics products and immunodiagnostics products. Operating income margin was 26.6% in 2017 and 27.3% in 2016. The decrease resulted primarily from strategic growth investments and, to a lesser extent, unfavorable sales mix, offset in part by profit on higher sales in local currencies and productivity improvements, net of inflationary cost increases. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $1.10 billion to $7.83 billion in 2017. Sales increased $727 million due to acquisitions, $361 million (5%) due to higher revenues at existing businesses and $13 million due to the favorable effects of currency translation. The increase in revenue at existing businesses was primarily due to increased demand for products sold through the segment's channel business and, to a lesser extent, laboratory equipment and consumables. Operating income margin was 12.8% in 2017 compared to 14.5% in 2016. The decrease was primarily due to unfavorable sales mix and strategic growth investments offset in part by profit on higher sales in local currencies and, to a lesser extent, the effect of acquisitions. Other Expense, Net The company reported other expense, net, of $531 million and $434 million in 2017 and 2016, respectively (Note 5). Interest expense increased $123 million, primarily due to an increase in outstanding debt. Provision for Income Taxes The company recorded a provision for income taxes in 2017 principally due to a net provision of $204 million from the effects of the Tax Act consisting primarily of a one-time transition tax on deemed repatriated earnings and profits of foreign subsidiaries, net of a benefit from adjusting the deferred tax balances for the U.S. statutory tax rate reduction. In 2017, the company refinanced certain long term inter-company debt which resulted in an income tax benefit of $237 million related to a foreign exchange loss recognized for income tax purposes. In addition, in 2017 the company recorded a $65 million favorable adjustment to deferred tax balances due to extension of a tax holiday agreement in Singapore. The company continued to implement tax planning initiatives related to non-U.S. subsidiaries in 2017. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $86 million, offset in part by additional U.S. income taxes of $53 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2017) for a net benefit of $33 million. The foreign tax credits are the result of foreign earnings and profits remitted or deemed remitted to the U.S. during the reporting year and the U.S. treatment of taxes paid in the foreign jurisdictions in the years those profits were originally earned. The company also implemented foreign tax credit planning in Sweden which resulted in $20 million of foreign tax credits, with no related incremental U.S. income tax expense. The company recorded a benefit from income taxes in 2016. In 2016, the company continued to implement tax planning initiatives related to non-U.S. subsidiaries. These non-U.S. subsidiaries incurred foreign tax obligations, and made cash and deemed distributions to the company’s U.S. operations which resulted in no net tax cost. As a result of these distributions, the company benefitted from U.S. foreign tax credits of $91 million, offset in part by additional U.S. taxes of $37 million on the related foreign income (which reduced the benefit from the foreign rate differential in 2016) for a net benefit of $54 million. The company also implemented foreign tax credit planning in Sweden which resulted in $100 million of foreign tax credits, with no related incremental U.S. income tax expense. In addition, the company recorded discrete benefits in 2016 totaling $39 million related to prior year tax filings and net charges of $12 million related to tax audits. The effective tax rate in both 2017 and 2016 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $479 million and $663 million in 2017 and 2016, respectively. Liquidity and Capital Resources Consolidated working capital was $4.48 billion at December 31, 2018, compared with $2.37 billion at December 31, 2017, primarily due to higher cash and lower short-term debt. Included in working capital were cash and cash equivalents of $2.10 billion at December 31, 2018 and $1.34 billion at December 31, 2017. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) Cash provided by operating activities was $4.54 billion during 2018. Cash provided by income was offset in part by investments in working capital. Increases in accounts receivable and inventories used cash of $366 million and $324 million, respectively, primarily to support growth in sales. Cash payments for income taxes increased to $591 million during 2018, compared with $479 million in 2017. The company made cash contributions to its pension and postretirement benefit plans totaling $93 million during 2018. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $83 million during 2018. During 2018, the company’s investing activities used $1.25 billion of cash. Acquisitions used cash of $536 million. The company’s investing activities also included the purchase of $758 million of property, plant and equipment. On January 28, 2019, the company entered into an agreement to sell its Anatomical Pathology business to PHC Holdings Corporation for approximately $1.14 billion. The sale is subject to customary closing conditions and applicable regulatory approvals. The company’s financing activities used $2.24 billion of cash during 2018. Repayment of senior notes used cash of $2.05 billion. New long-term borrowings provided cash of $690 million. A net decrease in commercial paper obligations used cash of $194 million. The company’s financing activities also included the repurchase of $500 million of the company’s common stock and the payment of $266 million in cash dividends, offset in part by $136 million of net proceeds from employee stock option exercises. On July 7, 2016, the Board of Directors authorized the repurchase of up to $1.50 billion of the company’s common stock. In 2018, the company repurchased $500 million of the company's common stock, depleting the 2016 authorization. On September 7, 2018, the Board of Directors authorized the repurchase of up to $2.00 billion of the company’s common stock. In January 2019, the company repurchased $750 million of the company's common stock. At February 27, 2019, authorization remained for $1.25 billion of future repurchases of the company’s common stock. As of December 31, 2018, the company’s short-term debt totaled $1.27 billion, including $693 million of commercial paper obligations and $573 million of senior notes due within the next twelve months. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2018, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $82 million as a result of outstanding letters of credit. Approximately half of the company’s cash balances and cash flows from operations are from outside the U.S. The company uses its non-U.S. cash for needs outside of the U.S. including acquisitions and repayment of acquisition-related intercompany debt to the U.S. In addition, the company also transfers cash to the U.S. using non-taxable returns of capital as well as dividends where the related U.S. dividend received deduction or foreign tax credit equals any tax cost arising from the dividends. As a result of using such means of transferring cash to the U.S., the company does not expect any material adverse liquidity effects from its significant non-U.S. cash balances for the foreseeable future. The company expects to fund the acquisition of Gatan Inc. with a combination of existing cash balances and short-term borrowings. The company believes that its existing cash and cash equivalents of $2.10 billion as of December 31, 2018 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Cash provided by operating activities was $4.01 billion during 2017. An increase in other liabilities provided cash of $1.02 billion primarily due to the Tax Act's one-time transition tax on deemed repatriated earnings and profits of foreign subsidiaries. Given the availability of foreign tax credits, the company does not expect the transition tax to result in significant cash requirements. An increase in accounts payable provided cash of $274 million due to the timing of payments. Increases in accounts receivable and inventories used cash of $362 million and $81 million, respectively, primarily to support growth in sales in local currencies. An increase in other assets used cash of $153 million primarily due to the timing of income tax refunds. Cash payments for income taxes decreased to $479 million during 2017, compared with $663 million in 2016. The company made cash contributions to its pension and postretirement benefit plans totaling $200 million during 2017. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $93 million during 2017. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) During 2017, the company’s investing activities used $7.73 billion of cash. Acquisitions used cash of $7.23 billion. The company’s investing activities also included the purchase of $508 million of property, plant and equipment. The company’s financing activities provided $3.85 billion of cash during 2017. Issuance of senior notes and borrowings under a term loan provided cash of $6.46 billion. The company also issued 10 million shares of its common stock for net proceeds of $1.69 billion. Repayment of senior notes and term loans used cash of $3.30 billion and a net decrease in commercial paper obligations used cash of $134 million. The company’s financing activities also included the repurchase of $750 million of the company’s common stock and the payment of $237 million in cash dividends, offset in part by $128 million of net proceeds from employee stock option exercises. Cash provided by operating activities was $3.26 billion during 2016. An increase in accounts receivable used cash of $352 million primarily to support growth in sales in local currencies and due to the mid-month timing of the acquisition of FEI when receivables are commonly lower than at quarter-end. Inventories provided cash of $98 million due to a reduction associated with fourth quarter 2016 sales. An increase in other assets used cash of $153 million primarily due to the timing of payments. An increase in other liabilities provided cash of $216 million primarily due to the timing of payments for income taxes and incentive compensation. Cash payments for income taxes increased to $663 million during 2016, compared with $477 million in 2015. The company made cash contributions to its pension and postretirement benefit plans totaling $43 million during 2016. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $122 million during 2016. During 2016, the company’s investing activities used $5.52 billion of cash. Acquisitions used cash of $5.18 billion. The company’s investing activities also included the purchase of $444 million of property, plant and equipment. The company’s financing activities provided $2.76 billion of cash during 2016. Issuance of senior notes and borrowings under term loans provided cash of $7.60 billion and an increase in commercial paper obligations provided cash of $904 million. Repayment of senior notes, the 364-day term loan and acquired debt used cash of $4.33 billion. The company’s financing activities also included the repurchase of $1.25 billion of the company’s common stock and the payment of $238 million in cash dividends, offset in part by $87 million of proceeds from employee stock option exercises. Off-Balance Sheet Arrangements The company did not use special purpose entities or other off-balance-sheet financing arrangements in 2016, 2017 or 2018, except for letters of credit, bank guarantees, residual value guarantees under three lease agreements, surety bonds and other guarantees disclosed in the table or discussed below. The amounts disclosed in the table below for letters of credit, bank guarantees, surety bonds and other guarantees relate to guarantees of the company’s performance, primarily in the ordinary course of business. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) Contractual Obligations and Other Commercial Commitments The table below summarizes, by period due or expiration of commitment, the company’s contractual obligations and other commercial commitments as of December 31, 2018. (a) Amounts represent the expected cash payments for debt and do not include any deferred issuance costs. (b) Unconditional purchase obligations include agreements to purchase goods, services or fixed assets that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable at any time without penalty. The contractual obligation at December 31, 2018 to acquire Gatan Inc. for approximately $925 million has been omitted from the above table. The transaction is subject to customary closing conditions, including regulatory approvals. Reserves for unrecognized tax benefits of $1.44 billion have not been included in the above table due to the inability to predict the timing of tax audit resolutions. The company has no material commitments for purchases of property, plant and equipment, other than those included in the above table, but expects that for 2019, such expenditures will be between $800 and $850 million. Guarantees of residual value under lease arrangements for three facilities have not been included in the above table due to the inability to predict if and when the guarantees may require payment (see Note 11). The residual value guarantees become operative at the end of the leases for up to a maximum of $147 million. The initial terms of these leases end in 2019, 2020 and 2023, although renewal options exist for each. A guarantee of pension plan obligations of a divested business has not been included in the preceding table due to the inability to predict if and when the guarantee may require payment. The purchaser of the divested business has agreed to pay for the pension benefits, however the company was required to guarantee payment of these pension benefits should the purchaser fail to do so. The amount of the guarantee at December 31, 2018 was $38 million. In disposing of assets or businesses, the company often provides representations, warranties and/or indemnities to cover various risks including, for example, unknown damage to the assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste facilities, and unidentified tax liabilities and related legal fees. The company does not have the ability to estimate the potential liability from such indemnities because they relate to unknown conditions. However, the company has no reason to believe that these uncertainties would have a material adverse effect on its financial position, annual results of operations or cash flows. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) The company has recorded liabilities for known indemnifications included as part of environmental liabilities. See Item 1. Business - Environmental Matters for a discussion of these liabilities.

<s>[INST] Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to Consolidated Financial Statements, which begin on page of this report. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s continuing operations fall into four business segments (see Note 4): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions are described below. On March 31, 2016, the company acquired, primarily within the Life Sciences Solutions segment, Affymetrix, Inc., a North Americabased provider of cellular and genetic analysis products, for a total purchase price of $1.34 billion, net of cash acquired, including the assumption of $254 million of debt. The acquisition expanded the company's existing portfolio of antibodies and assays for flow cytometry and singlecell biology applications. Additionally, the acquisition expanded the company's genetic analysis portfolio through the addition of microarrays. Revenues of Affymetrix were $360 million in 2015. On September 19, 2016, the company acquired, within the Analytical Instruments segment, FEI Company, a North Americabased provider of highperformance electron microscopy, for a total purchase price of $4.08 billion, net of cash acquired. The acquisition strengthened the company's analytical instrument portfolio with the addition of highend electron microscopes. Revenues of FEI were $930 million in 2015. On February 14, 2017, the company acquired, within the Life Sciences Solutions segment, Finesse Solutions, Inc., a North Americabased developer of scalable control automation systems and software for bioproduction, for a total purchase price of $221 million, net of cash acquired. The acquisition expanded the company's bioproduction offerings. Revenues of Finesse Solutions were approximately $50 million in 2016. On March 2, 2017, the company acquired, within the Analytical Instruments segment, Core Informatics, a North Americabased provider of cloudbased platforms supporting scientific data management, for a total purchase price of $94 million, net of cash acquired. The acquisition enhanced the company's existing informatics solutions. Revenues of Core Informatics were approximately $10 million in 2016. On August 29, 2017, the company acquired, within the Laboratory Products and Services segment, Patheon N.V., a leading global provider of highquality drug development and delivery solutions to the pharmaceutical and biopharma sectors, for $35.00 per share in cash, or $7.36 billion, including the assumption of net debt. The company financed the purchase price, including the repayment of indebtedness of Patheon, with issuances of debt and equity. Patheon provides comprehensive, integrated and highly customizable solutions as well as the expertise to help biopharmaceutical companies of all sizes satisfy complex development and manufacturing needs. The acquisition provided entry into the pharmaceutical contract development and manufacturing organization market and added a complementary service to the company's existing pharmaceutical services portfolio. Patheon's revenues totaled $1.87 billion for the year ended October 31, 2016. On October 25, 2018, the company acquired, within the Life Sciences Solutions segment, Becton Dickinson and Company's Advanced Bioprocessing business for $477 million in cash. This North Americabased business adds complementary cell culture products that expand the segment's bioproduction offerings to help customers increase yield during production of biologic drugs. Revenues of the Advanced Bioprocessing business were $100 million in 2017. [/INST] Positive. </s>

THERMO FISHER SCIENTIFIC INC.

2020-02-26

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Reference is made throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations to Notes to the Consolidated Financial Statements, which begin on page of this report. Management's discussion and analysis of financial condition and results of operations for 2017 is included in Item 7 of the company’s 2018 Annual Report on Form 10-K filed with the Securities and Exchange Commission. Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s operations fall into four segments (see Note 4): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestiture The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions and divestiture are described below. On October 25, 2018, the company acquired, within the Life Sciences Solutions segment, Becton Dickinson and Company's Advanced Bioprocessing business for $477 million in cash. This North America-based business adds complementary cell culture products that expand the segment’s bioproduction offerings to help customers increase yield during production of biologic drugs. The Advanced Bioprocessing business reported revenues of $100 million in 2017. On April 30, 2019, the company acquired, within the Laboratory Products and Services segment, Brammer Bio for approximately $1.67 billion in cash. Brammer Bio is a leading viral vector contract development and manufacturing organization for gene and cell therapies. The acquisition expands the segment’s contract manufacturing capabilities. Brammer Bio reported revenues of approximately $140 million in 2018. On June 28, 2019, the company sold its Anatomical Pathology business to PHC Holdings Corporation for $1.13 billion, net of cash divested. The business was part of the Specialty Diagnostics segment. The sale of this business resulted in a pre-tax gain of approximately $478 million, included in restructuring and other (income) costs, net. Revenues in 2019, through the date of sale, and the full year 2018 of the business sold were approximately $115 million and $238 million, respectively, net of retained sales through the company's healthcare market and research and safety market channel businesses. Overview of Results of Operations and Liquidity Sales in 2019 were $25.54 billion, an increase of $1.18 billion from 2018. Sales increased $153 million due to acquisitions, net of a divestiture. The unfavorable effects of currency translation resulted in a decrease in revenues of $440 million in 2019. Aside from the effects of acquisitions/divestitures and currency translation, revenues increased $1.47 billion (6%) primarily due to increased demand. Sales to customers in each of the company’s primary end markets grew with particular strength in sales to customers in the biotech and pharmaceutical industry. Sales growth was strong in each of the company’s primary geographic areas in 2019. In the fourth quarter of 2019, sales to industrial customers declined and sales growth in Asia was modest due to weaker end market conditions off of a strong fourth quarter in 2018. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) In 2019, total company operating income and operating income margin were $4.59 billion and 18.0%, respectively, compared with $3.78 billion and 15.5%, respectively, in 2018. The increase in operating income was primarily due to profit on higher sales, the gain on the sale of the Anatomical Pathology business and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by strategic growth investments, sales mix and unfavorable foreign currency exchange. The company’s references to strategic growth investments generally refer to targeted spending for enhancing commercial capabilities, including expansion of geographic sales reach and e-commerce platforms, marketing initiatives, expanded service and operational infrastructure, focused research projects and other expenditures to enhance the customer experience. The company’s references throughout this discussion to productivity improvements generally refer to improved cost efficiencies from its Practical Process Improvement (PPI) business system, reduced costs resulting from global sourcing initiatives, a lower cost structure following restructuring actions, including headcount reductions and consolidation of facilities, and low cost region manufacturing. The company recorded a $374 million provision for income taxes in 2019 including $191 million related to the gain on the sale of the Anatomical Pathology business. In 2019, the company recorded a $62 million income tax benefit related to a foreign exchange loss for tax purposes on certain intercompany financing arrangements, implemented foreign tax credit planning in Sweden which resulted in $75 million of foreign tax credits, with no related incremental U.S. income tax expense, and recorded a $79 million income tax benefit related to the deferred tax implications of intra-entity transactions which included a tax benefit to release a valuation allowance against net operating losses previously determined to be unrealizable. The company recorded a $324 million provision for income taxes in 2018 including a net provision of $68 million to adjust the estimated initial effects of the Tax Cuts and Jobs Act of 2017 (the Tax Act) recorded in 2017, consisting of an incremental provision of $117 million offset in part by a $49 million reduction of related unrecognized tax benefits established in 2017. These adjustments were required based on new U.S. Treasury guidance and further analysis of available tax accounting methods and elections, legislative updates, regulations, earnings and profit computations and foreign taxes. In 2018, the provision for income taxes also included a $71 million charge to establish a valuation allowance against net operating losses that will not be utilized as a result of the 2019 sale of the Anatomical Pathology business. The effective tax rate in both 2019 and 2018 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $896 million and $591 million in 2019 and 2018, respectively. The company expects its effective tax rate in 2020 will be between 8% and 10% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The effective tax rate can vary significantly from period to period as a result of discrete income tax factors and events. Income from continuing operations increased to $3.70 billion in 2019, from $2.94 billion in 2018 principally due to increase in operating income in 2019 (discussed above) offset in part by $184 million of losses on the early extinguishment of debt in 2019 (Note 10). During 2019, the company’s cash flow from operations totaled $4.97 billion compared with $4.54 billion for 2018. The increase primarily resulted from higher income before amortization and depreciation and lower investment in working capital in the 2019 period. As of December 31, 2019, the company’s short-term debt totaled $676 million, including $672 million of senior notes due within the next twelve months. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2019, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $72 million as a result of outstanding letters of credit. The company believes that its existing cash and cash equivalents of $2.40 billion as of December 31, 2019 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates The company’s discussion and analysis of its financial condition and results of operations is based upon its financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent liabilities. On an on-going basis, management evaluates its estimates, including those related to intangible assets and goodwill, income taxes and contingencies and litigation. Management believes the most complex and sensitive judgments, because of their significance to the consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Management bases its estimates on historical experience, current market and economic conditions and other assumptions that management believes are reasonable. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities where the values are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. The company believes the following represent its critical accounting policies and estimates used in the preparation of its financial statements: (a)Intangible Assets and Goodwill The company uses assumptions and estimates in determining the fair value of assets acquired and liabilities assumed in a business combination. The determination of the fair value of intangible assets, which represent a significant portion of the purchase price in many of the company’s acquisitions, requires the use of significant judgment with regard to (i) the fair value; and (ii) whether such intangibles are amortizable or non-amortizable and, if the former, the period and the method by which the intangible asset will be amortized. The company estimates the fair value of acquisition-related intangible assets principally based on projections of cash flows that will arise from identifiable intangible assets of acquired businesses. The projected cash flows are discounted to determine the present value of the assets at the dates of acquisition. Definite-lived intangible assets totaled $12.76 billion at December 31, 2019. The company reviews definite-lived intangible assets for impairment when indication of potential impairment exists, such as a significant reduction in cash flows associated with the assets. Actual cash flows arising from a particular intangible asset could vary from projected cash flows which could imply different carrying values from those established at the dates of acquisition and which could result in impairment of such asset. The company evaluates goodwill and indefinite-lived intangible assets for impairment annually and when events occur or circumstances change that would more-likely-than-not reduce the fair value of the asset below its carrying amount. Events or circumstances that might require an interim evaluation include unexpected adverse business conditions, economic factors, unanticipated technological changes or competitive activities, loss of key personnel and acts by governments and courts. Goodwill and indefinite-lived intangible assets totaled $25.71 billion and $1.25 billion, respectively, at December 31, 2019. Estimates of discounted future cash flows require assumptions related to revenue and operating income growth rates, discount rates and other factors. For the goodwill impairment tests, the company considers (i) peer revenues and earnings trading multiples from companies that have operational and financial characteristics that are similar to the respective reporting units and (ii) estimated weighted average costs of capital. Different assumptions from those made in the company’s analysis could materially affect projected cash flows and the company’s evaluation of goodwill and indefinite-lived intangible assets for impairment. For reporting units where the company performed the quantitative goodwill impairment test, indications of fair value based on projections of profitability and on peer revenues and earnings trading multiples were sufficient to conclude that no impairment of goodwill or indefinite-lived intangible assets existed at the end of the tenth fiscal month of 2019, the date of the company’s annual impairment testing. There can be no assurance, however, that an economic downturn will not materially adversely affect peer trading multiples and the company’s businesses such that they do not achieve their forecasted profitability and these assets become impaired. Should the fair value of the company’s goodwill or indefinite-lived intangible assets decline because of reduced operating performance, market declines, or other indicators of impairment, or as a result of changes in the discount rate, charges for impairment may be necessary. (b)Income Taxes In the ordinary course of business there is inherent uncertainty in quantifying the company’s income tax positions. The company assesses income tax positions and records tax benefits for all years subject to examination based upon management’s evaluation of the facts, circumstances and information available at the reporting date. For those tax THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies and Estimates (continued) positions where it is more likely than not that a tax benefit will be sustained, the company has recorded the largest amount of tax benefit with a greater than 50 percent likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. Should tax return positions that the company expects are sustainable not be sustained upon audit, the company could be required to record an incremental tax provision for such taxes. The company’s liability for these unrecognized tax benefits totaled $1.55 billion at December 31, 2019. The company operates in numerous countries under many legal forms and, as a result, is subject to the jurisdiction of numerous domestic and non-U.S. tax authorities, as well as to tax agreements and treaties among these governments. Determination of taxable income in any jurisdiction requires the company to interpret the related tax laws and regulations and the use of estimates and assumptions regarding significant future events, such as the amount, timing and character of deductions, permissible revenue recognition methods under the tax law and the sources and character of income and tax credits. Changes in tax laws, regulations, agreements and treaties, currency exchange restrictions or the company’s level of operations or profitability in each taxing jurisdiction could have an impact upon the amount of current and deferred tax balances and hence the company’s net income. The company estimates the degree to which tax assets will result in a benefit, after consideration of all positive and negative evidence, and provides a valuation allowance for tax assets that it believes will more likely than not go unused. In situations in which the company has been able to determine that its deferred tax assets will be realized, that determination generally relies on future reversals of taxable temporary differences and expected future taxable income. If it becomes more likely than not that a tax asset will be used, the company reverses the related valuation allowance. Any such reversals are recorded as a reduction of the company’s tax provision. The company’s tax valuation allowance totaled $408 million at December 31, 2019. Should the company’s actual future taxable income by tax jurisdiction vary from estimates, additional allowances or reversals thereof may be necessary. The company has not provided U.S. state income taxes or additional non-U.S. taxes on certain of its non-U.S. subsidiaries’ undistributed earnings, as such amounts are intended to be reinvested outside the United States indefinitely in the respective jurisdictions based on specific business plans and tax strategies. These business plans and tax strategies consider: short-term and long-term forecasts and budgets of the U.S. parent and non-U.S. subsidiaries; working capital and other needs in locations where earnings are generated; the company’s past practices regarding non-U.S. subsidiary dividends; sources of financing by the U.S. parent, such as issuing debt or equity; and uses of cash by the U.S. parent that are more discretionary in nature, such as business combinations and share repurchase programs. However, should the company change its business plans and tax strategies in the future and decide to repatriate a portion of these earnings to one of its U.S. subsidiaries, including cash maintained by these non-U.S. subsidiaries, the company would recognize additional tax liabilities. It is not practicable to estimate the amount of additional U.S. state income tax and non-U.S. tax liabilities that the company would incur. The company’s intent is to only make distributions from non-U.S. subsidiaries in the future when they can be made at no net tax costs. (c)Contingencies and Litigation The company records accruals for various contingencies, including legal proceedings, environmental, workers’ compensation, product, general and auto liabilities, and other claims that arise in the normal course of business. The accruals are based on management’s judgment, historical claims experience, the probability of losses and, where applicable, the consideration of opinions of internal and/or external legal counsel and actuarial estimates. Accruals of acquired businesses, including product liability and environmental accruals, are initially recorded at fair value and discounted to their net present value. Additionally, the company records receivables from third-party insurers when recovery has been determined to be probable. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations 2019 Compared With 2018 * Currency Translation/Other for the Laboratory Products and Services segment includes a reduction of revenue of $60 million for the impact of a change in the method of reporting certain intersegment sales with no impact on consolidated results. Sales in 2019 were $25.54 billion, an increase of $1.18 billion from 2018. Sales increased $153 million due to acquisitions. The unfavorable effects of currency translation resulted in a decrease in revenues of $440 million in 2019. Aside from the effects of acquisitions and currency translation, revenues increased $1.47 billion (6%) primarily due to increased demand. Sales to customers in each of the company’s primary end markets grew with particular strength in sales to customers in the biotech and pharmaceutical industry. Sales growth was strong in each of the company’s primary geographic areas in 2019. In the fourth quarter of 2019, sales to industrial customers declined and sales growth in Asia was modest due to weaker end market conditions off of a strong fourth quarter in 2018. In 2019, total company operating income and operating income margin were $4.59 billion and 18.0%, respectively, compared with $3.78 billion and 15.5%, respectively, in 2018. The increase in operating income was primarily due to profit on higher sales, the gain on the sale of the Anatomical Pathology business and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by strategic growth investments, sales mix and unfavorable foreign currency exchange. In 2019, the company recorded restructuring and other income, net, of $334 million, including $482 million of net gains on the sale of businesses, principally the Anatomical Pathology business (see Note 2). The company also recorded $17 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition, and $62 million of net charges to selling, general and administrative expenses, principally transaction and integration-related costs related to acquisitions and a divestiture. In addition, the company recorded $52 million of cash restructuring charges, net, primarily for employee severance and abandoned facilities costs associated with the closure and consolidation of facilities in the U.S. and Europe (see Note 16). In 2018, the company recorded restructuring and other costs, net, of $91 million, including $12 million of charges to cost of revenues primarily for the sale of inventories revalued at the date of acquisition. The company recorded $29 million of net charges to selling, general and administrative expenses, primarily for third-party transaction and integration costs associated with recent and pending acquisitions, offset in part by income from favorable results of product liability litigation. In addition, the company recorded $88 million of cash restructuring costs, in its continued effort to streamline operations, including severance at several businesses and abandoned facility expenses at businesses that have been or are being consolidated in the U.S. and Europe. The company also recorded $38 million of other income, net, principally for resolution of a litigation matter. As of February 26, 2020, the company has identified restructuring actions that will result in additional charges of approximately $65 million, primarily in 2020, and expects to identify additional actions during 2020 which will be recorded when specified criteria are met, such as communication of benefit arrangements or when the costs have been incurred. Approximately 25% of the additional charges will be incurred in the Life Sciences Solutions segment, 30% in the Analytical Instruments segment, 35% in the Laboratory Products and Services segment, and 10% in the Specialty Diagnostics segment. The restructuring projects for which charges were incurred in 2019 are expected to result in annual cost savings of approximately $60 million beginning in part in 2019 and, to a greater extent, in 2020, including $20 million in the Life Sciences Solutions segment, $15 million in the Analytical Instruments segment, $5 million in the Specialty Diagnostics segment and $20 THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) million in the Laboratory Products and Services segment. The restructuring actions for which charges were incurred in 2018 resulted in annual cost savings of approximately $65 million beginning in part in 2018 and to a greater extent in 2019, including $20 million in the Life Sciences Solutions segment, $10 million in the Analytical Instruments segment, $5 million in the Specialty Diagnostics segment and $30 million in the Laboratory Products and Services segment. Segment Results The company’s management evaluates segment operating performance using operating income before certain charges/credits to cost of revenues and selling, general and administrative expenses, principally associated with acquisition-related activities; restructuring and other costs/income including costs arising from facility consolidations such as severance and abandoned lease expense and gains and losses from the sale of real estate and product lines; and amortization of acquisition-related intangible assets. The company uses this measure because it helps management understand and evaluate the segments’ core operating results and facilitate comparison of performance for determining compensation (Note 4). Accordingly, the following segment data is reported on this basis. Income from the company’s reportable segments increased 6% to $5.97 billion in 2019 due primarily to profit on higher sales and, to a lesser extent, productivity improvements, net of inflationary cost increases, offset in part by strategic growth investments, sales mix and unfavorable foreign currency exchange. Life Sciences Solutions THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) Sales in the Life Sciences Solutions segment increased $587 million to $6.86 billion in 2019. Sales increased $620 million (10%) due to higher revenues at existing businesses and $89 million due to an acquisition. The unfavorable effects of currency translation resulted in a decrease in revenues of $122 million. The increase in revenue at existing businesses was primarily due to increased demand in each of the segment's principal businesses with particular strength in sales of bioproduction and biosciences products. Operating income margin was 35.7% in 2019 compared to 34.4% in 2018. The increase in operating margin resulted primarily from profit on higher sales offset in part by strategic growth investments and, to a lesser extent, sales mix and unfavorable foreign currency exchange. Analytical Instruments Sales in the Analytical Instruments segment increased $53 million to $5.52 billion in 2019. Sales increased $149 million (3%) due to higher revenues at existing businesses. The unfavorable effects of currency translation resulted in a decrease in revenues of $96 million. The increase in revenue at existing businesses was due to increased demand for products sold by each of the segment's primary businesses with particular strength in chromatography and mass spectrometry instruments. Sales decreased in the fourth quarter of 2019 due to industrial end market conditions off of a strong fourth quarter of 2018. Operating income margin was 23.1% in 2019 compared to 22.8% in 2018. The increase resulted primarily from profit on higher sales and productivity improvements, net of inflationary cost increases. These increases were offset in part by sales mix and strategic growth investments. Specialty Diagnostics Sales in the Specialty Diagnostics segment remained flat at $3.72 billion in 2019. Sales increased $186 million (5%) due to higher revenues at existing businesses. The unfavorable effects of currency translation resulted in a decrease in revenues of $66 million and the divestiture of the Anatomical Pathology business decreased revenues by $126 million. The increase in revenue at existing businesses was due to increased demand for products sold through the segment's healthcare market channel as well as clinical diagnostic and immunodiagnostic products. Operating income margin was 25.0% in 2019 and 25.6% in 2018. The decrease was primarily due to strategic growth investments and, to a lesser extent, sales mix and the divestiture of the Anatomical Pathology business. These decreases were offset in part by profit on higher sales and, to a lesser extent, productivity improvements, net of inflationary cost increases. Following multi-year extensions of several expiring licensing arrangements with commercial partners, segment revenues and operating income in 2020 will both be unfavorably affected by approximately $30 million. Laboratory Products and Services Sales in the Laboratory Products and Services segment increased $564 million to $10.60 billion in 2019. Sales increased $604 million (6%) due to higher revenues at existing businesses and $187 million due to acquisitions. The unfavorable effects of currency translation resulted in a decrease in revenues of $167 million. A change in the method of reporting certain intersegment sales reduced segment revenues by $60 million with no impact to consolidated results. The increase in revenue at THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations (continued) existing businesses was primarily due to increased demand in each of the segment's principal businesses with particular strength in service offerings of its pharma services business and products sold through its research and safety market channel business. Operating income margin was 12.5% in both 2019 and 2018. Increases from profit on higher sales and productivity improvements, net of inflationary cost increases, were offset by strategic growth investments and, to a lesser extent, sales mix. Other Expense/Income, Net In 2019, the company recorded $184 million of losses on the early extinguishment of debt, offset in part by $44 million of net gains on investments. The investment gains include a $28 million gain on the sale of a joint venture for net proceeds of $42 million. In 2018, the company recorded $15 million of net losses on investments. Provision for Income Taxes The company recorded a $374 million provision for income taxes in 2019 including $191 million related to the gain on the sale of the Anatomical Pathology business. In 2019, the company recorded a $62 million income tax benefit related to a foreign exchange loss for tax purposes on certain intercompany financing arrangements, implemented foreign tax credit planning in Sweden which resulted in $75 million of foreign tax credits, with no related incremental U.S. income tax expense, and recorded a $79 million income tax benefit related to the deferred tax implications of intra-entity transactions which included a tax benefit to release a valuation allowance against net operating losses previously determined to be unrealizable. The company recorded a $324 million provision for income taxes in 2018 including a net provision of $68 million to adjust the estimated initial effects of the Tax Cuts and Jobs Act of 2017 recorded in 2017, consisting of an incremental provision of $117 million offset in part by a $49 million reduction of related unrecognized tax benefits established in 2017. These adjustments were required based on new U.S. Treasury guidance and further analysis of available tax accounting methods and elections, legislative updates, regulations, earnings and profit computations and foreign taxes. In 2018, the provision for income taxes also included a $71 million charge to establish a valuation allowance against net operating losses that will not be utilized as a result of the 2019 sale of the Anatomical Pathology business. The effective tax rate in both 2019 and 2018 was also affected by relatively significant earnings in lower tax jurisdictions. Due primarily to the non-deductibility of intangible asset amortization for tax purposes, the company’s cash payments for income taxes were higher than its income tax expense for financial reporting purposes and totaled $896 million and $591 million in 2019 and 2018, respectively. The company expects its effective tax rate in 2020 will be between 8% and 10% based on currently forecasted rates of profitability in the countries in which the company conducts business and expected generation of foreign tax credits. The effective tax rate can vary significantly from period to period as a result of discrete income tax factors and events. The company has operations and a taxable presence in approximately 50 countries outside the U.S. Some of these countries have lower tax rates than the U.S. The company’s ability to obtain a benefit from lower tax rates outside the U.S. is dependent on its relative levels of income in countries outside the U.S. and on the statutory tax rates in those countries. Based on the dispersion of the company’s non-U.S. income tax provision among many countries, the company believes that a change in the statutory tax rate in any individual country is not likely to materially affect the company’s income tax provision or net income, aside from any resulting one-time adjustment to the company’s deferred tax balances to reflect a new rate. Recent Accounting Pronouncements A description of recently issued accounting standards is included under the heading “Recent Accounting Pronouncements” in Note 1. Contingent Liabilities The company is contingently liable with respect to certain legal proceedings and related matters. An unfavorable outcome that differs materially from current accrual estimates, if any, for one or more of the matters described under the headings “Product Liability, Workers Compensation and Other Personal Injury Matters,” and “Intellectual Property Matters” in Note 12 could have a material adverse effect on the company’s financial position as well as its results of operations and cash flows. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Consolidated working capital (current assets less current liabilities) was $5.70 billion at December 31, 2019, compared with $4.48 billion at December 31, 2018, primarily due to lower short-term debt and higher cash balances. Included in working capital were cash and cash equivalents of $2.40 billion at December 31, 2019 and $2.10 billion at December 31, 2018. Cash provided by operating activities was $4.97 billion during 2019. Cash provided by income was offset in part by increased investments in working capital. Increases in accounts receivable and inventories used cash of $225 million and $458 million, respectively, primarily to support growth in sales. An increase in other assets used cash of $408 million primarily due to the timing of customer billings and tax refunds. Other liabilities increased by $210 million primarily due to advance payments from customers. Cash payments for income taxes increased to $896 million during 2019, compared with $591 million in 2018. The company made cash contributions to its pension and postretirement benefit plans totaling $50 million during 2019. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $69 million during 2019. During 2019, the company’s investing activities used $1.49 billion of cash. Acquisitions used cash of $1.84 billion. Proceeds from the sale of the Anatomical Pathology business provided $1.13 billion. The company’s investing activities also included the purchase of $926 million of property, plant and equipment. The company’s financing activities used $3.12 billion of cash during 2019. Repayment of senior notes used cash of $6.36 billion. New long-term borrowings provided cash of $5.64 billion. A net decrease in commercial paper obligations used cash of $683 million. The company’s financing activities also included the repurchase of $1.50 billion of the company’s common stock and the payment of $297 million in cash dividends, offset in part by $153 million of net proceeds from employee stock option exercises. On November 8, 2019, the Board of Directors replaced the existing authorization to repurchase the company’s common stock, of which $500 million was remaining, with a new authorization to repurchase up to $2.50 billion of the company’s common stock. At February 26, 2020, authorization remained for $1.00 billion of future repurchases of the company’s common stock. As of December 31, 2019, the company’s short-term debt totaled $676 million, including $672 million of senior notes due within the next twelve months. The company has a revolving credit facility with a bank group that provides up to $2.50 billion of unsecured multi-currency revolving credit. If the company borrows under this facility, it intends to leave undrawn an amount equivalent to outstanding commercial paper to provide a source of funds in the event that commercial paper markets are not available. As of December 31, 2019, no borrowings were outstanding under the company’s revolving credit facility, although available capacity was reduced by approximately $72 million as a result of outstanding letters of credit. Approximately half of the company’s cash balances and cash flows from operations are from outside the U.S. The company uses its non-U.S. cash for needs outside of the U.S. including acquisitions and repayment of acquisition-related intercompany debt to the U.S. In addition, the company also transfers cash to the U.S. using non-taxable returns of capital as well as dividends where the related U.S. dividend received deduction or foreign tax credit equals any tax cost arising from the dividends. As a result of using such means of transferring cash to the U.S., the company does not expect any material adverse liquidity effects from its significant non-U.S. cash balances for the foreseeable future. The company believes that its existing cash and cash equivalents of $2.40 billion as of December 31, 2019 and its future cash flow from operations together with available borrowing capacity under its revolving credit agreement will be sufficient to meet the cash requirements of its existing businesses for the foreseeable future, including at least the next 24 months. Cash provided by operating activities was $4.54 billion during 2018. Cash provided by income was offset in part by investments in working capital. Increases in accounts receivable and inventories used cash of $366 million and $324 million, respectively, primarily to support growth in sales. Cash payments for income taxes increased to $591 million during 2018, compared with $479 million in 2017. The company made cash contributions to its pension and postretirement benefit plans totaling $93 million during 2018. Payments for restructuring actions, principally severance costs and lease and other expenses of real estate consolidation, used cash of $83 million during 2018. During 2018, the company’s investing activities used $1.25 billion of cash. Acquisitions used cash of $536 million. The company’s investing activities also included the purchase of $758 million of property, plant and equipment. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) The company’s financing activities used $2.24 billion of cash during 2018. Repayment of senior notes used cash of $2.05 billion. New long-term borrowings provided cash of $690 million. A net decrease in commercial paper obligations used cash of $194 million. The company’s financing activities also included the repurchase of $500 million of the company’s common stock and the payment of $266 million in cash dividends, offset in part by $136 million of net proceeds from employee stock option exercises. Off-Balance Sheet Arrangements The company did not use special purpose entities or other off-balance-sheet financing arrangements in 2017, 2018 or 2019, except for letters of credit, bank guarantees, residual value guarantees under three lease agreements, surety bonds and other guarantees disclosed in the table or discussed below. The amounts disclosed in the table below for letters of credit, bank guarantees, surety bonds and other guarantees relate to guarantees of the company’s performance, primarily in the ordinary course of business. Contractual Obligations and Other Commercial Commitments The table below summarizes, by period due or expiration of commitment, the company’s contractual obligations and other commercial commitments as of December 31, 2019. (a)Amounts represent the expected cash payments for debt and do not include any deferred issuance costs. (b)Unconditional purchase obligations include agreements to purchase goods, services or fixed assets that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable at any time without penalty. Reserves for unrecognized tax benefits of $1.55 billion have not been included in the above table due to the inability to predict the timing of tax audit resolutions. The company has no material commitments for purchases of property, plant and equipment, other than those included in the above table, but expects that for 2020, such expenditures will be between $1 and $1.1 billion. Guarantees of residual value under lease arrangements for three facilities have not been included in the above table due to the inability to predict if and when the guarantees may require payment (see Note 11). The residual value guarantees become operative at the end of the leases for up to a maximum of $147 million. The terms of these leases end in 2020, 2023 and 2024. A guarantee of pension plan obligations of a divested business has not been included in the preceding table due to the inability to predict if and when the guarantee may require payment. The purchaser of the divested business has agreed to pay for the pension benefits, however the company was required to guarantee payment of these pension benefits should the purchaser fail to do so. The amount of the guarantee at December 31, 2019 was $41 million. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources (continued) In disposing of assets or businesses, the company often provides representations, warranties and/or indemnities to cover various risks including, for example, unknown damage to the assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste facilities, and unidentified tax liabilities and related legal fees. The company does not have the ability to estimate the potential liability from such indemnities because they relate to unknown conditions. However, the company has no reason to believe that these uncertainties would have a material adverse effect on its financial position, annual results of operations or cash flows. The company has recorded liabilities for known indemnifications included as part of environmental liabilities. See Item 1. Business - Environmental Matters for a discussion of these liabilities.

<s>[INST] Overview The company develops, manufactures and sells a broad range of products that are sold worldwide. The company expands the product lines and services it offers by developing and commercializing its own technologies and by making strategic acquisitions of complementary businesses. The company’s operations fall into four segments (see Note 4): Life Sciences Solutions, Analytical Instruments, Specialty Diagnostics and Laboratory Products and Services. Recent Acquisitions and Divestiture The company’s strategy is to augment internal growth at existing businesses with complementary acquisitions. The company’s principal recent acquisitions and divestiture are described below. On October 25, 2018, the company acquired, within the Life Sciences Solutions segment, Becton Dickinson and Company's Advanced Bioprocessing business for $477 million in cash. This North Americabased business adds complementary cell culture products that expand the segment’s bioproduction offerings to help customers increase yield during production of biologic drugs. The Advanced Bioprocessing business reported revenues of $100 million in 2017. On April 30, 2019, the company acquired, within the Laboratory Products and Services segment, Brammer Bio for approximately $1.67 billion in cash. Brammer Bio is a leading viral vector contract development and manufacturing organization for gene and cell therapies. The acquisition expands the segment’s contract manufacturing capabilities. Brammer Bio reported revenues of approximately $140 million in 2018. On June 28, 2019, the company sold its Anatomical Pathology business to PHC Holdings Corporation for $1.13 billion, net of cash divested. The business was part of the Specialty Diagnostics segment. The sale of this business resulted in a pretax gain of approximately $478 million, included in restructuring and other (income) costs, net. Revenues in 2019, through the date of sale, and the full year 2018 of the business sold were approximately $115 million and $238 million, respectively, net of retained sales through the company's healthcare market and research and safety market channel businesses. Overview of Results of Operations and Liquidity Sales in 2019 were $25.54 billion, an increase of $1.18 billion from 2018. Sales increased $153 million due to acquisitions, net of a divestiture. The unfavorable effects of currency translation resulted in a decrease in revenues of $440 million in 2019. Aside from the effects of acquisitions/divestitures and currency translation, revenues increased $1.47 billion (6%) primarily due to increased demand. Sales to customers in each of the company’s primary end markets grew with particular strength in sales to customers in the biotech and pharmaceutical industry. Sales growth was strong in each of the company’s primary geographic areas in 2019. In the fourth quarter of 2019, sales to industrial customers declined and sales growth in Asia was modest due to weaker end market conditions off of a strong fourth quarter in 2018. THERMO FISHER SCIENTIFIC INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview of Results of Operations and Liquidity (continued) In 2019, total company operating income and operating income margin were $4.59 billion and 18.0%, respectively, compared with $3.78 billion and 15.5%, respectively, in 2018. The increase in operating income was primarily due to profit on higher sales, the gain on the sale of the Anatomical Pathology business and, to a lesser extent, productivity improvements, net of inflationary cost increases. These increases were offset in part by strategic growth investments, sales mix and unfavorable foreign currency exchange. The company’s references to strategic growth investments generally refer to targeted spending for enhancing commercial capabilities, including expansion of geographic sales reach and ecommerce platforms, marketing initiatives, expanded service and operational infrastructure, focused research projects and other expenditures to enhance the customer experience. The company’ [/INST] Positive. </s>

GENCORP INC

2015-01-30

2014-11-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Unless otherwise indicated or required by the context, as used in this Annual Report on Form 10-K, the terms “we,” “our” and “us” refer to GenCorp Inc. and all of its subsidiaries that are consolidated in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The following discussion should be read in conjunction with the other sections of this Report, including the Consolidated Financial Statements and Notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report, and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations. Overview We are a manufacturer of aerospace and defense products and systems with a real estate segment that includes activities related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. We develop and manufacture propulsion systems for defense and space applications, and armaments for precision tactical and long-range weapon systems applications. Our continuing operations are organized into two segments: Aerospace and Defense - includes the operations of our wholly-owned subsidiary Aerojet Rocketdyne, a leading technology-based designer, developer and manufacturer of aerospace and defense products and systems for the U.S. government, including the DoD, NASA, major aerospace and defense prime contractors as well as portions of the commercial sector. Aerojet Rocketdyne is a world-recognized engineering and manufacturing company that specializes in the development and production of propulsion systems for defense and space applications, armament systems for precision tactical systems and munitions, and is considered a domestic market leader in launch propulsion, in-space propulsion, missile defense propulsion, tactical missile propulsion and hypersonic propulsion systems. Real Estate - includes the activities of our wholly-owned subsidiary Easton Development Company, LLC related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. We own approximately 12,000 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento. We are currently in the process of seeking zoning changes and other governmental approvals on a portion of the Sacramento Land to optimize its value. In addition, we are currently in the process of completing certain infrastructure improvements to the Sacramento Land to reduce the time a developer would have to hold the Sacramento Land before development could start. A summary of the significant financial highlights for fiscal 2014 which management uses to evaluate our operating performance and financial condition is presented below. • Net sales for fiscal 2014 totaled $1,597.4 million compared to $1,383.1 million for fiscal 2013. Fiscal 2014 and 2013 results include 12 months and 5 1/2 months, respectively, of the Rocketdyne Business operating results (see below). • Net loss for fiscal 2014 was $(53.0) million, or $(0.92) loss per share, compared to net income of $167.9 million, or $2.11 diluted income per share, for fiscal 2013. The net loss for fiscal 2014 included pre-tax cost growth of $23.6 million on the Antares AJ-26 program and a pre-tax charge of $60.6 million related to the repurchase of $59.6 million of principal of our 4 1/16% Debentures. The net income for fiscal 2013 included a $193.9 million income tax benefit primarily associated with the release of deferred tax asset valuation allowance reserves. • Adjusted EBITDAP (Non-GAAP measure*) for fiscal 2014 was $174.2 million, or 10.9% of net sales, compared to $155.6 million, or 11.3% of net sales, for fiscal 2013. • Segment performance (Non-GAAP measure*) before environmental remediation provision adjustments, retirement benefit expense, and unusual items was $145.5 million for fiscal 2014, compared to $151.4 million for fiscal 2013. • Cash provided by operating activities in fiscal 2014 totaled $150.4 million, compared to $77.6 million in fiscal 2013. The cash generated from operating activities in fiscal 2014 included an increase of $94.1 million cash advances on long-term contracts. • Free cash flow (Non-GAAP measure*) in fiscal 2014 totaled $107.0 million, compared to $14.4 million in fiscal 2013. • As of November 30, 2014, we had $2.2 billion of funded backlog compared to $1.7 billion as of November 30, 2013. • As of November 30, 2014, we had $516.3 million in net debt (Non-GAAP measure*) compared to $501.6 million as of November 30, 2013. _________ * We provide Non-GAAP measures as a supplement to financial results based on GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading “Operating Segment Information” and “Use of Non-GAAP Financial Measures.” Our fiscal year ends on November 30 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday of November. As a result of the 2013 calendar, Aerojet Rocketdyne had 14 weeks of operations in the first quarter of fiscal 2013 compared to 13 weeks of operations in the first quarter of fiscal 2014. The additional week of operations in the first quarter of fiscal 2013 accounted for $27.8 million in additional net sales. In July 2012, we signed the Original Purchase Agreement with UTC to acquire the Rocketdyne Business from UTC for $550 million. On June 10, 2013, the FTC announced that it closed its investigation into the Acquisition under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. On June 12, 2013, we entered into an Amended and Restated Purchase Agreement with UTC, which amended and restated the Original Purchase Agreement, as amended. On June 14, 2013, we completed the acquisition of substantially all of the Rocketdyne Business pursuant to the Amended and Restated Purchase Agreement. The aggregate consideration to UTC was $411 million which represents the initial purchase price of $550 million reduced by $55 million relating to the pending future RDA Acquisition. The acquisition of UTC’s 50% ownership interest of RD Amross and UTC’s related business is contingent upon certain conditions including receipt of certain Russian governmental regulatory approvals, which may not be obtained. Pursuant to the terms of the Amended and Restated Purchase Agreement, either party to such agreement may terminate the obligations to consummate the RDA Acquisition on or after June 12, 2014; provided, however, that such termination date may be extended for up to four additional three-month periods (with the final termination date extended until June 12, 2015). Subject to the terms of Amended and Restated Purchase Agreement, in order to extend the termination date, either party may request the extension by providing written notice to the other party at least five business days prior to the termination date, provided that the requesting party must have a reasonable belief at the time such notice is given that the Russian government approvals will be forthcoming for completion of the RDA Acquisition. In December 2014, we exercised the third option to extend the terms of the Amended and Restated Purchase Agreement for three months through March 2015. The Rocketdyne Business integration costs incurred and capitalized through November 30, 2014 totaled $38.5 million. These integration costs are reimbursable by the U.S. government upon its audit and approval that our planned integration savings will exceed our restructuring costs by a factor of at least two to one. In December 2014, we were informed that the DCAA had completed its audit of our restructuring proposal and found that we had achieved the required minimum two to one savings to restructuring cost ratio. Actual recovery of the previously deferred integration costs will take place after the final execution of an Advance Agreement with the DCMA and determination from the Under Secretary of Defense that the audited restructuring savings exceed the costs by a factor of two to one. We believe these final two actions will be completed in fiscal 2015. We review on a quarterly basis the probability of recovery of these costs. The unaudited pro forma information for the periods set forth below gives effect to the Acquisition as if it had occurred at the beginning of each respective fiscal year. These amounts have been calculated after applying our accounting policies and adjusting the results of the Rocketdyne Business to reflect depreciation and amortization that would have been charged assuming the fair value adjustments to property, plant and equipment and intangible assets had been applied as at the beginning of each respective year, together with the tax effects, as applicable. The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the Acquisition been consummated as of that time or that may result in the future. We are operating in an environment that is characterized by both increasing complexity in the global security environment, as well as continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. We continuously evaluate a broad range of options that could be implemented to increase operational efficiency across all sites, and improve our overall market competitiveness. Our decisions will be focused on moving us forward to solidify our leadership in the propulsion markets. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our industry, integration of the Rocketdyne Business (including integration into our ERP system), environmental matters, capital structure and an underfunded pension plan. Major Customers The principal end user customers of our products and technology are agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within “budget top-line” limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. Customers that represented more than 10% of net sales for the periods presented are as follows: __________ * Less than 10%. Sales to the U.S. government and its agencies, including sales to our significant customers discussed above, were as follows (dollars in millions): The Standard Missile program, which is comprised of several contracts and is included in U.S. government sales, represented 12%, 22%, and 25% of net sales for fiscal 2014, 2013, and 2012, respectively. In addition, the THAAD program, which is comprised of several contracts and is included in U.S. government sales, represented 12%, 4%, and 5% of net sales for fiscal 2014, 2013, and 2012, respectively. Industry Update Our primary aerospace and defense customers include the DoD and its agencies, NASA, and the prime contractors that supply products to these customers. We are seeing more opportunities for commercial launch and in-space business. In addition, sales to our aerospace and defense customers that provide products to international customers continue to grow. However, we continue to rely on particular levels of U.S. government spending on propulsion systems for defense, space and armament systems, precision tactical weapon systems and munitions applications, and our backlog depends, in large part, on continued funding by the U.S. government for the programs in which we are involved. These funding levels are not generally correlated with any specific economic cycle, but rather follow the cycle of general public policy and political support for this type of funding. Moreover, although our contracts often contemplate that our services will be performed over a period of several years, the U.S. Congress must appropriate funds for a given program and the U.S. President must sign government budget legislation each GFY and may significantly increase, decrease or eliminate, funding for a program. A decrease in DoD and/or NASA expenditures, the elimination or curtailment of a material program in which we are or hope to be involved, or changes in payment patterns of our customers as a result of changes in U.S. government outlays, could have a material adverse effect on our operating results, financial condition, and/or cash flows. The Bipartisan Budget Act of 2013 set overall discretionary spending levels for GFY 2014 and 2015 and eased sequestration spending cuts to the DoD and other federal agencies (e.g., NASA) for GFY 2014 and 2015, paving the way for eventual agreements on GFY 2014 and 2015 Appropriations for all federal agencies. For GFY 2015, Congress approved a $1.0 trillion “Omnibus” Appropriations bill, averting a U.S. government shutdown and providing a sense of stability for industry. The omnibus legislation contains 11 full year appropriations bills - including Defense and Commerce, Justice, Science (that includes NASA funding) - and a shorter-term CR for the Department of Homeland Security. The defense portion of the bill provides $490.2 billion in discretionary funding for GFY 2015, which is $3.3 billion above the GFY 2014 amount, and nearly equal to the President’s Budget Request for GFY 2015. In addition, the bill includes $64.0 billion in Overseas Contingency Operations for the ongoing war efforts abroad. The NASA portion of the bill includes a top line of $18.0 billion, which is $0.5 billion above the President’s budget request for GFY 2015 and $0.4 billion above the GFY 2014 appropriated amount. Without Congressional action in 2015 to change or modify the Bipartisan Budget Act of 2013, sequestration will return in January 2016. Despite overall U.S. government budget pressures, we believe we are well-positioned to benefit from funding in DoD and NASA priority areas. This view reflects the DoD’s strategic guidance report released in January 2012, and the recently released 2014 QDR which affirms support for many of our core programs and points toward continued DoD investment in: access to space - in order to ensure access to this highly congested and contested “global commons”; missile defense - in order to protect the homeland, counter weapons of mass destruction and enhance space-based capabilities; and power projection by tactical missile systems. The QDR explicitly states Missile Defense, Space, Nuclear Deterrence, and Precision Strike as key capabilities for the DoD to preserve. The NASA Authorization Act has again identified the SLS program as one of its top priorities in the NASA GFY 2015 budget. The SLS program also has enjoyed wide, bipartisan support in both chambers of Congress. We maintain a strong relationship with NASA and our propulsion systems have been powering NASA launch vehicles and spacecraft since the inception of the U.S. space program. Our booster and upper stage propulsion systems are currently baselined on the new SLS vehicle and both upper stage and booster engines are in development for future SLS variants. Due to the retirement of the space shuttle fleet, U.S. astronauts are now dependent on Russian Soyuz flights for access to and from the ISS for the better part of this decade. NASA has been working to re-establish U.S. manned space capability as soon as possible through development of the commercial cargo and crew ISS resupply capability and the heavy lift SLS designed for manned deep space exploration. In both instances, we have significant propulsion content. The competitive dynamics of our multi-faceted marketplace vary by product sector and customer and see many of the same influences felt by the larger Aerospace and Defense sector. The large majority of products we manufacture are highly complex, technically sophisticated and extremely hazardous to build, demanding rigorous manufacturing procedures and highly specialized manufacturing equipment. These factors, coupled with the very high cost to establish the infrastructure required to meet these needs, pose substantial barriers to entry. As a result, the number of qualified competitors has been, and will likely continue to be, limited to a small handful of participants who tend to be narrowly focused on products that are sub-elements of our overall propulsion product portfolio. For example, competitor ATK manufactures solid rocket motors but does not develop or produce liquid engines. There are a number of small liquid engine manufacturers that neither develop or produce liquid-fueled propulsion systems. There has been a recent emergence of propulsion entrepreneurs such as SpaceX and Blue Origin who have or are in the process of developing liquid fuel propulsion capabilities, but these potential competitors are primarily focused on the development of space propulsion systems for heavy lift launch vehicles and are not pursuing or participating in the missile defense or tactical propulsion business segments that make up a substantial portion of our overall business. These new entrepreneurs have signaled their intent to compete primarily on price and are therefore bringing pressure to bear on existing cost paradigms and manufacturing methodologies. Environmental Matters Our current and former business operations are subject to, and affected by, federal, state, local, and foreign environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. Our policy is to conduct our business with due regard for the preservation and protection of the environment. We continually assess compliance with these regulations and we believe our current operations are materially in compliance with all applicable environmental laws and regulations. A summary of our recoverable amounts, environmental reserves, and range of liability, as of November 30, 2014 is presented below: _____ (1) Excludes the long-term receivable from Northrop of $74.8 million as of November 30, 2014 related to environmental costs already paid (and therefore not reserved) by the Company in prior years that are expected to be reimbursed by Northrop. Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowable to be included in our contracts with the U.S. government and allocable to Northrop until the cumulative expenditure limitation is reached. See Note 8(c) and (d) of the Notes to Consolidated Financial Statements and "Environmental Matters" below for summary of our environmental reserve activity. Capital Structure We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of November 30, 2014, we had $782.2 million of debt principal outstanding. The fair value of the debt outstanding at November 30, 2014 was $920.4 million. Retirement Benefits We do not expect to make any significant cash contributions to our tax-qualified defined benefit pension plan until fiscal 2016. We estimate that approximately 86% of our unfunded pension obligation as of November 30, 2014 is related to Aerojet Rocketdyne which will be recoverable through our U.S. government contracts. The funded status of our pension plans may be adversely affected by the investment experience of the plans’ assets, by any changes in U.S. law and by changes in the statutory interest rates used by tax-qualified pension plans in the U.S. to calculate funding requirements. Accordingly, if the performance of our plans’ assets does not meet our assumptions, if there are changes to the Internal Revenue Service regulations or other applicable law or if other actuarial assumptions are modified, our future contributions to our underfunded pension plans could be higher than we expect. Additionally, the level of returns on retirement benefit assets, changes in interest rates, changes in legislation, and other factors affect our financial results. The timing of recognition of pension expense or income in our financial statements differs from the timing of the required pension funding under PPA or the amount of funding that can be recorded in our overhead rates through our U.S. government contracting business. Our earnings are positively or negatively impacted by the amount of expense or income we record for our employee retirement benefit plans. Rocketdyne Business ERP Integration We integrated the Rocketdyne Business into our ERP system on January 1, 2015, but have not yet completed our data validation process. Results of Operations Net Sales: * Primary reason for change. The increase in net sales was primarily due to an increase of $360.0 million of net sales from the acquired Rocketdyne Business. Fiscal 2014 and 2013 results include 12 months and 51/2 months, respectively, of the acquired Rocketdyne Business. The increase in net sales also included increased deliveries on the Atlas V, THAAD, and Orion programs totaling $71.9 million. The increase in net sales was partially offset by (i) a decrease of $113.9 million in the various Standard Missile contracts primarily from the transitioning of the Standard Missile-3 Block IB contract from development activities to low-rate initial production, decreased development activities for the TDACS for the Standard Missile-3 Block IIA contract, and the cessation of deliveries on the Standard Missile-1 Regrain contract in fiscal 2014 as a result of contract completion; (ii) an additional week of operations in the first quarter of fiscal 2013 resulting in $27.8 million in net sales; (iii) a decrease of $21.7 million as a result of the completion of the T3 IIA and IIB contracts as the program enters the next development phase; (iv) a decrease of $26.4 million from lower deliveries and changes in the estimated measurement of progress toward completion on the Antares program; and (v) a decrease of $24.6 million as a result of lower deliveries on the Guidance Enhanced Missile TBM ("GEM-T") program. See net sales information below: ______ (1) Includes net sales beginning June 14, 2013 from the Rocketdyne Business (acquisition date). ** Primary reason for change. The increase in net sales was primarily due to the following: (i) sales from the Rocketdyne Business contributed $319.4 million of net sales from the acquisition date of June 14, 2013; (ii) an increase of $53.7 million in the various Standard Missile programs primarily from increased development activities for the TDACS for the Standard Missile-3 Block IIA program and increased deliveries on the Standard Missile-1 Regrain program; and (iii) increased deliveries on the Atlas V program generating additional sales of $21.0 million. The increase in net sales was partially offset by a reduction of $16.1 million on the Bomb Live Unit - 129B (“BLU-129B”) composite case program due to completion of the contract in fiscal 2012 and the timing of the follow-on BLU-129B contract which is valued at $16.0 million. Our fiscal year ends on November 30 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday of November. As a result of the 2013 calendar, we had 53 weeks of operations in fiscal 2013 compared to 52 weeks of operations in the fiscal 2012. The additional week of operations in fiscal 2013 accounted for $27.8 million in additional net sales. Sales by contract type were as follows: Cost of Sales (exclusive of items shown separately below): * Primary reason for change. The increase in cost of sales excluding retirement benefit expense and step-up in fair value of inventory as a percentage of net sales was primarily due to $23.6 million, 1.5% of net sales, of cost growth on the Antares AJ-26 program, including the cost to repair or replace engines as necessary in light of the previously reported engine test failures, an associated increase in hardware inspections and corrective actions on remaining engines, costs to repair the damaged test stand, and costs resulting from delayed deliveries. ** Primary reason for change. Cost of sales as a percentage of net sales excluding retirement benefit expense and step-up in fair value of inventory was essentially unchanged. Selling, General and Administrative (“SG&A”): * Primary reason for change. The decrease in SG&A expense was primarily driven by (i) lower non-cash retirement benefit expense (see discussion of “Retirement Benefit Plans” below) and (ii) a decrease of $8.4 million in stock-based compensation primarily as a result of decreases in the fair value of the stock appreciation rights. ** Primary reason for change. The increase in SG&A expense was primarily due to (i) an increase of $7.6 million in stock-based compensation primarily as a result of increases in the fair value of the stock appreciation rights and (ii) an increase in legal and consulting expenses related to various corporate activities. Depreciation and Amortization: * Primary reason for change. The increase in depreciation and amortization is primarily due to (i) an increase of $10.4 million of depreciation expense related to the Rocketdyne Business since the acquisition; (ii) an increase $7.0 million of amortization of intangible assets associated with the Rocketdyne Business which is not allocable to our U.S. government contracts; and (iii) an increase of $3.1 million of depreciation expense associated with the ERP system which was placed into service in June 2013. ** Primary reason for change. The increase in depreciation and amortization is primarily related to the following: (i) $15.2 million of depreciation expense related to the Rocketdyne Business since the acquisition of which $10.3 million was associated with the step-up in fair value of the tangible assets not allocable to our U.S. government contracts and (ii) $5.0 million of amortization of intangibles associated with the Rocketdyne Business since the acquisition which is not allocable to our U.S. government contracts. Other Expense, net: * Primary reason for change. The increase in other expense, net was primarily due to (i) an increase of $37.2 million in unusual item charges; (ii) an increase of $2.8 million in losses on the disposal of long-lived assets; and (iii) an increase of $2.4 million in environmental remediation expenses. See Notes 8(c) and 8(d) in Notes to Consolidated Financial Statements for additional discussion of environmental remediation matters. See discussion of unusual items below. ** Primary reason for change. The increase in other expense, net was primarily due to an increase in unusual item charges of $11.8 million partially offset by a decrease of $3.2 million in environmental remediation expenses and a $1.5 million contribution pledged in fiscal 2012 to support space science education. See Notes 8(c) and 8(d) in Notes to Consolidated Financial Statements for additional discussion of environmental remediation matters. See discussion of unusual items below. Total unusual items expense, a component of other expense, net in the consolidated statements of operations, was as follows: Fiscal 2014 Activity: A summary of the loss on the 4 1/16% Debentures repurchased during fiscal 2014 is as follows (in millions): We recorded a charge of $0.2 million related to an amendment to the Senior Credit Facility. We recorded $0.9 million for realized losses and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. Fiscal 2013 Activity: We recorded a charge of $0.5 million related to a legal settlement. We recorded ($1.0) million in gains and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. We incurred expenses of $20.0 million, including internal labor costs of $1.4 million, related to the Rocketdyne Business acquisition. A summary of our losses on the 4 1/16% Debentures repurchased during fiscal 2013 is as follows (in millions): Fiscal 2012 Activity We recorded $0.7 million for realized losses and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. We incurred expenses of $11.6 million, including internal labor costs of $2.0 million, related to the Rocketdyne Business acquisition announced in July 2012. We redeemed $75.0 million of our 9 1/2% Senior Subordinated Notes (“9 1/2% Notes”) at a redemption price of 100% of the principal amount. The redemption resulted in a charge of $0.4 million associated with the write-off of the 9 1/2% Notes deferred financing costs. Interest Income: * Primary reason for change. Interest income was essentially unchanged for the periods presented. Interest Expense: * Primary reason for change. The increase in interest expense was primarily due to (i) two additional months in fiscal 2014 of interest expense associated with the issuance of the 7 1/8% Notes and (ii) the issuance of $89.0 million under the subordinated delayed draw term loan facility in fiscal 2014. The increase in interest expense was partially offset by the 4 1/16% Debentures repurchased during fiscal 2014. ** Primary reason for change. The increase in interest expense was primarily due to the issuance of the 7 1/8% Notes in January 2013 related to the acquisition of the Rocketdyne Business. Income Tax Provision: The following table shows the reconciling items between the income tax provision (benefit) using the federal statutory rate and our reported income tax provision (benefit). In fiscal 2014, our effective tax rate was an income tax expense of 32.7% on a pre-tax loss from continuing operations of $39.4 million. Our effective tax rate differed from the 35% statutory federal income tax rate due largely to the non-deductible premiums paid upon the redemption of portions of the convertible debt, state income taxes, impacts from the final Research and Development ("R&D") credit study, the benefit related to manufacturing deductions, and certain non-deductible interest expense. In fiscal 2013, our effective tax rate was an income tax benefit of 740.1% on a pre-tax loss of $26.2 million. Our effective tax rate differed from the 35% statutory federal income tax rate due largely to the release of a significant portion of the valuation allowance previously recorded against deferred tax assets, the impact of state income taxes, and certain non-deductible interest expense. We released $282.4 million of the valuation allowance that existed at the beginning of the year, of which approximately $178.7 million was recorded as an income tax benefit to continuing operations, $1.1 million to discontinued operations, and $102.6 million was recorded in other comprehensive income. The carrying value of our deferred tax assets is dependent on our ability to generate sufficient taxable income in the future. We need $439.5 million in pre-tax income and $401.1 million in other comprehensive income to realize the net deferred tax assets as of November 30, 2014. We project that future taxable income will increase as a result of increased income from continuing operations resulting from improved contract profit margins related to the Rocketdyne acquisition integration and improved margins beginning in fiscal 2015 due to anticipated contributions to our tax qualified defined benefit pension plan, which are recoverable through our U.S. government contracts. These increases in income from continuing operations will be partially offset by book to tax adjustments, primarily related to retirement benefit plan payments, state tax deductions, and our manufacturing deductions. The timing of recording or releasing a valuation allowance requires significant management judgment. The amount of the valuation allowance released by us represents a portion of deferred tax assets that was deemed more-likely-than-not that we will realize the benefits based on the analysis in which the positive evidence outweighed the negative evidence. A valuation allowance is required when it is more-likely-than-not that all or a portion of deferred tax assets may not be realized. Establishment and removal of a valuation allowance requires management to consider all positive and negative evidence and make a judgmental decision regarding the amount of valuation allowance required as of a reporting date. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. In the evaluation as of November 30, 2014 and 2013, management has considered all available evidence, both positive and negative, including but not limited to the following: Positive evidence • The three year comprehensive cumulative income position exclusive of other comprehensive income impact or non-recurring charges; • The improved operating results when combined with that of the Rocketdyne Business, continued growth in contract backlog, and the anticipated impact of the Rocketdyne Business financial results on our forecasted financial performance; • Our recent history of generating taxable income which has allowed for the utilization of tax credit carryforwards, and the expected taxable income position for the current year; • Favorable trends with respect to Congressional action regarding the easing of sequestration from the Bipartisan Budget Act of 2013; and • Favorable trends with respect to the market value of certain real estate assets. Negative evidence • Our exposure to environmental remediation obligations and the related uncertainty as to the ultimate exposure upon settlement; • The significance of our defined benefit pension obligation and related impact it could have in future years; • The additional indebtedness incurred in fiscal 2013 related to the acquisition of the Rocketdyne Business that continues to generate interest expense; and • The three year comprehensive cumulative loss position as of the end of fiscal 2014. During fiscal 2013, we concluded the positive evidence supporting the release of the valuation allowance previously recorded against substantially all of our net deferred tax assets outweighed the negative evidence supporting retention of the reserve. The evidence included the improved expected operating profits as a result of the Rocketdyne Business acquisition in the third quarter of fiscal 2013 and significant improvements surrounding the measurement of our defined benefit pension plan liability as of November 30, 2013. Accordingly, the valuation allowance that relates to expected future operating income was released in the third quarter of fiscal 2013 and allocated to continuing operations. The valuation allowance that was related to the gain in other comprehensive income, due to significant improvements surrounding the measurement of our defined benefit pension plan liability, was released through other comprehensive income in the fourth quarter of fiscal 2013 when the defined benefit pension plan gain was recognized. During fiscal 2014, we continued to evaluate the need for a valuation allowance and have concluded in each quarter, including year end, that the amount of valuation allowance currently recorded was appropriate. We will continue to evaluate the ability to realize our net deferred tax assets and the remaining valuation allowance on a quarterly basis. The Tax Increase Prevention Act of 2014 passed in December 2014, retroactively reinstating the federal R&D credit and “bonus” depreciation. As a result, we expect to record an estimated benefit to our income tax expense in the first quarter of fiscal 2015 of approximately $1.6 million related to the R&D credit. The impact of the additional tax depreciation will reduce our income taxes payable and long-term deferred tax assets by approximately $6.6 million. Discontinued Operations: On August 31, 2004, we completed the sale of our GDX Automotive (“GDX”) business. On November 30, 2005, we completed the sale of the Fine Chemicals business. During fiscal 2014 and 2013, the loss before income taxes from discontinued operations was primarily due to liabilities associated with our former Fine Chemicals business divestiture. During fiscal 2012, we released a $3.8 million loss contingency reserve for discharged employee claims related to our former GDX business and we recorded a charge of $1.0 million for environmental obligations related to our former Fine Chemicals business. Summarized financial information for discontinued operations is set forth below: Retirement Benefit Plans: Components of retirement benefit expense are: The decrease in retirement benefit expense in fiscal 2014 compared to fiscal 2013 was primarily due to lower actuarial losses recognized in fiscal 2014 compared to fiscal 2013. The decrease in actuarial losses was primarily the result of better than expected investment returns on pension plan assets and an increase in the discount rate due to higher market interest rates used to determine our retirement benefit plans' obligations. Actual rate of return on pension plan assets was 12.5% in fiscal 2013 compared to an assumed rate of 8% in fiscal 2013. The discount rate was 4.54% as of November 30, 2013 compared to 3.68% as of November 30, 2012. We estimate that our non-cash retirement benefit expense will be approximately $67 million in fiscal 2015 compared to $35.6 million in fiscal 2014. The increase is primarily due to higher actuarial losses arising from the November 30, 2014 measurement associated with the updated mortality assumption and a decrease in the discount rate used to determine our retirement benefit plans' obligations at November 30, 2014. The discount rate was 3.96% as of November 30, 2014 compared to 4.54% as of November 30, 2013. The timing of recognition of pension expense in our financial statements differs from the timing of the required pension funding under PPA or the amount of funding that can be recorded in our overhead rates through our U.S. government contracting business. Market conditions and interest rates significantly affect the assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This “smoothing” results in the creation of other accumulated income or losses which will be amortized to retirement benefit expense or benefit in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses associated with the market-related value of pension assets and all other gains and losses, including changes in the discount rate used to calculate benefit costs each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual retirement benefit expense, future expenses are impacted by changes in the market value of pension plan assets and changes in interest rates. Additionally, we sponsor a defined contribution 401(k) plan and participation in the plan is available to substantially all employees. Our contributions to the 401(k) plan were $24.4 million in fiscal 2014, $14.7 million in fiscal 2013, and $10.8 million in fiscal 2012. The cost is recoverable through our overhead rates on our U.S. government contracts. Operating Segment Information: We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance, which is a non-GAAP financial measure, represents net sales from continuing operations less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, legacy income or expenses, and unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our underlying operational performance. In addition, we provide the Non-GAAP financial measure of our operational performance called segment performance before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items. We believe the exclusion of the items listed above permits an evaluation and a comparison of results for ongoing business operations, and it is on this basis that management internally assesses operational performance. Aerospace and Defense Segment * Primary reason for change. The increase in net sales was primarily due to an increase of $360.0 million of net sales from the acquired Rocketdyne Business. Fiscal 2014 and 2013 results include 12 months and 51/2 months, respectively, of the acquired Rocketdyne Business. The increase in net sales also included increased deliveries on the Atlas V, THAAD, and Orion programs totaling $71.9 million. The increase in net sales was partially offset by (i) a decrease of $113.9 million in the various Standard Missile contracts primarily from the transitioning of the Standard Missile-3 Block IB contract from development activities to low-rate initial production, decreased development activities for the TDACS for the Standard Missile-3 Block IIA contract, and the cessation of deliveries on the Standard Missile-1 Regrain contract in fiscal 2014 as a result of contract completion; (ii) an additional week of operations in the first quarter of fiscal 2013 resulting in $27.8 million in net sales; (iii) a decrease of $21.7 million as a result of the completion of the T3 IIA and IIB contracts as the program enters the next development phase; (iv) a decrease of $26.4 million from lower deliveries and changes in the estimated measurement of progress toward completion on the Antares program; and (v) a decrease of $24.6 million as a result of lower deliveries on the GEM-T program. See net sales information below: ______ (1) Includes net sales beginning June 14, 2013 from the Rocketdyne Business (acquisition date). The decrease in the segment margin before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items in fiscal 2014 compared to fiscal 2013, was primarily due to $23.6 million, 1.5% of net sales, of cost growth on the Antares AJ-26 program, including the cost to repair or replace engines as necessary in light of the previously reported engine test failures, an associated increase in hardware inspections and corrective actions on remaining engines, costs to repair the damaged test stand, and costs resulting from delayed deliveries. ** Primary reason for change. The increase in net sales was primarily due to the following: (i) sales from the Rocketdyne Business contributed $319.4 million of net sales from the acquisition date of June 14, 2013; (ii) an increase of $53.7 million in the various Standard Missile programs primarily from increased development activities for the TDACS for the Standard Missile-3 Block IIA program and increased deliveries on the Standard Missile-1 Regrain program; and (iii) increased deliveries on the Atlas V program generating additional sales of $21.0 million. The increase in net sales was partially offset by a reduction of $16.1 million on the BLU-129B composite case program due to completion of the contract in fiscal 2012 and the timing of the follow-on BLU-129B contract which is valued at $16.0 million. Our fiscal year ends on November 30 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday of November. As a result of the 2013 calendar, Aerojet Rocketdyne had 53 weeks of operations in fiscal 2013 compared to 52 weeks of operations in fiscal 2014 and 2012. The additional week of operations, which occurred in the first quarter of fiscal 2013, accounted for $27.8 million in additional net sales. Segment margin before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items in fiscal 2013 compared to fiscal 2012 was essentially unchanged. A summary of our backlog is as follows: The increase in contract backlog from November 30, 2013 is primarily due to the receipt of large, multi-year awards on several programs including RS-68, RS-27, Atlas V, and THAAD. Total backlog includes both funded backlog (unfilled orders for which funding is authorized, appropriated and contractually obligated by the customer) and unfunded backlog (firm orders for which funding has not been appropriated). Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. Backlog is subject to funding delays or program restructurings/cancellations which are beyond our control. Of our November 30, 2014 total contract backlog, approximately 48%, or approximately $1.5 billion, is expected to be filled within one year. Real Estate Segment * Primary reason for change. Net sales and segment performance consist primarily of rental property operations, and were essentially unchanged for the periods presented. Use of Non-GAAP Financial Measures In addition to segment performance (discussed above), we provide the Non-GAAP financial measure of our operational performance called Adjusted EBITDAP. We use this metric to further our understanding of the historical and prospective consolidated core operating performance of our segments, net of expenses resulting from our corporate activities in the ordinary, on-going and customary course of our operations. Further, we believe that to effectively compare the core operating performance metric from period to period on a historical and prospective basis, the metric should exclude items relating to retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the ordinary, on-going and customary course of our operations. Accordingly, we define Adjusted EBITDAP as GAAP (loss) income from continuing operations before income taxes adjusted by interest expense, interest income, depreciation and amortization, retirement benefit expense, and unusual items which we do not believe are reflective of such ordinary, on-going and customary course activities. Adjusted EBITDAP does not represent, and should not be considered an alternative to, net (loss) income, as determined in accordance with GAAP. In addition to segment performance and Adjusted EBITDAP, we provide the Non-GAAP financial measures of free cash flow and net debt. We use these financial measures, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that these financial measures are useful because it presents our business using the same tools that management uses to evaluate progress in achieving our goals. _________ (1) Free Cash Flow, a Non-GAAP financial measure, is defined as cash flow from operating activities less capital expenditures. Free Cash Flow excludes any mandatory debt service requirements and other non-discretionary expenditures. Free Cash Flow should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to cash flows from operations presented in accordance with GAAP. The Company believes Free Cash Flow is useful as it provides supplemental information to assist investors in viewing the business using the same tools that management uses to evaluate progress in achieving the Company’s goals. Because our method for calculating the Non-GAAP measures may differ from other companies’ methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures. Environmental Matters Our policy is to conduct our businesses with due regard for the preservation and protection of the environment. We devote a significant amount of resources and management attention to environmental matters and actively manage our ongoing processes to comply with environmental laws and regulations. We are involved in the remediation of environmental conditions that resulted from generally accepted manufacturing and disposal practices at certain plants in the 1950s and 1960s. In addition, we have been designated a PRP with other companies at third party sites undergoing investigation and remediation. Estimating environmental remediation costs is difficult due to the significant uncertainties inherent in these activities, including the extent of remediation required, changing governmental regulations and legal standards regarding liability, evolving technologies and the long period of time over which most remediation efforts take place. We: • accrue for costs associated with the remediation of environmental pollution when it becomes probable that a liability has been incurred and when our proportionate share of the costs can be reasonably estimated; and • record related estimated recoveries when such recoveries are deemed probable. In addition to the costs associated with environmental remediation discussed above, we incur expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations which totaled $7.1 million in fiscal 2014, $4.9 million in fiscal 2013, and $6.3 million in fiscal 2012. A summary of our recoverable amounts, environmental reserves, and range of liability, as of November 30, 2014 is presented below: ________ (1) Excludes the long-term receivable from Northrop of $74.8 million as of November 30, 2014 related to environmental costs already paid (and therefore not reserved) by the Company in prior years that are expected to be reimbursed by Northrop. Reserves We review on a quarterly basis estimated future remediation costs that could be incurred over the contractual term or the next fifteen years of the expected remediation. These liabilities have not been discounted to their present value as the timing of cash payments is not fixed or reliably determinable. We have an established practice of estimating environmental remediation costs over a fifteen year period, except for those environmental remediation costs with a specific contractual term. With respect to the BPOU site, our estimates of anticipated environmental remediation costs only extend through the term of the project agreement for such site, which expires in 2017, since we cannot yet estimate the future cost due to the uncertainty of project definition, participation and approval by numerous third parties and the regulatory agencies, and the length of a project agreement. Therefore, no reserve has been accrued for this site for the period after the expiration of the project agreement and we will reevaluate the environmental reserves related to the BPOU site once the terms of a new agreement related to the site are available and we are able to reasonably estimate the related environmental remediation costs. At that time, the amount of reserves accrued following such reevaluation may be significant. As the period for which estimated environmental remediation costs increase, the reliability of such estimates decrease. These estimates consider the investigative work and analysis of engineers, outside environmental consultants, and the advice of legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum amount is used when no single amount in the range is more probable. Accordingly, such estimates can change as we periodically evaluate and revise such estimates as new information becomes available. We cannot predict whether new information gained as projects progress will affect the estimated liability accrued. The timing of payment for estimated future environmental costs is influenced by a number of factors such as the regulatory approval process and the time required to design, construct, and implement the remedy. A summary of our environmental reserve activity is shown below: The $33.7 million of environmental reserve additions in fiscal 2014 was primarily due to the following items: (i) $8.1 million of additional operations and maintenance for treatment facilities; (ii) $5.8 million associated with annual detailed review estimate updates; (iii) $4.0 million associated with water replacement; (iv) $3.0 million of remediation related to operable treatment units; (v) $1.5 million of additional estimated costs related to the Camden, Arkansas site; and (vi) $11.3 million related to other environmental clean-up matters. The $18.8 million of environmental reserve additions in fiscal 2013 was primarily due to the following items: (i) $6.6 million of additional operations and maintenance for treatment facilities; (ii) $4.4 million of remediation related to operable treatment units; (iii) $2.3 million of additional estimated costs related to the former Toledo, Ohio site; (iv) $1.5 million associated with water replacement; and (v) $4.0 million related to other environmental clean-up matters. The $34.7 million of environmental reserve additions in fiscal 2012 was primarily due to the following items: (i) $15.3 million of additional operations and maintenance for treatment facilities; (ii) $6.7 million of remediation related to operable treatment units; (iii) $3.5 million of additional estimated costs related to the Camden, Arkansas site; (iv) $1.4 million associated with water replacement; and (v) $7.8 million related to other environmental clean-up matters. The effect of the final resolution of environmental matters and our obligations for environmental remediation and compliance cannot be predicted with complete certainty due to changes in both the amount and timing of future expenditures as well as regulatory or technological changes. We believe, on the basis of presently available information, that the resolution of environmental matters and our obligations for environmental remediation and compliance will not have a material adverse effect on our business, liquidity and/or financial condition. We will continue our efforts to mitigate past and future costs through pursuit of claims for recoveries from insurance coverage and other PRPs and continued investigation of new and more cost effective remediation alternatives and associated technologies. As part of the acquisition of the Atlantic Research Corporation (“ARC”) propulsion business in 2003, Aerojet Rocketdyne entered into an agreement with ARC pursuant to which Aerojet Rocketdyne is responsible for up to $20.0 million of costs (“Pre-Close Environmental Costs”) associated with environmental issues that arose prior to Aerojet Rocketdyne’s acquisition of the ARC propulsion business. ARC is responsible for any cleanup costs relating to the ARC acquired businesses in excess of $20.0 million. Pursuant to a separate agreement with the U.S. government which was entered into prior to the completion of the ARC acquisition, these costs are recovered through the establishment of prices for Aerojet Rocketdyne’s products and services sold to the U.S. government. A summary of the Pre-Close Environmental Costs is shown below (in millions): Estimated Recoveries On January 12, 1999, Aerojet Rocketdyne and the U.S. government implemented the Global Settlement resolving certain prior environmental and facility disagreements, with retroactive effect to December 1, 1998. Under the Global Settlement, Aerojet Rocketdyne and the U.S. government resolved disagreements about an appropriate cost-sharing ratio with respect to the cleanup costs of the environmental contamination at the Sacramento and Azusa sites. The Global Settlement cost-sharing ratio does not have a defined term over which costs will be recovered. Additionally, in conjunction with the sale of the EIS business in 2001, Aerojet Rocketdyne entered into the Northrop Agreement whereby Aerojet Rocketdyne is reimbursed by Northrop for a portion of environmental expenditures eligible for recovery under the Global Settlement, subject to annual and cumulative limitations. Pursuant to the Global Settlement, prior to the third quarter of fiscal 2010, approximately 12% of environmental costs related to Aerojet Rocketdyne’s Sacramento site and its former Azusa site were charged to the consolidated statements of operations. Subsequent to the third quarter of fiscal 2010, because the Company’s estimated environmental costs reached the reimbursement ceiling under the Northrop Agreement, approximately 37% of such costs will not be reimbursable and were therefore directly charged to the consolidated statements of operations. Allowable environmental costs are charged to our contracts as the costs are incurred. Aerojet Rocketdyne’s mix of contracts can affect the actual reimbursement made by the U.S. government. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet Rocketdyne to continue recovering these costs from the U.S. government depends on Aerojet Rocketdyne’s sustained business volume under U.S. government contracts and programs. Pursuant to the Northrop Agreement, environmental expenditures to be reimbursed are subject to annual limitations and the total reimbursements are limited to a ceiling of $189.7 million. A summary of the Northrop Agreement activity is shown below (in millions): _______ (1) Includes the short-term receivable from Northrop of $6.0 million as of November 30, 2014. Our applicable cost estimates reached the cumulative limitation under the Northrop Agreement during the third quarter of fiscal 2010. We have expensed $30.5 million of environmental remediation provision adjustments above the cumulative limitation under the Northrop Agreement through November 30, 2014. Accordingly, subsequent to the third quarter of fiscal 2010, we have incurred a higher percentage of expense related to additions to the Sacramento site and BPOU site environmental reserve until, and if, an arrangement is reached with the U.S. government. While we are currently seeking an arrangement with the U.S. government to recover environmental expenditures in excess of the reimbursement ceiling identified in the Northrop Agreement, there can be no assurances that such a recovery will be obtained, or if not obtained, that such unreimbursed environmental expenditures will not have a materially adverse effect on our operating results, financial condition, and/or cash flows. A summary of the current and non-current recoverable amounts from Northrop and the U.S. government is shown below: ______ (1) Excludes amounts recoverable from Northrop associated with legal settlements. The amounts recoverable from Northrop for legal settlements totaled $0.2 million and $0.6 million as of November 30, 2014 and 2013, respectively. In the aggregate, amounts recoverable from Northrop totaled $82.5 million and $88.5 million at November 30, 2014 and 2013, respectively. Fiscal 2014 Activity Fiscal 2014 additions - The $21.4 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $5.1 million of additional operations and maintenance for treatment facilities; (ii) $3.7 million associated with annual detailed review estimate updates; (iii) $2.5 million associated with water replacement; (iv) $1.9 million of remediation related to operable treatment units; (v) $1.5 million of additional estimated costs related to the Camden, Arkansas site; and (vi) $6.7 million related to other environmental clean-up matters. Fiscal 2014 reimbursements -The $31.0 million of environmental expenditures that were reimbursed related to the following items: (i) $12.6 million for operations and maintenance of treatment facilities; (ii) $8.1 million of remediation related to operable treatment units; (iii) $2.7 million associated with test sampling and analysis; (iv) $1.7 million of additional estimated costs related to the Camden, Arkansas site; (v) $1.3 million associated with water supply replacement; and (vi) $4.6 million related to other environmental clean-up matters. Fiscal 2013 Activity Fiscal 2013 additions - The $8.7 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $3.9 million of additional operations and maintenance for treatment facilities; (ii) $2.6 million of remediation related to operable treatment units; (iii) $0.9 million associated with water replacement; and (iv) $1.3 million related to other environmental clean-up matters. Fiscal 2013 reimbursements - The $30.5 million of environmental expenditures that were reimbursed related to the following items: (i) $11.5 million for operations and maintenance of treatment facilities; (ii) $9.3 million of remediation related to operable treatment units; (iii) $2.1 million associated with water supply replacement; (iv) $1.6 million of additional estimated costs related to the Camden, Arkansas site; and (v) $6.0 million related to other environmental clean-up matters. Fiscal 2012 Activity Fiscal 2012 additions - The $21.7 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $9.0 million of additional operations and maintenance for treatment facilities; (ii) $4.3 million of remediation related to operable treatment units; (iii) $3.3 million of additional estimated costs related to the Camden, Arkansas site; (iv) $0.8 million associated with water replacement; and (v) $4.3 million related to other environmental clean-up matters. Fiscal 2012 reimbursements - The $29.7 million of environmental expenditures that were reimbursed related to the following items: (i) $14.7 million for operations and maintenance of treatment facilities; (ii) $7.1 million of remediation related to operable treatment units; (iii) $1.8 million of additional estimated costs related to the Camden, Arkansas site; (iv) $1.3 million associated with water supply replacement; and (v) $4.8 million related to other environmental clean-up matters. Environmental reserves and recoveries impact to the Consolidated Statements of Operations The expenses associated with adjustments to the environmental reserves are recorded as a component of other expense, net in the consolidated statements of operations. Summarized financial information for the impact of environmental reserves and recoveries to the consolidated statements of operations is set forth below: Adoption of New Accounting Principle In July 2013, the Financial Accounting Standards Board (“FASB”) issued an amendment to the accounting guidance related to the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carryforward exists. The guidance requires an unrecognized tax benefit to be presented as a decrease in a deferred tax asset where a net operating loss, a similar tax loss, or a tax credit carryforward exists and certain criteria are met. We adopted this guidance beginning in the first quarter of fiscal 2014. As the accounting standard only impacted presentation, the new standard did not have an impact on our financial position, results of operations, or cash flows. In April 2014, the FASB issued authoritative guidance which specifies that only disposals, such as a disposal of a major line of business, representing a strategic shift in operations should be presented as discontinued operations. In addition, the new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. We adopted this guidance in the fourth quarter of fiscal 2014. An entity should not apply the amendments in this new guidance to a component of an entity that is classified as held for sale before the effective date even if the component of an entity is disposed of after the effective date. As the accounting standard only impacted presentation, the new standard did not have an impact on our financial position, results of operations, or cash flows. New Accounting Pronouncements In May 2014, the FASB amended the existing accounting standards for revenue recognition. The amendments are based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. We are required to adopt the amendments in the first quarter of fiscal 2018. Early adoption is not permitted. The amendments may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of initial application. We are currently evaluating the impact of these amendments and the transition alternatives on our consolidated financial statements. In August 2014, the FASB issued an amendment to the accounting guidance related to the evaluation of an entity to continue as a going concern. The amendment establishes management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern in connection with preparing financial statements for each annual and interim reporting period. The update also gives guidance to determine whether to disclose information about relevant conditions and events when there is substantial doubt about an entity’s ability to continue as a going concern. This guidance is effective for us as of November 30, 2017. The new guidance will not have an impact on our financial position, results of operations, or cash flows. Liquidity and Capital Resources Net Cash Provided by (Used In) Operating, Investing, and Financing Activities The change in cash and cash equivalents was as follows: Net Cash Provided by Operating Activities The $150.4 million of cash provided by operating activities in fiscal 2014 was primarily the result of loss from continuing operations before income taxes adjusted for non-cash items which generated $125.2 million. In addition, we generated $62.3 million from working capital (defined as accounts receivables, inventories, other current assets, accounts payable, contract advances, real estate activities, and other liabilities excluding income taxes payable). The cash generated from working capital was primarily due to an increase of $94.1 million in cash advances on long-term contracts. This amount was partially offset by the cash used of $29.9 million for the Rocketdyne Business integration activities. In addition, we paid $4.9 million for income taxes, net in fiscal 2014. The $77.6 million of cash provided by operating activities in fiscal 2013 was primarily the result of loss from continuing operations before income taxes adjusted for non-cash items which generated $106.0 million. This amount was partially offset by cash used to fund working capital (excluding the impact of changes in current deferred income taxes) including our real estate activities of $18.3 million. The funding of working capital is primarily due to the following (i) a decrease in contract advances due to the timing of customer payments and (ii) an increase in accounts receivables due to timing of sales and billing during the quarter. These factors were partially offset by (i) an increase in accounts payable related to the increase in cost-reimbursable contract sales and timing of payments and (ii) an increase in other current liabilities primarily related to the timing of payments. The $86.2 million of cash provided by operating activities in fiscal 2012 was primarily the result of the net loss adjusted for non-cash items which generated $64.1 million of cash and an increase of $22.3 million in accounts payable which was primarily due to the timing of payments. Net Cash Used In Investing Activities During fiscal 2014, 2013 and 2012, we had capital expenditures of $43.4 million, $63.2 million and $37.2 million, respectively. During fiscal 2013 and 2012, the capital expenditures total included $16.4 million and $14.9 million, respectively, related to our ERP implementation. Additionally in fiscal 2014 and 2013, capital expenditures total included $11.3 million and $25.4 million, respectively, related to consolidating the Rocketdyne Business facilities. During fiscal 2014, we received $0.2 million for a purchase price adjustment for the Rocketdyne Business and we generated proceeds of $7.5 million from the sale of non-core technology. During fiscal 2013, we purchased the Rocketdyne Business for $411.2 million (see Note 4 in Notes to Consolidated Financial Statements.) During fiscal 2012, we generated proceeds of $0.6 million from the sale of a property. Net Cash (Used in) Provided by Financing Activities During fiscal 2014, we repurchased 3.5 million of our common shares at a cost of $64.5 million. We also issued $189.0 million of debt and had $166.3 million in debt cash payments (see below). In addition, we incurred $4.2 million of debt issuance costs. During fiscal 2013, we issued $460.0 million of debt and had $12.8 million in cash payments of debt (see below). In addition, we incurred $14.9 million of debt issuance costs. During fiscal 2012, we had $77.7 million in debt repayments. In addition, other financing activities provided $2.2 million of cash. Debt Activity and Covenants Our debt activity during fiscal 2014 was as follows: We are subject to certain limitations including the ability to incur additional debt, make certain investments and acquisitions, and make certain restricted payments, including stock repurchases and dividends. The Senior Credit Facility includes events of default usual and customary for facilities of this nature, the occurrence of which could lead to an acceleration of our obligations thereunder. Additionally, the Senior Credit Facility includes certain financial covenants, including that we maintain (i) a maximum total leverage ratio, calculated net of cash up to a maximum of $150.0 million, of 4.50 to 1.00 through fiscal periods ending November 30, 2015, 4.25 to 1.00 through fiscal periods ending November 30, 2017, and 4.00 to 1.00 thereafter; and (ii) a minimum interest coverage ratio of 2.40 to 1.00. We were in compliance with our financial and non-financial covenants as of November 30, 2014. Outlook Short-term liquidity requirements consist primarily of recurring operating expenses, including but not limited to costs related to our capital and environmental expenditures, integration costs of the Rocketdyne Business, debt service requirements, and retirement benefit plans. We believe that our existing cash and cash equivalents and existing credit facilities will provide sufficient funds to meet our operating plan for the next twelve months. The operating plan for this period provides for full operation of our businesses, and interest and principal payments on our debt. As of November 30, 2014, we had $164.2 million of available borrowings under our Senior Credit Facility and Subordinated Credit Facility. Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of November 30, 2014. Our failure to comply with these covenants could result in an event of default that, if not cured or waived, could result in the acceleration of the Senior Credit Facility, the Subordinated Credit Facility, the 7 1/8% Notes, and the 4 1/16% Debentures. In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility, and in certain cases, would cause cross defaults on the Subordinated Credit Facility, 7 1/8% Notes and 4 1/16% Debentures. We are committed to a cash management strategy that maintains liquidity to adequately support the operation of the business, our growth strategy and to withstand unanticipated business volatility. We believe that cash generated from operations, together with our current levels of cash and investments as well as availability under our revolving credit facility and delayed draw term loan, should be sufficient to maintain our ongoing operations, support working capital requirements and fund anticipated capital expenditures related to projected business growth. Our cash management strategy includes maintaining the flexibility to pay down debt and/or repurchase shares depending on economic and other conditions. In connection with the implementation of our cash management strategy, our Board of Directors and management may seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise if we believe that it is in our best interests. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. As disclosed in Note 8(e) of the Notes to Consolidated Financial Statements, we have a $55.0 million commitment associated with the pending future acquisition of UTC’s 50% ownership interest of RD Amross. As disclosed in Notes 8(b) and 8(c) of the Notes to Consolidated Financial Statements, we have exposure for certain legal and environmental matters. We believe that it is currently not possible to estimate the impact, if any, that the ultimate resolution of certain of these matters will have on our financial position, results of operations, or cash flows. Major factors that could adversely impact our forecasted operating cash flows and our financial condition are described in Part I, Item 1A. Risk Factors. In addition, our liquidity and financial condition will continue to be affected by changes in prevailing interest rates on the portion of debt that bears interest at variable interest rates. Contractual Obligations We have contractual obligations and commitments in the form of debt obligations, operating leases, certain other liabilities, and purchase commitments. The following table summarizes our contractual obligations as of November 30, 2014: ________ (1) Includes our 4 1/16% Debentures debt obligation. With respect to the 4 1/16% Debentures holders option to require us to repurchase all of the outstanding 4 1/16% Debentures, or any portion thereof that is a multiple of $1,000 principal amount, on December 31, 2014 ("2014 Put Rights"), we have the unilateral option to pay the 4 1/16% Debentures holders in shares of our common stock and have the intent and ability to settle the 2014 Put Rights in shares of our common stock rather than the use of our current assets or short term funding as of November 30, 2014. As of November 30, 2014, we had $133.6 million outstanding principal of our 4 1/16% Debentures, convertible into 14.8 million of shares of our common stock. As of December 31, 2014, none of the holders of the 4 1/16% Debentures surrendered their 4 1/16% Debentures for repurchase prior to the expiration of the optional repurchase date of December 31, 2014. See January 2015 activity related to our 4 1/16% Debentures in Note 16 in Notes to Consolidated Financial Statements. (2) Includes interest on variable debt calculated based on interest rates at November 30, 2014. (3) The payments presented above are expected payments for the next 10 years. The payments for postretirement medical and life insurance benefits reflect the estimated benefit payments of the plans using the provisions currently in effect. The obligation related to postretirement medical and life insurance benefits is actuarially determined on an annual basis. The estimated payments have been reduced to reflect the provisions of the Medicare Prescription Drug, Improvement and Modernization Act of 2003. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (4) The conditional asset retirement obligations presented are related to our Aerospace and Defense segment, and certain of these future obligations are allowable costs under our contracts with the U.S. government. As of November 30, 2014, the liability for uncertain income tax positions was $6.2 million. Due to the uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We may be required to make significant cash contributions in the future to fund our defined benefit pension plan, a portion of which we may not be able to immediately recover from our U.S. government contracts. We also issue purchase orders and make other commitments to suppliers for equipment, materials, and supplies in the normal course of business. These purchase commitments are generally for volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers and would be subject to reimbursement if a cost-plus contract was terminated. Arrangements with Off-Balance Sheet Risk As of November 30, 2014, arrangements with off-balance sheet risk consisted of: • $46.8 million in outstanding commercial letters of credit expiring through October 2015, the majority of which may be renewed, primarily to collateralize obligations for environmental remediation and insurance coverage. • $43.9 million in outstanding surety bonds to primarily satisfy indemnification obligations for environmental remediation coverage. • Up to $120.0 million aggregate in guarantees by GenCorp of Aerojet Rocketdyne’s obligations to U.S. government agencies for environmental remediation activities. • $55.0 million related to the pending future acquisition of UTC’s 50% ownership interest of RD Amross. • Guarantees, jointly and severally, by our material domestic subsidiaries of their obligations under our Senior Credit Facility and 7 1/8% Notes. In addition to the items discussed above, we have and will from time to time enter into certain types of contracts that require us to indemnify parties against potential third-party and other claims. These contracts primarily relate to: (i) divestiture agreements, under which we may provide customary indemnification to purchasers of our businesses or assets including, for example, claims arising from the operation of the businesses prior to disposition, liability to investigate and remediate environmental contamination existing prior to disposition; (ii) certain real estate leases, under which we may be required to indemnify property owners for claims arising from the use of the applicable premises; and (iii) certain agreements with officers and directors, under which we may be required to indemnify such persons for liabilities arising out of their relationship with us. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. We provide product warranties in conjunction with certain product sales. The majority of our warranties are one-year standard warranties for parts, workmanship, and compliance with specifications. On occasion, we have made commitments beyond the standard warranty obligation. While we have contracts with warranty provisions, there is not a history of any significant warranty claims experience. A reserve for warranty exposure is made on a product by product basis when it is both estimable and probable. These costs are included in the program’s estimate at completion and are expensed in accordance with our revenue recognition methodology as allowed under GAAP for that particular contract. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP that offer acceptable alternative methods for accounting for certain items affecting our financial results, such as determining inventory cost, depreciating long-lived assets, and recognizing revenues. The preparation of financial statements requires the use of estimates, assumptions, judgments, and interpretations that can affect the reported amounts of assets, liabilities, revenues, and expenses, the disclosure of contingent assets and liabilities and other supplemental disclosures. The development of accounting estimates is the responsibility of our management. Management discusses those areas that require significant judgment with the audit committee of our board of directors. All of our financial disclosures in our filings with the SEC have been reviewed with the audit committee. Although we believe that the positions we have taken with regard to uncertainties are reasonable, others might reach different conclusions and our positions can change over time as more information becomes available. If an accounting estimate changes, its effects are accounted for prospectively and, if significant, disclosed in the Notes to Consolidated Financial Statements. The areas most affected by our accounting policies and estimates are revenue recognition, other contract considerations, goodwill, retirement benefit plans, litigation, environmental remediation costs and recoveries, and income taxes. Except for income taxes and litigation matters related to discontinued operations, which are not allocated to our operating segments, these areas affect the financial results of our business segments. For a discussion of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the Notes to Consolidated Financial Statements. Revenue Recognition In our Aerospace and Defense segment, recognition of profit on long-term contracts requires the use of assumptions and estimates related to the contract value or total contract revenue, the total cost at completion and the measurement of progress towards completion. Due to the nature of the programs, developing the estimated total cost at completion requires the use of significant judgment. Estimates are continually evaluated as work progresses and are revised as necessary. Factors that must be considered in estimating the work to be completed include labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements and inflationary trends, schedule and performance delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. We review contract performance and cost estimates for some contracts at least monthly and for others at least quarterly and more frequently when circumstances significantly change. When a change in estimate is determined to have an impact on contract profit, we will record a positive or negative adjustment to the statement of operations. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact from changes in estimates and assumptions on the statement of operations on key contracts, representing 75% of our net sales over the last three fiscal years, accounted for under the percentage-of-completion method of accounting: The fiscal 2014 unfavorable changes in contract estimates were primarily driven by unanticipated inefficiencies and cost growth on the Antares AJ-26 program and higher overhead costs. The fiscal 2013 favorable changes in contract estimates was primarily driven by better than expected performance on tactical systems programs due to manufacturing efficiencies and lower overhead costs. The improvements in fiscal 2013 were offset by unexpected cost growth on the Antares AJ-26 program. The fiscal 2012 favorable changes in contract estimates were primarily driven by better than expected performance on the Atlas V program and several tactical systems programs due to manufacturing efficiencies and lower overhead costs. These improvements in fiscal 2012 were offset by unanticipated inefficiencies and cost growth on a space launch contract. We consider the nature of the individual underlying contract and the type of products and services provided in determining the proper accounting for a particular contract. Each method is applied consistently to all contracts having similar characteristics, as described below. We typically account for our contracts using the percentage-of-completion method, and progress is measured on a cost-to-cost or units-of-delivery basis. Sales are recognized using various measures of progress depending on the contractual terms and scope of work of the contract. We recognize revenue on a units-of-delivery basis when contracts require unit deliveries on a frequent and routine basis. Sales using this measure of progress are recognized at the contractually agreed upon unit price. Where the scope of work on contracts principally relates to research and/or development efforts, or the contract is predominantly a development effort with few deliverable units, we recognize revenue on a cost-to-cost basis. In this case, sales are recognized as costs are incurred and include estimated earned fees or profits calculated on the basis of the relationship between costs incurred and total estimated costs at completion. Revenue on service or time and material contracts is recognized when performed. If at any time expected costs exceed the value of the contract, the loss is recognized immediately. If change orders are in dispute or are unapproved in regard to both scope and price they are evaluated as claims. We recognize revenue on claims when recovery of the claim is probable and the amount can be reasonably estimated. Revenue on claims is recognized only to the extent that contract costs related to the claims have been incurred and when it is probable that the claim will result in a bona fide addition to contract value that can be reliably estimated. No profit is recognized on a claim until final settlement occurs. Certain government contracts contain cost or performance incentive provisions that provide for increased or decreased fees or profits based upon actual performance against established targets or other criteria. Incentive and award fees, which are generally awarded at the discretion of the customer, are considered in estimating profit rates at the time the amounts can be reasonably determined and are reasonably assured based on historical experience and anticipated performance. We continually evaluate our performance and incorporate any anticipated changes in penalties and cost incentives into our revenue and earnings calculations. Performance incentives, which increase or decrease earnings based solely on a single significant event, generally are not recognized until an event occurs. Revenue from real estate asset sales is recognized when a sufficient down-payment has been received, financing has been arranged and title, possession and other attributes of ownership have been transferred to the buyer. The allocation to cost of sales on real estate asset sales is based on a relative fair market value computation of the land sold which includes the basis on our books, capitalized entitlement costs, and an estimate of our continuing financial commitment. Revenue that is not derived from long-term development and production contracts, or real estate asset transactions, is recognized when persuasive evidence of a final agreement exists, delivery has occurred, the selling price is fixed or determinable and payment from the customer is reasonably assured. Sales are recorded net of provisions for customer pricing allowances. Other Contract Considerations Our sales are driven by pricing based on costs incurred to produce products and perform services under contracts with the U.S. government. Cost-based pricing is determined under the FAR and Cost Accounting Standards ("CAS"). The FAR and CAS provide guidance on the types of costs that are allowable and allocable in establishing prices for goods and services under U.S. government contracts. For example, costs such as those related to pension contributions in accordance with the PPA that are in excess of CAS allowable pension costs, charitable contributions, advertising, interest expense, and public relations are unallowable, and therefore not recoverable through sales. In addition, we may enter into agreements with the U.S. government that address the subjects of allowability and allocability of costs to contracts for specific matters. We closely monitor compliance with and the consistent application of our critical accounting policies related to contract accounting. We review the status of contracts through periodic contract status and performance reviews. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel independent from the business segment performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are reviewed for compliance with regulatory standards by our personnel, and are subject to audit by the DCAA. Accordingly, we record an allowance on our unbilled receivables for amounts of potential contract overhead costs which may not be successfully negotiated and collected. Goodwill Goodwill represents the excess of the purchase price of an acquired enterprise or assets over the fair values of the identifiable assets acquired and liabilities assumed. Tests for impairment of goodwill are performed on an annual basis, or at any other time, if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. We evaluated goodwill for impairment as of September 1, 2014 and 2013, and determined that goodwill was not impaired. All of our recorded goodwill resides in the Aerospace and Defense reporting unit. As of September 1, 2014, we performed a “Step One” analysis to evaluate goodwill impairment and determined that the fair value of the Aerospace and Defense reporting unit exceeded its carrying amount. As of September 1, 2013 , we evaluated goodwill using a “Step Zero analysis” and determined that it was more likely than not that the fair value of the Aerospace and Defense reporting unit exceeded its carrying amount. To determine the fair value of our Aerospace and Defense reporting unit, we primarily relied upon a discounted cash flow analysis which requires significant assumptions and estimates about future operations, including judgments about expected revenue growth and operating margins, and timing and amounts of expected future cash flows. The cash flows employed in the discounted cash flow analysis are based on five-year financial forecasts developed by management. The analysis also involves discounting the future cash flows to a present value using a discount rate that properly accounts for the risk and nature of the reporting unit cash flows and the rates of return debt and equity holders would require to invest their capital in the Aerospace and Defense reporting unit. In assessing the reasonableness of our estimated fair value of the Aerospace and Defense reporting unit, we evaluate the results of the discounted cash flow analysis in light of what investors are paying for similar interests in comparable aerospace and defense companies as of the valuation date. We also ensure that the reporting unit fair value is reasonable given the market value of us as of the valuation date. We evaluate qualitative factors (including macroeconomic conditions, industry and market considerations, cost factors, and overall financial performance) to determine whether it is necessary to perform the first step of the two-step goodwill test. This step is referred to as the “Step Zero analysis”. If it is determined that it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, we will need to proceed to the first step (“Step One”) of the two-step goodwill test. In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, relevant events and circumstances as discussed below shall be assessed. If, after assessing the totality of events or circumstances, we determine that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the first and second steps of the impairment test are unnecessary. Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business climate or legal factors; adverse cash flow trends; an adverse action or assessment by a regulator; unanticipated competition; loss of key personnel; decline in stock price; and results of testing for recoverability of a significant asset group within a reporting unit. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recorded. There can be no assurance that our estimates and assumptions made for purposes of its goodwill impairment testing will prove to be accurate predictions of the future. If our assumptions and estimates are incorrect, we may be required to record goodwill impairment charges in future periods. Retirement Benefit Plans Our defined benefit pension plan future benefit accrual was discontinued in fiscal 2009. In addition, we provide medical and life insurance benefits (“postretirement benefits”) to certain eligible retired employees, with varied coverage by employee group. Annual charges are made for the cost of the plans, including administrative costs, interest costs on benefit obligations, and net amortization and deferrals, increased or reduced by the return on assets. We also sponsor a defined contribution 401(k) plan and participation in the plan is available to substantially all employees Retirement benefits are a significant cost of doing business and represent obligations that will be ultimately settled far in the future and therefore are subject to estimates. We will recover portions of any required retirement benefits funding through our government contracts. Our pension and medical and life insurance benefit obligations and related costs are calculated using actuarial concepts in accordance with GAAP. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine service cost and interest cost to arrive at pension income or expense for the year. We used the following discount rate to determine the benefit obligations for the applicable fiscal year. We used the following assumptions to determine the net periodic benefit expense for the applicable fiscal year. ______ * Not applicable The discount rate represents the current market interest rate used to determine the present value of future cash flows currently expected to be required to settle pension obligations. Based on market conditions, discount rates can experience significant variability. Changes in discount rates can significantly change the liability and, accordingly, the funded status of the pension plan. The assumed discount rate represents the market rate available for investments in high-quality fixed income instruments with maturities matched to the expected benefit payments for pension and medical and life insurance benefit plans. The expected long-term rate of return on plan assets represents the rate of earnings expected in the funds invested, and funds to be invested, to provide for anticipated benefit payments to plan participants. We evaluated the plan’s historical investment performance, its current and expected asset allocation, and, with input from our external advisors and investment managers, developed best estimates of future investment performance of the plan’s assets. Based on this analysis, we have assumed a long-term rate of return on plan assets of 8.00%. Market conditions and interest rates significantly affect assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This “smoothing” results in the creation of other accumulated income or loss which will be amortized to pension costs in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses in the market-related value of pension assets and all other gains and losses including changes in the discount rate used to calculate benefit costs each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual pension costs, future pension costs are impacted by changes in the market value of pension plan assets and changes in interest rates. In addition, we maintain medical and life insurance benefits other than pensions that are not funded. A one percentage point change in the key assumptions would have the following effects on the projected benefit obligations as of November 30, 2014 and on expense for fiscal 2014: Contingencies and Litigation We are currently involved in certain legal proceedings and, as required, have accrued our estimate of the probable costs and recoveries for resolution of these claims. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in assumptions or the effectiveness of strategies related to these proceedings. See Notes 8(b) and 8(c) in Notes to Consolidated Financial Statements for more detailed information on litigation exposure. Reserves for Environmental Remediation and Recoverable from the U.S. Government and Other Third Parties for Environmental Remediation Costs For a discussion of our accounting for environmental remediation obligations and costs and related legal matters, see “Environmental Matters” above and Notes 8(c) and 8(d) in Notes to Consolidated Financial Statements. We accrue for costs associated with the remediation of environmental contamination when it becomes probable that a liability has been incurred, and when our costs can be reasonably estimated. Management has a well-established process in place to identify and monitor our environmental exposures. In most cases, only a range of reasonably probable costs can be estimated. In establishing the reserves, the most probable estimated amount is used when determinable, and the minimum amount is used when no single amount in the range is more probable. Environmental reserves include the costs of completing remedial investigation and feasibility studies, remedial and corrective actions, regulatory oversight costs, the cost of operation and maintenance of the remedial action plan, and employee compensation costs for employees who are expected to devote a significant amount of time to remediation efforts. Calculation of environmental reserves is based on the evaluation of currently available information with respect to each individual environmental site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. Such estimates are based on the expected costs of investigation and remediation and the likelihood that other potentially responsible parties will be able to fulfill their commitments at sites where we may be jointly or severally liable. At the time a liability is recorded for future environmental costs, we record an asset for estimated future recoveries that are estimable and probable. Some of our environmental costs are eligible for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements. We consider the recovery probable based on the Global Settlement Agreement, Northrop Agreement, government contracting regulations, and our long history of receiving reimbursement for such costs. Income Taxes We file a consolidated U.S. federal income tax return for the Company and our 100% owned consolidated subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in the period of the enactment date of the change. The carrying value of our deferred tax assets is dependent upon our ability to generate sufficient taxable income in the future. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence is considered, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, the length of carryback and carryforward periods, and evaluation of potential tax planning strategies. Despite our belief that our tax return positions are consistent with applicable tax laws, we believe that certain positions are likely to be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or some partial adjustment reached through negotiations or litigation. Our tax reserves reflect the difference between the tax benefit claimed on tax returns and the amount recognized in the financial statements. The accounting standards provide guidance for the recognition and measurement in financial statements for uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process, the first step being recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate resolution with a taxing authority. As the examination process progresses with tax authorities, adjustments to tax reserves may be necessary to reflect taxes payable upon settlement. Tax reserve adjustments related to positions impacting the effective tax rate affect the provision for income taxes. Tax reserve adjustments related to positions impacting the timing of deductions impact deferred tax assets and liabilities.

<s>[INST] The following discussion should be read in conjunction with the other sections of this Report, including the Consolidated Financial Statements and Notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report, and the disclaimer regarding forwardlooking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations. Overview We are a manufacturer of aerospace and defense products and systems with a real estate segment that includes activities related to the rezoning, entitlement, sale, and leasing of our excess real estate assets. We develop and manufacture propulsion systems for defense and space applications, and armaments for precision tactical and longrange weapon systems applications. Our continuing operations are organized into two segments: Aerospace and Defense includes the operations of our whollyowned subsidiary Aerojet Rocketdyne, a leading technologybased designer, developer and manufacturer of aerospace and defense products and systems for the U.S. government, including the DoD, NASA, major aerospace and defense prime contractors as well as portions of the commercial sector. Aerojet Rocketdyne is a worldrecognized engineering and manufacturing company that specializes in the development and production of propulsion systems for defense and space applications, armament systems for precision tactical systems and munitions, and is considered a domestic market leader in launch propulsion, inspace propulsion, missile defense propulsion, tactical missile propulsion and hypersonic propulsion systems. Real Estate includes the activities of our whollyowned subsidiary Easton Development Company, LLC related to the rezoning, entitlement, sale, and leasing of our excess real estate assets. We own approximately 12,000 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento. We are currently in the process of seeking zoning changes and other governmental approvals on a portion of the Sacramento Land to optimize its value. In addition, we are currently in the process of completing certain infrastructure improvements to the Sacramento Land to reduce the time a developer would have to hold the Sacramento Land before development could start. A summary of the significant financial highlights for fiscal 2014 which management uses to evaluate our operating performance and financial condition is presented below. Net sales for fiscal 2014 totaled $1,597.4 million compared to $1,383.1 million for fiscal 2013. Fiscal 2014 and 2013 results include 12 months and 5 1/2 months, respectively, of the Rocketdyne Business operating results (see below). Net loss for fiscal 2014 was $(53.0) million, or $(0.92) loss per share, compared to net income of $167.9 million, or $2.11 diluted income per share, for fiscal 2013. The net loss for fiscal 2014 included pretax cost growth of $23.6 million on the Antares AJ26 program and a pretax charge of $60.6 million related to the repurchase of $59.6 million of principal of our 4 1/16% Debentures. The net income for fiscal 2013 included a $193.9 million income tax benefit primarily associated with the release of deferred tax asset valuation allowance reserves. Adjusted EBITDAP (NonGAAP measure*) for fiscal 2014 was $174.2 million, or 10.9% of net sales, compared to $155.6 million, or 11.3% of net sales, for fiscal 2013. Segment performance (NonGAAP measure*) before environmental remediation provision adjustments, retirement benefit expense, and unusual items was $145.5 million for fiscal 2014, compared to $151.4 million for fiscal 2013. Cash provided by operating activities in fiscal 2014 totaled $150.4 million, [/INST] Positive. </s>

AEROJET ROCKETDYNE HOLDINGS, INC.

2016-02-16

2015-11-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Unless otherwise indicated or required by the context, as used in this Form 10-K, the terms “we,” “our” and “us” refer to Aerojet Rocketdyne Holdings, Inc. and all of its subsidiaries that are consolidated in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report, and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations. Restatement As indicated in Note 2 to our consolidated financial statements included in Part II, Item 8, of this Form 10-K, we corrected errors in our previously issued consolidated financial statements for the Restated Periods primarily related to the following matters: (i) purchase accounting associated with contracts acquired as part of the acquisition of the Rocketdyne Business; (ii) contract accounting related to subsequent modifications to one significant acquired contract; (iii) contract accounting related to the improper recognition of sales associated with incentives; and (iv) other individually immaterial items. A summary of the impact to pretax income (loss) from continuing operations by reporting period is presented below (in millions): ___________ (1) Our errors associated with purchase accounting primarily related to the following: (i) fair value assessment of Rocketdyne Business acquired customer contracts at the acquisition date following the close of the transaction. The Company failed to fair value three acquired contracts in purchase accounting; and (ii) the estimates of the Rocketdyne Business contracts' percentage of completion used to recognize net sales should have been based on its estimate of remaining effort on such contracts at the acquisition date instead of the inception date of the contract. (2) We did not appropriately account for one significant Rocketdyne Business contract amendment. Instead of being accounted for as a modification, the amendment was accounted for as a new contract. (3) We immediately recognized incentives as sales based on the full amount received rather than on the percentage of completion of the related contract. The correction of the matters described above resulted in the following adjustments to the previously issued consolidated financial statements: (i) an increase of $0.3 million, or $0.00 loss per share, to net loss for the first nine months of fiscal 2015; (ii) a decrease of $3.0 million, or $0.06 loss per share, to net loss for fiscal 2014; and (iii) a decrease of $5.0 million, or $0.06 diluted income per share, to net income for fiscal 2013. A summary of the impact to net (loss) income on the consolidated statements of operations by reporting period is presented below (in millions): Overview We are a manufacturer of aerospace and defense products and systems which develops and manufactures propulsion systems for defense and space applications, and armaments for precision tactical and long-range weapon systems applications. We also have a real estate segment that includes activities related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. Our continuing operations are organized into two segments: Aerospace and Defense - includes the operations of our wholly-owned subsidiary Aerojet Rocketdyne, a leading technology-based designer, developer and manufacturer of aerospace and defense products and systems for the U.S. government, including the DoD, NASA, major aerospace and defense prime contractors as well as portions of the commercial sector. Aerojet Rocketdyne is a world-recognized engineering and manufacturing company that specializes in the development and production of propulsion systems for defense and space applications, armament systems for precision tactical systems and munitions, and is considered a domestic market leader in launch propulsion, in-space propulsion, missile defense propulsion, tactical missile propulsion and hypersonic propulsion systems. Real Estate - includes the activities of our wholly-owned subsidiary Easton related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. We own approximately 11,500 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento. We are currently in the process of seeking zoning changes and other governmental approvals on a portion of the Sacramento Land to optimize its value. In addition, we are currently in the process of completing certain infrastructure improvements to the Sacramento Land to enhance its value. A summary of the significant financial highlights for fiscal 2015 which management uses to evaluate our operating performance and financial condition is presented below. • Net sales for fiscal 2015 totaled $1,708.3 million compared to $1,602.2 million for fiscal 2014. • Net loss for fiscal 2015 was $(16.2) million, or $(0.27) loss per share, compared to net loss of $(50.0) million, or $(0.86) loss per share, for fiscal 2014. • Adjusted EBITDAP (Non-GAAP measure*) for fiscal 2015 was $217.9 million, or 12.8% of net sales, compared to $181.5 million, or 11.3% of net sales, for fiscal 2014. • Segment performance (Non-GAAP measure*) before environmental remediation provision adjustments, retirement benefit expense, and unusual items was $200.1 million for fiscal 2015, compared to $152.8 million for fiscal 2014. • Cash provided by operating activities in fiscal 2015 totaled $65.1 million, compared to $150.6 million in fiscal 2014. • Free cash flow (Non-GAAP measure*) in fiscal 2015 totaled $28.3 million, compared to $107.2 million in fiscal 2014. • As of November 30, 2015, we had $2.4 billion of total funded contract backlog compared to $2.2 billion as of November 30, 2014. • As of November 30, 2015, we had $4.1 billion of total contract backlog (total funded and unfunded backlog) compared to $3.1 billion as of November 30, 2014. • As of November 30, 2015, we had $440.9 million in net debt (Non-GAAP measure*) compared to $516.3 million as of November 30, 2014. _________ * We provide Non-GAAP measures as a supplement to financial results based on GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading “Operating Segment Information” and “Use of Non-GAAP Financial Measures.” Our fiscal year ends on November 30 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday of November. As a result of the 2013 calendar, Aerojet Rocketdyne had 14 weeks of operations in the first quarter of fiscal 2013 compared to 13 weeks of operations in the first quarter of fiscal 2015 and 2014. The additional week of operations in the first quarter of fiscal 2013 accounted for $27.8 million in additional net sales. On January 20, 2016, our board of directors approved a change in our fiscal year-end from November 30 of each year to December 31 of each year. In July 2012, we signed the Original Purchase Agreement with UTC to acquire the Rocketdyne Business from UTC for $550 million. On June 12, 2013, we entered into an Amended and Restated Purchase Agreement with UTC, which amended and restated the Original Purchase Agreement, as amended. On June 14, 2013, we completed the acquisition of substantially all of the Rocketdyne Business pursuant to the Amended and Restated Purchase Agreement. The aggregate consideration to UTC was $411 million which represents the initial purchase price of $550 million reduced by $55 million relating to the potential future acquisition of UTC’s 50% ownership interest of RD Amross (a joint venture with NPO Energomash of Khimki, Russia which sells RD-180 engines to RD Amross) and the portion of the UTC business that markets and supports the sale of RD-180 engines. The acquisition of UTC’s 50% ownership interest of RD Amross and UTC’s related business was contingent upon certain conditions including receipt of certain Russian governmental regulatory approvals, which was not obtained. Pursuant to the terms of the Amended and Restated Purchase Agreement, on June 14, 2015, our obligations to consummate the RDA Acquisition expired. The unaudited pro forma information for fiscal 2013 set forth below gives effect to the Acquisition as if it had occurred at the beginning of the year. These amounts have been calculated after applying our accounting policies and adjusting the results of the Rocketdyne Business to reflect depreciation and amortization that would have been charged assuming the fair value adjustments to property, plant and equipment and intangible assets had been applied as at the beginning of the year, together with the tax effects, as applicable. The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the Acquisition been consummated as of that time or that may result in the future. We are operating in an environment that is characterized by both increasing complexity in the global security environment, as well as continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. We continuously evaluate a broad range of options that could be implemented to increase operational efficiency across all sites, and improve our overall market competitiveness. Our decisions will be focused on moving us forward to solidify our leadership in the propulsion markets. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, implementation of our CIP, environmental matters, capital structure, and underfunded pension plan. Major Customers The principal end user customers of our products and technology are agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within “budget top-line” limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. Customers that represented more than 10% of net sales for the periods presented are as follows: __________ * Less than 10%. Our sales to each of the major customers listed above involve several product lines and programs. Sales to the U.S. government and its agencies, including sales to our significant customers discussed above, were as follows (dollars in millions): The Standard Missile program, which is comprised of several contracts and is included in U.S. government sales, represented 14%, 12%, and 22% of net sales for fiscal 2015, 2014, and 2013, respectively. In addition, the THAAD program, which is comprised of several contracts and is included in U.S. government sales, represented 13%, 12%, and 3% of net sales for fiscal 2015, 2014, and 2013, respectively. Industry Update Our primary aerospace and defense customers include the DoD and its agencies, NASA, and the prime contractors that supply products to these customers. We are seeing more opportunities for commercial launch and in-space business. In addition, sales to our aerospace and defense customers that provide products to international customers continue to grow. However, we continue to rely on particular levels of U.S. government spending on propulsion systems for defense, space and armament systems, precision tactical weapon systems and munitions applications, and our backlog depends, in large part, on continued funding by the U.S. government for the programs in which we are involved. These funding levels are not generally correlated with any specific economic cycle, but rather follow the cycle of general public policy and political support for this type of funding. Moreover, although our contracts often contemplate that our services will be performed over a period of several years, the U.S. Congress must appropriate funds for a given program and the U.S. President must sign government budget legislation each GFY and may significantly increase, decrease or eliminate, funding for a program. A decrease in DoD and/or NASA expenditures, the elimination or curtailment of a material program in which we are or hope to be involved, or changes in payment patterns of our customers as a result of changes in U.S. government outlays, could have a material adverse effect on our operating results, financial condition, and/or cash flows. The Budget Control Act of 2011 established statutory limits on U.S. government discretionary spending, or budgets caps, for both defense and non-defense over the next 10 years. The Bipartisan Budget Act of 2013 provided temporary relief to the Budget Control Act of 2011 cap levels in GFY 2014 and 2015 and eased sequestration spending cuts to the DoD and other federal agencies (e.g., NASA) for GFY 2014 and 2015, paving the way for eventual agreements on GFY 2014 and 2015 appropriations for all federal agencies. Similarly, in November 2015, the U.S. President signed into law the Bipartisan Budget Act of 2015, providing another two years of relief to the Budget Control Act cap numbers. The Bipartisan Budget Act of 2015 covers both GFY 2016 and 2017 and allows for increased spending levels for DoD and other U.S. government agencies including NASA. This paved the way for the U.S. Congress to pass and the U.S. President to sign into law a $1.1 trillion “Omnibus” appropriations bill for GFY 2016, funding all government agencies. The defense portion of the bill provides $514.1 billion in base defense funding and $58.6 billion in overseas contingency operations. The base funding level is $12.8 billion below the GFY 2016 budget request while the overseas contingency operations portion is $7.7 billion above the GFY 2016 budget request. The NASA portion contains a top line of $19.3 billion, a $1.3 billion increase over GFY 2015 level. Despite overall U.S. government budget pressures, we believe we are well-positioned to benefit from funding in DoD and NASA priority areas. This view reflects the DoD’s strategic guidance report released in January 2012, and the 2014 QDR which affirms support for many of our core programs and explicitly states Missile Defense, Space, Nuclear Deterrence, and Precision Strike as key capabilities for the DoD to preserve. The NASA Authorization Act has again identified the SLS program as one of its top priorities in the NASA GFY 2016 budget. The SLS program also has enjoyed wide, bipartisan support in both chambers of Congress. We maintain a strong relationship with NASA and our propulsion systems have been powering NASA launch vehicles and spacecraft since the inception of the U.S. space program. Our booster, upper stage and Orion vehicle propulsion systems are currently baselined on the new SLS vehicle and both upper stage and booster engines are in development for future SLS variants. Due to the retirement of the space shuttle fleet, U.S. astronauts are now dependent on Russian Soyuz flights for access to and from the ISS for the better part of this decade. NASA has been working to re-establish U.S. manned space capability as soon as possible through development of a new “space taxi” to ferry astronauts and cargo to the ISS. In 2014, Boeing’s CST-100 Starliner capsule, powered by Aerojet Rocketdyne propulsion, was selected by NASA to transport astronauts to and from the ISS. As Boeing’s teammate, Aerojet Rocketdyne will be providing the propulsion system for this new vehicle, thereby supplementing its work for NASA on the SLS designed for manned deep space exploration. In both instances, we have significant propulsion content and we look forward to supporting these generational programs for NASA. The competitive dynamics of our multi-faceted marketplace vary by product sector and customer as we experience many of the same influences felt by the broader aerospace and defense industry. The large majority of products we manufacture are highly complex, technically sophisticated and extremely hazardous to build, demanding rigorous manufacturing procedures and highly specialized manufacturing equipment. While historically these factors, coupled with the high cost to establish the infrastructure required to meet these needs, posed substantial barriers to entry, modern design tools and manufacturing techniques (additive manufacturing) available to new entrants with the ability to self-fund start-up as well as development costs has led to increased competition in space related markets. To date, the competition has been limited to a few participants who tend to be narrowly focused on products that are sub-elements of our overall product portfolio. For example, entrepreneurs such as SpaceX and Blue Origin, who have been or are in the process of developing liquid fuel propulsion capabilities are primarily focused on the development of space propulsion systems for heavy lift launch vehicles and are not pursuing or participating in the missile defense or tactical propulsion business segments that make up a substantial portion of our overall business. These new entrepreneurs have signaled their intent to compete primarily on price and are therefore bringing pressure to bear on existing cost paradigms and manufacturing methodologies. Competitive Improvement Program In March 2015, we initiated the CIP comprised of activities and initiatives aimed at reducing costs in order for us to continue to compete successfully. The company-wide initiative is being undertaken after a comprehensive assessment of our product portfolio to underpin Aerojet Rocketdyne’s technological and competitive leadership in our markets through continued research and development. The CIP is composed of three major components: (i) facilities optimization and footprint reduction; (ii) product affordability; and (iii) reduced administrative and overhead costs. Under the CIP, we expect an estimated 500 headcount reduction in our total employee population. We currently estimate that we will incur restructuring and related costs over the next four years totaling approximately $110 million. When fully implemented, we anticipate that the CIP will result in annual cost savings of approximately $145 million beginning in fiscal 2019. As a result of this effort, we will be better positioned to deliver our innovative, high quality and reliable products at a lower cost to our customers. The CIP costs will consist primarily of severance and other employee related costs totaling approximately $43 million, operating facility costs totaling approximately $27 million, and $40 million for other costs relating to product re-qualification, knowledge transfer and other CIP implementation costs. A summary of our CIP reserve activity in fiscal 2015 is shown below: The costs associated with the CIP will be a component of our U.S. government forward pricing rates, and therefore, will be recovered through the pricing of our products and services to the U.S. government. In addition to the employee-related CIP obligations, we incurred non-cash accelerated depreciation expense of $0.8 million in fiscal 2015 associated with changes in the estimated useful life of long-lived assets impacted by the CIP. As part of our ongoing effort to optimize business resources and achieve headcount reduction goals established through the CIP, we offered a Voluntary Reduction in Force ("VRIF") in July 2015 to our employees. In connection with the VRIF, we recorded a liability of $2.6 million in the third quarter of fiscal 2015, consisting of costs for severance, employee-related benefits and other associated expenses. These costs will be a component of our U.S. government forward pricing rates, and therefore, will be recovered through the pricing of our products and services to the U.S. government. Successful implementation of the CIP initiative will directly benefit our ability to win important, new development work thereby advancing our wide range of next generation propulsion solutions including our newest liquid booster engine, the AR1. Here we plan to supplement the benefits from the CIP by continuing to invest in significant company-funded research and development activities toward the successful development of this engine to meet current and future U.S. space launch needs. Environmental Matters Our current and former business operations are subject to, and affected by, federal, state, local, and foreign environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. Our policy is to conduct our business with due regard for the preservation and protection of the environment. We continually assess compliance with these regulations and we believe our current operations are materially in compliance with all applicable environmental laws and regulations. A summary of our recoverable amounts, environmental reserves, and range of liability, as of November 30, 2015 is presented below: _____ (1) Excludes the receivable from Northrop of $68.7 million as of November 30, 2015 related to environmental costs already paid (and therefore not reserved) by the Company in prior years and reimbursable under the Northrop Agreement. Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowable to be included in our contracts with the U.S. government and allocable to Northrop until the cumulative expenditure limitation is reached. See Note 9(c) and (d) of the notes to consolidated financial statements and "Environmental Matters" below for summary of our environmental reserve activity. Capital Structure We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of November 30, 2015, we had $652.0 million of debt principal outstanding. The fair value of the debt outstanding at November 30, 2015 was $751.5 million. Retirement Benefits We expect to make cash contributions of approximately $23 million to our tax-qualified defined benefit pension plan in fiscal 2016. We estimate that approximately 83% of our unfunded pension obligation as of November 30, 2015 is related to Aerojet Rocketdyne which will be recoverable through our U.S. government contracts. The funded status of our tax-qualified defined benefit pension plan may be adversely affected by the investment experience of the plan's assets, by any changes in U.S. law and by changes in the statutory interest rates used by tax-qualified pension plans in the U.S. to calculate funding requirements. Accordingly, if the performance of our plan's assets does not meet our assumptions, if there are changes to the IRS regulations or other applicable law or if other actuarial assumptions are modified, our future contributions to our underfunded pension plans could be higher than we expect. Additionally, the level of returns on retirement benefit assets, changes in interest rates, changes in legislation, and other factors affect our financial results. The timing of recognition of pension expense or income in our financial statements differs from the timing of the required pension funding under PPA or the amount of funding that can be recorded in our overhead rates through our U.S. government contracting business. Our earnings are positively or negatively impacted by the amount of expense or income we record for our employee retirement benefit plans. Results of Operations Net Sales: Year Ended Year Ended Change* Change** As Restated As Restated As Restated (In millions) Net sales: $ 1,708.3 $ 1,602.2 $ 106.1 $ 1,602.2 $ 1,378.1 $ 224.1 * Primary reason for change. The increase in net sales was primarily due to the following: (i) an increase of $84.3 million in space advanced programs primarily driven by the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS development program and increased development work on the Orion program partially offset by the successful completion of current J-2X program; (ii) an increase of $80.3 million in missile defense and strategic systems programs primarily driven by the increased deliveries on the THAAD and Standard Missile programs; and (iii) sale of approximately 550 acres of our Sacramento Land for $42.0 million. The increase in net sales was partially offset by a decrease of $109.7 million in space launch programs primarily associated with the RL10 and RS-68 programs as a result of the timing of deliveries and costs incurred on these multi-year contracts and lower sales related to the Antares AJ-26 program close-out (see discussion below). ** Primary reason for change. The increase in net sales was primarily due to the net sales from the acquired Rocketdyne Business. The Rocketdyne Business generated sales of $681.9 million in fiscal 2014 compared to $311.8 million in fiscal 2013. Fiscal 2014 and 2013 results include 12 months and 51/2 months, respectively, of the acquired Rocketdyne Business. The increase in net sales also included increased deliveries on the AJ60, THAAD, and Orion programs totaling $71.9 million. The increase in net sales was partially offset by (i) a decrease in the various Standard Missile contracts primarily from the transitioning of the Standard Missile-3 Block IB contract from development activities to low-rate initial production, decreased development activities for the TDACS for the Standard Missile-3 Block IIA contract, and the cessation of deliveries on the Standard Missile-1 Regrain contract in fiscal 2014 as a result of contract completion; (ii) an additional week of operations in the first quarter of fiscal 2013 resulting in $27.8 million in net sales; (iii) lower sales a result of the completion of the T3 IIA and IIB contracts as the program entered the next development phase; and (iv) decreased deliveries and changes in the estimated measurement of progress toward completion on the Antares program. Cost of Sales (exclusive of items shown separately below): * Primary reason for change. The decrease in cost of sales as a percentage of net sales excluding retirement benefit expense and the step-up in fair value of inventory is primarily due to (i) land sale of approximately 550 acres of Sacramento Land resulting in gross profit of $30.6 million, 1.8% of net sales, and (ii) the close-out of the Antares AJ-26 program. Aerojet Rocketdyne entered into a Settlement and Mutual Release Agreement (the “Agreement”) with Orbital Sciences Corporation (“Orbital”) pursuant to which the parties mutually agreed to a termination for convenience of the contract relating to the provision by Aerojet Rocketdyne of 20 AJ-26 liquid propulsion rocket engines to Orbital for the Antares program (the “Contract”). The Agreement also settles all claims the parties may have had against one another arising out of the Contract and the launch failure that occurred on October 28, 2014 of an Antares launch vehicle carrying the Cygnus ORB-3 service and cargo module. We incurred a $50.0 million legal settlement charge reported as an unusual item and not included in cost of sales related to the legal settlement. See table below and Note 9(b) of the notes to consolidated financial statements. ** Primary reason for change. The increase in cost of sales excluding retirement benefit expense and step-up in fair value of inventory as a percentage of net sales was primarily due to $23.6 million of cost growth in fiscal 2014 on the Antares AJ-26 program, including the cost to repair or replace engines as necessary in light of the previously reported engine test failures, an associated increase in hardware inspections and corrective actions on remaining engines, costs to repair the damaged test stand, and costs resulting from delayed deliveries. AR1 Research and Development ("R&D"): * Primary reason for change. During the third quarter of fiscal 2015, we began separately reporting the portion of the engine development expenses associated with our newest liquid booster engine, the AR1, which are currently not allocated across all contracts and programs in progress under U.S. governmental contractual arrangements. See additional discussion in Note 1 of the notes to consolidated financial statements. Selling, General and Administrative (“SG&A”): * Primary reason for change. The increase in SG&A expense was primarily driven by: (i) an increase of $6.1 million in non-cash retirement benefit plan expense (see discussion of “Retirement Benefit Plans” below) and (ii) an increase of $2.9 million in stock-based compensation primarily as a result of increases in the fair value of the stock appreciation rights. ** Primary reason for change. The decrease in SG&A expense was primarily driven by (i) lower non-cash retirement benefit expense (see discussion of “Retirement Benefit Plans” below) and (ii) a decrease of $8.4 million in stock-based compensation primarily as a result of decreases in the fair value of the stock appreciation rights. Depreciation and Amortization: * Primary reason for change. The increase in depreciation and amortization is primarily due to the non-cash accelerated depreciation expense of $0.8 million in fiscal 2015 associated with changes in the estimated useful life of long-lived assets impacted by the CIP. ** Primary reason for change. The increase in depreciation and amortization is primarily due to (i) an increase in depreciation expense related to the Rocketdyne Business since the acquisition; (ii) an increase of $7.0 million of amortization of intangible assets associated with the Rocketdyne Business which is not allocable to our U.S. government contracts; and (iii) an increase of $3.1 million of depreciation expense associated with the ERP system which was placed into service in June 2013. Other Expense, net: Year Ended Year Ended Change* Change** As Restated (In millions) Other expense, net: $ 69.3 $ 74.5 $ (5.2 ) $ 74.5 $ 33.9 $ 40.6 * Primary reason for change. The decrease in other expense, net was primarily due to a decrease of $9.8 million in unusual items charges (see discussion of unusual items below). The decrease in unusual items was partially offset by an increase of $6.5 million in environmental remediation expense primarily associated with higher reserve requirements at the BPOU site offset by the Advance Agreement with the U.S. government entered into in the fourth quarter of fiscal 2015 (see discussion of “Environmental Matters” below). ** Primary reason for change. The increase in other expense, net was primarily due to (i) an increase of $37.2 million in unusual item charges (see discussion of unusual items below); (ii) an increase of $2.8 million in losses on the disposal of long-lived assets; and (iii) an increase of $2.4 million in environmental remediation expenses (see discussion of “Environmental Matters” below). Total unusual items expense, a component of other expense, net in the consolidated statements of operations, was as follows: Fiscal 2015 Activity: We recorded an expense of $50.0 million associated with a legal settlement. See Note 9(b) of the notes to consolidated financial statements. We retired $76.0 million principal amount of our delayed draw term loan resulting in $1.9 million of losses associated with the write-off of deferred financing fees. Fiscal 2014 Activity: A summary of the loss on the 4 1/16% Debentures repurchased during fiscal 2014 is as follows (in millions): We recorded a charge of $0.2 million related to an amendment to the Senior Credit Facility. We recorded $0.9 million for realized losses and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. Fiscal 2013 Activity: We recorded a charge of $0.5 million related to a legal settlement. We recorded ($1.0) million in gains net of interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. We incurred expenses of $20.0 million, including internal labor costs of $1.4 million, related to the Rocketdyne Business acquisition. A summary of our losses on the 4 1/16% Debentures repurchased during fiscal 2013 is as follows (in millions): Interest Income: * Primary reason for change. Interest income was essentially unchanged for the periods presented. Interest Expense: * Primary reason for change. The decrease in interest expense is primarily due to the $49.0 million of 4 1/16% Debentures that were converted to 5.5 million shares of our common stock in fiscal 2015 (including the associated deferred financing costs). ** Primary reason for change. The increase in interest expense was primarily due to (i) two additional months in fiscal 2014 of interest expense associated with the issuance of the 7 1/8% Notes and (ii) the issuance of $89.0 million under the subordinated delayed draw term loan facility in fiscal 2014. The increase in interest expense was partially offset by the 4 1/16% Debentures repurchased during fiscal 2014. Income Tax Provision (Benefit): Year Ended As Restated As Restated (In millions) Income tax provision (benefit) $ 0.3 $ 16.3 $ (198.4 ) The following table shows the reconciling items between the income tax (benefit) provision using the federal statutory rate and our reported income tax provision (benefit). In fiscal 2015, our effective tax rate was an income tax expense of 1.8% on a pre-tax loss from continuing operations of $16.8 million. Our effective tax rate differed from the 35.0% statutory federal income tax rate due largely to state income taxes and certain non-deductible interest expense partially offset by the retroactive reinstatement of the federal R&D credit and the benefit related to manufacturing deductions. In fiscal 2014, our effective tax rate was an income tax expense of 49.4% on a pre-tax loss from continuing operations of $33.0 million. Our effective tax rate differed from the 35% statutory federal income tax rate due largely to the non-deductible premiums paid upon the redemption of portions of the convertible debt, state income taxes, impacts from the final research and development credit study, the benefit related to manufacturing deductions, and certain non-deductible interest expense. In fiscal 2013, our effective tax rate was an income tax benefit of 555.7% on a pre-tax loss from continuing operations of $35.7 million. Our effective tax rate differed from the 35% statutory federal income tax rate due largely to the release of a significant portion of the valuation allowance previously recorded against deferred tax assets, the impact of state income taxes, and certain non-deductible interest expense. We released $282.4 million of the valuation allowance that existed at the beginning of the year, of which approximately $178.7 million was recorded as an income tax benefit to continuing operations, $1.1 million to discontinued operations, and $102.6 million was recorded in other comprehensive income. The carrying value of our deferred tax assets is dependent on our ability to generate sufficient taxable income in the future. We need $473.6 million in pre-tax income and $409.9 million in other comprehensive income to realize the net deferred tax assets as of November 30, 2015. We project that future taxable income will increase as a result of increased income from continuing operations resulting from improved contract profit margins related to the Rocketdyne acquisition integration and improved margins beginning in fiscal 2015 due to anticipated contributions to our tax qualified defined benefit pension plan, which are recoverable through our U.S. government contracts. These increases in income from continuing operations will be partially offset by book to tax adjustments, primarily related to retirement benefit plan payments, state tax deductions, and our manufacturing deductions. The timing of recording or releasing a valuation allowance requires significant management judgment. The amount of the valuation allowance released by us represents a portion of deferred tax assets that was deemed more-likely-than-not that we will realize the benefits based on the analysis in which the positive evidence outweighed the negative evidence. A valuation allowance is required when it is more-likely-than-not that all or a portion of deferred tax assets may not be realized. Establishment and removal of a valuation allowance requires management to consider all positive and negative evidence and make a judgmental decision regarding the amount of valuation allowance required as of a reporting date. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. In the evaluation as of November 30, 2015 and 2014, management has considered all available evidence, both positive and negative, including but not limited to the following: Positive evidence • The three year comprehensive cumulative income position as of November 30, 2015; • Our recent history of generating taxable income which has allowed for the utilization of tax credit carryforwards, and the expected taxable income position for the current year; • Pension rules that allow us to recover pension funding cash contributions through our U.S. government contracts; • Continuing positive results of operations from the acquisition of the Rocketdyne Business; • Establishment and execution of the Competitive Improvement Program evidencing increasing growth and profitability; • Increase in our contract backlog; and • Favorable trends with respect to the market value of certain real estate assets. Negative evidence • Our exposure to environmental remediation obligations and the related uncertainty as to the ultimate exposure upon settlement; • The significance of our defined benefit pension obligation and related impact it could have in future years; • The additional indebtedness incurred in fiscal 2013 related to the acquisition of the Rocketdyne Business that continues to generate interest expense; and • Potential three-year cumulative loss position at the end of fiscal 2016. During fiscal 2015 and 2014, we continued to evaluate the need for a valuation allowance and have concluded in each quarter, including year end, that the amount of valuation allowance currently recorded was appropriate. We will continue to evaluate the ability to realize our net deferred tax assets to determine if an increase to our valuation allowance may be required to reduce deferred tax assets, which could have a material impact on our results of operations. The Protecting Americans from Tax Hikes Act of 2015 passed in December 2015, retroactively reinstating the federal R&D credit and "bonus" depreciation. As a result, we expect to record an estimated benefit to our income tax expense in the first quarter of fiscal 2016 of approximately $2.7 million related to the R&D credit. The impact of the additional tax depreciation will reduce our income taxes payable and long-term deferred tax assets by approximately $3 million. Retirement Benefit Plans: Components of retirement benefit expense are: The increase in retirement benefit expense in fiscal 2015 compared to fiscal 2014 was primarily due to higher actuarial losses arising from the November 30, 2014 measurement associated with the updated mortality assumption and a decrease in the discount rate used to determine our retirement benefit plans' obligations at November 30, 2014. The discount rate was 3.96% as of November 30, 2014 compared to 4.54% as of November 30, 2013. We estimate that our non-cash retirement benefit expense will be approximately $67 million in fiscal 2016. Market conditions and interest rates significantly affect the assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This “smoothing” results in the creation of other accumulated income or losses which will be amortized to retirement benefit expense or benefit in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses associated with the market-related value of pension assets and all other gains and losses, including changes in the discount rate used to calculate benefit costs each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes market related asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual retirement benefit expense, future expenses are impacted by changes in the market value of pension plan assets and changes in interest rates. Additionally, we sponsor a defined contribution 401(k) plan and participation in the plan is available to substantially all employees. Our contributions to the 401(k) plan were $24.9 million in fiscal 2015, $24.4 million in fiscal 2014, and $14.7 million in fiscal 2013. The cost is recoverable through our overhead rates on our U.S. government contracts. Operating Segment Information: We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance, which is a non-GAAP financial measure, represents net sales from continuing operations less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, legacy income or expenses, and unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our underlying operational performance. In addition, we provide the Non-GAAP financial measure of our operational performance called segment performance before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items. We believe the exclusion of the items listed above permits an evaluation and a comparison of results for ongoing business operations, and it is on this basis that management internally assesses operational performance. Aerospace and Defense Segment * Primary reason for change. The increase in net sales was primarily due to the following: (i) an increase of $84.3 million in space advanced programs primarily driven by the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS development program and increased development work on the Orion program partially offset by the successful completion of current J-2X program and (ii) an increase of $80.3 million in missile defense and strategic systems programs primarily driven by the increased deliveries on the THAAD and Standard Missile programs. The increase in net sales was partially offset by a decrease of $109.7 million in space launch programs primarily associated with the RL10 and RS-68 programs as a result of the timing of deliveries and costs incurred on these multi-year contracts and lower sales related to the Antares AJ-26 program close-out (see discussion below). The increase in the segment margin before environmental remediation provision adjustments, retirement benefit plan expense, Rocketdyne purchase accounting adjustments, and unusual items in fiscal 2015 compared to fiscal 2014 was primarily due to the close-out of the Antares AJ-26 program (see discussion of “Cost of Sales” above) and costs associated with the AR1 program. During the third quarter of fiscal 2015, we began separately reporting the portion of the engine development expenses associated with our newest liquid booster engine, the AR1, which are currently not allocated across all contracts and programs in progress under U.S. governmental contractual arrangements (see additional discussion in Note 1 of the notes to consolidated financial statements). See segment information below: ______ (1) We incurred a $50.0 million legal settlement charge related to the Antares AJ-26 program reported as an unusual item. See Note 9(b) of the notes to consolidated financial statements. ** Primary reason for change. The increase in net sales was primarily due to the net sales from the acquired Rocketdyne Business. The Rocketdyne Business generated sales of $681.9 million in fiscal 2014 compared to $311.8 million in fiscal 2013. Fiscal 2014 and 2013 results include 12 months and 51/2 months, respectively, of the acquired Rocketdyne Business. The increase in net sales also included increased deliveries on the AJ60, THAAD, and Orion programs totaling $71.9 million. The increase in net sales was partially offset by (i) a decrease in the various Standard Missile contracts primarily from the transitioning of the Standard Missile-3 Block IB contract from development activities to low-rate initial production, decreased development activities for the TDACS for the Standard Missile-3 Block IIA contract, and the cessation of deliveries on the Standard Missile-1 Regrain contract in fiscal 2014 as a result of contract completion; (ii) an additional week of operations in the first quarter of fiscal 2013 resulting in $27.8 million in net sales; (iii) lower sales a result of the completion of the T3 IIA and IIB contracts as the program entered the next development phase; and (iv) decreased deliveries and changes in the estimated measurement of progress toward completion on the Antares program. The decrease in the segment margin before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items in fiscal 2014 compared to fiscal 2013, was primarily due to $23.6 million, 1.5% of net sales, of cost growth on the Antares AJ-26 program, including the cost to repair or replace engines as necessary in light of the previously reported engine test failures, an associated increase in hardware inspections and corrective actions on remaining engines, costs to repair the damaged test stand, and costs resulting from delayed deliveries. A summary of our backlog is as follows: Total backlog includes both funded backlog (unfilled orders for which funding is authorized, appropriated and contractually obligated by the customer) and unfunded backlog (firm orders for which funding has not been appropriated). Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. Backlog is subject to funding delays or program restructurings/cancellations which are beyond our control. Of our November 30, 2015 total contract backlog, approximately 39%, or approximately $1.6 billion, is expected to be filled within one year. As of November 30, 2015, the Company's funded backlog included $333.0 million on the AJ60 program, of which $110.9 million is expected to be filled within one year. The AJ60 solid rocket booster production order will be completed when the current contract concludes at the end of 2018. Real Estate Segment * Primary reason for change. During the second quarter of fiscal 2015, we finalized the sale of the Hillsborough land for a total purchase price of $57.0 million which was comprised of $46.7 million cash and $10.3 million of promissory notes. The total acreage covered by the Hillsborough land transaction was approximately 700 acres, of which approximately 550 acres was recognized as a sale in the second quarter of fiscal 2015. At the initial closing, the buyer paid $40.0 million cash and executed a $9.0 million promissory note secured by a first lien Deed of Trust on a portion of the sale property which resulted in a gain of $30.6 million in the second quarter of fiscal 2015. The $9.0 million promissory note secured by a first lien Deed of Trust is divided into two components: (i) a $3.0 million 7% promissory note payable 7 years after close of escrow, which includes a possible $1.0 million reduction in principal if we are unable to obtain the necessary road and utility approvals, and (ii) a $6.0 million 7% promissory note payable 7 years after close of escrow and only payable after certain environmental clearances associated with "Area 40" (discussed below) are obtained by us. The sale also included a $1.3 million non-interest bearing promissory note secured by a first lien Deed of Trust on a portion of the sale property associated with the location of future city roads. In addition, approximately 150 acres of this land, including a 50-acre portion known as “Area 40,” was held back from the initial closing. Upon receipt of regulatory approvals, a closing will take place for the sale of the developable portions of such holdback acreage for a purchase price of $6.7 million in cash. ** Primary reason for change. Net sales and segment performance consist primarily of rental property operations, and were essentially unchanged for the periods presented. Use of Non-GAAP Financial Measures In addition to segment performance (discussed above), we provide the Non-GAAP financial measure of our operational performance called Adjusted EBITDAP. We use this metric to further our understanding of the historical and prospective consolidated core operating performance of our segments, net of expenses resulting from our corporate activities in the ordinary, on-going and customary course of our operations. Further, we believe that to effectively compare the core operating performance metric from period to period on a historical and prospective basis, the metric should exclude items relating to retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the ordinary, on-going and customary course of our operations. Accordingly, we define Adjusted EBITDAP as GAAP loss from continuing operations before income taxes adjusted by interest expense, interest income, depreciation and amortization, retirement benefit expense, and unusual items which we do not believe are reflective of such ordinary, on-going and customary course activities. Adjusted EBITDAP does not represent, and should not be considered an alternative to, net (loss) income, as determined in accordance with GAAP. In addition to segment performance and Adjusted EBITDAP, we provide the Non-GAAP financial measures of free cash flow and net debt. We use these financial measures, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that these financial measures are useful because it presents our business using the same tools that management uses to evaluate progress in achieving our goals. _________ (1) Free Cash Flow, a Non-GAAP financial measure, is defined as cash flow from operating activities less capital expenditures. Free Cash Flow excludes any mandatory debt service requirements and other non-discretionary expenditures. Free Cash Flow should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to cash flows from operations presented in accordance with GAAP. The Company believes Free Cash Flow is useful as it provides supplemental information to assist investors in viewing the business using the same tools that management uses to evaluate progress in achieving the Company’s goals. Because our method for calculating the Non-GAAP measures may differ from other companies’ methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures. Environmental Matters Our policy is to conduct our businesses with due regard for the preservation and protection of the environment. We devote a significant amount of resources and management attention to environmental matters and actively manage our ongoing processes to comply with environmental laws and regulations. We are involved in the remediation of environmental conditions that resulted from generally accepted manufacturing and disposal practices at certain plants in the 1950s and 1960s. In addition, we have been designated a PRP with other companies at third party sites undergoing investigation and remediation. Estimating environmental remediation costs is difficult due to the significant uncertainties inherent in these activities, including the extent of remediation required, changing governmental regulations and legal standards regarding liability, evolving technologies and the long period of time over which most remediation efforts take place. We: • accrue for costs associated with the remediation of environmental pollution when it becomes probable that a liability has been incurred and when our proportionate share of the costs can be reasonably estimated; and • record related estimated recoveries when such recoveries are deemed probable. In addition to the costs associated with environmental remediation discussed above, we incur expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations which totaled $5.5 million in fiscal 2015, $7.1 million in fiscal 2014, and $4.9 million in fiscal 2013. A summary of our recoverable amounts, environmental reserves, and range of liability, as of November 30, 2015 is presented below: _____ (1) Excludes the receivable from Northrop of $68.7 million as of November 30, 2015 related to environmental costs already paid (and therefore not reserved) by the Company in prior years and reimbursable under the Northrop Agreement. Reserves We review on a quarterly basis estimated future remediation costs and have an established practice of estimating environmental remediation costs over a fifteen year period, except for those environmental remediation costs with a specific contractual term. Environmental liabilities at the BPOU site are currently estimated through the anticipated term of the new Project Agreement. There can be no assurance that the term of a new Project Agreement will not be longer than the term we estimated and, if so, we may be required to make an additional accrual to reflect the longer term. As the period for which estimated environmental remediation costs lengthens, the reliability of such estimates decreases. These estimates consider the investigative work and analysis of engineers, outside environmental consultants, and the advice of legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum amount is used when no single amount in the range is more probable. Accordingly, such estimates can change as we periodically evaluate and revise these estimates as new information becomes available. We cannot predict whether new information gained as projects progress will affect the estimated liability accrued. The timing of payment for estimated future environmental costs is influenced by a number of factors such as the regulatory approval process, and the time required for designing, constructing, and implementing the remedy. A summary of our environmental reserve activity is shown below: The $176.6 million of environmental reserve additions in fiscal 2015 was primarily due to the following items: (i) $126.3 million associated with our detailed review estimate related to the BPOU site to reflect the anticipated costs through the term of a new Project Agreement, and the amount reserved is based on the proposal by Aerojet Rocketdyne; (ii) $13.8 million associated with water replacement; (iii) $13.5 million of remediation related to operable treatment units; (iv) $5.2 million of additional operations and maintenance for treatment facilities; and (v) $17.8 million related to other environmental clean-up matters. The $33.7 million of environmental reserve additions in fiscal 2014 was primarily due to the following items: (i) $8.1 million of additional operations and maintenance for treatment facilities; (ii) $5.8 million associated with annual detailed review estimate updates; (iii) $4.0 million associated with water replacement; (iv) $3.0 million of remediation related to operable treatment units; (v) $1.5 million of costs related to the Camden, Arkansas site; and (vi) $11.3 million related to other environmental clean-up matters. The $18.8 million of environmental reserve additions in fiscal 2013 was primarily due to the following items: (i) $6.6 million of additional operations and maintenance for treatment facilities; (ii) $4.4 million of remediation related to operable treatment units; (iii) $2.3 million of additional estimated costs related to the former Toledo, Ohio site; (iv) $1.5 million associated with water replacement; and (v) $4.0 million related to other environmental clean-up matters. The effect of the final resolution of environmental matters and our obligations for environmental remediation and compliance cannot be predicted with complete certainty due to changes in both the amount and timing of future expenditures as well as regulatory or technological changes. We believe, on the basis of presently available information, that the resolution of environmental matters and our obligations for environmental remediation and compliance will not have a material adverse effect on our business, liquidity and/or financial condition. We will continue our efforts to mitigate past and future costs through pursuit of claims for recoveries from insurance coverage and other PRPs and continued investigation of new and more cost effective remediation alternatives and associated technologies. As part of the acquisition of the Atlantic Research Corporation (“ARC”) propulsion business in 2003, Aerojet Rocketdyne entered into an agreement with ARC pursuant to which Aerojet Rocketdyne is responsible for up to $20.0 million of costs (“Pre-Close Environmental Costs”) associated with environmental issues that arose prior to Aerojet Rocketdyne’s acquisition of the ARC propulsion business. ARC is responsible for any cleanup costs relating to the ARC acquired businesses in excess of $20.0 million. Pursuant to a separate agreement with the U.S. government which was entered into prior to the completion of the ARC acquisition, these costs are recovered through the establishment of prices for Aerojet Rocketdyne’s products and services sold to the U.S. government. A summary of the Pre-Close Environmental Costs is shown below (in millions): Estimated Recoveries On January 12, 1999, Aerojet Rocketdyne and the U.S. government implemented the Global Settlement resolving certain prior environmental and facility disagreements, with retroactive effect to December 1, 1998. Under the Global Settlement, Aerojet Rocketdyne and the U.S. government resolved disagreements about an appropriate cost-sharing ratio with respect to the cleanup costs of the environmental contamination at the Sacramento and Azusa sites. The Global Settlement cost-sharing ratio does not have a defined term over which costs will be recovered. Additionally, in conjunction with the sale of the EIS business in 2001, Aerojet Rocketdyne entered into the Northrop Agreement whereby Aerojet Rocketdyne is reimbursed by Northrop for a portion of environmental expenditures eligible for recovery under the Global Settlement, subject to an annual and a cumulative limitation. Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowable to be included in our contracts with the U.S. government and allocable to Northrop until the cumulative expenditure limitation is reached. We currently estimate approximately 24% of our Aerospace and Defense segment environmental costs will not likely be reimbursable and are expensed to the consolidated statements of operations. Allowable environmental costs are charged to our contracts as the costs are incurred. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet Rocketdyne to continue recovering these costs from the U.S. government depends on Aerojet Rocketdyne’s sustained business volume under U.S. government contracts and programs. Pursuant to the Northrop Agreement, environmental expenditures to be reimbursed are subject to annual limitations and the total reimbursements are limited to a ceiling of $189.7 million. A summary of the Northrop Agreement activity is shown below (in millions): A summary of the current and non-current recoverable amounts from Northrop and the U.S. government is shown below: Fiscal 2015 Activity Fiscal 2015 additions - The $133.6 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $95.6 million associated with our detailed review estimate related to the BPOU site to reflect the anticipated costs through the term of a new Project Agreement, and the amount reserved is based on the proposal by Aerojet Rocketdyne; (ii) $10.5 million associated with water replacement; (iii) $10.2 million of remediation related to operable treatment units; (iv) $3.9 million of additional operations and maintenance for treatment facilities; and (v) $13.4 million related to other environmental clean-up matters. Fiscal 2015 reimbursements -The $31.2 million of environmental expenditures that were reimbursed related to the following items: (i) $13.8 million for operations and maintenance of treatment facilities; (ii) $6.8 million of remediation related to operable treatment units; (iii) $3.4 million associated with water supply replacement; (iv) $2.8 million associated with test sampling and analysis; (v) $1.1 million of costs related to the Camden, Arkansas site; and (vi) $3.3 million related to other environmental clean-up matters. Fiscal 2015 other adjustments - The $25.4 million of other adjustments primarily relates to the impact of the Advance Agreement with the U.S. government revising the percent of environmental costs allocable to Northrop and the U.S. government. We currently estimate approximately 24% of our Aerospace and Defense segment environmental costs will not likely be reimbursable and are expensed to the consolidated statements of operations. Fiscal 2014 Activity Fiscal 2014 additions - The $21.4 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $5.1 million of additional operations and maintenance for treatment facilities; (ii) $3.7 million associated with annual detailed review estimate updates; (iii) $2.5 million associated with water replacement; (iv) $1.9 million of remediation related to operable treatment units; (v) $1.5 million of additional estimated costs related to the Camden, Arkansas site; and (vi) $6.7 million related to other environmental clean-up matters. Fiscal 2014 reimbursements -The $31.0 million of environmental expenditures that were reimbursed related to the following items: (i) $12.6 million for operations and maintenance of treatment facilities; (ii) $8.1 million of remediation related to operable treatment units; (iii) $2.7 million associated with test sampling and analysis; (iv) $1.7 million of additional estimated costs related to the Camden, Arkansas site; (v) $1.3 million associated with water supply replacement; and (vi) $4.6 million related to other environmental clean-up matters. Fiscal 2013 Activity Fiscal 2013 additions - The $8.7 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $3.9 million of additional operations and maintenance for treatment facilities; (ii) $2.6 million of remediation related to operable treatment units; (iii) $0.9 million associated with water replacement; and (iv) $1.3 million related to other environmental clean-up matters. Fiscal 2013 reimbursements - The $30.5 million of environmental expenditures that were reimbursed related to the following items: (i) $11.5 million for operations and maintenance of treatment facilities; (ii) $9.3 million of remediation related to operable treatment units; (iii) $2.1 million associated with water supply replacement; (iv) $1.6 million of additional estimated costs related to the Camden, Arkansas site; and (v) $6.0 million related to other environmental clean-up matters. Environmental reserves and recoveries impact to the consolidated statements of operations The expenses associated with adjustments to the environmental reserves are recorded as a component of other expense, net in the consolidated statements of operations. Summarized financial information for the impact of environmental reserves and recoveries to the consolidated statements of operations is set forth below: Recently Adopted Accounting Pronouncements See Note 1 to our consolidated financial statements in Item 8. Consolidated Financial Statements of this Report for information relating to our discussion of the effects of recent accounting pronouncements. Liquidity and Capital Resources Net Cash Provided by (Used In) Operating, Investing, and Financing Activities The change in cash and cash equivalents was as follows: Net Cash Provided by Operating Activities The $65.1 million of cash provided by operating activities in fiscal 2015 was primarily the result of cash provided by loss from continuing operations before income taxes adjusted for non-cash items which generated $125.4 million which was offset by cash used to fund the following: (i) a decrease of $17.8 million in other current liabilities primarily related to the CIP, cost reduction initiatives, and the amounts paid to UTC related to Transition Service Agreements; (ii) an increase of $19.5 million in inventories primarily due to the timing of milestone billings and deliveries on the PAC-3 and Standard Missile programs; and (iii) $7.8 million of real estate activities. The $150.6 million of cash provided by operating activities in fiscal 2014 was primarily the result of loss from continuing operations before income taxes adjusted for non-cash items which generated $132.7 million. In addition, we generated $69.6 million from working capital (defined as accounts receivables, inventories, other current assets, accounts payable, contract advances, real estate activities, and other current liabilities). The cash generated from working capital was primarily due to an increase of $96.9 million in cash advances on long-term contracts. This amount was partially offset by the cash used for the Rocketdyne Business integration activities. In addition, we paid $4.9 million for income taxes, net in fiscal 2014. The $77.4 million of cash provided by operating activities in fiscal 2013 was primarily the result of loss from continuing operations before income taxes adjusted for non-cash items which generated $96.0 million. This amount was partially offset by cash used to fund working capital (excluding the impact of changes in current deferred income taxes) including our real estate activities. The funding of working capital is primarily due to the following (i) a decrease in contract advances due to the timing of customer payments and (ii) an increase in accounts receivables due to timing of sales and billing during the quarter. These factors were partially offset by (i) an increase in accounts payable related to the increase in cost-reimbursable contract sales and timing of payments and (ii) an increase in other current liabilities primarily related to the timing of payments. Net Cash Used In Investing Activities During fiscal 2015, 2014 and 2013, we had capital expenditures of $36.8 million, $43.4 million and $63.2 million, respectively. During fiscal 2014 and 2013, capital expenditures total included $11.3 million and $25.4 million, respectively, related to consolidating the Rocketdyne Business facilities. Additionally, during fiscal 2013 the capital expenditures total included $16.4 million related to our ERP implementation. During fiscal 2014, we received $0.2 million for a purchase price adjustment for the Rocketdyne Business and we generated proceeds of $7.5 million from the sale of non-core technology. During fiscal 2013, we purchased the Rocketdyne Business for $411.2 million (see Note 5 in notes to consolidated financial statements.) Net Cash (Used in) Provided by Financing Activities During fiscal 2015, we had $81.2 million in debt cash payments (see below). During fiscal 2014, we repurchased 3.5 million of our common shares at a cost of $64.5 million. We also issued $189.0 million of debt and had $166.3 million in debt cash payments (see below). In addition, we incurred $4.2 million of debt issuance costs. During fiscal 2013, we issued $460.0 million of debt and had $12.8 million in cash payments of debt. In addition, we incurred $14.9 million of debt issuance costs. Debt Activity and Covenants Our debt activity during fiscal 2015 was as follows: We are subject to certain limitations including the ability to incur additional debt, make certain investments and acquisitions, and make certain restricted payments, including stock repurchases and dividends. The Senior Credit Facility includes events of default usual and customary for facilities of this nature, the occurrence of which could lead to an acceleration of our obligations thereunder. Additionally, the Senior Credit Facility includes certain financial covenants, including that we maintain (i) a maximum total leverage ratio, calculated net of cash up to a maximum of $150.0 million, of 4.50 to 1.00 through the fiscal period ended November 30, 2015, 4.25 to 1.00 through fiscal periods ending November 30, 2017, and 4.00 to 1.00 thereafter; and (ii) a minimum interest coverage ratio of 2.40 to 1.00. We were in compliance with our financial and non-financial covenants as of November 30, 2015. Outlook Short-term liquidity requirements consist primarily of recurring operating expenses, including but not limited to costs related to our capital and environmental expenditures, company-funded research and development expenditures, debt service requirements, and retirement benefit plans. We believe that our existing cash and cash equivalents and availability under our revolving credit facility will provide sufficient funds to meet our operating plan, which includes our CIP and AR1 engine development costs, for the next twelve months. The operating plan for this period provides for full operation of our businesses, and interest and principal payments on our debt. As of November 30, 2015, we had $155.9 million of available borrowings under our Senior Credit Facility. Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of November 30, 2015. Our failure to comply with these covenants could result in an event of default that, if not cured or waived, could result in the acceleration of the Senior Credit Facility, the Subordinated Credit Facility, the 7 1/8% Notes, and the 4 1/16% Debentures. In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility, and in certain cases, would cause cross defaults on the Subordinated Credit Facility, 7 1/8% Notes and 4 1/16% Debentures. We are committed to a cash management strategy that maintains liquidity to adequately support the operation of the business, our growth strategy and to withstand unanticipated business volatility. We believe that cash generated from operations, together with our current levels of cash and investments as well as availability under our revolving credit facility, should be sufficient to maintain our ongoing operations, support working capital requirements, fund the CIP, make required cash contributions of approximately $23 million in fiscal 2016 to our tax-qualified defined benefit pension plan, and fund anticipated capital expenditures related to projected business growth. Our cash management strategy includes maintaining the flexibility to pay down debt and/or repurchase shares depending on economic and other conditions. In connection with the implementation of our cash management strategy, our management may seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise if we believe that it is in our best interests. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. Potential future acquisitions depend, in part, on the availability of financial resources at an acceptable cost of capital. We expect to utilize cash on hand and cash generated by operations, as well as cash available under our Senior Credit Facility, which may involve renegotiation of credit limits to finance future acquisitions. Other sources of capital could include the issuance of common and/or preferred stock, and the placement of debt. We periodically evaluate capital markets and may access such markets when circumstances appear favorable. We believe that sufficient capital resources will be available from one or several of these sources to finance future acquisitions. However, no assurances can be made that acceptable financing will be available, or that acceptable acquisition candidates will be identified, or that any such acquisitions will be accretive to earnings. As disclosed in Notes 9(b) and 9(c) of the notes to consolidated financial statements, we have exposure for certain legal and environmental matters. We believe that it is currently not possible to estimate the impact, if any, that the ultimate resolution of certain of these matters will have on our financial position, results of operations, or cash flows. Major factors that could adversely impact our forecasted operating cash flows and our financial condition are described in Part I, Item 1A. Risk Factors. In addition, our liquidity and financial condition will continue to be affected by changes in prevailing interest rates on the portion of debt that bears interest at variable interest rates. Contractual Obligations We have contractual obligations and commitments in the form of debt obligations, operating leases, certain other liabilities, and purchase commitments. The following table summarizes our contractual obligations as of November 30, 2015: ________ (1) Includes interest on variable debt calculated based on interest rates at November 30, 2015. (2) The payments presented above are expected payments for the next 10 years. The payments for postretirement medical and life insurance benefits reflect the estimated benefit payments of the plans using the provisions currently in effect. The obligation related to postretirement medical and life insurance benefits is actuarially determined on an annual basis. The estimated payments have been reduced to reflect the provisions of the Medicare Prescription Drug, Improvement and Modernization Act of 2003. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (3) The conditional asset retirement obligations presented are related to our Aerospace and Defense segment, and certain of these future obligations are allowable costs under our contracts with the U.S. government. As of November 30, 2015, the liability for uncertain income tax positions was $7.8 million. Due to the uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We may be required to make significant cash contributions in the future to fund our defined benefit pension plan, a portion of which we may not be able to immediately recover from our U.S. government contracts. In fiscal 2016, we expect to make cash contributions of approximately $23 million to our tax-qualified defined benefit pension plan. We also issue purchase orders and make other commitments to suppliers for equipment, materials, and supplies in the normal course of business. These purchase commitments are generally for volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers and would be subject to reimbursement if a cost-plus contract was terminated. Arrangements with Off-Balance Sheet Risk As of November 30, 2015, arrangements with off-balance sheet risk consisted of: • $44.1 million in outstanding commercial letters of credit expiring through April 2016, the majority of which may be renewed, primarily to collateralize obligations for environmental remediation and insurance coverage. • $45.5 million in outstanding surety bonds to primarily satisfy indemnification obligations for environmental remediation coverage. • Up to $120.0 million aggregate in guarantees by us of Aerojet Rocketdyne’s obligations to U.S. government agencies for environmental remediation activities. • Guarantees, jointly and severally, by our material domestic subsidiaries of their obligations under our Senior Credit Facility and 7 1/8% Notes. In addition to the items discussed above, we have and will from time to time enter into certain types of contracts that require us to indemnify parties against potential third-party and other claims. These contracts primarily relate to: (i) divestiture agreements, under which we may provide customary indemnification to purchasers of our businesses or assets including, for example, claims arising from the operation of the businesses prior to disposition, liability to investigate and remediate environmental contamination existing prior to disposition; (ii) certain real estate leases, under which we may be required to indemnify property owners for claims arising from the use of the applicable premises; and (iii) certain agreements with officers and directors, under which we may be required to indemnify such persons for liabilities arising out of their relationship with us. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. We provide product warranties in conjunction with certain product sales. The majority of our warranties are one-year standard warranties for parts, workmanship, and compliance with specifications. On occasion, we have made commitments beyond the standard warranty obligation. While we have contracts with warranty provisions, there is not a history of any significant warranty claims experience. A reserve for warranty exposure is made on a product by product basis when it is both estimable and probable. These costs are included in the program’s estimate at completion and are expensed in accordance with our revenue recognition methodology as allowed under GAAP for that particular contract. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP that offer acceptable alternative methods for accounting for certain items affecting our financial results, such as determining inventory cost, depreciating long-lived assets, and recognizing revenues. The preparation of financial statements requires the use of estimates, assumptions, judgments, and interpretations that can affect the reported amounts of assets, liabilities, revenues, and expenses, the disclosure of contingent assets and liabilities and other supplemental disclosures. The development of accounting estimates is the responsibility of our management. Management discusses those areas that require significant judgment with the audit committee of our board of directors. All of our financial disclosures in our filings with the SEC have been reviewed with the audit committee. Although we believe that the positions we have taken with regard to uncertainties are reasonable, others might reach different conclusions and our positions can change over time as more information becomes available. If an accounting estimate changes, its effects are accounted for prospectively and, if significant, disclosed in notes of the consolidated financial statements. The areas most affected by our accounting policies and estimates are revenue recognition, other contract considerations, goodwill, retirement benefit plans, litigation, environmental remediation costs and recoveries, and income taxes. Except for income taxes and litigation matters related to discontinued operations, which are not allocated to our operating segments, these areas affect the financial results of our business segments. For a discussion of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the consolidated financial statements. Revenue Recognition In our Aerospace and Defense segment, recognition of profit on long-term contracts requires the use of assumptions and estimates related to the contract value or total contract revenue, the total cost at completion and the measurement of progress towards completion. Due to the nature of the programs, developing the estimated total cost at completion requires the use of significant judgment. Estimates are continually evaluated as work progresses and are revised as necessary. Factors that must be considered in estimating the work to be completed include labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements and inflationary trends, schedule and performance delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. We review contract performance and cost estimates for some contracts at least monthly and for others at least quarterly and more frequently when circumstances significantly change. When a change in estimate is determined to have an impact on contract profit, we will record a positive or negative adjustment to the statement of operations. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact from changes in estimates and assumptions on the statement of operations on key contracts, representing 83% of our aerospace and defense segment net sales over the last three fiscal years, accounted for under the percentage-of-completion method of accounting: The fiscal 2015 favorable changes in contract estimates were primarily driven by the following (i) better than expected performance on space launch systems and missile defense programs primarily due to affordability initiatives and lower overhead costs and (ii) unexpected favorable contract performance on close-out activities on the J-2X program. The fiscal 2014 favorable changes in contract estimates were primarily driven by better than expected performance on a space launch system program due to favorable contract negotiations and affordability initiatives partially offset by unanticipated inefficiencies and cost growth on the Antares AJ-26 program. The fiscal 2013 favorable changes in contract estimates was primarily driven by better than expected performance on tactical systems programs due to manufacturing efficiencies and lower overhead costs. The improvements in fiscal 2013 were offset by unexpected cost growth on the Antares AJ-26 program. We consider the nature of the individual underlying contract and the type of products and services provided in determining the proper accounting for a particular contract. Each method is applied consistently to all contracts having similar characteristics, as described below. We typically account for our contracts using the percentage-of-completion method, and progress is measured on a cost-to-cost or units-of-delivery basis. Sales are recognized using various measures of progress depending on the contractual terms and scope of work of the contract. We recognize revenue on a units-of-delivery basis when contracts require unit deliveries on a frequent and routine basis. Sales using this measure of progress are recognized at the contractually agreed upon unit price. Where the scope of work on contracts principally relates to research and/or development efforts, or the contract is predominantly a development effort with few deliverable units, we recognize revenue on a cost-to-cost basis. In this case, sales are recognized as costs are incurred and include estimated earned fees or profits calculated on the basis of the relationship between costs incurred and total estimated costs at completion. Revenue on service or time and material contracts is recognized when performed. If at any time expected costs exceed the value of the contract, the loss is recognized immediately. If change orders are in dispute or are unapproved in regard to both scope and price they are evaluated as claims. We recognize revenue on claims when recovery of the claim is probable and the amount can be reasonably estimated. Revenue on claims is recognized only to the extent that contract costs related to the claims have been incurred and when it is probable that the claim will result in a bona fide addition to contract value that can be reliably estimated. No profit is recognized on a claim until final settlement occurs. Certain government contracts contain cost or performance incentive provisions that provide for increased or decreased fees or profits based upon actual performance against established targets or other criteria. Incentive and award fees, which are generally awarded at the discretion of the customer, are considered in estimating profit rates at the time the amounts can be reasonably determined and are reasonably assured based on historical experience and anticipated performance. We continually evaluate our performance and incorporate any anticipated changes in penalties and incentives into our revenue and earnings calculations. Revenue from real estate asset sales is recognized when a sufficient down-payment has been received, financing has been arranged and title, possession and other attributes of ownership have been transferred to the buyer. The allocation to cost of sales on real estate asset sales is based on a relative fair market value computation of the land sold which includes the basis on our books, capitalized entitlement costs, and an estimate of our continuing financial commitment. Revenue that is not derived from long-term development and production contracts, or real estate asset transactions, is recognized when persuasive evidence of a final agreement exists, delivery has occurred, the selling price is fixed or determinable and payment from the customer is reasonably assured. Sales are recorded net of provisions for customer pricing allowances. Other Contract Considerations Our sales are driven by pricing based on costs incurred to produce products and perform services under contracts with the U.S. government. Cost-based pricing is determined under the FAR and Cost Accounting Standards ("CAS"). The FAR and CAS provide guidance on the types of costs that are allowable and allocable in establishing prices for goods and services under U.S. government contracts. For example, costs such as those related to pension contributions in accordance with the PPA that are in excess of CAS allowable pension costs, charitable contributions, advertising, interest expense, and public relations are unallowable, and therefore not recoverable through sales. In addition, we may enter into agreements with the U.S. government that address the subjects of allowability and allocability of costs to contracts for specific matters. We closely monitor compliance with and the consistent application of our critical accounting policies related to contract accounting. We review the status of contracts through periodic contract status and performance reviews. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel independent from the business segment performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are reviewed for compliance with regulatory standards by our personnel, and are subject to audit by the DCAA. Accordingly, we record an allowance on our unbilled receivables for amounts of potential contract overhead costs which may not be successfully negotiated and collected. Goodwill Goodwill represents the excess of the purchase price of an acquired enterprise or assets over the fair values of the identifiable assets acquired and liabilities assumed. Tests for impairment of goodwill are performed on an annual basis, or at any other time, if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. We evaluated goodwill for impairment as of September 1, 2015 and 2014, and determined that goodwill was not impaired. All of our recorded goodwill resides in the Aerospace and Defense reporting unit. As of September 1, 2015, we evaluated goodwill using a “Step Zero" analysis and determined that it was more likely than not that the fair value of the Aerospace and Defense reporting unit exceeded its carrying amount. As of September 1, 2014, we performed a “Step One” analysis to evaluate goodwill impairment and determined that the fair value of the Aerospace and Defense reporting unit exceeded its carrying amount. To determine the fair value of our Aerospace and Defense reporting unit, we primarily relied upon a discounted cash flow analysis which requires significant assumptions and estimates about future operations, including judgments about expected revenue growth and operating margins, and timing and amounts of expected future cash flows. The cash flows employed in the discounted cash flow analysis are based on five-year financial forecasts developed by management. The analysis also involves discounting the future cash flows to a present value using a discount rate that properly accounts for the risk and nature of the reporting unit cash flows and the rates of return debt and equity holders would require to invest their capital in the Aerospace and Defense reporting unit. In assessing the reasonableness of our estimated fair value of the Aerospace and Defense reporting unit, we evaluate the results of the discounted cash flow analysis in light of what investors are paying for similar interests in comparable aerospace and defense companies as of the valuation date. We also ensure that the reporting unit fair value is reasonable given the market value of us as of the valuation date. We evaluate qualitative factors (including macroeconomic conditions, industry and market considerations, cost factors, and overall financial performance) to determine whether it is necessary to perform the first step of the two-step goodwill test. This step is referred to as the “Step Zero" analysis. If it is determined that it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, we will need to proceed to the first step (“Step One”) of the two-step goodwill test. In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, relevant events and circumstances as discussed below shall be assessed. If, after assessing the totality of events or circumstances, we determine that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the first and second steps of the impairment test are unnecessary. Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business climate or legal factors; adverse cash flow trends; an adverse action or assessment by a regulator; unanticipated competition; loss of key personnel; decline in stock price; and results of testing for recoverability of a significant asset group within a reporting unit. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recorded. There can be no assurance that our estimates and assumptions made for purposes of its goodwill impairment testing will prove to be accurate predictions of the future. If our assumptions and estimates are incorrect, we may be required to record goodwill impairment charges in future periods. Retirement Benefit Plans Our defined benefit pension plan future benefit accrual was discontinued in fiscal 2009. In addition, we provide medical and life insurance benefits (“postretirement benefits”) to certain eligible retired employees, with varied coverage by employee group. Annual charges are made for the cost of the plans, including administrative costs, interest costs on benefit obligations, and net amortization and deferrals, increased or reduced by the return on assets. We also sponsor a defined contribution 401(k) plan and participation in the plan is available to substantially all employees Retirement benefits are a significant cost of doing business and represent obligations that will be ultimately settled far in the future and therefore are subject to estimates. We will recover portions of any required retirement benefits funding through our government contracts. Our pension and medical and life insurance benefit obligations and related costs are calculated using actuarial concepts in accordance with GAAP. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine service cost and interest cost to arrive at pension income or expense for the year. We used the following discount rate to determine the benefit obligations for the applicable fiscal year. We used the following assumptions to determine the net periodic benefit expense for the applicable fiscal year. ______ * Not applicable The discount rate represents the current market interest rate used to determine the present value of future cash flows currently expected to be required to settle pension obligations. Based on market conditions, discount rates can experience significant variability. Changes in discount rates can significantly change the liability and, accordingly, the funded status of the pension plan. The assumed discount rate represents the market rate available for investments in high-quality fixed income instruments with maturities matched to the expected benefit payments for pension and medical and life insurance benefit plans. The expected long-term rate of return on plan assets represents the rate of earnings expected in the funds invested, and funds to be invested, to provide for anticipated benefit payments to plan participants. We evaluated the plan’s historical investment performance, its current and expected asset allocation, and, with input from our external advisors, developed best estimates of future investment performance of the plan’s assets. Based on this analysis, we assumed a long-term rate of return on plan assets of 8.0% for fiscal 2015. As of November 30, 2015, after evaluating the historical investment performance of plan assets, expected asset allocation, and recent input from our external advisors, we decided to change the long-term expected rate of return on plan assets from 8.0% to 7.0% effective December 1, 2015. Market conditions and interest rates significantly affect assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This “smoothing” results in the creation of other accumulated income or loss which will be amortized to pension costs in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses in the market-related value of pension assets and all other gains and losses including changes in the discount rate used to calculate benefit costs each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual pension costs, future pension costs are impacted by changes in the market value of pension plan assets and changes in interest rates. In addition, we maintain medical and life insurance benefits other than pensions that are not funded. A one percentage point change in the key assumptions would have the following effects on the projected benefit obligations as of November 30, 2015 and on expense for fiscal 2015: Contingencies and Litigation We are currently involved in certain legal proceedings and, as required, have accrued our estimate of the probable costs and recoveries for resolution of these claims. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in assumptions or the effectiveness of strategies related to these proceedings. See Notes 9(b) and 9(c) in notes to consolidated financial statements for more detailed information on litigation exposure. Reserves for Environmental Remediation and Recoverable from the U.S. Government and Other Third Parties for Environmental Remediation Costs For a discussion of our accounting for environmental remediation obligations and costs and related legal matters, see “Environmental Matters” above and Notes 9(c) and 9(d) in notes to consolidated financial statements. We accrue for costs associated with the remediation of environmental contamination when it becomes probable that a liability has been incurred, and when our costs can be reasonably estimated. Management has a well-established process in place to identify and monitor our environmental exposures. In most cases, only a range of reasonably probable costs can be estimated. In establishing the reserves, the most probable estimated amount is used when determinable, and the minimum amount is used when no single amount in the range is more probable. Environmental reserves include the costs of completing remedial investigation and feasibility studies, remedial and corrective actions, regulatory oversight costs, the cost of operation and maintenance of the remedial action plan, and employee compensation costs for employees who are expected to devote a significant amount of time to remediation efforts. Calculation of environmental reserves is based on the evaluation of currently available information with respect to each individual environmental site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. Such estimates are based on the expected costs of investigation and remediation and the likelihood that other potentially responsible parties will be able to fulfill their commitments at sites where we may be jointly or severally liable. At the time a liability is recorded for future environmental costs, we record an asset for estimated future recoveries that are estimable and probable. Some of our environmental costs are eligible for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements. We consider the recovery probable based on the Global Settlement Agreement, Northrop Agreement, government contracting regulations, and our long history of receiving reimbursement for such costs. Income Taxes We file a consolidated U.S. federal income tax return for the Company and our 100% owned consolidated subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in the period of the enactment date of the change. The carrying value of our deferred tax assets is dependent upon our ability to generate sufficient taxable income in the future. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence is considered, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, the length of carryback and carryforward periods, and evaluation of potential tax planning strategies. Despite our belief that our tax return positions are consistent with applicable tax laws, we believe that certain positions are likely to be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or some partial adjustment reached through negotiations or litigation. Our tax reserves reflect the difference between the tax benefit claimed on tax returns and the amount recognized in the financial statements. The accounting standards provide guidance for the recognition and measurement in financial statements for uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process, the first step being recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate resolution with a taxing authority. As the examination process progresses with tax authorities, adjustments to tax reserves may be necessary to reflect taxes payable upon settlement. Tax reserve adjustments related to positions impacting the effective tax rate affect the provision for income taxes. Tax reserve adjustments related to positions impacting the timing of deductions impact deferred tax assets and liabilities.

<s>[INST] The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report, and the disclaimer regarding forwardlooking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations. Restatement As indicated in Note 2 to our consolidated financial statements included in Part II, Item 8, of this Form 10K, we corrected errors in our previously issued consolidated financial statements for the Restated Periods primarily related to the following matters: (i) purchase accounting associated with contracts acquired as part of the acquisition of the Rocketdyne Business; (ii) contract accounting related to subsequent modifications to one significant acquired contract; (iii) contract accounting related to the improper recognition of sales associated with incentives; and (iv) other individually immaterial items. A summary of the impact to pretax income (loss) from continuing operations by reporting period is presented below (in millions): ___________ (1) Our errors associated with purchase accounting primarily related to the following: (i) fair value assessment of Rocketdyne Business acquired customer contracts at the acquisition date following the close of the transaction. The Company failed to fair value three acquired contracts in purchase accounting; and (ii) the estimates of the Rocketdyne Business contracts' percentage of completion used to recognize net sales should have been based on its estimate of remaining effort on such contracts at the acquisition date instead of the inception date of the contract. (2) We did not appropriately account for one significant Rocketdyne Business contract amendment. Instead of being accounted for as a modification, the amendment was accounted for as a new contract. (3) We immediately recognized incentives as sales based on the full amount received rather than on the percentage of completion of the related contract. The correction of the matters described above resulted in the following adjustments to the previously issued consolidated financial statements: (i) an increase of $0.3 million, or $0.00 loss per share, to net loss for the first nine months of fiscal 2015; (ii) a decrease of $3.0 million, or $0.06 loss per share, to net loss for fiscal 2014; and (iii) a decrease of $5.0 million, or $0.06 diluted income per share, to net income for fiscal 2013. A summary of the impact to net (loss) income on the consolidated statements of operations by reporting period is presented below (in millions): Overview We are a manufacturer of aerospace and defense products and systems which develops and manufactures propulsion systems for defense and space applications, and armaments for precision tactical and longrange weapon systems applications. We also have a real estate segment that includes activities related to the rezoning, entitlement, sale, and leasing of our excess real estate assets. Our continuing operations are organized into two segments: Aerospace and Defense includes the operations of our whollyowned subsidiary Aerojet Rocketdyne, a leading technologybased designer, developer and manufacturer of aerospace and defense products and systems for the U.S. government, including the DoD, NASA, major aerospace and defense prime contractors as well as portions of the commercial sector. Aerojet Rocketdyne is a worldrecognized engineering and manufacturing company that specializes in the development and production of propulsion systems for defense and space applications, armament systems for precision tactical systems and munitions, and is considered a domestic market leader in launch propulsion, inspace propulsion, missile defense propulsion, tactical missile propulsion and hypersonic propulsion systems. Real Estate includes the activities of our whollyowned subsidiary Easton related to the rezoning, entitlement, sale, and leasing of our excess real estate assets. We own approximately 11,500 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento. We are currently in the process of seeking zoning changes and other governmental approvals on a portion [/INST] Negative. </s>

AEROJET ROCKETDYNE HOLDINGS, INC.

2017-03-01

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Unless otherwise indicated or required by the context, as used in this Form 10-K, the terms “we,” “our” and “us” refer to Aerojet Rocketdyne Holdings, Inc. and all of its subsidiaries that are consolidated in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report, and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations. In January 2016, our board of directors approved a change in our fiscal year-end from November 30 of each year to December 31 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday in December. As a result of the change, we had a one month transition period in December 2015. The audited results for the one month ended December 31, 2015 and the unaudited results for the one month ended December 31, 2014 are included in Item 8 of this Report. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in the twelve months ended December 31, 2016 compared to 52 weeks of operations in the twelve months ended November 30, 2015 and 2014. The additional week of operations, which occurred in the fourth quarter of fiscal 2016, accounted for $32.2 million in additional net sales. Financial information for twelve months ended December 31, 2015 has not been included in this Form 10-K for the following reasons: (i) the twelve months ended November 30, 2015 provide a meaningful comparison for the twelve months ended December 31, 2016; (ii) there are no significant factors, seasonal or other, that would impact the comparability of information if the results for the twelve months ended December 31, 2015 were presented in lieu of results for twelve months ended November 30, 2015; and (iii) it was not practicable or cost justified to prepare this information. Overview We are a manufacturer of aerospace and defense products and systems with a real estate segment. Our operations are organized into two segments: Aerospace and Defense - includes the operations of our wholly-owned subsidiary Aerojet Rocketdyne, a leading technology-based designer, developer and manufacturer of aerospace and defense products and systems for the U.S. government, including the DoD, NASA, major aerospace and defense prime contractors as well as portions of the commercial sector. Real Estate - includes the activities of our wholly-owned subsidiary Easton related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. We are currently in the process of seeking zoning changes and other governmental approvals on our excess real estate assets to optimize its value. A summary of the significant financial highlights for fiscal 2016 which management uses to evaluate our operating performance and financial condition is presented below. • Net sales for fiscal 2016 totaled $1,761.3 million compared to $1,708.3 million for fiscal 2015. • Net income for fiscal 2016 was $18.0 million, or $0.27 diluted income per share, compared to net loss of $(16.2) million, or $(0.27) loss per share, for fiscal 2015. • Adjusted EBITDAP (Non-GAAP measure*) for fiscal 2016 was $202.0 million, or 11.5% of net sales, compared to $217.9 million, or 12.8% of net sales, for fiscal 2015. • Segment performance before environmental remediation provision adjustments, retirement benefit expense, and unusual items was $188.4 million for fiscal 2016, compared to $200.1 million for fiscal 2015. • Cash provided by operating activities in fiscal 2016 totaled $158.4 million, compared to $65.1 million in fiscal 2015. • Free cash flow (Non-GAAP measure*) in fiscal 2016 totaled $110.8 million, compared to $28.3 million in fiscal 2015. • Funded contract backlog as of December 31, 2016 was $2.3 billion compared to $2.4 billion as of December 31, 2015. • Total contract backlog as of December 31, 2016 was $4.5 billion compared to $4.0 billion as of December 31, 2015. • Net debt (Non-GAAP measure*) as of December 31, 2016 was $315.3 million compared to $442.1 million as of December 31, 2015. _________ * We provide Non-GAAP measures as a supplement to financial results based on GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading “Operating Segment Information” and “Use of Non-GAAP Financial Measures.” We are operating in an environment that is characterized by both increasing complexity in the global security environment and continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. We continuously evaluate a broad range of options that could be implemented to increase operational efficiency across all sites, and improve our overall market competitiveness. Our decisions will be focused on moving us forward to solidify our leadership in the propulsion markets. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, implementation of the CIP, environmental matters, capital structure, and our underfunded retirement benefit plans. Major Customers The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within “budget top-line” limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. Sales to the U.S. government and its agencies, including sales to our significant customers disclosed below, were as follows: The Standard Missile program, which is included in the U.S. government sales and is comprised of multiple contracts, represented 12%, 14%, 12%, and 12% of net sales for fiscal 2016, fiscal 2015, fiscal 2014, and the one month ended December 31, 2015, respectively. The THAAD program, which is included in the U.S. government sales and is comprised of multiple contracts, represented 13%, 13%, 12%, and 13% of net sales for fiscal 2016, fiscal 2015, fiscal 2014, and the one month ended December 31, 2015, respectively. The demand for certain of our services and products is directly related to the level of funding of U.S. government programs. Customers that represented more than 10% of net sales for the periods presented were as follows: Our sales to each of the major customers listed above involve several product lines and programs. Industry Update Our primary aerospace and defense customers include the DoD and its agencies, NASA, and the prime contractors that supply products to these customers. We rely on U.S. government spending on propulsion systems for defense, space and armament systems, precision tactical weapon systems and munitions applications, and our backlog depends, in large part, on continued funding by the U.S. government for the programs in which we are involved. These funding levels are not generally correlated with any specific economic cycle, but rather follow the cycle of general public policy and political support for this type of funding. Moreover, although our contracts often contemplate that our services will be performed over a period of several years, the U.S. Congress must appropriate funds for a given program and the U.S. President must sign government budget legislation each GFY and may significantly increase, decrease or eliminate, funding for a program. A decrease in DoD and/or NASA expenditures, the elimination or curtailment of a material program in which we are or hope to be involved, or changes in payment patterns of our customers as a result of changes in U.S. government outlays, could have a material adverse effect on our operating results, financial condition, and/or cash flows. Even with overall budget levels set for GFY 2017, Congress was not able to pass a full year appropriation for either the DoD or NASA prior to the start of GFY 2017 on October 1, 2016. As a result, Congress passed a short-term CR to fund the U.S. government until December 9, 2016. After the November U.S. presidential election, at the request of the incoming Trump Administration, Congress passed another CR through April 28, 2017 to allow the new Administration to shape federal spending. Although details of the plans to address perceived shortfalls in DoD readiness and modernization remain unsettled, the Trump Administration has signaled strong support for nuclear modernization and missile defense. The SLS appears to remain a top Congressional priority as the CR included a provision to allow NASA the funding flexibility for SLS and deep exploration to remain on track. The SLS program also has enjoyed wide, bipartisan support in both chambers of Congress. We maintain a strong relationship with NASA and our propulsion systems have been powering NASA launch vehicles and spacecraft since the inception of the U.S. space program. Our booster, upper stage and Orion vehicle propulsion systems are currently baselined on the new SLS vehicle and both upper stage and booster engines are in development for future SLS variants. Due to the retirement of the space shuttle fleet, U.S. astronauts are now dependent on Russian Soyuz flights for access to and from the ISS for the better part of this decade. NASA has been working to re-establish U.S. manned space capability as soon as possible through development of a new “space taxi” to ferry astronauts and cargo to the ISS. In 2014, Boeing’s CST-100 Starliner capsule, powered by Aerojet Rocketdyne propulsion, was selected by NASA to transport astronauts to and from the ISS. As Boeing’s teammate, Aerojet Rocketdyne will be providing the propulsion system for this new capsule, thereby supplementing its work for NASA on the SLS designed for manned deep space exploration. In both instances, we have significant propulsion content and we look forward to supporting these generational programs for NASA. The competitive dynamics of our multi-faceted marketplace vary by product sector and customer as we experience many of the same influences felt by the broader aerospace and defense industry. The large majority of products we manufacture are highly complex, technically sophisticated and extremely hazardous to build, demanding rigorous manufacturing procedures and highly specialized manufacturing equipment. While historically these factors, coupled with the high cost to establish the infrastructure required to meet these needs, posed substantial barriers to entry, modern design tools and manufacturing techniques (e.g., additive manufacturing) available to new entrants with the ability to self-fund start-up as well as development costs has led to increased competition in space related markets. To date, the competition has been limited to a few participants who tend to be narrowly focused on products that are sub-elements of our overall product portfolio. For example, entrepreneurs such as SpaceX and Blue Origin, who have been or are in the process of developing liquid fuel propulsion capabilities are primarily focused on the development of space propulsion systems for heavy lift launch vehicles and are not pursuing or participating in the missile defense or tactical propulsion business segments that make up a substantial portion of our overall business. These new entrepreneurs have signaled their intent to compete primarily on price and are therefore bringing pressure to bear on existing cost paradigms and manufacturing methodologies. Competitive Improvement Program In March 2015, we initiated the CIP comprised of activities and initiatives aimed at reducing costs in order for us to continue to compete successfully. The company-wide initiative is being undertaken after a comprehensive assessment of our product portfolio to underpin Aerojet Rocketdyne’s technological and competitive leadership in our markets through continued research and development. The CIP is composed of three major components: (i) facilities optimization and footprint reduction; (ii) product affordability; and (iii) reduced administrative and overhead costs. Under the CIP, we expect an estimated 500 headcount reduction. We currently estimate that we will incur restructuring and related costs over the four-year CIP program of approximately $82 million (excluding approximately $31 million of capital expenditures). The revisions to the estimated costs of the CIP in fiscal 2016 were primarily driven by reduced severance costs as employees left voluntarily at a higher rate than anticipated. When fully implemented, we anticipate that the CIP will result in annual cost savings of approximately $145 million beginning in fiscal 2019. As a result of this effort, we will be better positioned to deliver our innovative, high quality and reliable products at a lower cost to our customers. The cost savings will be realized by the U.S. government in the form of more competitive pricing. The CIP costs will consist primarily of severance and other employee related costs totaling approximately $25 million, operating facility costs totaling approximately $19 million, and $38 million for other costs relating to product re-qualification, knowledge transfer and other CIP implementation costs. We have incurred $18.4 million related to the CIP program through December 31, 2016 and additionally we have incurred $28.9 million in capital expenditures to support the CIP. The costs associated with the CIP will be a component of our U.S. government forward pricing rates, and therefore, will be recovered through the pricing of our products and services to the U.S. government. Environmental Matters Our current and former business operations are subject to, and affected by, federal, state, local, and foreign environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. Our policy is to conduct our business with due regard for the preservation and protection of the environment. We continually assess compliance with these regulations and we believe our current operations are materially in compliance with all applicable environmental laws and regulations. The following table summarizes our recoverable amounts, environmental reserves, and range of liability, as of December 31, 2016: _____ (1) Excludes the receivable from Northrop of $68.0 million as of December 31, 2016 related to environmental costs already paid (and therefore not reserved) in prior years and reimbursable under the Northrop Agreement. Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowable to be included in our contracts with the U.S. government and allocable to Northrop until the cumulative expenditure limitation is reached. See Note 7(c) and (d) of the notes to consolidated financial statements and "Environmental Matters" below for summary of our environmental reserve activity. Capital Structure We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of December 31, 2016, we had $725.6 million of debt principal outstanding. Retirement Benefits We expect to make cash contributions of approximately $72.0 million to our tax-qualified defined benefit pension plan in fiscal 2017 of which $37.0 million is expected to be recoverable in our U.S. government contracts in fiscal 2017 with the remaining $35.0 million being potentially recoverable in our U.S. government contracts in the future. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there is a lag between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under the CAS. During fiscal 2016, we made cash contributions of $32.8 million to our tax-qualified defined benefit pension plan of which $27.5 million was recoverable in our U.S. government contracts in fiscal 2016 with the remaining $5.3 million being potentially recoverable in our U.S. government contracts in the future. The funded status of our retirement benefit plans may be adversely affected by investment experience, by any changes in U.S. law and by changes in the statutory interest rates used by tax-qualified pension plans in the U.S. to calculate funding requirements. Accordingly, if the performance of our retirement benefit assets does not meet our assumptions, if there are changes to the IRS regulations or other applicable law or if other actuarial assumptions are modified, our future contributions to our underfunded retirement benefit plans could be higher than we expect. Additionally, the level of returns on retirement benefit assets, changes in interest rates, changes in legislation, and other factors affect our financial results. The timing of recognition of retirement benefit expense or income in our financial statements differs from the timing of the required funding under the PPA or the amount of funding that can be recorded in our overhead rates through our U.S. government contracting business. Results of Operations: Net Sales: * Primary reason for change. The increase in net sales was primarily due to the following (i) an increase of $95.0 million on space launch programs primarily driven by increased deliveries on the RL10 program, and the transition of the Commercial Crew Development program from development activities to initial production and (ii) an increase of $37.2 million on air defense programs primarily driven by the transition of the PAC-3 contracts to full-rate production. These factors were partially offset by (i) the sale of approximately 550 acres of our Sacramento Land for $42.0 million in fiscal 2015 and (ii) a decrease of $36.8 million in the various Standard Missile contracts primarily from the timing of deliveries on the Standard Missile-3 Block IB contract and Standard Missile MK72 booster contract. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in fiscal 2016 compared to 52 weeks of operations in fiscal 2015. The additional week of operations, which occurred in the fourth quarter of fiscal 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. ** Primary reason for change. The increase in net sales was primarily due to the following: (i) an increase of $84.3 million in space advanced programs primarily driven by the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS development program and increased development work on the Orion program partially offset by the successful completion of current J-2X program; (ii) an increase of $80.3 million in missile defense and strategic systems programs primarily driven by the increased deliveries on the THAAD and Standard Missile programs; and (iii) sale of approximately 550 acres of our Sacramento Land for $42.0 million. The increase in net sales was partially offset by a decrease of $109.7 million in space launch programs primarily associated with the RL10 and RS-68 programs as a result of the timing of deliveries and costs incurred on these multi-year contracts and lower sales related to the Antares AJ-26 program close-out (see discussion below). Net sales for the month ended December 31, 2015 was primarily comprised of the following: (i) sales of $32.4 million in missile defense and strategic systems programs primarily driven by the deliveries on the THAAD and Standard Missile programs; (ii) sales of $26.4 million in our space launch programs primarily associated with the RL10 program as a result of deliveries on this multi-year contract and deliveries on the Atlas V program; and (iii) sales of $26.1 million in space advanced programs primarily driven by work on the Commercial Crew Development program and the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS program. Cost of Sales (exclusive of items shown separately below): * Primary reason for change. The increase in cost of sales as a percentage of net sales excluding retirement benefit expense and the step-up in fair value of inventory was primarily due to the fiscal 2015 land sale of approximately 550 acres of Sacramento Land resulting in gross profit of $30.6 million. ** Primary reason for change. The decrease in cost of sales as a percentage of net sales excluding retirement benefit expense and the step-up in fair value of inventory was primarily due to (i) land sale of approximately 550 acres of Sacramento Land resulting in gross profit of $30.6 million and (ii) the close-out of the Antares AJ-26 program. Aerojet Rocketdyne entered into a Settlement and Mutual Release Agreement (the “Agreement”) with Orbital Sciences Corporation (“Orbital”) pursuant to which the parties mutually agreed to a termination for convenience of the contract relating to the provision by Aerojet Rocketdyne of 20 AJ-26 liquid propulsion rocket engines to Orbital for the Antares program (the “Contract”). The Agreement also settles all claims the parties may have had against one another arising out of the Contract and the launch failure that occurred on October 28, 2014 of an Antares launch vehicle carrying the Cygnus ORB-3 service and cargo module. We incurred a $50.0 million legal settlement charge reported as an unusual item and not included in cost of sales related to the legal settlement. Cost of sales as a percentage of net sales excluding retirement benefit expense and the step-up in fair value of inventory for the month ended December 31, 2015 included favorable changes in contract estimates due to better than expected performance primarily on the Standard Missile and THAAD programs as a result of manufacturing efficiencies and risk mitigation. These favorable factors were partially offset by contract losses on an electric propulsion contract. AR1 Research and Development: * Primary reason for change. Our company-sponsored R&D expenses (reported as a component of cost of sales) are generally allocated among all contracts and programs in progress under U.S. government contractual arrangements. From time to time, we believe it is in our best interests to self-fund and not allocate costs for certain R&D activities to the U.S. government contracts. In fiscal 2015, we self-funded $32.1 million of engine development expenses associated with our newest liquid booster engine, the AR1, and did not allocate these costs to the U.S. government. The table below summarizes total AR1 R&D costs net of reimbursements: Selling, General and Administrative (“SG&A”): * Primary reason for change. The increase in SG&A expense was primarily driven by an increase of $4.3 million in stock-based compensation which was primarily a result of an increase in performance based stock compensation. ** Primary reason for change. The increase in SG&A expense was primarily driven by: (i) an increase of $6.1 million in non-cash retirement benefit plan expense (see discussion of “Retirement Benefit Plans” below) and (ii) an increase of $2.9 million in stock-based compensation primarily as a result of increases in the fair value of the stock appreciation rights. SG&A expense as a percentage of net sales for the month ended December 31, 2015 was relatively proportional to the first quarter of fiscal 2016 and 2015. Depreciation and Amortization: * Primary reason for change. Depreciation and amortization expense was essentially unchanged for the period. ** Primary reason for change. The increase in depreciation and amortization was primarily due to the non-cash accelerated depreciation expense of $0.8 million in fiscal 2015 associated with changes in the estimated useful life of long-lived assets impacted by the CIP. Depreciation and amortization expense for the month ended December 31, 2015 was relatively proportional to the first quarter of fiscal 2016. Other Expense, net: * Primary reason for change. The decrease in other expense, net was primarily due to a decrease of $17.4 million in unusual items charges (see discussion of unusual items below). ** Primary reason for change. The decrease in other expense, net was primarily due to a decrease of $9.8 million in unusual items charges (see discussion of unusual items below). The decrease in unusual items was partially offset by an increase of $6.5 million in environmental remediation expense primarily associated with higher reserve requirements at the BPOU site offset by the advance agreement between Aerojet Rocketdyne and the U.S. government entered into in the fourth quarter of fiscal 2015 (see discussion of “Environmental Matters” below). The $0.2 million of other expense, net for the month ended December 31, 2015 was insignificant. Total unusual items expense, a component of other expense, net in the consolidated statements of operations: Fiscal 2016 Activity: On July 18, 2016, we redeemed $460.0 million principal amount of our 7.125% Second-Priority Senior Secured Notes (“7 1/8% Notes”), representing all of the outstanding 7 1/8% Notes, at a redemption price equal to 105.344% of the principal amount, plus accrued and unpaid interest. We incurred a pre-tax charge of $34.1 million in fiscal 2016 associated with the extinguishment of the 7 1/8% Notes. The $34.1 million pre-tax charge was the result of the $24.6 million paid in excess of the par value and $9.5 million associated with the write-off of unamortized deferred financing costs. We retired $13.0 million principal amount of our delayed draw term loan resulting in a loss of $0.3 million. We recorded a charge of $0.1 million associated with an amendment to the Senior Credit Facility. Fiscal 2015 Activity: We recorded an expense of $50.0 million associated with a legal settlement. See discussion in ("Cost of Sales" section above). We retired $76.0 million principal amount of our delayed draw term loan resulting in $1.9 million of losses associated with the write-off of deferred financing fees. Fiscal 2014 Activity: We recorded $0.9 million for realized losses and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. A summary of our loss on the 4 1/16% Convertible Subordinated Debentures ("4 1/16% Debentures") repurchased (in millions): We recorded a charge of $0.2 million related to an amendment to the Senior Credit Facility. December 2015 Activity: We recorded $0.4 million for realized losses and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. Interest Income: * Primary reason for change. Interest income was immaterial for the periods presented. Interest Expense: * Primary reason for change. The decrease in interest expense was primarily due to the retirement of the principal amount of our delayed draw term loan in the first quarter of fiscal 2016 and the redemption of the 7 1/8% Notes in the third quarter of fiscal 2016. The decrease was partially offset by interest expense on the debt incurred on the Senior Credit Facility at a lower variable interest rate (3.02% as of December 31, 2016) and to a lesser extent the issuance of the 2¼% Notes in December 2016 at an effective interest rate of 5.8%. ** Primary reason for change. The decrease in interest expense was primarily due to the $49.0 million of 4 1/16% Debentures that were converted to 5.5 million shares of our common stock in fiscal 2015. Interest expense for the month ended December 31, 2015 was proportional to our interest expense for the first quarter of fiscal 2016. Income Tax Provision: The following table shows the reconciling items between the income tax provision using the federal statutory rate and our reported income tax provision. In fiscal 2016, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our income before income taxes primarily due to the impacts from state income taxes, and certain expenditures which are permanently not deductible for tax purposes, partially offset by the impact of R&D credits. In fiscal 2015, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our loss before income taxes primarily due to state income taxes and certain non-deductible interest expense, partially offset by the retroactive reinstatement of the federal R&D credit and benefits allowed by Section 199 of the IRS code allowed to manufacturers. In fiscal 2014, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our loss before income taxes primarily due to the non-deductible premiums paid upon the redemption of portions of the convertible debt, certain non-deductible interest expense, state income taxes, and impacts from the final R&D credit study, partially offset by benefits allowed by Section 199 of the IRS code allowed to manufacturers. In the month ended December 31, 2015, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our income before income taxes primarily due to the re-enactment of the federal R&D credit in December 2015 for calendar year 2015 which has been treated as a discrete event for the December 2015 one-month period, as well as impacts from state income taxes, benefits allowed by Section 199 of the IRS code allowed to manufacturers, and R&D credits. The carrying value of our deferred tax assets is dependent on our ability to generate sufficient taxable income in the future. We need $439.7 million in pre-tax income and $343.7 million in other comprehensive income to realize the net deferred tax assets as of December 31, 2016. We project that future taxable income will increase as a result of increased income from continuing operations resulting from improved contract profit margins related to the Rocketdyne Business acquisition integration and improved margins beginning in fiscal 2015 due to anticipated contributions to our tax qualified defined benefit pension plan, which are recoverable through our U.S. government contracts. These increases in income from continuing operations will be partially offset by book to tax adjustments, primarily related to retirement benefit plan payments, state tax deductions, and our manufacturing deductions. The timing of recording or releasing a valuation allowance requires significant management judgment. The amount of the valuation allowance released by us represents a portion of deferred tax assets that was deemed more-likely-than-not that we will realize the benefits based on the analysis in which the positive evidence outweighed the negative evidence. A valuation allowance is required when it is more-likely-than-not that all or a portion of deferred tax assets may not be realized. Establishment and removal of a valuation allowance requires management to consider all positive and negative evidence and make a judgmental decision regarding the amount of valuation allowance required as of a reporting date. The weight given to the evidence is commensurate with the extent to which it can be objectively verified. In the evaluation as of December 31, 2016 and 2015, management has considered all available evidence, both positive and negative, including but not limited to the following: Positive evidence • Positive results from continuing operations before income taxes for the year ended December 31, 2016; • Our recent history of generating taxable income which has allowed for the utilization of tax credit carryforwards; • CAS rules that allow us to recover certain tax-qualified defined benefit pension plan cash contributions through our U.S. government contracts; • Eligibility of some of our environmental costs for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements; • Establishment and execution of the Competitive Improvement Program evidencing increasing growth and profitability; • Increase in our contract backlog; • Lower interest costs as a result of our fiscal 2016 debt refinancing efforts; and • Favorable trends with respect to the market value of certain real estate assets. Negative evidence • Our three year comprehensive cumulative loss position as of December 31, 2016; • Our exposure to environmental remediation obligations and the related uncertainty as to the ultimate exposure upon settlement; • The significance of our defined benefit pension obligation and related impact it could have in future years; and • The interest expense arising from additional indebtedness incurred in fiscal 2016. During fiscal 2016 and 2015, we continued to evaluate the need for a valuation allowance and have concluded in each quarter, including year end, that the amount of valuation allowance currently recorded was appropriate. We will continue to evaluate the ability to realize our net deferred tax assets to determine if an increase to our valuation allowance may be required to reduce deferred tax assets, which could have a material impact on our results of operations. Retirement Benefit Plans: Components of retirement benefit expense: We estimate that our retirement benefit expense will be approximately $73 million in fiscal 2017. Market conditions and interest rates significantly affect the assets and liabilities of our retirement benefit plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This “smoothing” results in the creation of other accumulated income or losses which will be amortized to retirement benefit expense or benefit in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses associated with the market-related value of pension assets and all other gains and losses, including changes in the discount rate used to calculate benefit costs each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes market related asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual retirement benefit expense, future expenses are impacted by changes in the market value of assets and changes in interest rates. Operating Segment Information: We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance represents net sales from continuing operations less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, legacy income or expenses, and unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our underlying operational performance. In addition, we provide the Non-GAAP financial measure of our operational performance called segment performance before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items. We believe the exclusion of the items listed above permits an evaluation and a comparison of results for ongoing business operations, and it is on this basis that management internally assesses operational performance. Aerospace and Defense Segment ________ (1) Retirement benefit expense is net of cash funding to our tax-qualified defined benefit pension plan which are recoverable costs under our U.S. government contracts. We funded $27.5 million to our tax-qualified defined benefit pension plan in fiscal 2016 that was recoverable in our fiscal 2016 U.S. government contracts. * Primary reason for change. The increase in net sales was primarily due to the following (i) an increase of $95.0 million on space launch programs primarily driven by increased deliveries on the RL10 program, and the transition of the Commercial Crew Development program from development activities to initial production and (ii) an increase of $37.2 million on air defense programs primarily driven by the transition of the PAC-3 contracts to full-rate production. These factors were partially offset by a decrease of $36.8 million in the various Standard Missile contracts primarily from the timing of deliveries on the Standard Missile-3 Block IB contract and Standard Missile MK72 booster contract. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in fiscal 2016 compared to 52 weeks of operations in fiscal 2015. The additional week of operations, which occurred in the fourth quarter of fiscal 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. Segment margin before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items in fiscal 2016 compared to fiscal 2015 was relatively unchanged. Items that had a significant impact include the following: (i) favorable contract performance on the THAAD program as a result of operating performance and lower overhead costs; (ii) a gross contract benefit of $8.1 million in fiscal 2015 associated with the Antares AJ-26 Settlement Agreement (see discussion in “Cost of Sales” above); and (iii) cost growth and manufacturing inefficiencies in the current period on electric propulsion contracts. ** Primary reason for change. The increase in net sales was primarily due to the following (i) an increase of $84.3 million in space advanced programs primarily driven by the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS development program and increased development work on the Orion program partially offset by the successful completion of current J-2X program and (ii) an increase of $80.3 million in missile defense and strategic systems programs primarily driven by the increased deliveries on the THAAD and Standard Missile programs. The increase in net sales was partially offset by a decrease of $109.7 million in space launch programs primarily associated with the RL10 and RS-68 programs as a result of the timing of deliveries and costs incurred on these multi-year contracts and lower sales related to the Antares AJ-26 program close-out (see discussion below). The increase in the segment margin before environmental remediation provision adjustments, retirement benefit expense, Rocketdyne purchase accounting adjustments, and unusual items in fiscal 2015 compared to fiscal 2014 was primarily due to the close-out of the Antares AJ-26 program (see discussion of “Cost of Sales” above) and costs associated with the AR1 program. During the third quarter of fiscal 2015, we began separately reporting the portion of the engine development expenses associated with our newest liquid booster engine, the AR1, which are currently not allocated across all contracts and programs in progress under U.S. governmental contractual arrangements (see additional discussion in Note 1(r) of the notes to consolidated financial statements). See segment information below: ______ (1) We incurred a $50.0 million legal settlement charge related to the Antares AJ-26 program reported as an unusual item in fiscal 2015. Net sales for the month ended December 31, 2015 was primarily comprised of the following: (i) sales of $32.4 million in missile defense and strategic systems programs primarily driven by the deliveries on the THAAD and Standard Missile programs; (ii) sales of $26.4 million in our space launch programs primarily associated with the RL10 program as a result of deliveries on this multi-year contract and deliveries on the Atlas V program; and (iii) sales of $26.1 million in space advanced programs primarily driven by development work on the Commercial Crew Development program and the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS program. The segment margin before environmental remediation provision adjustments, retirement benefit plan expense, Rocketdyne purchase accounting adjustments, and unusual items included (i) favorable changes in contract estimates due to better than expected performance on the Standard Missile and THAAD programs as a result of manufacturing efficiencies and risk mitigation and (ii) costs recoveries on retirement benefit plan contributions. These favorable factors were partially offset by contract losses on an electric propulsion contract. The following table summarizes our backlog: Real Estate Segment * Primary reason for change. During fiscal 2016 and 2014, net sales and segment performance consisted primarily of rental property operations. During fiscal 2015, we recognized net sales of $42.0 million associated with a land sale of approximately 550 acres which resulted in a pre-tax gain of $30.6 million. Net sales and segment performance consisted primarily of rental property operations. Use of Non-GAAP Financial Measures In addition to segment performance (discussed above), we provide the Non-GAAP financial measure of our operational performance called Adjusted EBITDAP. We use this metric to measure our operating performance. We believe that to effectively compare core operating performance from period to period, the metric should exclude items relating to retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the ordinary, on-going and customary course of our operations. Accordingly, we define Adjusted EBITDAP as GAAP income (loss) from continuing operations before income taxes adjusted to exclude interest expense, interest income, depreciation and amortization, retirement benefit expense net of cash funding to our tax-qualified defined benefit pension plan that are recoverable under our U.S. government contracts, and unusual items which we do not believe are reflective of such ordinary, on-going and customary activities. Adjusted EBITDAP does not represent, and should not be considered an alternative to, net income (loss), as determined in accordance with GAAP. ________ (1) Retirement benefit expense is net of cash funding to our tax-qualified defined benefit pension plan which are recoverable costs under our U.S. government contracts. We funded $27.5 million to our tax-qualified defined benefit pension plan in fiscal 2016 that was recoverable in our fiscal 2016 U.S. government contracts. In addition to segment performance and Adjusted EBITDAP, we provide the Non-GAAP financial measures of free cash flow and net debt. We use these financial measures, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that these financial measures are useful because it presents our business using the same tools that management uses to evaluate progress in achieving our performance metrics for annual cash and long-term compensation incentive plans. _________ (1) Free Cash Flow, a Non-GAAP financial measure, is defined as cash flow from operating activities less capital expenditures. Free Cash Flow should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to cash flows from operations presented in accordance with GAAP. We believe Free Cash Flow is useful as it provides supplemental information to assist investors in viewing the business using the same tools that management uses to evaluate progress in achieving our goals. Because our method for calculating the Non-GAAP measures may differ from other companies’ methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures. Environmental Matters Our policy is to conduct our businesses with due regard for the preservation and protection of the environment. We devote a significant amount of resources and management attention to environmental matters and actively manage our ongoing processes to comply with environmental laws and regulations. We are involved in the remediation of environmental conditions that resulted from generally accepted manufacturing and disposal practices at certain plants in the 1950s and 1960s. In addition, we have been designated a Potentially Responsible Parties ("PRP") with other companies at third party sites undergoing investigation and remediation. Estimating environmental remediation costs is difficult due to the significant uncertainties inherent in these activities, including the extent of remediation required, changing governmental regulations and legal standards regarding liability, evolving technologies and the long period of time over which most remediation efforts take place. We: • accrue for costs associated with the remediation of environmental pollution when it becomes probable that a liability has been incurred and when our proportionate share of the costs can be reasonably estimated; and • record related estimated recoveries when such recoveries are deemed probable. In addition to the costs associated with environmental remediation discussed above, we incur expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations which totaled $6.5 million in fiscal 2016, $5.5 million in fiscal 2015, $7.1 million in fiscal 2014, and $0.3 million in the one month ended December 31, 2015. The following table summarizes our recoverable amounts, environmental reserves, and range of liability, as of December 31, 2016: _____ (1) Excludes the receivable from Northrop of $68.0 million as of December 31, 2016 related to environmental costs already paid (and therefore not reserved) in prior years and reimbursable under the Northrop Agreement. Reserves We review on a quarterly basis estimated future remediation costs and has an established practice of estimating environmental remediation costs over a fifteen year period, except for those environmental remediation costs with a specific contractual term. Environmental liabilities at the BPOU site are currently estimated through the term of a new project agreement as proposed by Aerojet Rocketdyne, which the Water Entities and the EPA have rejected. There can be no assurance that the term of the new project agreement will not be longer than the term we estimated and/or broader in scope and, if so, we may be required to make an additional accrual to reflect the longer term and/or broader scope. As the period for which estimated environmental remediation costs lengthens, the reliability of such estimates decreases. These estimates consider the investigative work and analysis of engineers, outside environmental consultants, and the advice of legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum amount is used when no single amount in the range is more probable. Accordingly, such estimates can change as we periodically evaluate and revise these estimates as new information becomes available. We cannot predict whether new information gained as projects progress will affect the estimated liability accrued. The timing of payment for estimated future environmental costs is influenced by a number of factors such as the regulatory approval process, and the time required to design, construct, and implement the remedy. A summary of our environmental reserve activity: _____ (1) Related to the Company's legacy business operations that are primarily non-recoverable environmental remediation expenses from the U.S. government. The $87.4 million of environmental reserve additions in fiscal 2016 was primarily due to the following items: (i) in fiscal 2016 we reached a decision with the U.S. government on the treatment of certain utility costs related to the Sacramento site resulting in a reserve increase of $59.4 million for the estimated impact over the current period and a fifteen year reserve period; (ii) $10.4 million of additional operations and maintenance for treatment facilities; (iii) $5.9 million of remediation related to inactive test sites and landfill clean-up; and (iv) $2.7 million of remediation related to operable treatment units; and (v) $9.0 million related to other environmental clean-up matters. The $0.5 million of environmental reserve additions in the one month ended December 31, 2015 were insignificant. The $176.6 million of environmental reserve additions in fiscal 2015 was primarily due to the following items: (i) $126.3 million associated with our detailed review estimate related to the BPOU site to reflect the anticipated costs through the term of a new project agreement, and the amount reserved is based on the proposal by Aerojet Rocketdyne; (ii) $13.8 million associated with water replacement; (iii) $13.5 million of remediation related to operable treatment units; (iv) $5.2 million of additional operations and maintenance for treatment facilities; and (v) $17.8 million related to other environmental clean-up matters. The $33.7 million of environmental reserve additions in fiscal 2014 was primarily due to the following items: (i) $8.1 million of additional operations and maintenance for treatment facilities; (ii) $5.8 million associated with annual detailed review estimate updates; (iii) $4.0 million associated with water replacement; (iv) $3.0 million of remediation related to operable treatment units; (v) $1.5 million of costs related to the Camden, Arkansas site; and (vi) $11.3 million related to other environmental clean-up matters. The effect of the final resolution of environmental matters and our obligations for environmental remediation and compliance cannot be predicted with complete certainty due to changes in both the amount and timing of future expenditures as well as regulatory or technological changes. We believe, on the basis of presently available information, that the resolution of environmental matters and our obligations for environmental remediation and compliance will not have a material adverse effect on our business, liquidity and/or financial condition. We will continue our efforts to mitigate past and future costs through pursuit of claims for recoveries from insurance coverage and other PRPs and continued investigation of new and more cost effective remediation alternatives and associated technologies. As part of the acquisition of the Atlantic Research Corporation (“ARC”) propulsion business in 2003, Aerojet Rocketdyne entered into an agreement with ARC pursuant to which Aerojet Rocketdyne is responsible for up to $20.0 million of costs (“Pre-Close Environmental Costs”) associated with environmental issues that arose prior to Aerojet Rocketdyne’s acquisition of the ARC propulsion business. ARC is responsible for any cleanup costs relating to the ARC acquired businesses in excess of $20.0 million. Pursuant to a separate agreement with the U.S. government which was entered into prior to the completion of the ARC acquisition, these costs are recovered through the establishment of prices for Aerojet Rocketdyne’s products and services sold to the U.S. government. A summary of the Pre-Close Environmental Costs (in millions): We expect that the cumulative clean-up costs will exceed $20 million in fiscal 2017 after which ARC will be responsible for such costs due to contamination existing at the time of the acquisition and still requiring remediation and monitoring. On May 6, 2016, ARC informed Aerojet Rocketdyne that it is disputing certain costs that Aerojet Rocketdyne is attributing to the $20 million Pre-Close Environmental Costs. Aerojet Rocketdyne is evaluating the claim. Estimated Recoveries On January 12, 1999, Aerojet Rocketdyne and the U.S. government implemented the Global Settlement resolving certain prior environmental and facility disagreements, with retroactive effect to December 1, 1998. Under the Global Settlement, Aerojet Rocketdyne and the U.S. government resolved disagreements about an appropriate cost-sharing ratio with respect to the cleanup costs of the environmental contamination. The Global Settlement cost-sharing ratio does not have a defined term over which costs will be recovered. Additionally, in conjunction with the sale of the EIS business in 2001, Aerojet Rocketdyne entered into the Northrop Agreement whereby Aerojet Rocketdyne is reimbursed by Northrop for a portion of environmental expenditures eligible for recovery under the Global Settlement, subject to a cumulative limitation. Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowable to be included in our contracts with the U.S. government and allocable to Northrop until the cumulative expenditure limitation is reached. Excluding the receivable from Northrop of $68.0 million discussed in Note 7(d) in notes to consolidated financial statements in Item 8 of this Report, we currently estimate approximately 24% of our future Aerospace and Defense segment environmental costs will not likely be reimbursable and are expensed. Allowable environmental costs are charged to our contracts as the costs are incurred. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet Rocketdyne to continue recovering these costs from the U.S. government depends on Aerojet Rocketdyne’s sustained business volume under U.S. government contracts and programs. Pursuant to the Northrop Agreement, environmental expenditures to be reimbursed are subject to annual limitations and the total reimbursements are limited to a ceiling of $189.7 million. A summary of the Northrop Agreement activity (in millions): While we are currently seeking an arrangement with the U.S. government to recover environmental expenditures in excess of the reimbursement ceiling identified in the Northrop Agreement and Global Settlement, there can be no assurances that such a recovery will be obtained, or if not obtained, that such unreimbursed environmental expenditures will not have a materially adverse effect on our operating results, financial condition, and/or cash flows. The following table summarizes the activity in the current and non-current recoverable amounts from Northrop and the U.S. government: Fiscal 2016 Activity Fiscal 2016 additions - The $67.3 million of additions to the environmental recoverable asset was primarily due to the following items: (i) the treatment of certain utility costs related to the Sacramento site resulting in an increase of $45.0 million; (ii) $7.8 million of additional operations and maintenance for treatment facilities; (iii) $5.1 million of remediation related to inactive test sites and landfill clean-up; and (iv) $2.0 million of remediation related to operable treatment units; and (v) $7.4 million related to other environmental clean-up matters. Fiscal 2016 reimbursements -The $35.1 million of environmental expenditures that were reimbursed related to the following items: (i) $15.7 million for operations and maintenance of treatment facilities; (ii) $3.8 million associated with water supply replacement; (iii) $3.6 million of remediation related to operable treatment units; (iv) $2.7 million associated with test sampling and analysis; (v) $2.1 million of costs related to the Camden, Arkansas site; and (vi) $7.2 million related to other environmental clean-up matters. One month ended December 31, 2015 Activity One month ended December 31, 2015 additions - The $0.4 million of additions to the environmental recoverable were insignificant. One month ended December 31, 2015 reimbursements -The $3.8 million of environmental expenditures that were reimbursed related primarily to $3.6 million of additional operations and maintenance for treatment facilities. Fiscal 2015 Activity Fiscal 2015 additions - The $133.6 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $95.6 million associated with our detailed review estimate related to the BPOU site to reflect the anticipated costs through the term of a new project agreement, and the amount reserved is based on the proposal by Aerojet Rocketdyne; (ii) $10.5 million associated with water replacement; (iii) $10.2 million of remediation related to operable treatment units; (iv) $3.9 million of additional operations and maintenance for treatment facilities; and (v) $13.4 million related to other environmental clean-up matters. Fiscal 2015 reimbursements -The $31.2 million of environmental expenditures that were reimbursed related to the following items: (i) $13.8 million for operations and maintenance of treatment facilities; (ii) $6.8 million of remediation related to operable treatment units; (iii) $3.4 million associated with water supply replacement; (iv) $2.8 million associated with test sampling and analysis; (v) $1.1 million of costs related to the Camden, Arkansas site; and (vi) $3.3 million related to other environmental clean-up matters. Fiscal 2015 other adjustments - The $25.4 million of other adjustments primarily relates to the impact of the Advance Agreement with the U.S. government revising the percent of environmental costs allocable to Northrop and the U.S. government. We currently estimate approximately 24% of our Aerospace and Defense segment environmental costs will not likely be reimbursable and are expensed to the consolidated statements of operations. Fiscal 2014 Activity Fiscal 2014 additions - The $21.4 million of additions to the environmental recoverable asset was primarily due to the following items: (i) $5.1 million of additional operations and maintenance for treatment facilities; (ii) $3.7 million associated with annual detailed review estimate updates; (iii) $2.5 million associated with water replacement; (iv) $1.9 million of remediation related to operable treatment units; (v) $1.5 million of additional estimated costs related to the Camden, Arkansas site; and (vi) $6.7 million related to other environmental clean-up matters. Fiscal 2014 reimbursements -The $31.0 million of environmental expenditures that were reimbursed related to the following items: (i) $12.6 million for operations and maintenance of treatment facilities; (ii) $8.1 million of remediation related to operable treatment units; (iii) $2.7 million associated with test sampling and analysis; (iv) $1.7 million of additional estimated costs related to the Camden, Arkansas site; (v) $1.3 million associated with water supply replacement; and (vi) $4.6 million related to other environmental clean-up matters. Environmental reserves and recoveries impact to the consolidated statements of operations The expenses associated with adjustments to the environmental reserves are recorded as a component of other expense, net in the consolidated statements of operations. Summarized financial information for the impact of environmental reserves and recoveries to the consolidated statements of operations were as follows: Recently Adopted Accounting Pronouncements See Note 1(x) to our consolidated financial statements in Item 8. Consolidated Financial Statements of this Report for information relating to our discussion of the effects of recent accounting pronouncements. Liquidity and Capital Resources Net Cash Provided By (Used In) Operating, Investing, and Financing Activities The change in cash and cash equivalents was as follows: Net Cash Provided By Operating Activities The $158.4 million of cash provided by operating activities in fiscal 2016 was primarily the result of cash provided by income from continuing operations before income taxes adjusted for non-cash items which generated $176.0 million which was primarily offset by cash used to fund working capital (defined as accounts receivables, inventories, other current assets, accounts payable, contract advances, real estate activities, and other current liabilities) of $44.0 million. The cash used to fund working capital was primarily due to (i) a decrease of $37.5 million in other current liabilities primarily due to the timing of payments associated with income taxes and interest expense and (ii) an increase of $28.9 million in inventories primarily due to the timing of milestone billings and deliveries on the Atlas V and Standard Missile programs. The funding of working capital was partially offset by a decrease of $33.1 million in accounts receivable primarily due to the timing of cash receipts. The $65.1 million of cash provided by operating activities in fiscal 2015 was primarily the result of cash provided by loss from continuing operations before income taxes adjusted for non-cash items which generated $120.5 million which was offset by cash used to fund the following: (i) a decrease of $17.8 million in other current liabilities primarily related to the CIP, cost reduction initiatives, and the amounts paid to UTC related to Transition Service Agreements; (ii) an increase of $19.5 million in inventories primarily due to the timing of milestone billings and deliveries on the PAC-3 and Standard Missile programs; and (iii) $7.8 million of real estate activities. The $150.6 million of cash provided by operating activities in fiscal 2014 was primarily the result of loss from continuing operations before income taxes adjusted for non-cash items which generated $127.4 million. In addition, we generated $69.6 million from working capital. The cash generated from working capital was primarily due to an increase of $96.9 million in cash advances on long-term contracts. This amount was partially offset by the cash used for the Rocketdyne Business integration activities. In addition, we paid $4.9 million for income taxes, net in fiscal 2014. The $2.3 million of cash used in operating activities in December 2015 was primarily due to the result of cash used to fund working capital. The funding of working capital is primarily due to a decrease of $41.0 million in accounts payable related to the timing of payments partially offset by an increase of $27.2 million in cash advances on long-term contracts. Additionally, income from continuing operations before income taxes adjusted for non-cash items generated $16.9 million. Net Cash Used In Investing Activities During fiscal 2016, 2015, and 2014 and the one month ended December 31, 2015, we had capital expenditures of $47.6 million, $36.8 million, $43.4 million, and $1.2 million, respectively. The increase in capital expenditures in fiscal 2016 compared to fiscal 2015 is primarily related to construction projects associated with supporting our Competitive Improvement Plan. Net Cash Provided By (Used In) Financing Activities During fiscal 2016, we had $700.6 million in debt cash payments and borrowings of $800.0 million (see below). During the one month ended December 31, 2015, we had immaterial financing activities. During fiscal 2015, we had debt cash payments of $81.2 million. During fiscal 2014, we repurchased 3.5 million of our common shares at a cost of $64.5 million. We also issued $189.0 million of debt and had $166.3 million in debt cash payments. In addition, we incurred $4.2 million of debt issuance costs. Debt Activity and Covenants Our debt principal activity since December 31, 2015 was as follows: The Senior Credit Facility contains covenants requiring us to (i) maintain an interest coverage ratio (the "Consolidated Interest Coverage Ratio") of not less than 3.00 to 1.00 and (ii) maintain a leverage ratio ( the "Consolidated Net Leverage Ratio") not to exceed (a) 4.00 to 1.00 for periods ending December 31, 2016 through September 30, 2017; (b) 3.75 to 1.00 for periods ending from December 31, 2017 through September 30, 2018; and (c) 3.50 to 1.00 for periods ending from December 31, 2018 thereafter, provided that the maximum leverage ratio for all periods shall be increased by 0.50 to 1.00 for two quarters after consummation of a qualified acquisition. We may generally make certain investments, redeem debt subordinated to the Senior Credit Facility and make certain restricted payments (such as stock repurchases) if our Consolidated Net Leverage Ratio does not exceed 3.25 to 1.00 pro forma for such transaction. We are otherwise subject to customary covenants including limitations on asset sales, incurrence of additional debt, and limitations on certain investments and restricted payments. We were in compliance with our financial and non-financial covenants as of December 31, 2016. Outlook Short-term liquidity requirements consist primarily of recurring operating expenses, including but not limited to costs related to our capital and environmental expenditures, company-funded R&D expenditures, debt service requirements, and retirement benefit plans. We believe that our existing cash and cash equivalents and availability under our revolving credit facility will provide sufficient funds to meet our operating plan, which includes our CIP and AR1 engine development costs, for the next twelve months. The operating plan for this period provides for full operation of our businesses, and interest and principal payments on our debt. As of December 31, 2016, we had $304.7 million of available borrowings under our Senior Credit Facility. Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of December 31, 2016. Our failure to comply with these covenants could result in an event of default that, if not cured or waived by the lenders, could result in the acceleration of the Senior Credit Facility and 2¼% Notes. In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility, and in certain cases, would cause a cross default on the 2¼% Notes. In December 2016, we notified holders of our 4 1/16% Debentures that we would redeem, on February 3, 2017, all of their 4 1/16% Debentures at a purchase price equal to 100% of the principal amount of the 4 1/16% Debentures to be redeemed, plus any accrued and unpaid interest. In January 2017, $35.6 million of the 4 1/16% Debentures (the entire amount outstanding as of December 31, 2016) were converted to 3.9 million shares of common stock. We are committed to a cash management strategy that maintains liquidity to adequately support the operation of the business, our growth strategy and to withstand unanticipated business volatility. We believe that cash generated from operations, together with our current levels of cash and investments as well as availability under our revolving credit facility, should be sufficient to maintain our ongoing operations, support working capital requirements, fund the CIP, make cash contributions of approximately $72.0 million in fiscal 2017 to our tax-qualified defined benefit pension plan, and fund anticipated capital expenditures related to projected business growth. Our cash management strategy includes maintaining the flexibility to pay down debt and/or repurchase shares depending on economic and other conditions. In connection with the implementation of our cash management strategy, our management may seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise if we believe that it is in our best interests. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. Potential future acquisitions depend, in part, on the availability of financial resources at an acceptable cost of capital. We expect to utilize cash on hand and cash generated by operations, as well as cash available under our Senior Credit Facility, which may involve renegotiation of credit limits to finance future acquisitions. Other sources of capital could include the issuance of common and/or preferred stock, and the placement of debt. We periodically evaluate capital markets and may access such markets when circumstances appear favorable. We believe that sufficient capital resources will be available from one or several of these sources to finance future acquisitions. However, no assurances can be made that acceptable financing will be available, or that acceptable acquisition candidates will be identified, or that any such acquisitions will be accretive to earnings. As disclosed in Notes 7(b) and 7(c) of the notes to consolidated financial statements, we have exposure for certain legal and environmental matters. We believe that it is currently not possible to estimate the impact, if any, that the ultimate resolution of certain of these matters will have on our financial position, results of operations, or cash flows. Major factors that could adversely impact our forecasted operating cash flows and our financial condition are described in Part I, Item 1A. Risk Factors. In addition, our liquidity and financial condition will continue to be affected by changes in prevailing interest rates on the portion of debt that bears interest at variable interest rates. Contractual Obligations We have contractual obligations and commitments in the form of debt obligations, operating leases, certain other liabilities, and purchase commitments. The following table summarizes our contractual obligations as of December 31, 2016: ________ (1) In December 2016, we notified holders of our 4 1/16% Debentures that we would redeem, in February 2017, all of their 4 1/16% Debentures at a purchase price equal to 100% of the principal amount of the 4 1/16% Debentures to be redeemed, plus any accrued and unpaid interest. In January 2017, $35.6 million of the 4 1/16% Debentures (the entire amount outstanding as of December 31, 2016) were converted to 3.9 million shares of common stock. (2) Includes interest on variable debt calculated based on interest rates at December 31, 2016. (3) The payments presented above are expected payments for the next 10 years. The payments for postretirement medical and life insurance benefits reflect the estimated benefit payments of the plans using the provisions currently in effect. The obligation related to postretirement medical and life insurance benefits is actuarially determined on an annual basis. The estimated payments have been reduced to reflect the provisions of the Medicare Prescription Drug, Improvement and Modernization Act of 2003. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (4) The conditional asset retirement obligations presented are related to our Aerospace and Defense segment and are allowable costs under our contracts with the U.S. government. As of December 31, 2016, the liability for uncertain income tax positions was $32.0 million. Due to the uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We may be required to make significant cash contributions in the future to fund our retirement benefit plans, a portion of which we may not be able to immediately recover from our U.S. government contracts. We expect to make cash contributions of approximately $72.0 million to our tax-qualified defined benefit pension plan in fiscal 2017 of which $37.0 million is expected to be recoverable in our U.S. government contracts in fiscal 2017 with the remaining $35.0 million being potentially recoverable in our U.S. government contracts in the future. We also issue purchase orders and make other commitments to suppliers for equipment, materials, and supplies in the normal course of business. These purchase commitments are generally for volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers and would be subject to reimbursement if a cost-plus contract was terminated. Arrangements with Off-Balance Sheet Risk As of December 31, 2016, arrangements with off-balance sheet risk consisted of: • $45.3 million in outstanding commercial letters of credit expiring throughout 2017, the majority of which may be renewed, primarily to collateralize obligations for environmental remediation and insurance coverage. • $44.5 million in outstanding surety bonds to primarily satisfy indemnification obligations for environmental remediation coverage. • Up to $120.0 million aggregate in guarantees by us of Aerojet Rocketdyne’s obligations to U.S. government agencies for environmental remediation activities. • Guarantees, jointly and severally, by our material domestic subsidiaries of their obligations under our Senior Credit Facility. In addition to the items discussed above, we have and will from time to time enter into certain types of contracts that require us to indemnify parties against potential third-party and other claims. These contracts primarily relate to: (i) divestiture agreements, under which we may provide customary indemnification to purchasers of our businesses or assets including, for example, claims arising from the operation of the businesses prior to disposition, liability to investigate and remediate environmental contamination existing prior to disposition; (ii) certain real estate leases, under which we may be required to indemnify property owners for claims arising from the use of the applicable premises; and (iii) certain agreements with officers and directors, under which we may be required to indemnify such persons for liabilities arising out of their relationship with us. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. We provide product warranties in conjunction with certain product sales. The majority of our warranties are one-year standard warranties for parts, workmanship, and compliance with specifications. On occasion, we have made commitments beyond the standard warranty obligation. While we have contracts with warranty provisions, there is not a history of any significant warranty claims experience. A reserve for warranty exposure is made on a product by product basis when it is both estimable and probable. These costs are included in the program’s estimate at completion and are expensed in accordance with our revenue recognition methodology as allowed under GAAP for that particular contract. Critical Accounting Policies Our financial statements are prepared in accordance with GAAP that offer acceptable alternative methods for accounting for certain items affecting our financial results, such as determining inventory cost, depreciating long-lived assets, and recognizing revenues. The preparation of financial statements requires the use of estimates, assumptions, judgments, and interpretations that can affect the reported amounts of assets, liabilities, revenues, and expenses, the disclosure of contingent assets and liabilities and other supplemental disclosures. The development of accounting estimates is the responsibility of our management. Management discusses those areas that require significant judgment with the audit committee of our board of directors. All of our financial disclosures in our filings with the SEC have been reviewed with the audit committee. Although we believe that the positions we have taken with regard to uncertainties are reasonable, others might reach different conclusions and our positions can change over time as more information becomes available. If an accounting estimate changes, its effects are accounted for prospectively and, if significant, disclosed in notes of the consolidated financial statements. The areas most affected by our accounting policies and estimates are revenue recognition, other contract considerations, goodwill, retirement benefit plans, litigation, environmental remediation costs and recoveries, and income taxes. Except for income taxes and litigation matters related to discontinued operations, which are not allocated to our operating segments, these areas affect the financial results of our business segments. For a discussion of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the consolidated financial statements. Revenue Recognition We consider the nature of the individual underlying contract and the type of products and services provided in determining the proper accounting for a particular contract. Each method is applied consistently to all contracts having similar characteristics, as described below. Under the percentage of completion method, we recognize sales based upon our progress against the contracted performance objectives. Progress is generally measured as costs are incurred (cost-to-cost method) or as units are delivered to customers (units-of-delivery) depending on the contractual terms and scope of work of the each contract. We use the cost-to-cost measure, where the scope of work on contracts principally relates to research and/or development efforts, or the contract is predominantly a development effort with few deliverable units. Under cost-to-cost, we recognize sales as costs are incurred. We use the units-of-delivery measure to recognize sales when contracts require unit deliveries on a frequent and routine basis. Under units-of-delivery, we recognize sales at the contractually agreed upon unit price as units are sold. For fixed-priced contracts, variance in actual costs from the cost estimates used in determining the fixed price impact the overall profit from the contract. We recognize these variances during the contact performance period. Fixed-priced and cost-reimbursable contracts may provide for variable consideration including awards, incentives, and/or penalties based upon the customer’s assessment of our performance against pre-established targets or other criteria. These targets may include factors such as cost, performance, quality, and schedule. We recognize variable consideration over the contract performance period based upon estimates of performance against the established criteria. The recognition of sales and profit on long-term contracts requires the use of assumptions and estimates related to the contract value or total contract revenue, variable consideration, the total cost at completion and the measurement of progress towards completion. Due to the nature of the programs, developing these estimates requires the use of significant judgment. Estimates are continually evaluated as work progresses and are revised as necessary. Factors considered include, but are not limited to, labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements and inflationary trends, schedule and performance delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. We continually evaluate the facts, circumstances, and assumptions supporting these estimates. Any adjustments to net sales resulting from changes in estimates are recognized in the current period for the inception-to-date effect of such changes. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact from changes in estimates and assumptions on the statement of operations on key contracts, representing 94% of our aerospace and defense segment net sales over the last three fiscal years and one month ended December 31, 2015, accounted for under the percentage-of-completion method of accounting: The fiscal 2016 favorable changes in contract estimates were primarily driven by better than expected performance on space launch systems primarily due to affordability initiatives and lower overhead costs partially offset by cost growth and manufacturing inefficiencies on electric propulsion contracts. The one month ended December 31, 2015 favorable changes in contract estimates were primarily driven by better than expected performance on tactical and missile defense programs primarily due to affordability initiatives and lower overhead costs partially offset by cost growth and manufacturing inefficiencies on an electric propulsion contract. The fiscal 2015 favorable changes in contract estimates were primarily driven by the following (i) better than expected performance on space launch systems and missile defense programs primarily due to affordability initiatives and lower overhead costs and (ii) unexpected favorable contract performance on close-out activities on the J-2X program. The fiscal 2014 favorable changes in contract estimates were primarily driven by better than expected performance on a space launch system program due to favorable contract negotiations and affordability initiatives partially offset by unanticipated inefficiencies and cost growth on the Antares AJ-26 program. Revenue on service or time and material contracts is recognized when performed. If at any time expected costs exceed the value of the contract, the loss is recognized immediately. If change orders are in dispute or are unapproved in regard to both scope and price they are evaluated as claims. We recognize revenue on claims when recovery of the claim is probable and the amount can be reasonably estimated. Revenue on claims is recognized only to the extent that contract costs related to the claims have been incurred and when it is probable that the claim will result in a bona fide addition to contract value that can be reliably estimated. No profit is recognized on a claim until final settlement occurs. Revenue from real estate asset sales is recognized when a sufficient down-payment has been received, financing has been arranged and title, possession and other attributes of ownership have been transferred to the buyer. The allocation to cost of sales on real estate asset sales is based on a relative fair market value computation of the land sold which includes the basis on our books, capitalized entitlement costs, and an estimate of our continuing financial commitment. Revenue that is not derived from long-term development and production contracts, or real estate asset transactions, is recognized when persuasive evidence of a final agreement exists, delivery has occurred, the selling price is fixed or determinable and payment from the customer is reasonably assured. Sales are recorded net of provisions for customer pricing allowances. Other Contract Considerations Our sales are driven by pricing based on costs incurred to produce products and perform services under contracts with the U.S. government. Cost-based pricing is determined under the FAR and CAS. The FAR and CAS provide guidance on the types of costs that are allowable and allocable in establishing prices for goods and services under U.S. government contracts. For example, costs such as charitable contributions, advertising, interest expense, and public relations are unallowable, and therefore not recoverable through sales. In addition, we may enter into agreements with the U.S. government that address the subjects of allowability and allocability of costs to contracts for specific matters. We closely monitor compliance with and the consistent application of our critical accounting policies related to contract accounting. We review the status of contracts through periodic contract status and performance reviews. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel independent from the business segment performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are reviewed for compliance with regulatory standards by our personnel, and are subject to audit by the DCAA. Accordingly, we record an allowance on our unbilled receivables for amounts of potential contract overhead costs which may not be successfully negotiated and collected. Goodwill Goodwill represents the excess of the purchase price of an acquired enterprise or assets over the fair values of the identifiable assets acquired and liabilities assumed. Tests for impairment of goodwill are performed on an annual basis, or at any other time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. All of our recorded goodwill resides in the Aerospace and Defense reporting unit. We evaluated goodwill using a “Step Zero" analysis as of October 1, 2016, September 1, 2016, and September 1, 2015, and determined that goodwill was not impaired. We evaluate qualitative factors (including macroeconomic conditions, industry and market considerations, cost factors, and overall financial performance) to determine whether it is necessary to perform the first step of the two-step goodwill test. This step is referred to as the “Step Zero" analysis. If it is determined that it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, we will need to proceed to the first step (“Step One”) of the two-step goodwill impairment test. In evaluating whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount, relevant events and circumstances as discussed below shall be assessed. If, after assessing the totality of events or circumstances, we determine that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the first and second steps of the impairment test are unnecessary. Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business climate or legal factors; adverse cash flow trends; an adverse action or assessment by a regulator; unanticipated competition; loss of key personnel; decline in stock price; and results of testing for recoverability of a significant asset group within a reporting unit. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recorded. There can be no assurance that our estimates and assumptions made for purposes of our goodwill impairment testing will prove to be accurate predictions of the future. If our assumptions and estimates are incorrect, we may be required to record goodwill impairment charges in future periods. During the year ended December 31, 2016, and in connection with our change in fiscal year end from November 30 to December 31, we changed our annual test of goodwill impairment from September 1 of each year to October 1 of each year. With respect to its annual goodwill testing date, management believes that this voluntary change in accounting method is preferable as it aligns the annual impairment testing date with our long-range planning cycle, the timing of which has changed consistent with the change in our fiscal year end and which is a significant element in the testing process. In connection with this change, we first performed an impairment test as of September 1, 2016 and then performed an additional test as of October 1, 2016. This change in annual testing date does not delay, accelerate or avoid an impairment charge. Retirement Benefit Plans Our defined benefit pension plan future benefit accrual was discontinued in fiscal 2009. In addition, we provide medical and life insurance benefits (“postretirement benefits”) to certain eligible retired employees, with varied coverage by employee group. Annual charges are made for the cost of the plans, including administrative costs, interest costs on benefit obligations, and net amortization and deferrals, increased or reduced by the return on assets. We also sponsor a defined contribution 401(k) plan and participation in the plan is available to all employees. Retirement benefits are a significant cost of doing business and represent obligations that will be ultimately settled far in the future and therefore are subject to estimates. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there is a lag between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under our U.S. government contracts. Our pension and medical and life insurance benefit obligations and related costs are calculated using actuarial concepts in accordance with GAAP. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine service cost and interest cost to arrive at income or expense for the year. We used the following discount rate to determine the benefit obligations for the applicable period: We used the following assumptions to determine the retirement benefit expense for the applicable period: ______ * Not applicable The discount rate represents the current market interest rate used to determine the present value of future cash flows currently expected to be required to settle pension obligations. Based on market conditions, discount rates can experience significant variability. Changes in discount rates can significantly change the liability and, accordingly, the funded status of the pension plan. The assumed discount rate represents the market rate available for investments in high-quality fixed income instruments with maturities matched to the expected benefit payments for pension and medical and life insurance benefit plans. The expected long-term rate of return on assets represents the rate of earnings expected in the funds invested, and funds to be invested, to provide for anticipated benefit payments to plan participants. We evaluated the historical investment performance, current and expected asset allocation, and, with input from our external advisors, developed best estimates of future investment performance. Based on this analysis, we decided to change the long-term expected rate of return on assets from 8.0% to 7.0% effective December 1, 2015. Market conditions and interest rates significantly affect assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This “smoothing” results in the creation of other accumulated income or loss which will be amortized to pension costs in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses in the market-related value of pension assets and all other gains and losses including changes in the discount rate used to calculate benefit costs each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual pension costs, future pension costs are impacted by changes in the market value of assets and changes in interest rates. In addition, we maintain medical and life insurance benefits other than pensions that are not funded. A one percentage point change in the key assumptions would have the following effects on the projected benefit obligations as of December 31, 2016 and on retirement benefit expense for fiscal 2016: Contingencies and Litigation We are currently involved in certain legal proceedings and, as required, have accrued our estimate of the probable costs and recoveries for resolution of these claims. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in assumptions or the effectiveness of strategies related to these proceedings. See Notes 7(b) and 7(c) in notes to consolidated financial statements for more detailed information on litigation exposure. Reserves for Environmental Remediation and Recoverable from the U.S. Government and Other Third Parties for Environmental Remediation Costs For a discussion of our accounting for environmental remediation obligations and costs and related legal matters, see “Environmental Matters” above and Notes 7(c) and 7(d) in notes to consolidated financial statements. We accrue for costs associated with the remediation of environmental contamination when it becomes probable that a liability has been incurred, and when our costs can be reasonably estimated. Management has a well-established process in place to identify and monitor our environmental exposures. In most cases, only a range of reasonably probable costs can be estimated. In establishing the reserves, the most probable estimated amount is used when determinable, and the minimum amount is used when no single amount in the range is more probable. Environmental reserves include the costs of completing remedial investigation and feasibility studies, remedial and corrective actions, regulatory oversight costs, the cost of operation and maintenance of the remedial action plan, and employee compensation costs for employees who are expected to devote a significant amount of time to remediation efforts. Calculation of environmental reserves is based on the evaluation of currently available information with respect to each individual environmental site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. Such estimates are based on the expected costs of investigation and remediation and the likelihood that other potentially responsible parties will be able to fulfill their commitments at sites where we may be jointly or severally liable. At the time a liability is recorded for future environmental costs, we record an asset for estimated future recoveries that are estimable and probable. Some of our environmental costs are eligible for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements. We consider the recovery probable based on the Global Settlement, Northrop Agreement, U.S. government contracting regulations, and our long history of receiving reimbursement for such costs. Income Taxes We file a consolidated U.S. federal income tax return for the Company and our 100% owned consolidated subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in the period of the enactment date of the change. The carrying value of our deferred tax assets is dependent upon our ability to generate sufficient taxable income in the future. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence is considered, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, the length of carryback and carryforward periods, and evaluation of potential tax planning strategies. Despite our belief that our tax return positions are consistent with applicable tax laws, we believe that certain positions are likely to be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or some partial adjustment reached through negotiations or litigation. Our tax reserves reflect the difference between the tax benefit claimed on tax returns and the amount recognized in the financial statements. The accounting standards provide guidance for the recognition and measurement in financial statements for uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process, the first step being recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate resolution with a taxing authority. As the examination process progresses with tax authorities, adjustments to tax reserves may be necessary to reflect taxes payable upon settlement. Tax reserve adjustments related to positions impacting the effective tax rate affect the provision for income taxes. Tax reserve adjustments related to positions impacting the timing of deductions impact deferred tax assets and liabilities.

<s>[INST] The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report, and the disclaimer regarding forwardlooking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations. In January 2016, our board of directors approved a change in our fiscal yearend from November 30 of each year to December 31 of each year. The fiscal year of our subsidiary, Aerojet Rocketdyne, ends on the last Saturday in December. As a result of the change, we had a one month transition period in December 2015. The audited results for the one month ended December 31, 2015 and the unaudited results for the one month ended December 31, 2014 are included in Item 8 of this Report. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in the twelve months ended December 31, 2016 compared to 52 weeks of operations in the twelve months ended November 30, 2015 and 2014. The additional week of operations, which occurred in the fourth quarter of fiscal 2016, accounted for $32.2 million in additional net sales. Financial information for twelve months ended December 31, 2015 has not been included in this Form 10K for the following reasons: (i) the twelve months ended November 30, 2015 provide a meaningful comparison for the twelve months ended December 31, 2016; (ii) there are no significant factors, seasonal or other, that would impact the comparability of information if the results for the twelve months ended December 31, 2015 were presented in lieu of results for twelve months ended November 30, 2015; and (iii) it was not practicable or cost justified to prepare this information. Overview We are a manufacturer of aerospace and defense products and systems with a real estate segment. Our operations are organized into two segments: Aerospace and Defense includes the operations of our whollyowned subsidiary Aerojet Rocketdyne, a leading technologybased designer, developer and manufacturer of aerospace and defense products and systems for the U.S. government, including the DoD, NASA, major aerospace and defense prime contractors as well as portions of the commercial sector. Real Estate includes the activities of our whollyowned subsidiary Easton related to the rezoning, entitlement, sale, and leasing of our excess real estate assets. We are currently in the process of seeking zoning changes and other governmental approvals on our excess real estate assets to optimize its value. A summary of the significant financial highlights for fiscal 2016 which management uses to evaluate our operating performance and financial condition is presented below. Net sales for fiscal 2016 totaled $1,761.3 million compared to $1,708.3 million for fiscal 2015. Net income for fiscal 2016 was $18.0 million, or $0.27 diluted income per share, compared to net loss of $(16.2) million, or $(0.27) loss per share, for fiscal 2015. Adjusted EBITDAP (NonGAAP measure*) for fiscal 2016 was $202.0 million, or 11.5% of net sales, compared to $217.9 million, or 12.8% of net sales, for fiscal 2015. Segment performance before environmental remediation provision adjustments, retirement benefit expense, and unusual items was $188.4 million for fiscal 2016, compared to $200.1 million for fiscal 2015. Cash provided by operating activities in fiscal 2016 totaled $158.4 [/INST] Positive. </s>

AEROJET ROCKETDYNE HOLDINGS, INC.

2018-02-21

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8. Consolidated Financial Statements and Supplementary Data of this Report, the risk factors appearing in Item 1A. Risk Factors of this Report, and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1. Business of this Report. Historical results set forth in Item 6. Selected Financial Data and Item 8. Consolidated Financial Statements and Supplementary Data of this Report should not be taken as indicative of our future operations. Overview A summary of the significant financial highlights for fiscal 2017 which management uses to evaluate our operating performance and financial condition is presented below. • Net sales for fiscal 2017 totaled $1,877.2 million compared with $1,761.3 million for fiscal 2016. • Net loss for fiscal 2017 was $(9.2) million, or $(0.13) loss per share, compared with net income of $18.0 million, or $0.27 diluted income per share, for fiscal 2016. • On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code. Among other provisions, the Tax Act reduced the federal corporate statutory income tax rate from 35% to 21% beginning in 2018. In accordance with the rate reduction, we wrote down our net deferred tax assets by $64.6 million which unfavorably affected our effective tax rate by 74.4%. We expect the tax rate in future years to be between 27% and 29%. • Adjusted EBITDAP (Non-GAAP measure*) for fiscal 2017 was $225.4 million, compared with $201.9 million for fiscal 2016. • Segment performance before environmental remediation provision adjustments, retirement benefits, net, and unusual items (Non-GAAP measure*) was $205.4 million for fiscal 2017, compared with $188.4 million for fiscal 2016. • Cash provided by operating activities in fiscal 2017 totaled $212.8 million, compared with $158.7 million in fiscal 2016. • Free cash flow (Non-GAAP measure*) in fiscal 2017 totaled $183.4 million, compared with $111.1 million in fiscal 2016. • Total contract backlog as of December 31, 2017 was $4.6 billion compared with $4.5 billion as of December 31, 2016. • Total funded backlog as of December 31, 2017 was $2.1 billion compared with $2.3 billion as of December 31, 2016. _________ * We provide Non-GAAP measures as a supplement to financial results based on GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading “Operating Segment Information” and “Use of Non-GAAP Financial Measures.” We have a long-term view on value creation and may take initiatives that we believe offer substantial future prospects even if they may dampen near term performance. In addition, our portfolio of contracts includes programs which last for decades and range from lower margin cost-plus development programs to higher margin fixed-price production programs. Further, the mix of those programs can vary substantially. We intend to strengthen our competitive advantage by continuously improving operational excellence through our CIP programs and continue to invest in R&D initiatives. We also intend to grow our business and plan to work with our customers to expand markets for current products, develop upgrades to extend product life, and develop the requirements for future systems. We plan to maintain a diversified and broad business mix, a favorable balance of cost-reimbursable and fixed-price type contracts, a significant follow-on business and an attractive customer profile. Finally, we intend to complement our growth strategy through select acquisitions that broaden our product and service offerings, deepen our capabilities, and provide entry into new markets. Some of the significant challenges we face are dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, implementation of the CIP, environmental matters, capital structure, and our underfunded retirement benefit plans. Major Customers The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within “budget top-line” limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. Sales to the U.S. government and its agencies, including sales to our significant customers disclosed below, were as follows: The following are percentages of net sales by principal end user in fiscal 2017: The following are percentages of net sales for significant programs, all of which are included in the U.S. government sales and are comprised of multiple contracts. The demand for certain of our services and products is directly related to the level of funding of U.S. government programs. Customers that represented more than 10% of net sales for the periods presented were as follows: Our sales to each of the major customers listed above involve several product lines and programs. Industry Update Information concerning our industry appears in Part I, Item 1. Business under the caption “Industry Overview.” Competitive Improvement Program During fiscal 2015, we initiated Phase I of the CIP comprised of activities and initiatives aimed at reducing costs in order for us to continue to compete successfully. Phase I is composed of three major components: (i) facilities optimization and footprint reduction; (ii) product affordability; and (iii) reduced administrative and overhead costs. On April 6, 2017, the Board of Directors approved Phase II of our previously announced CIP. Pursuant to Phase II, our plans are to expand CIP and further consolidate our Sacramento, California, and Gainesville, Virginia sites, while centralizing and expanding our existing presence in Huntsville, Alabama. When fully implemented, we anticipate that the CIP will result in annual cost reductions of $230 million. We currently estimate that we will incur restructuring and related costs of the Phase I and II programs of approximately $235.1 million (including approximately $60.5 million of capital expenditures). We incurred $79.5 million of such costs through December 31, 2017, including $32.5 million in capital expenditures. Environmental Matters Our current and former business operations are subject to, and affected by, federal, state, local, and foreign environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. See Notes 8(c) and 8(d) of the notes to consolidated financial statements and "Environmental Matters" below for summary of our environmental reserve activity. Capital Structure We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of December 31, 2017, we had $670.9 million of debt principal outstanding. Retirement Benefits We expect to make cash contributions of approximately $42.0 million to our tax-qualified defined benefit pension plan in fiscal 2018 of which $37.5 million is expected to be recoverable from our U.S. government contracts in fiscal 2018 with the remaining $4.5 million being potentially recoverable from our U.S. government contracts in the future. During fiscal 2017, we made cash contributions of $75.8 million to our tax-qualified defined benefit pension plan of which $33.7 million was recoverable from our U.S. government contracts in fiscal 2017 with the remaining $42.1 million expected to be recoverable from our U.S. government contracts in the future. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there can be differences between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under CAS. The funded status of our retirement benefit plans may be adversely affected by investment experience, by any changes in U.S. law and by changes in the statutory interest rates used by tax-qualified pension plans in the U.S. to calculate funding requirements. Accordingly, if the performance of our retirement benefit assets does not meet our assumptions, if there are changes to the IRS regulations or other applicable law or if other actuarial assumptions are modified, our future contributions to our underfunded retirement benefit plans could be higher than we expect. Additionally, the level of returns on retirement benefit assets, changes in interest rates, changes in legislation, and other factors affect our financial results. The timing of recognition of retirement benefit expense or income in our financial statements differs from the timing of the required funding under the PPA or the amount of funding that can be recorded in our overhead rates through our U.S. government contracting business. Results of Operations: Net Sales: * Primary reason for change. The increase in net sales was primarily due to an increase of $158.0 million in space programs primarily driven by the following (i) the RS-25 program development and integration effort in support of the SLS development program; (ii) increased development effort and volume on the Commercial Crew Development program; and (iii) increased deliveries on the Atlas V program. The increase in net sales was partially offset by a decrease of $36.5 million in defense programs primarily driven by the timing of deliveries on the THAAD and Standard Missile programs partially offset by the net sales generated from the Coleman Aerospace acquisition. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in fiscal 2016 compared with 52 weeks of operations in fiscal 2017. The additional week of operations, which occurred in the fourth quarter of fiscal 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. ** Primary reason for change. The increase in net sales was primarily due to the following (i) an increase of $95.0 million on space launch programs primarily driven by increased deliveries on the RL10 program and the transition of the Commercial Crew Development program from development activities to initial production and (ii) an increase of $37.2 million on air defense programs primarily driven by the transition of the PAC-3 contracts to full-rate production. These factors were partially offset by (i) the sale of approximately 550 acres of our Sacramento Land for $42.0 million in fiscal 2015 and (ii) a decrease of $36.8 million in the various Standard Missile contracts primarily from the timing of deliveries on the Standard Missile-3 Block IB contract and Standard Missile MK72 booster contract. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in fiscal 2016 compared with 52 weeks of operations in fiscal 2015. The additional week of operations, which occurred in the fourth quarter of fiscal 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. Net sales for the month ended December 31, 2015 was primarily comprised of the following: (i) sales of $32.4 million in missile defense and strategic systems programs primarily driven by the deliveries on the THAAD and Standard Missile programs; (ii) sales of $26.4 million in our space launch programs primarily associated with the RL10 program as a result of deliveries on this multi-year contract and deliveries on the Atlas V program; and (iii) sales of $26.1 million in space advanced programs primarily driven by work on the Commercial Crew Development program and the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS program. Cost of Sales (exclusive of items shown separately below): * Primary reason for change. The decrease in cost of sales as a percentage of net sales excluding retirement benefits was primarily due to favorable contract performance on numerous programs as a result of overhead cost reductions and reduced program risks, most notably on the THAAD program, partially offset by cost growth and manufacturing inefficiencies in fiscal 2017 on electric propulsion contracts. ** Primary reason for change. The increase in cost of sales as a percentage of net sales excluding retirement benefits was primarily due to the fiscal 2015 land sale of approximately 550 acres of Sacramento Land resulting in gross profit of $30.6 million. Cost of sales as a percentage of net sales excluding retirement benefits for the month ended December 31, 2015 included favorable changes in contract estimates due to better than expected performance primarily on the Standard Missile and THAAD programs as a result of manufacturing efficiencies and risk mitigation. These favorable factors were partially offset by contract losses on an electric propulsion contract. AR1 Research and Development: * Primary reason for change. Our company-sponsored R&D expenses (reported as a component of cost of sales) are generally allocated among all contracts and programs in progress under U.S. government contractual arrangements. From time to time, we believe it is in our best interests to self-fund and not allocate costs for certain R&D activities to the U.S. government contracts. In fiscal 2015, we self-funded $32.1 million of engine development expenses associated with our newest liquid booster engine, the AR1, and did not allocate these costs to the U.S. government. The table below summarizes total AR1 R&D costs net of reimbursements: Selling, General and Administrative Expense (“SG&A”): * Primary reason for change. The increase in SG&A expense was primarily driven by an increase of $9.1 million in stock-based compensation primarily as a result of increases in the fair value of stock appreciation rights, the accelerated vesting of stock awards to a former executive officer, and the August 2016 stock award granted to the Executive Chairman that vested according to the attainment of share prices ranging from $22 per share to $27 per share of our common stock. ** Primary reason for change. The increase in SG&A expense was primarily driven by an increase of $4.3 million in stock-based compensation which was primarily a result of an increase in performance based stock compensation. SG&A expense as a percentage of net sales for the month ended December 31, 2015 was relatively proportional to the first quarter of fiscal 2016. Depreciation and Amortization: * Primary reason for change. The increase in depreciation expense was primarily the result of increased accelerated depreciation associated with changes in the estimated useful lives of long-lived assets and capital projects being placed in service to support the cost saving initiatives of the CIP. ** Primary reason for change. Depreciation and amortization expense was essentially unchanged for the period. Depreciation and amortization expense for the month ended December 31, 2015 was relatively proportional to the first quarter of fiscal 2016. Other Expense, Net and Loss On Debt: * Primary reason for change. The decrease was primarily due to a decrease of $35.5 million in unusual items (discussed below) and a decrease of $10.1 million in environmental remediation expenses (see discussion of "Environmental Matters" below). ** Primary reason for change. The decrease in other expense, net was primarily due to a decrease of $17.4 million in unusual items charges (see discussion of unusual items below). The $0.2 million of other expense, net for the month ended December 31, 2015 was insignificant. Total unusual items, comprised of a component of other expense, net and loss on debt in the consolidated statements of operations, was as follows: ________ (1) Operating (income) expense (2) Non-operating expense Fiscal 2017 Activity: We recorded $2.0 million of realized gains, net of interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. On May 30, 2017, we made a registered rescission offer to buy back unregistered shares from eligible Plan participants at the original purchase price plus interest, or to reimburse eligible Plan participants for losses they may have incurred if their shares had been sold. The actual cost of the registered rescission offer was less than the previously estimated costs. The registered rescission offer expired on June 30, 2017 and settlement payments of $3.5 million under the offer have been completed in the third quarter of fiscal 2017. We recorded $1.0 million of costs related to the acquisition of Coleman Aerospace from L3 Technologies, Inc. Fiscal 2016 Activity: On July 18, 2016, we redeemed $460.0 million principal amount of our 7.125% Second-Priority Senior Secured Notes (“7 1/8% Notes”), representing all of the outstanding 7 1/8% Notes, at a redemption price equal to 105.344% of the principal amount, plus accrued and unpaid interest. We incurred a pre-tax charge of $34.1 million in fiscal 2016 associated with the extinguishment of the 7 1/8% Notes. The $34.1 million pre-tax charge was the result of the $24.6 million paid in excess of the par value and $9.5 million associated with the write-off of unamortized deferred financing costs. We retired $13.0 million principal amount of our delayed draw term loan resulting in a loss of $0.3 million. We recorded a charge of $0.1 million associated with an amendment to the Senior Credit Facility. Fiscal 2015 Activity: We recorded an expense of $50.0 million associated with a legal settlement. Aerojet Rocketdyne entered into a Settlement and Mutual Release Agreement (the “Agreement”) with Orbital Sciences Corporation (“Orbital”) pursuant to which the parties mutually agreed to a termination for convenience of the contract relating to the provision by Aerojet Rocketdyne of 20 AJ-26 liquid propulsion rocket engines to Orbital for the Antares program (the “Contract”). The Agreement also settles all claims the parties may have had against one another arising out of the Contract and the launch failure that occurred on October 28, 2014 of an Antares launch vehicle carrying the Cygnus ORB-3 service and cargo module. We retired $76.0 million principal amount of our delayed draw term loan resulting in $1.9 million of losses associated with the write-off of deferred financing fees. December 2015 Activity: We recorded $0.4 million for realized losses and interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. Interest Income: * Primary reason for change. The increase in interest income was primarily due to higher average cash balances and interest rates. ** Primary reason for change. Interest income was immaterial for the period presented. Interest Expense: * Primary reason for change. The decrease in interest expense was primarily due to the retirement of the principal amount of our delayed draw term loan in the first quarter of fiscal 2016, the redemption of the 7 1/8% Senior Secured Notes in the third quarter of fiscal 2016, and the conversion of 4 1/16% Convertible Subordinated Debentures (“4 1/16% Debentures”) to common shares. The decrease was partially offset by interest expense on the debt incurred on the Senior Credit Facility at a variable interest rate of 3.82% as of December 31, 2017 and the issuance of the 2 1/4% Notes in December 2016 at an effective interest rate of 5.8%. ** Primary reason for change. The decrease in interest expense was primarily due to the retirement of the principal amount of our delayed draw term loan in the first quarter of fiscal 2016 and the redemption of the 7 1/8% Notes in the third quarter of fiscal 2016. The decrease was partially offset by interest expense on the debt incurred on the Senior Credit Facility at a lower variable interest rate (3.02% as of December 31, 2016). Interest expense for the month ended December 31, 2015 was proportional to our interest expense for the first quarter of fiscal 2016. Income Tax Provision: In fiscal 2017, our effective tax rate was an income tax expense of 110.6% on pre-tax income of $86.9 million. Our effective tax rate differed from the 35.0% statutory federal income tax rate primarily due to the change in the federal statutory tax rate from 35% to 21% under the Tax Act of 2017. The one time reduction to deferred tax assets due to the Tax Act was $64.6 million or a 74.4% increase to the effective tax rate. Before applying the effects of the Tax Act, the effective tax rate was 36.2%. This rate differs from the 35% federal income tax rate due to an increase from state income taxes partially offset by R&D credits and favorable adjustments to uncertain tax positions. We expect the tax rate in future years to be between 27% and 29%. In fiscal 2016, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our income before income taxes primarily due to the impacts from state income taxes, and certain expenditures which are permanently not deductible for tax purposes, partially offset by the impact of R&D credits. In fiscal 2015, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our loss before income taxes primarily due to state income taxes and certain non-deductible interest expense, partially offset by the retroactive reinstatement of the federal R&D credit and benefits allowed by Section 199 of the IRS code allowed to manufacturers. In the month ended December 31, 2015, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our income before income taxes primarily due to the re-enactment of the federal R&D credit in December 2015 for calendar year 2015 which has been treated as a discrete event for the December 2015 one-month period, as well as impacts from state income taxes, benefits allowed by Section 199 of the IRS code allowed to manufacturers, and R&D credits. The carrying value of our deferred tax assets is dependent on our ability to generate sufficient taxable income in the future. Our valuation allowance of $1.7 million remained unchanged from prior year. As of December 31, 2017, the liability for uncertain income tax positions was $2.8 million. Due to the uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. Retirement Benefit Plans: Components of retirement benefits are: We estimate that our retirement benefits expense will be approximately $60 million in fiscal 2018. See “Critical Accounting Policies - Retirement Benefit Plans” for more information about our accounting practices with respect to retirement benefits. Operating Segment Information: We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance represents net sales less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, legacy income or expenses, and unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our underlying operational performance. In addition, we provide the Non-GAAP financial measure of our operational performance called segment performance before environmental remediation provision adjustments, retirement benefits, and segment unusual items. We believe the exclusion of the items listed above permits an evaluation and a comparison of results for ongoing business operations, and it is on this basis that management internally assesses operational performance. Aerospace and Defense Segment ________ (1) Retirement benefits are net of cash funding to our tax-qualified defined benefit pension plan which are recoverable costs under our U.S. government contracts. Our recoverable tax-qualified pension costs in fiscal 2017 and 2016 totaled $33.7 million and $27.5 million, respectively. * Primary reason for change. The increase in net sales was primarily due to an increase of $158.0 million in space programs primarily driven by the following (i) the RS-25 program development and integration effort in support of the SLS development program; (ii) increased development effort and volume on the Commercial Crew Development program; and (iii) increased deliveries on the Atlas V program. The increase in net sales was partially offset by a decrease of $36.5 million in defense programs primarily driven by the timing of deliveries on the THAAD and Standard Missile programs partially offset by the net sales generated from the Coleman Aerospace acquisition. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in fiscal 2016 compared with 52 weeks of operations in fiscal 2017. The additional week of operations, which occurred in the fourth quarter of fiscal 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. Segment margin before environmental remediation provision adjustments, retirement benefits, net, and unusual items in fiscal 2017 compared with fiscal 2016 was up 30 basis points. Items that had a significant impact were favorable contract performance on numerous programs as a result of overhead cost reductions and reduced program risks, most notably on the THAAD program, partially offset by cost growth and manufacturing inefficiencies in fiscal 2017 on electric propulsion contracts. ** Primary reason for change. The increase in net sales was primarily due to the following (i) an increase of $95.0 million on space launch programs primarily driven by increased deliveries on the RL10 program, and the transition of the Commercial Crew Development program from development activities to initial production and (ii) an increase of $37.2 million on air defense programs primarily driven by the transition of the PAC-3 contracts to full-rate production. These factors were partially offset by a decrease of $36.8 million in the various Standard Missile contracts primarily from the timing of deliveries on the Standard Missile-3 Block IB contract and Standard Missile MK72 booster contract. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in fiscal 2016 compared with 52 weeks of operations in fiscal 2015. The additional week of operations, which occurred in the fourth quarter of fiscal 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. Segment margin before environmental remediation provision adjustments, retirement benefits, net, and unusual items in fiscal 2016 compared with fiscal 2015 was up 50 basis points. Items that had a significant impact include the following: (i) favorable contract performance on the THAAD program as a result of operating performance and lower overhead costs; (ii) a gross contract benefit of $8.1 million in fiscal 2015 associated with the Antares AJ-26 Settlement Agreement; and (iii) cost growth and manufacturing inefficiencies in the current period on electric propulsion contracts. Net sales for the month ended December 31, 2015 was primarily comprised of the following: (i) sales of $32.4 million in missile defense and strategic systems programs primarily driven by the deliveries on the THAAD and Standard Missile programs; (ii) sales of $26.4 million in our space launch programs primarily associated with the RL10 program as a result of deliveries on this multi-year contract and deliveries on the Atlas V program; and (iii) sales of $26.1 million in space advanced programs primarily driven by development work on the Commercial Crew Development program and the RS-25 program which is currently engaged in a significant development and integration effort in support of the SLS program. The segment margin before environmental remediation provision adjustments, retirement benefits, net and unusual items included (i) favorable changes in contract estimates due to better than expected performance on the Standard Missile and THAAD programs as a result of manufacturing efficiencies and risk mitigation and (ii) costs recoveries on retirement benefit plan contributions. These favorable factors were partially offset by contract losses on an electric propulsion contract. The following table summarizes our backlog: Total backlog includes both funded backlog (unfilled orders for which funding is authorized, appropriated and contractually obligated by the customer) and unfunded backlog (firm orders for which funding has not been appropriated). Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. Backlog is subject to funding delays or program restructurings/cancellations which are beyond our control. Real Estate Segment * Primary reason for change. During fiscal 2017 and 2016, net sales and segment performance consisted primarily of rental property operations. During fiscal 2015, we recognized net sales of $42.0 million associated with a land sale of approximately 550 acres which resulted in a pre-tax gain of $30.6 million. Net sales and segment performance consisted primarily of rental property operations. Use of Non-GAAP Financial Measures: In addition to segment performance (discussed above), we provide the Non-GAAP financial measure of our operational performance called Adjusted EBITDAP. We use this metric to measure our operating performance. We believe that to effectively compare core operating performance from period to period, the metric should exclude items relating to retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the ordinary, on-going and customary course of our operations. Accordingly, we define Adjusted EBITDAP as GAAP net (loss) income adjusted to exclude income taxes, interest expense, interest income, depreciation and amortization, retirement benefits net of cash funding to our tax-qualified defined benefit pension plan that are recoverable under our U.S. government contracts, and unusual items which we do not believe are reflective of such ordinary, on-going and customary activities. Adjusted EBITDAP does not represent, and should not be considered an alternative to, net (loss) income, as determined in accordance with GAAP. ________ (1) Retirement benefits are net of cash funding to our tax-qualified defined benefit pension plan which are recoverable costs under our U.S. government contracts. Our recoverable tax-qualified pension costs in fiscal 2017 and 2016 totaled $33.7 million and $27.5 million, respectively. In addition to segment performance and Adjusted EBITDAP, we provide the Non-GAAP financial measure of free cash flow. We use this financial measure, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that this financial measure is useful because it provides supplemental information to assist investors in viewing the business using the same tools that management uses to evaluate progress in achieving our goals (including under our annual cash and long-term compensation incentive plans). _________ (1) Free Cash Flow, a Non-GAAP financial measure, is defined as cash flow from operating activities less capital expenditures. Free Cash Flow should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to cash flows from operations presented in accordance with GAAP. Because our method for calculating these Non-GAAP measures may differ from other companies’ methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures. Environmental Matters: Our policy is to conduct our businesses with due regard for the preservation and protection of the environment. We devote a significant amount of resources and management attention to environmental matters and actively manage our ongoing processes to comply with environmental laws and regulations. We are involved in the remediation of environmental conditions that resulted from generally accepted manufacturing and disposal practices at certain plants in the 1950s and 1960s. In addition, we have been designated a PRP with other companies at third party sites undergoing investigation and remediation. Estimating environmental remediation costs is difficult due to the significant uncertainties inherent in these activities, including the extent of remediation required, changing governmental regulations and legal standards regarding liability, evolving technologies and the long period of time over which most remediation efforts take place. We: • accrue for costs associated with the remediation of environmental pollution when it becomes probable that a liability has been incurred and when our proportionate share of the costs can be reasonably estimated; and • record related estimated recoveries when such recoveries are deemed probable. In addition to the costs associated with environmental remediation discussed above, we incur expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations which were immaterial for fiscal 2017, 2016, 2015, and the one month ended December 31, 2015. The following table summarizes our recoverable amounts, environmental reserves, and range of liability, as of December 31, 2017: _____ (1) Excludes the receivable from Northrop of $64.5 million as of December 31, 2017 related to environmental costs already paid (and therefore not reserved) by us in prior years and reimbursable under our agreement with Northrop. The cumulative limitation under our agreement with Northrop was reached in the second quarter of fiscal 2017. See Notes 8(c) and 8(d) of the Notes to Consolidated Financial Statements for additional information. Environmental Reserves On a quarterly basis, we review estimated future remediation costs and have an established practice of estimating environmental remediation costs over a fifteen year period, except for those environmental remediation costs with a specific contractual term. Environmental liabilities at the BPOU site are currently estimated through the term of the new project agreement which expires in May 2027. As the period for which estimated environmental remediation costs lengthens, the reliability of such estimates decreases. These estimates consider the investigative work and analysis of engineers, outside environmental consultants, and the advice of legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum amount is used when no single amount in the range is more probable. Accordingly, such estimates can change as we periodically evaluate and revise these estimates as new information becomes available. We cannot predict whether new information gained as projects progress will affect the estimated liability accrued. The timing of payment for estimated future environmental costs is influenced by a number of factors such as the regulatory approval process, and the time required designing, constructing, and implementing the remedy. A summary of our environmental reserve activity: The $31.3 million of environmental reserve additions in fiscal 2017 was primarily due to the following items: (i) $13.4 million of additional operations and maintenance for treatment facilities; (ii) $6.7 million of additional estimated costs related to the Camden, Arkansas site; (iii) $2.3 million associated with water replacement; and (iv) $8.9 million related to other environmental clean-up matters. The $87.4 million of environmental reserve additions in fiscal 2016 was primarily due to the following items: (i) in fiscal 2016 we reached a decision with the U.S. government on the treatment of certain utility costs related to the Sacramento site resulting in a reserve increase of $59.4 million for the estimated impact over the current period and a fifteen year reserve period; (ii) $10.4 million of additional operations and maintenance for treatment facilities; (iii) $5.9 million of remediation related to inactive test sites and landfill clean-up; and (iv) $2.7 million of remediation related to operable treatment units; and (v) $9.0 million related to other environmental clean-up matters. The $0.5 million of environmental reserve additions in the one month ended December 31, 2015 were insignificant. The $176.6 million of environmental reserve additions in fiscal 2015 was primarily due to the following items: (i) $126.3 million associated with our detailed review estimate related to the BPOU site to reflect the anticipated costs through the term of a new project agreement, and the amount reserved is based on the proposal by Aerojet Rocketdyne; (ii) $13.8 million associated with water replacement; (iii) $13.5 million of remediation related to operable treatment units; (iv) $5.2 million of additional operations and maintenance for treatment facilities; and (v) $17.8 million related to other environmental clean-up matters. The effect of the final resolution of environmental matters and our obligations for environmental remediation and compliance cannot be accurately predicted due to the uncertainty concerning both the amount and timing of future expenditures and due to regulatory or technological changes. We continue our efforts to mitigate past and future costs through pursuit of claims for recoveries from insurance coverage and other PRPs and continued investigation of new and more cost effective remediation alternatives and associated technologies. Estimated Recoveries Environmental remediation costs are primarily incurred by our Aerospace and Defense segment, and certain of these costs are recoverable from our contracts with the U.S. government. We currently estimate approximately 24% of our future Aerospace and Defense segment environmental remediation costs will not likely be reimbursable and are expensed. Allowable environmental remediation costs are charged to our contracts as the costs are incurred. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet Rocketdyne to continue recovering these costs from the U.S. government depends on Aerojet Rocketdyne’s sustained business volume from U.S. government contracts and programs. While we are currently seeking an arrangement with the U.S. government to recover environmental expenditures in excess of the reimbursement ceiling identified in the Northrop Agreement and Global Settlement, there can be no assurances that such a recovery will be obtained, or if not obtained, that such unreimbursed environmental expenditures will not have a materially adverse effect on our operating results, financial condition, and/or cash flows. The following table summarizes the activity in the current and non-current recoverable amounts from the U.S. government and Northrop: The activity for recoveries is commensurate with the activity associated with the environmental reserve activity. Environmental reserves and recoveries impact to the consolidated statements of operations The expenses associated with adjustments to the environmental reserves are recorded as a component of other expense, net in the consolidated statements of operations. Summarized financial information for the impact of environmental reserves and recoveries to the consolidated statements of operations were as follows: Recently Adopted Accounting Pronouncements: See Note 1(w) to our consolidated financial statements in Item 8. Consolidated Financial Statements of this Report for information relating to our discussion of the effects of recent accounting pronouncements. Liquidity and Capital Resources: Net Cash Provided By (Used In) Operating, Investing, and Financing Activities The change in cash and cash equivalents was as follows: Net Cash Provided by Operating Activities The $212.8 million of cash provided by operating activities in fiscal 2017 was primarily the result of cash provided by income before income taxes adjusted for non-cash items which generated $263.9 million and income tax refunds of $19.9 million which was partially offset by cash of $75.8 million to fund our tax-qualified defined benefit pension plan. The $158.7 million of cash provided by operating activities in fiscal 2016 was primarily the result of cash provided by income before income taxes adjusted for non-cash items which generated $213.2 million, primarily offset by cash used to fund working capital (defined as accounts receivables, inventories, other current assets, accounts payable, contract advances, real estate activities, and other current liabilities) and cash contributions of $32.8 million to our tax-qualified defined benefit pension plan. The cash used to fund working capital was primarily due to (i) a decrease of $37.4 million in other current liabilities primarily due to the timing of payments associated with income taxes and interest expense and (ii) an increase of $28.9 million in inventories primarily due to the timing of milestone billings and deliveries on the Atlas V and Standard Missile programs. The funding of working capital was partially offset by a decrease of $33.1 million in accounts receivable primarily due to the timing of cash receipts. The $67.6 million of cash provided by operating activities in fiscal 2015 was primarily the result of cash provided by net loss before income taxes adjusted for non-cash items which generated $129.7 million, offset by cash used to fund the following: (i) a decrease of $18.8 million in other current liabilities primarily related to the CIP, cost reduction initiatives, and the amounts paid to UTC related to Transition Service Agreements; (ii) an increase of $19.5 million in inventories primarily due to the timing of milestone billings and deliveries on the PAC-3 and Standard Missile programs; and (iii) $7.8 million of real estate activities. The $0.1 million of cash provided by operating activities in December 2015 was primarily due to the cash used to fund working capital offset by net income before income taxes adjusted for non-cash items. Net Cash Used in Investing Activities During fiscal 2017, 2016, and 2015 and the one month ended December 31, 2015, we had capital expenditures of $29.4 million, $47.6 million, $36.8 million, and $1.2 million, respectively. The increase in capital expenditures in fiscal 2016 compared with fiscal 2015 is primarily related to construction projects associated with supporting our CIP. During fiscal 2017, we purchased Coleman Aerospace for $17.0 million and we made a net cash investment of $20.0 million in marketable securities. Net Cash (Used in) Provided by Financing Activities During fiscal 2017, we had debt cash payments of $20.0 million (see below). During fiscal 2016, we had $700.6 million in debt cash payments and borrowings of $800.0 million. During fiscal 2015, we had debt cash payments of $81.2 million. During the one month ended December 31, 2015, we had immaterial financing activities. Debt Activity and Covenants Our debt principal activity since December 31, 2016 was as follows: Our Senior Credit Facility contains covenants requiring us to (i) maintain an interest coverage ratio (the "Consolidated Interest Coverage Ratio") of not less than 3.00 to 1.00 and (ii) maintain a leverage ratio ( the "Consolidated Net Leverage Ratio") not to exceed 3.75 to 1.00 for periods ending from December 31, 2017 through September 30, 2018; and 3.50 to 1.00 for periods ending from December 31, 2018 thereafter, provided that the maximum leverage ratio for all periods shall be increased by 0.50 to 1.00 for two quarters after consummation of a qualified acquisition. We may generally make certain investments, redeem debt subordinated to the Senior Credit Facility and make certain restricted payments (such as stock repurchases) if our Consolidated Net Leverage Ratio does not exceed 3.25 to 1.00 pro forma for such transaction. We are otherwise subject to customary covenants including limitations on asset sales, incurrence of additional debt, and limitations on certain investments and restricted payments. We were in compliance with our financial and non-financial covenants as of December 31, 2017. Outlook Short-term liquidity requirements consist primarily of recurring operating expenses, including but not limited to costs related to our capital and environmental expenditures, company-funded R&D expenditures, debt service requirements, and retirement benefit plans. We believe that our existing cash and cash equivalents and availability under our revolving credit facility coupled with cash generated from our future operations will provide sufficient funds to meet our operating plan, which includes our CIP Phase I and Phase II, and AR1 engine development costs, for the next twelve months. The operating plan for this period provides for full operation of our businesses, and interest and principal payments on our debt. As of December 31, 2017, we had $535.0 million of cash and cash equivalents and $20.0 million of marketable securities as well as $311.4 million of available borrowings under our Senior Credit Facility. Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of December 31, 2017. Our failure to comply with these covenants could result in an event of default that, if not cured or waived by the lenders, could result in the acceleration of the Senior Credit Facility and 2¼% Notes. In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility, and in certain cases, would cause a cross default on the 2¼% Notes. We are committed to a cash management strategy that maintains liquidity to adequately support the operation of the business, our growth strategy and to withstand unanticipated business volatility. Our cash management strategy includes maintaining the flexibility to pay down debt and/or repurchase shares depending on economic and other conditions. In connection with the implementation of our cash management strategy, our management may seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise if we believe that it is in our best interests. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. Potential future acquisitions depend, in part, on the availability of financial resources at an acceptable cost of capital. We expect to utilize cash on hand and cash generated by operations, as well as cash available under our Senior Credit Facility, which may involve renegotiation of credit limits to finance any future acquisitions. Other sources of capital could include the issuance of common and/or preferred stock, and the placement of debt. We periodically evaluate capital markets and may access such markets when circumstances appear favorable. We believe that sufficient capital resources will be available from one or several of these sources to finance any future acquisitions. However, no assurances can be made that acceptable financing will be available, or that acceptable acquisition candidates will be identified, or that any such acquisitions will be accretive to earnings. As disclosed in Notes 8(b) and 8(c) of the notes to consolidated financial statements, we have exposure for certain legal and environmental matters. We believe that it is currently not possible to estimate the impact, if any, that the ultimate resolution of certain of these matters will have on our financial position, results of operations, or cash flows. Major factors that could adversely impact our forecasted operating cash flows and our financial condition are described in Part I, Item 1A. Risk Factors. In addition, our liquidity and financial condition will continue to be affected by changes in prevailing interest rates on the portion of debt that bears interest at variable interest rates. Contractual Obligations: We have contractual obligations and commitments in the form of debt obligations, operating leases, certain other liabilities, and other commitments. The following table summarizes our contractual obligations as of December 31, 2017: ________ (1) Includes interest on variable debt calculated based on interest rates at December 31, 2017. (2) See Note 6(d) to our consolidated financial statements in Item 8. Consolidated Financial Statements of this Report for additional information. (3) The payments presented above are expected payments for the next 10 years. The payments for postretirement medical and life insurance benefits reflect the estimated benefit payments of the plans using the provisions currently in effect. The obligation related to postretirement medical and life insurance benefits is actuarially determined on an annual basis. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (4) The conditional asset retirement obligations presented are related to our Aerospace and Defense segment and are allowable costs under our contracts with the U.S. government. We may be required to make significant cash contributions in the future to fund our retirement benefit plans, a portion of which we may not be able to immediately recover from our U.S. government contracts. We expect to make cash contributions of approximately $42.0 million to our tax-qualified defined benefit pension plan in fiscal 2018 of which $37.5 million is expected to be recoverable from our U.S. government contracts in fiscal 2018 with the remaining $4.5 million being potentially recoverable from our U.S. government contracts in the future. We also issue purchase orders and make other commitments to suppliers for equipment, materials, and supplies in the normal course of business. These purchase commitments are generally for volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers and would be subject to reimbursement if a cost-plus contract was terminated. Arrangements with Off-Balance Sheet Risk: As of December 31, 2017, arrangements with off-balance sheet risk consisted of: • $38.6 million in outstanding commercial letters of credit, the majority of which may be renewed, primarily to collateralize obligations for environmental remediation and insurance coverage. • $52.8 million in outstanding surety bonds to primarily satisfy indemnification obligations for environmental remediation coverage. • Up to $120.0 million aggregate in guarantees by us of Aerojet Rocketdyne’s obligations to U.S. government agencies for environmental remediation activities. • $121.9 million in commitments associated with outsourcing certain information technology and cyber security functions. • $83.1 million in commitments associated with our new facilities located in Huntsville, Alabama. • Guarantees, jointly and severally, by our material domestic subsidiaries of their obligations under our Senior Credit Facility. In addition to the items discussed above, we have and will from time to time enter into certain types of contracts that require us to indemnify parties against potential third-party and other claims. These contracts primarily relate to: (i) divestiture agreements, under which we may provide customary indemnification to purchasers of our businesses or assets including, for example, claims arising from the operation of the businesses prior to disposition, liability to investigate and remediate environmental contamination existing prior to disposition; (ii) certain real estate leases, under which we may be required to indemnify property owners for claims arising from the use of the applicable premises; and (iii) certain agreements with officers and directors, under which we may be required to indemnify such persons for liabilities arising out of their relationship with us. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Additionally, we issue purchase orders and make other commitments to suppliers for equipment, materials, and supplies in the normal course of business. These purchase commitments are generally for volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers and would be subject to reimbursement if the contract is terminated. We provide product warranties in conjunction with certain product sales. The majority of our warranties are one-year standard warranties for parts, workmanship, and compliance with specifications. On occasion, we have made commitments beyond the standard warranty obligation. While we have contracts with warranty provisions, there is not a history of any significant warranty claims experience. A reserve for warranty exposure is made on a product by product basis when it is both estimable and probable. These costs are included in the program’s estimate at completion and are expensed in accordance with our revenue recognition methodology as allowed under GAAP for that particular contract. Critical Accounting Policies: Our financial statements are prepared in accordance with GAAP that offer acceptable alternative methods for accounting for certain items affecting our financial results, such as determining inventory cost, depreciating long-lived assets, and recognizing revenues. The preparation of financial statements requires the use of estimates, assumptions, judgments, and interpretations that can affect the reported amounts of assets, liabilities, revenues, and expenses, the disclosure of contingent assets and liabilities and other supplemental disclosures. The development of accounting estimates is the responsibility of our management. Management discusses those areas that require significant judgment with the audit committee of our Board of Directors. All of our financial disclosures in our filings with the SEC have been reviewed with the audit committee. Although we believe that the positions we have taken with regard to uncertainties are reasonable, others might reach different conclusions and our positions can change over time as more information becomes available. If an accounting estimate changes, its effects are accounted for prospectively and, if significant, disclosed in notes of the consolidated financial statements. The areas most affected by our accounting policies and estimates are revenue recognition, other contract considerations, goodwill, retirement benefit plans, litigation, environmental remediation costs and recoveries, and income taxes. Except for income taxes, which are not allocated to our operating segments, these areas affect the financial results of our business segments. For a discussion of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the consolidated financial statements. Revenue Recognition We consider the nature of the individual underlying contract and the type of products and services provided in determining the proper accounting for a particular contract. Each method is applied consistently to all contracts having similar characteristics, as described below. Under the percentage of completion method, we recognize sales based upon our progress against the contracted performance objectives. Progress is generally measured as costs are incurred (cost-to-cost) or as units are delivered to customers (units-of-delivery) depending on the contractual terms and scope of work of each contract. We use the cost-to-cost measure where the scope of work on contracts principally relates to research and/or development efforts, or the contract is predominantly a development effort with few deliverable units. Under cost-to-cost, we recognize sales as costs are incurred. We use the units-of-delivery measure to recognize sales when contracts require unit deliveries on a frequent and routine basis. Under units-of-delivery, we recognize sales at the contractually agreed upon unit price as units are sold. For fixed-priced contracts, variance in actual costs from the cost estimates used in determining the fixed price impact the overall profit from the contract. We recognize these variances during the contact performance period. Fixed-priced and cost-reimbursable contracts may provide for variable consideration including awards, incentives, and/or penalties based upon the customer’s assessment of our performance against pre-established targets or other criteria. These targets may include factors such as cost, performance, quality, and schedule. We recognize variable consideration over the contract performance period based upon estimates of performance against the established criteria. In our Aerospace and Defense segment, recognition of profit on long-term contracts requires the use of assumptions and estimates related to total contract revenue, the total cost at completion and the measurement of progress towards completion. Due to the nature of the programs, developing the estimated total contract revenue and cost at completion requires the use of significant judgment. Estimates are continually evaluated as work progresses and are revised as necessary. Factors that must be considered in estimating the work to be completed include, but are not limited to: labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements, inflationary trends, schedule delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. We review contract performance and cost estimates at least quarterly and more frequently when circumstances significantly change. When a change in estimate is determined to have an impact on contract profit, we will record a positive or negative adjustment to the statement of operations. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact of the change in significant contract accounting estimates on our Aerospace and Defense segment operating results accounted for under the percentage-of-completion method of accounting: The fiscal 2017 favorable changes in contract estimates were primarily driven by improved performance on numerous programs as a result of overhead cost reductions and reduced program risks, most notably on the THAAD program, partially offset by cost growth and manufacturing inefficiencies in fiscal 2017 on electric propulsion contracts. The fiscal 2016 favorable changes in contract estimates were primarily driven by improved performance on space launch systems primarily due to affordability initiatives and lower overhead costs, partially offset by cost growth and manufacturing inefficiencies on electric propulsion contracts. The one month ended December 31, 2015 favorable changes in contract estimates were primarily driven by improved performance on tactical and missile defense programs primarily due to affordability initiatives and lower overhead costs, partially offset by cost growth and manufacturing inefficiencies on an electric propulsion contract. The fiscal 2015 favorable changes in contract estimates were primarily due to improved performance on space launch systems and missile defense programs primarily due to affordability initiatives and lower overhead costs, and unexpected favorable contract performance on close-out activities on the J-2X program. Revenue on service or time and material contracts is recognized when performed. If at any time expected costs exceed the value of the contract, the loss is recognized immediately. If change orders are in dispute or are unapproved in regard to both scope and price they are evaluated as claims. We recognize revenue on claims when recovery of the claim is probable and the amount can be reasonably estimated. Revenue on claims is recognized only to the extent that contract costs related to the claims have been incurred and when it is probable that the claim will result in a bona fide addition to contract value that can be reliably estimated. No profit is recognized on a claim until final settlement occurs. Revenue from real estate asset sales is recognized when a sufficient down-payment has been received, financing has been arranged and title, possession and other attributes of ownership have been transferred to the buyer. The allocation to cost of sales on real estate asset sales is based on a relative fair market value computation of the land sold which includes the basis on our books, capitalized entitlement costs, and an estimate of our continuing financial commitment. Revenue that is not derived from long-term development and production contracts, or real estate asset transactions, is recognized when persuasive evidence of a final agreement exists, delivery has occurred, the selling price is fixed or determinable and payment from the customer is reasonably assured. Sales are recorded net of provisions for customer pricing allowances. Other Contract Considerations The majority of Aerospace and Defense segment sales are driven by pricing based on costs incurred to produce products and perform services under contracts with the U.S. government. Cost-based pricing is determined under the FAR and CAS. The FAR and CAS provide guidance on the types of costs that are allowable and allocable in establishing prices for goods and services from U.S. government contracts. For example, costs such as charitable contributions, advertising, interest expense, and public relations are unallowable, and therefore not recoverable through sales. In addition, we may enter into agreements with the U.S. government that address the subjects of allowability and allocability of costs to contracts for specific matters. We closely monitor compliance with and the consistent application of our critical accounting policies related to contract accounting. We review the status of contracts through periodic contract status and performance reviews. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel independent from the business segment performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are reviewed for compliance with regulatory standards by our personnel, and are subject to audit by the DCAA. Accordingly, we record an allowance on our unbilled receivables for amounts of potential contract overhead costs which may not be successfully negotiated and collected. Goodwill Goodwill represents the excess of the purchase price of an acquired enterprise or assets over the fair values of the identifiable assets acquired and liabilities assumed. All of our recorded goodwill resides in the Aerospace and Defense reporting unit. Tests for impairment of goodwill are performed on an annual basis, or at any other time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business climate or legal factors; adverse cash flow trends; an adverse action or assessment by a regulator; unanticipated competition; loss of key personnel; decline in stock price; and results of testing for recoverability of a significant asset group within a reporting unit. We evaluate qualitative factors (including macroeconomic conditions, industry and market considerations, cost factors, and overall financial performance) to determine whether it is necessary to perform the first step of the goodwill test. This step is referred to as the “Step Zero" analysis. If it is determined that it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, we will proceed to the quantitative (“Step One”) analysis to determine the existence and amount of any goodwill impairment. We evaluated goodwill using a “Step Zero" analysis as of October 1, 2017, October 1, 2016, and September 1, 2016 (first day of our fourth quarter), and determined that goodwill was not impaired. On a periodic basis, we will perform a Step One analysis to determine any potential goodwill impairment. There can be no assurance that our estimates and assumptions made for purposes of our goodwill impairment testing will prove to be accurate predictions of the future. If our assumptions and estimates are incorrect, we may be required to record goodwill impairment charges in future periods. Retirement Benefit Plans We discontinued future benefit accruals for our defined benefit pension plans in fiscal 2009. In addition, we provide medical and life insurance benefits to certain eligible retired employees, with varied coverage by employee group. Annual charges are made for the cost of the plans, including administrative costs, interest costs on benefit obligations, and net amortization and deferrals, increased or reduced by the return on assets. We also sponsor a defined contribution 401(k) plan and participation in the plan is available to all employees. Retirement benefits are a significant cost of doing business and represent obligations that will be ultimately settled far in the future and therefore are subject to estimates. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there is a lag between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under our U.S. government contracts. Our pension and medical and life insurance benefit obligations and related costs are calculated using actuarial concepts in accordance with GAAP. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine service cost and interest cost to arrive at income or expense for the year. We used the following discount rate to determine the benefit obligations for the applicable period: We used the following assumptions to determine the retirement benefits expense (income) for the applicable period: ______ * Not applicable as our medical and life insurance benefits are unfunded. The discount rate represents the current market interest rate used to determine the present value of future cash flows currently expected to be required to settle pension obligations. Based on market conditions, discount rates can experience significant variability. Changes in discount rates can significantly change the liability and, accordingly, the funded status of the pension plan. The assumed discount rate represents the market rate available for investments in high-quality fixed income instruments with maturities matched to the expected benefit payments for pension and medical and life insurance benefit plans. The expected long-term rate of return on assets represents the rate of earnings expected in the funds invested, and funds to be invested, to provide for anticipated benefit payments to plan participants. We evaluated the historical investment performance, current and expected asset allocation, and, with input from our external advisors, developed best estimates of future investment performance. Market conditions and interest rates significantly affect assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This “smoothing” results in the creation of other accumulated income or loss which will be amortized to pension costs in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses in the market-related value of pension assets and all other gains and losses including changes in the discount rate used to calculate the benefit obligation each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual pension costs, future pension costs are impacted by changes in the market value of assets and changes in interest rates. A one percentage point change in the key assumptions would have the following effects on the projected benefit obligations as of December 31, 2017 and on retirement benefits for fiscal 2017: Contingencies and Litigation We are currently involved in certain legal proceedings and, as required, have accrued our estimate of the probable costs and recoveries for resolution of these claims. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in assumptions or the effectiveness of strategies related to these proceedings. See Notes 8(b) and 8(c) in notes to consolidated financial statements for more detailed information on litigation exposure. Environmental Reserves and Estimated Recoveries For a discussion of our accounting for environmental remediation obligations and costs and related legal matters, see “Environmental Matters” above and Notes 8(c) and 8(d) in notes to consolidated financial statements. We accrue for costs associated with the remediation of environmental contamination when it becomes probable that a liability has been incurred, and when our costs can be reasonably estimated. Management has a well-established process in place to identify and monitor our environmental exposures. In most cases, only a range of reasonably probable costs can be estimated. In establishing the reserves, the most probable estimated amount is used when determinable, and the minimum amount is used when no single amount in the range is more probable. Environmental reserves include the costs of completing remedial investigation and feasibility studies, remedial and corrective actions, regulatory oversight costs, the cost of operation and maintenance of the remedial action plan, and employee compensation costs for employees who are expected to devote a significant amount of time to remediation efforts. Calculation of environmental reserves is based on the evaluation of currently available information with respect to each individual environmental site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. Such estimates are based on the expected costs of investigation and remediation and the likelihood that other potentially responsible parties will be able to fulfill their commitments at sites where we may be jointly or severally liable. At the time a liability is recorded for future environmental costs, we record an asset for estimated future recoveries that are estimable and probable. Some of our environmental costs are eligible for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements. We consider the recovery probable based on the Global Settlement, Northrop Agreement, U.S. government contracting regulations, and our long history of receiving reimbursement for such costs. Income Taxes We file a consolidated U.S. federal income tax return for the Company and our 100% owned consolidated subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in the period of the enactment date of the change. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Act of 2017. The Tax Act makes broad and complex changes to the U.S. tax code. Among other provisions, the Tax Act reduced the federal corporate statutory income tax rate from 35% to 21% beginning in 2018. In accordance with the rate reduction, we wrote down our net deferred tax assets by $64.6 million which unfavorably affected our effective tax rate by 74.4%. The carrying value of our deferred tax assets is dependent upon our ability to generate sufficient taxable income in the future. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence is considered, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, the length of carryback and carryforward periods, and evaluation of potential tax planning strategies. Despite our belief that our tax return positions are consistent with applicable tax laws, we believe that certain positions are likely to be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or some partial adjustment reached through negotiations or litigation. Our tax reserves reflect the difference between the tax benefit claimed on tax returns and the amount recognized in the financial statements. The accounting standards provide guidance for the recognition and measurement in financial statements for uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process, the first step being recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate resolution with a taxing authority. As the examination process progresses with tax authorities, adjustments to tax reserves may be necessary to reflect taxes payable upon settlement. Tax reserve adjustments related to positions impacting the effective tax rate affect the provision for income taxes. Tax reserve adjustments related to positions impacting the timing of deductions impact deferred tax assets and liabilities.

<s>[INST] Overview A summary of the significant financial highlights for fiscal 2017 which management uses to evaluate our operating performance and financial condition is presented below. Net sales for fiscal 2017 totaled $1,877.2 million compared with $1,761.3 million for fiscal 2016. Net loss for fiscal 2017 was $(9.2) million, or $(0.13) loss per share, compared with net income of $18.0 million, or $0.27 diluted income per share, for fiscal 2016. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code. Among other provisions, the Tax Act reduced the federal corporate statutory income tax rate from 35% to 21% beginning in 2018. In accordance with the rate reduction, we wrote down our net deferred tax assets by $64.6 million which unfavorably affected our effective tax rate by 74.4%. We expect the tax rate in future years to be between 27% and 29%. Adjusted EBITDAP (NonGAAP measure*) for fiscal 2017 was $225.4 million, compared with $201.9 million for fiscal 2016. Segment performance before environmental remediation provision adjustments, retirement benefits, net, and unusual items (NonGAAP measure*) was $205.4 million for fiscal 2017, compared with $188.4 million for fiscal 2016. Cash provided by operating activities in fiscal 2017 totaled $212.8 million, compared with $158.7 million in fiscal 2016. Free cash flow (NonGAAP measure*) in fiscal 2017 totaled $183.4 million, compared with $111.1 million in fiscal 2016. Total contract backlog as of December 31, 2017 was $4.6 billion compared with $4.5 billion as of December 31, 2016. Total funded backlog as of December 31, 2017 was $2.1 billion compared with $2.3 billion as of December 31, 2016. _________ * We provide NonGAAP measures as a supplement to financial results based on GAAP. A reconciliation of the NonGAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading “Operating Segment Information” and “Use of NonGAAP Financial Measures.” We have a longterm view on value creation and may take initiatives that we believe offer substantial future prospects even if they may dampen near term performance. In addition, our portfolio of contracts includes programs which last for decades and range from lower margin costplus development programs to higher margin fixedprice production programs. Further, the mix of those programs can vary substantially. We intend to strengthen our competitive advantage by continuously improving operational excellence through our CIP programs and continue to invest in R&D initiatives. We also intend to grow our business and plan to work with our customers to expand markets for current products, develop upgrades to extend product life, and develop the requirements for future systems. We plan to maintain a diversified and broad business mix, a favorable balance of costreimbursable and fixedprice type contracts, a significant followon business and an attractive customer profile. Finally, we intend to complement our growth strategy through select acquisitions that broaden our product and service offerings, deepen our capabilities, and provide entry into new markets. Some of the significant challenges we face are dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, implementation of the CIP, environmental matters, capital structure, and our underfunded retirement benefit plans. Major Customers The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S [/INST] Negative. </s>

AEROJET ROCKETDYNE HOLDINGS, INC.

2019-02-19

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8 of this Report, the risk factors appearing in Item 1A of this Report, and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1 of this Report. Overview A summary of the significant financial highlights for 2018, which management uses to evaluate our operating performance and financial condition, is presented below. • Net sales for 2018 totaled $1,895.9 million compared with $1,877.2 million for 2017. • Net income for 2018 was $137.3 million, or $1.75 diluted income per share ("EPS"), compared with net loss of $(9.2) million, or $(0.13) diluted EPS for 2017. • Adjusted Net Income (Non-GAAP measure*) for 2018 was $151.5 million, or $1.93 Adjusted EPS (Non-GAAP measure*), compared with $76.0 million, or $1.02 Adjusted EPS for 2017. • Adjusted EBITDAP (Non-GAAP measure*) for 2018 was $304.9 million compared with $222.9 million for 2017. • Segment performance before environmental remediation provision adjustments, retirement benefits, net, and unusual items (Non-GAAP measure*) was $236.2 million for 2018, compared with $202.9 million for 2017. • Cash provided by operating activities in 2018 totaled $252.7 million compared with $212.8 million in 2017. • Free cash flow (Non-GAAP measure*) in 2018 totaled $209.5 million compared with $183.4 million in 2017. • Effective January 1, 2018, we adopted the new revenue recognition guidance. Consistent with the standard, net assets increased by $37.6 million and $578.0 million of net sales were recognized in the cumulative effect at January 1, 2018, with a corresponding reduction to backlog. • Total backlog as of December 31, 2018, was $4.1 billion compared with $4.6 billion as of December 31, 2017. _________ * We provide Non-GAAP measures as a supplement to financial results presented in accordance with GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading "Operating Segment Information" and "Use of Non-GAAP Financial Measures." In May 2014, the Financial Accounting Standards Board ("FASB") amended the existing accounting standards for revenue recognition. The amendments are based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. We adopted the guidance effective January 1, 2018, using the modified retrospective method, with the cumulative effect recognized as of January 1, 2018. All applicable amounts and disclosures for 2018 reflect the impact of adoption. As we elected to use the modified retrospective method, prior periods presented have not been restated to reflect the impact of adoption. Reclassifications have been made where noted for conforming presentation only (see Notes 1(p) and 14 in the consolidated financial statements in Item 8 of this Report). Our business outlook is affected by both increasing complexity in the global security environment and continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, successful implementation of our cost reduction plans, environmental matters, capital structure, underfunded retirement benefit plans, and information technology and cyber security. Major Customers The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within "budget top-line" limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. The following table summarizes net sales to the U.S. government and its agencies, including net sales to significant customers disclosed below: The following table summarizes net sales by principal end user in 2018: The following table summarizes the percentages of net sales for significant programs, all of which are included in the U.S. government sales and are comprised of multiple contracts: The following table summarizes customers that represented more than 10% of net sales, each of which involves sales of several product lines and programs: Industry Update Information concerning our industry appears in Part I, Item 1. Business under the caption "Industry Overview." Competitive Improvement Program During 2015, we initiated Phase I of our CIP comprised of activities and initiatives aimed at reducing costs in order for us to continue to compete successfully. Phase I is comprised of three major components: (i) facilities optimization and footprint reduction; (ii) product affordability; and (iii) reduced administrative and overhead costs. On April 6, 2017, the Board of Directors approved Phase II of our previously announced CIP. Pursuant to Phase II, we expanded CIP and further consolidated our Sacramento, California, and Gainesville, Virginia sites, while centralizing and expanding our existing presence in Huntsville, Alabama. When fully implemented, we anticipate that the CIP will result in annual costs that are $230 million below levels anticipated prior to CIP. We currently estimate that we will incur restructuring and related costs of the Phase I and II programs of approximately $210.0 million (including approximately $60.5 million of capital expenditures). Our current estimate is down from the initial estimate of $235.0 million primarily due to efficiencies in program transitions and lower than expected employee costs. We have incurred $131.4 million of such costs through December 31, 2018, including $48.1 million in capital expenditures. Environmental Matters Our current and former business operations are subject to, and affected by, federal, state, local, and foreign environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. See Notes 8(c) and 8(d) in the consolidated financial statements in Item 8 of this Report and "Environmental Matters" below for summary of our environmental reserve activity. Capital Structure We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of December 31, 2018, we had $625.4 million of debt outstanding. In 2018, we entered into an industrial bond transaction with a subsidiary to realize property tax savings. Retirement Benefits As of the last measurement date at December 31, 2018, the pension assets, projected benefit obligations, and unfunded pension obligation were $894.8 million, $1,288.7 million, and $393.9 million, respectively. We estimate that 82% of our unfunded pension obligation as of December 31, 2018, is related to our U.S. government contracting business, Aerojet Rocketdyne. On September 10, 2018, we made a discretionary contribution of 2.7 million treasury stock, or $95.0 million, of our common stock to our tax-qualified defined benefit pension plan. This voluntary contribution will help address the current underfunding of the tax-qualified defined benefit pension plan. This contribution was tax deductible in the current period and will be used as a pre-funding credit. We expect to make cash contributions of approximately $37.0 million to our tax-qualified defined benefit pension plan in 2019. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there can be differences between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under CAS. Information Technology and Cyber Security We routinely experience cyber security threats, threats to our information technology infrastructure and unauthorized attempts to gain access to our sensitive information, as do our customers, suppliers, subcontractors, and other partners. In 2017, we outsourced certain information technology and cyber security functions to third-party contractors in order to take advantage of advanced cyber security technologies. The visibility provided by the additional cyber security technologies identified vulnerabilities and resulted in additional costs to remediate throughout 2018. The transition to the outsourced provider impacted our level of control over the performance and delivery of such service to the business. We continue to assess our information technology systems and are engaged in cooperative efforts with our customers, suppliers, and subcontractors to seek to minimize the impact of cyber threats, other security threats or business disruptions. Results of Operations: Net Sales: * Primary reason for change. Net sales were impacted by the adoption of new revenue recognition guidance effective January 1, 2018, using the modified retrospective method. The primary impact of the new guidance was a change in the timing of revenue recognition on certain long-term contracts. Under this new guidance, we discontinued the use of the unit-of-delivery method on certain customer contracts and re-measured the performance obligations using the cost-to-cost method. Net sales in 2018 would have been $1,910.0 million under the previous revenue recognition guidance which is $32.8 million higher than net sales reported in 2017, resulting from an increase of $126.0 million in defense programs primarily driven by increased deliveries on the Standard Missile and PAC-3 programs. The increase in net sales was partially offset by a decrease of $94.6 million in space programs primarily driven by cost growth and performance issues on the Commercial Crew Development program and lower deliveries on the Atlas V program as this program winds down. The Atlas V program contributed sales of $42.6 million under the new revenue recognition guidance in 2018, and sales of $89.1 million under the previous revenue recognition guidance in 2018. ** Primary reason for change. The increase in net sales was primarily due to an increase of $158.0 million in space programs primarily driven by the following (i) the RS-25 program development and integration effort in support of the SLS development program; (ii) increased development effort and volume on the Commercial Crew Development program; and (iii) increased deliveries on the Atlas V program. The increase in net sales was partially offset by a decrease of $36.5 million in defense programs primarily driven by the timing of deliveries on the THAAD and Standard Missile programs partially offset by the net sales generated from the Coleman Aerospace acquisition. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in 2016 compared with 52 weeks of operations in 2017. The additional week of operations, which occurred in the fourth quarter of 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. Cost of Sales (exclusive of items shown separately below): * Primary reason for change. The decrease in cost of sales as a percentage of net sales was primarily due to the following: (i) risk retirements on the RS-68 program, (ii) favorable overhead rate performance, and (iii) cost growth and manufacturing inefficiencies in 2017 on electric propulsion contracts. These factors were partially offset by cost growth and performance issues in the current period on the Commercial Crew Development program and favorable contract performance on the THAAD program in 2017 as a result of risk retirements and cost reductions. The same factors drove the decrease in cost of sales as a percentage of net sales under the previous revenue recognition guidance. ** Primary reason for change. The decrease in cost of sales as a percentage of net sales was primarily due to favorable contract performance on numerous programs as a result of overhead cost reductions and reduced program risks, most notably on the THAAD program, partially offset by cost growth and manufacturing inefficiencies in 2017 on electric propulsion contracts. Selling, General and Administrative Expense ("SG&A"): * Primary reason for change. The decrease in SG&A expense was primarily driven by (i) a decrease of $1.5 million in stock-based compensation primarily as a result of decreases in the fair value of the stock appreciation rights in the current period and accelerated vesting of stock awards to a former executive officer in 2017 and (ii) a decrease in legal and professional services expenses. ** Primary reason for change. The increase in SG&A expense was primarily driven by an increase of $9.1 million in stock-based compensation primarily as a result of increases in the fair value of stock appreciation rights, the accelerated vesting of stock awards to a former executive officer, and the August 2016 stock award granted to the Executive Chairman that vested according to the attainment of share prices ranging from $22 per share to $27 per share of our common stock. Depreciation and Amortization: * Primary reason for change. Depreciation and amortization expense did not change significantly in 2018 compared with 2017. ** Primary reason for change. The increase in depreciation expense was primarily the result of increased accelerated depreciation associated with changes in the estimated useful lives of long-lived assets and capital projects being placed in service to support the cost saving initiatives of the CIP. Other (Income) Expense, Net and Loss On Debt: * Primary reason for change. The increase in other income, net was primarily due to a one-time benefit of $43.0 million in environmental remediation provision adjustments as a result of reaching a determination with the U.S. government that certain environmental expenditures are reimbursable under the Global Settlement (see discussion of "Environmental Matters" below). ** Primary reason for change. The decrease in other expense, net was primarily due to a decrease of $35.5 million in unusual items (discussed below) and a decrease of $10.1 in environmental remediation expenses (see discussion of "Environmental Matters" below). The following table summarizes unusual items, comprised of a component of other (income) expense, net and loss on debt in the consolidated statements of operations: ________ (1) Operating expense (income) (2) Non-operating expense 2018 Activity: We recorded a charge of $0.2 million associated with an amendment to the Senior Credit Facility. 2017 Activity: We recorded $2.0 million of realized gains, net of interest associated with the failure to register with the SEC the issuance of certain of our common shares under the defined contribution 401(k) employee benefit plan. On May 30, 2017, we made a registered rescission offer to buy back unregistered shares from eligible Plan participants at the original purchase price plus interest, or to reimburse eligible Plan participants for losses they may have incurred if their shares had been sold. The actual cost of the registered rescission offer was less than the previously estimated costs. The registered rescission offer expired on June 30, 2017, and settlement payments of $3.5 million under the offer were completed in the third quarter of 2017. We recorded $1.0 million of costs related to the acquisition of Coleman Aerospace from L3 Technologies, Inc. 2016 Activity: On July 18, 2016, we redeemed $460.0 million principal amount of our 7.125% Second-Priority Senior Secured Notes ("7 1/8% Notes"), representing all of the outstanding 7 1/8% Notes, at a redemption price equal to 105.344% of the principal amount, plus accrued and unpaid interest. We incurred a pre-tax charge of $34.1 million in 2016 associated with the extinguishment of the 7 1/8% Notes. The $34.1 million pre-tax charge was the result of the $24.6 million paid in excess of the par value and $9.5 million associated with the write-off of unamortized deferred financing costs. We retired $13.0 million principal amount of our delayed draw term loan resulting in a loss of $0.3 million. We recorded a charge of $0.1 million associated with an amendment to the Senior Credit Facility. Interest Income: * Primary reason for change. The increase in interest income was primarily due to higher average cash balances and interest rates for both period comparisons. Interest Expense: * Primary reason for change. The increase in interest expense was primarily due to a higher variable interest rate on our Senior Credit Facility partially offset by a lower principal balance on the Senior Credit Facility. The Senior Credit Facility variable interest rate was 4.52% as of December 31, 2018, compared with 3.82% as of December 31, 2017. ** Primary reason for change. The decrease in interest expense was primarily due to the retirement of the principal amount of our delayed draw term loan in the first quarter of 2016, the redemption of the 7 1/8% Notes in the third quarter of 2016, and the conversion of 41/16% Convertible Subordinated Debentures to common shares. The decrease was partially offset by interest expense on the debt incurred on the Senior Credit Facility at a variable interest rate of 3.82% as of December 31, 2017, and the issuance of the 2¼% Notes in December 2016 at an effective interest rate of 5.8%. Income Tax Provision: In 2018, our effective tax rate was 27.2%. Our effective tax rate differed from the 21% statutory federal income tax rate primarily due to an increase from state income taxes and unfavorable adjustments to uncertain tax positions partially offset by R&D credits. In 2017, our effective tax rate was 110.6%. Our effective tax rate differed from the 35.0% statutory federal income tax rate primarily due to the change in the federal statutory tax rate from 35% to 21% under Tax Cuts and Jobs Act ("Tax Act"). The one time reduction to deferred tax assets due to the Tax Act was $64.6 million or a 74.4% increase to the effective tax rate. Before applying the effects of the Tax Act, the effective tax rate was 36.2%. This rate differs from the 35% federal income tax rate due to an increase from state income taxes partially offset by R&D credits and favorable adjustments to uncertain tax positions. In 2016, the income tax provision recorded differs from the expected tax that would be calculated by applying the federal statutory rate to our income before income taxes primarily due to the impacts from state income taxes, and certain expenditures which are permanently not deductible for tax purposes, partially offset by the impact of R&D credits. We recorded an initial estimate of our current tax payable of $127.7 million during the first quarter ended March 31, 2018, based on our best estimate of the impact of the adoption of new revenue recognition guidance and the enactment of certain provisions of tax reform under the Tax Act, both effective on January 1, 2018. Subsequently, guidance was issued by federal taxing authorities providing clarification on provisions within the Tax Act. This new clarification allows us to spread the impact of adoption of the new revenue recognition guidance over a four-year period, reducing the single-year impact in 2018. The current tax payable of $19.8 million as of December 31, 2018, reflects this reduction as well as other refinements to the estimated impacts from both the new revenue recognition guidance and the Tax Act. As of December 31, 2018, the liability for uncertain income tax positions was $5.9 million. Due to the uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. Retirement Benefit Expense: * Primary reason for change. The decrease in retirement benefits expense was primarily due to better than expected investment returns on our pension plan assets and lower interest costs on the benefit obligation. We estimate that our retirement benefits expense will be approximately $26 million in 2019. See "Critical Accounting Policies - Retirement Benefit Plans" for more information about our accounting practices with respect to retirement benefits. Operating Segment Information: We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance represents net sales less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, legacy income or expenses, and unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our underlying operational performance. In addition, we provide the Non-GAAP financial measure of our operational performance called segment performance before environmental remediation provision adjustments, retirement benefits, and segment unusual items. We believe the exclusion of the items listed above permits an evaluation and a comparison of results for ongoing business operations, and it is on this basis that management internally assesses operational performance. Aerospace and Defense Segment Net sales were impacted by the adoption of new revenue recognition guidance effective January 1, 2018, using the modified retrospective method. The primary impact of the new guidance was a change in the timing of revenue recognition on certain long-term contracts. Under this new guidance, we discontinued the use of the unit-of-delivery method on certain customer contracts and re-measured the performance obligations using the cost-to-cost method. Segment performance during 2018 was significantly impacted by a one-time benefit of $43.0 million as a result of reaching a determination with the U.S. government that certain environmental expenditures are reimbursable under the Global Settlement. See Note 8(d) in the consolidated financial statements in Item 8 of this Report for additional information. * Primary reason for change. Net sales in 2018 would have been $1,902.2 million under the previous revenue recognition guidance which is $31.4 million higher than net sales reported in 2017, resulting from an increase of $126.0 million in defense programs primarily driven by increased deliveries on the Standard Missile and PAC-3 programs. The increase in net sales was partially offset by a decrease of $94.6 million in space programs primarily driven by cost growth and performance issues on the Commercial Crew Development program and lower deliveries on the Atlas V program as this program winds down. The Atlas V program contributed sales of $42.6 million under the new revenue recognition guidance in 2018, and sales of $89.1 million under the previous revenue recognition guidance in 2018. The increase in the segment margin before environmental remediation provision adjustments, retirement benefits, net and unusual items was primarily due to the following: (i) risk retirements on the RS-68 program, (ii) favorable overhead rate performance, and (iii) cost growth and manufacturing inefficiencies in 2017 on electric propulsion contracts. These factors were partially offset by cost growth and performance issues in the current period on the Commercial Crew Development program and favorable contract performance on the THAAD program in 2017 as a result of risk retirements and cost reductions. During 2018, we had $59.1 million of favorable changes in contract estimates on operating results before income taxes compared with favorable changes of $37.2 million during 2017. ** Primary reason for change. The increase in net sales was primarily due to an increase of $158.0 million in space programs primarily driven by the following (i) the RS-25 program development and integration effort in support of the SLS development program; (ii) increased development effort and volume on the Commercial Crew Development program; and (iii) increased deliveries on the Atlas V program. The increase in net sales was partially offset by a decrease of $36.5 million in defense programs primarily driven by the timing of deliveries on the THAAD and Standard Missile programs partially offset by the net sales generated from the Coleman Aerospace acquisition. Further, as a result of the 2016 calendar, Aerojet Rocketdyne had 53 weeks of operations in 2016 compared with 52 weeks of operations in 2017. The additional week of operations, which occurred in the fourth quarter of 2016 and accounted for $32.2 million in additional net sales, is included in the above discussion of program changes. Segment margin before environmental remediation provision adjustments, retirement benefits, net, and unusual items in 2017 compared with 2016 was up 30 basis points. Items that had a significant impact were favorable contract performance on numerous programs as a result of overhead cost reductions and reduced program risks, most notably on the THAAD program, partially offset by cost growth and manufacturing inefficiencies in 2017 on electric propulsion contracts. Real Estate Segment In 2018, we recognized net sales of $1.4 million from a land sale of 57 acres of the Sacramento Land. During 2017 and 2016, net sales and segment performance consisted primarily of rental property operations. Backlog: As of December 31, 2018, our total remaining performance obligations, also referred to as backlog, totaled $4.1 billion. We expect to recognize approximately 45%, or $1.8 billion, of the remaining performance obligations as sales over the next twelve months, an additional 29% the following twelve months, and 26% thereafter. The following table summarizes backlog: Our adoption of the new revenue recognition guidance accelerated the timing of revenue recognition on some of our contracts which resulted in a $0.6 billion reduction in our backlog as of December 31, 2017. Total backlog includes both funded backlog (unfilled orders for which funding is authorized, appropriated and contractually obligated by the customer) and unfunded backlog (firm orders for which funding has not been appropriated). Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. Backlog is subject to funding delays or program restructurings/cancellations which are beyond our control. Use of Non-GAAP Financial Measures: In addition to segment performance (discussed above), we provide the Non-GAAP financial measures of our performance called Adjusted EBITDAP, Adjusted Net Income, and Adjusted EPS. We use these metrics to measure our operating and total Company performance. We believe that for management and investors to effectively compare core performance from period to period, the metrics should exclude items that are not indicative of, or are unrelated to, results from our ongoing business operations such as retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the ordinary, on-going and customary course of our business. Accordingly, we define Adjusted EBITDAP as GAAP net income (loss) adjusted to exclude interest expense, interest income, income taxes, depreciation and amortization, retirement benefits net of amounts that are recoverable under our U.S. government contracts, and unusual items which we do not believe are reflective of such ordinary, on-going and customary activities. Adjusted Net Income and Adjusted EPS exclude retirement benefits net of amounts that are recoverable under our U.S. government contracts and unusual items which we do not believe are reflective of such ordinary, on-going and customary activities. Adjusted Net Income and Adjusted EPS do not represent, and should not be considered an alternative to, net income (loss) or diluted EPS as determined in accordance with GAAP. _________ (1) The income tax impact is calculated using the federal and state statutory rates in the corresponding year. We also provide the Non-GAAP financial measure of Free Cash Flow. Free Cash Flow, a Non-GAAP financial measure, is defined as cash flow from operating activities less capital expenditures. Free Cash Flow should not be considered in isolation, as a measure of residual cash flow available for discretionary purposes, or as an alternative to cash flows from operations presented in accordance with GAAP. We use Free Cash Flow, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that this financial measure is useful because it provides supplemental information to assist investors in viewing the business using the same tools that management uses to evaluate progress in achieving our goals (including under our annual cash and long-term compensation incentive plans). The following table summarizes Free Cash Flow: _________ (1) Free Cash Flow, a Non-GAAP financial measure, is defined as cash flow from operating activities less capital expenditures. Because our method for calculating these Non-GAAP measures may differ from other companies’ methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures. Environmental Matters: Our policy is to conduct our businesses with due regard for the preservation and protection of the environment. We devote a significant amount of resources and management attention to environmental matters and actively manage our ongoing processes to comply with environmental laws and regulations. We are involved in the remediation of environmental conditions that resulted from generally accepted manufacturing and disposal practices at certain plants in the 1950s and 1960s. In addition, we have been designated a PRP with other companies at third party sites undergoing investigation and remediation. Estimating environmental remediation costs is difficult due to the significant uncertainties inherent in these activities, including the extent of remediation required, changing governmental regulations and legal standards regarding liability, evolving technologies and the long period of time over which most remediation efforts take place. We: • accrue for costs associated with the remediation of environmental pollution when it becomes probable that a liability has been incurred and when our proportionate share of the costs can be reasonably estimated; and • record related estimated recoveries when such recoveries are deemed probable. In addition to the costs associated with environmental remediation discussed above, we incur expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations which were immaterial for 2018, 2017, and 2016. The following table summarizes our recoverable amounts, environmental reserves, and range of liability, as of December 31, 2018: _____ (1) Excludes the receivable from Northrop of $58.5 million as of December 31, 2018, related to environmental costs already paid (and therefore not reserved) by us in prior years and reimbursable under our agreement with Northrop. Environmental Reserves We review on a quarterly basis estimated future remediation costs and have an established practice of estimating environmental remediation costs over a fifteen year period, except for those environmental remediation costs with a specific contractual term. Environmental liabilities at the BPOU site are currently estimated through the term of the new project agreement, which expires in May 2027. As the period for which estimated environmental remediation costs lengthens, the reliability of such estimates decreases. These estimates consider the investigative work and analysis of engineers, outside environmental consultants, and the advice of legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum amount is used when no single amount in the range is more probable. Accordingly, such estimates can change as we periodically evaluate these estimates when new information becomes available. We cannot predict whether new information gained as projects progress will affect the estimated liability accrued. The timing of payment for estimated future environmental costs is influenced by a number of factors, such as the regulatory approval process and the time required designing, constructing, and implementing the remedy. The following tables summarizes our environmental reserve activity: The $23.3 million of environmental reserve additions in 2018 was primarily due to the following items: (i) $8.8 million of additional operations and maintenance for treatment facilities; (ii) $4.6 million of regulatory oversight costs and fees; (iii) $3.8 million of remediation related to operable treatment units; (iv) $2.2 million of sampling analysis costs; and (v) $3.9 million related to other environmental clean-up matters. The $31.3 million of environmental reserve additions in 2017 was primarily due to the following items: (i) $13.4 million of additional operations and maintenance for treatment facilities; (ii) $6.7 million of additional estimated costs related to the Camden, Arkansas site; (iii) $2.3 million associated with water replacement; and (iv) $8.9 million related to other environmental clean-up matters. The $87.4 million of environmental reserve additions in 2016 was primarily due to the following items: (i) in 2016, we reached a decision with the U.S. government on the treatment of certain utility costs related to the Sacramento site resulting in a reserve increase of $59.4 million for the estimated impact over the current period and a fifteen year reserve period; (ii) $10.4 million of additional operations and maintenance for treatment facilities; (iii) $5.9 million of remediation related to inactive test sites and landfill clean-up; (iv) $2.7 million of remediation related to operable treatment units; and (v) $9.0 million related to other environmental clean-up matters. The effect of the final resolution of environmental matters and our obligations for environmental remediation and compliance cannot be accurately predicted due to the uncertainty concerning both the amount and timing of future expenditures and due to regulatory or technological changes. We continue our efforts to mitigate past and future costs through pursuit of claims for recoveries from our insurance carriers and other PRPs and continued investigation of new and more cost effective remediation alternatives and associated technologies. Estimated Recoveries Environmental remediation costs are primarily incurred by our Aerospace and Defense segment, and certain of these costs are recoverable from our contracts with the U.S. government. We currently estimate approximately 12% of our future Aerospace and Defense segment environmental remediation costs will not likely be reimbursable and are expensed. Allowable environmental remediation costs are charged to our contracts as the costs are incurred. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet Rocketdyne to continue recovering these costs from the U.S. government depends on Aerojet Rocketdyne’s sustained business volume from U.S. government contracts and programs. While we are currently seeking an arrangement with the U.S. government to recover environmental expenditures in excess of the reimbursement ceiling identified in the Global Settlement, there can be no assurances that such a recovery will be obtained, or if not obtained, that such unreimbursed environmental expenditures will not have a materially adverse effect on our operating results, financial condition, and/or cash flows. The following table summarizes the activity in the current and non-current recoverable amounts from the U.S. government and Northrop: _____ (1) The adjustment in 2018 was primarily a result of reaching a determination with the U.S. government that certain environmental expenditures are reimbursable under the Global Settlement. See Note 8(d) in the consolidated financial statements in Item 8 of this Report for additional information. The activity for recoveries is commensurate with the activity associated with the environmental reserve activity. Environmental reserves and recoveries impact on the consolidated statements of operations The expenses associated with adjustments to the environmental reserves are recorded as a component of other (income) expense, net in the consolidated statements of operations. The following table summarizes the impact of environmental reserves and recoveries to the consolidated statements of operations: Recently Adopted Accounting Pronouncements: See Note 1(v) in the consolidated financial statements in Item 8 of this Report for information relating to our discussion of the effects of recent accounting pronouncements. Liquidity and Capital Resources: Net Cash Provided By (Used In) Operating, Investing, and Financing Activities The following table summarizes the change in cash, cash equivalents and restricted cash: Net Cash Provided by Operating Activities The $39.9 million increase in cash provided by operating activities in 2018 compared with 2017 was primarily driven by improved operating results and a reduction of $39.7 million in retirement benefit cash funding partially offset by cash usage from working capital. The increased cash usage from working capital was primarily due to (i) an increase of $47.3 million in accounts receivable primarily due to the timing of cash receipts; (ii) an increase of $38.7 million in net income tax payments; and (iii) a decrease of $39.4 million in accounts payable due to vendor payment schedules. These factors were partially offset by improved cash flow from contracts of $39.7 million primarily due to the timing of contract performance payments. The $54.1 million increase in cash provided by operating activities in 2017 compared with 2016 was primarily driven by improved operating results and cash generation from working capital partially offset by $43.0 million of increased retirement benefit funding. The improved cash generation from working capital was primarily due to (i) a decrease in inventories on the Atlas V and PAC-3 contracts and (ii) an increase in customer advances partially offset by an increase in accounts receivables due to the timing of sales and milestone billings on a space program contract. Net Cash Used in Investing Activities During 2018, 2017, and 2016, we had capital expenditures of $43.2 million, $29.4 million, and $47.6 million. The higher capital expenditures in 2016 compared with 2018 and 2017 was primarily related to construction projects associated with supporting our CIP. During the 2018, we received insurance proceeds of $1.9 million and received net proceeds of $20.4 million in marketable securities. During 2017, we purchased Coleman Aerospace for $17.0 million and we made a net cash investment of $20.0 million in marketable securities. Net Cash (Used in) Provided by Financing Activities During 2018, we had debt cash payments of $25.3 million. During 2017, we had debt cash payments of $20.0 million. During 2016, we had $700.6 million in debt cash payments and borrowings of $800.0 million. Debt Activity The following table summarizes our debt principal activity: On September 20, 2018, we amended our Senior Credit Facility to a $1.0 billion commitment (see Note 6 in the consolidated financial statements in Item 8 of this Report). Outlook Short-term liquidity requirements consist primarily of recurring operating expenses, including but not limited to costs related to our capital and environmental expenditures, company-funded R&D expenditures, debt service requirements, and retirement benefit plans. We believe that our existing cash and cash equivalents and availability under the Senior Credit Facility coupled with cash generated from our future operations will provide sufficient funds to meet our operating plan for the next twelve months. The operating plan for this period provides for full operation of our businesses, including interest and debt payments. As of December 31, 2018, we had $735.3 million of cash and cash equivalents as well as $620.6 million of available borrowings under our Senior Credit Facility. Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of December 31, 2018. Our failure to comply with these covenants could result in an event of default that, if not cured or waived by the lenders, could result in the acceleration of the Senior Credit Facility and 2¼% Notes. In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility, and in certain cases, would cause a cross default on the 2¼% Notes. We are committed to a cash management strategy that maintains liquidity to adequately support the operation of the business, our growth strategy and to withstand unanticipated business volatility. Our cash management strategy includes maintaining the flexibility to pay down debt and/or repurchase shares depending on economic and other conditions. In connection with the implementation of our cash management strategy, our management may seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise if we believe that it is in our best interests. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. Potential future acquisitions depend, in part, on the availability of financial resources at an acceptable cost of capital. We expect to utilize cash on hand and cash generated by operations, as well as cash available under our Senior Credit Facility, which may involve renegotiation of credit limits to finance any future acquisitions. Other sources of capital could include the issuance of common and/or preferred stock, and the placement of debt. We periodically evaluate capital markets and may access such markets when circumstances appear favorable. We believe that sufficient capital resources will be available from one or several of these sources to finance any future acquisitions. However, no assurances can be made that acceptable financing will be available, or that acceptable acquisition candidates will be identified, or that any such acquisitions will be accretive to earnings. As disclosed in Notes 8(b) and 8(c) in the consolidated financial statements in Item 8 of this Report, we have exposure for certain legal and environmental matters. We believe that it is currently not possible to estimate the impact, if any, that the ultimate resolution of certain of these matters will have on our financial position, results of operations, or cash flows. Major factors that could adversely impact our forecasted operating cash flows and our financial condition are described in Part I, Item 1A. Risk Factors. In addition, our liquidity and financial condition will continue to be affected by changes in prevailing interest rates on the portion of debt that bears interest at variable interest rates. Contractual Obligations: We have contractual obligations and commitments in the form of debt obligations, operating leases, certain other liabilities, and other commitments. The following table summarizes our contractual obligations as of December 31, 2018: ________ (1) Holders may convert their 2¼% Notes at their option from January 1, 2019, through March 31, 2019, because our closing stock price exceeded $33.80 for at least 20 days in the 30 day period prior to December 31, 2018. We have a stated intention to cash settle the principal amount of the 2¼% Notes with the conversion premium to be settled in common shares. Accordingly, the 2¼% Notes are classified as a current liability as of December 31, 2018. The classification of the 2¼% Notes as current or noncurrent on the balance sheet is evaluated at each reporting date and may change depending on whether the sale price contingency has been met. See Note 6 in the consolidated financial statements in Item 8 of this Report for additional information. (2) Includes interest on variable debt calculated based on interest rates at December 31, 2018. (3) See Note 6(c) in the consolidated financial statements in Item 8 of this Report for additional information. (4) The payments presented above are expected payments for the next 10 years. The payments for postretirement medical and life insurance benefits reflect the estimated benefit payments of the plans using the provisions currently in effect. The obligation related to postretirement medical and life insurance benefits is actuarially determined on an annual basis. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (5) Purchase obligations represent open purchase orders and other commitments to suppliers, subcontractors, and other outsourcing partners for equipment, materials, and supplies in the normal course of business. These amounts are based on volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (6) The conditional asset retirement obligations presented are related to our Aerospace and Defense segment and are allowable costs under our contracts with the U.S. government. We expect to make cash contributions of approximately $37.0 million to our tax-qualified defined benefit pension plan in 2019. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there can be differences between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under CAS. Arrangements with Off-Balance Sheet Risk: See Note 8(e) in the consolidated financial statements in Item 8 of this Report for information relating to our off-balance sheet risk. Critical Accounting Policies: Our financial statements are prepared in accordance with GAAP that offer acceptable alternative methods for accounting for certain items affecting our financial results, such as determining inventory cost, depreciating long-lived assets, and recognizing revenues. The preparation of financial statements requires the use of estimates, assumptions, judgments, and interpretations that can affect the reported amounts of assets, liabilities, revenues, and expenses, the disclosure of contingent assets and liabilities and other supplemental disclosures. The development of accounting estimates is the responsibility of our management. Although we believe that the positions we have taken with regard to uncertainties are reasonable, others might reach different conclusions and our positions can change over time as more information becomes available. If an accounting estimate changes, its effects are accounted for prospectively and, if significant, disclosed in notes of the consolidated financial statements. The areas most affected by our accounting policies and estimates are revenue recognition, other contract considerations, goodwill, retirement benefit plans, litigation, environmental remediation costs and recoveries, and income taxes. Except for income taxes, which are not allocated to our operating segments, these areas affect the financial results of our business segments. For a discussion of all of our accounting policies, including the accounting policies discussed below, see Note 1 in the consolidated financial statements in Item 8 of this Report. Revenue Recognition In our Aerospace and Defense segment, the majority of our revenue is earned from long-term contracts to design, develop, and manufacture aerospace and defense products, and provide related services, for our customers, including the U.S. government, major aerospace and defense prime contractors, and the commercial sector. Each customer contract defines our distinct performance obligations and the associated transaction price for each obligation. A contract may contain one or multiple performance obligations. In certain circumstances, multiple contracts with a customer are required to be combined in determining the distinct performance obligation. For contracts with multiple performance obligations, we allocate the contracted transaction price to each performance obligation based upon the relative standalone selling price, which represents the price at which we would sell the promised good or service separately to the customer. We determine the standalone selling price based upon the facts and circumstances of each obligated good or service. The majority of our contracts have no observable standalone selling price since the associated products and services are customized to customer specifications. As such, the standalone selling price generally reflects our forecast of the total cost to satisfy the performance obligation plus an appropriate profit margin. Contract modifications are routine in the performance of our long-term contracts. Contracts are often modified to account for changes in contract specifications or requirements. In most instances, contract modifications are for goods or services that are not distinct, and, therefore, are accounted for as part of the existing contract. We recognize revenue as each performance obligation is satisfied. The majority of our aerospace and defense performance obligations are satisfied over time either as the service is provided, or as control transfers to the customer. Transfer of control is evidenced by our contractual right to payment for work performed to date plus a reasonable profit on contracts with highly customized products that we have no alternative use for. We measure progress on substantially all our performance obligations using the cost-to-cost method, which we believe best depicts the transfer of control of goods and services to the customer. Under the cost-to-cost method, we record revenues based upon costs incurred to date relative to the total estimated cost at completion. Contract costs include labor, material, overhead, and general and administrative expenses, as appropriate. Recognition of revenue and profit on long-term contracts requires the use of assumptions and estimates related to the total contract value, the total cost at completion, and the measurement of progress towards completion for each performance obligation. Due to the nature of the programs, developing the estimated total contract value and total cost at completion for each performance obligation requires the use of significant judgment. The contract value of long-term contracts may include variable consideration, such as incentives, awards, or penalties. The value of variable consideration is generally determined by contracted performance metrics, which may include targets for cost, performance, quality, and schedule. We include variable consideration in the transaction price for the respective performance obligation at either estimated value, or most likely amount to be earned, based upon our assessment of expected performance. We record these amounts only to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. We evaluate the contract value and cost estimates for performance obligations at least quarterly and more frequently when circumstances significantly change. Factors considered in estimating the work to be completed include, but are not limited to: labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements, inflationary trends, schedule and performance delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. When our estimate of total costs to be incurred to satisfy a performance obligation exceeds the expected revenue, we recognize the loss immediately. When we determine that a change in estimates has an impact on the associated profit of a performance obligation, we record the cumulative positive or negative adjustment to the statement of operations. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact of the changes in significant contract accounting estimates on our Aerospace and Defense segment operating results: See Note 1(p) in the consolidated financial statements in Item 8 of this Report for additional information. Other Contract Considerations The majority of Aerospace and Defense segment sales are driven by pricing based on costs incurred to produce products and perform services under contracts with the U.S. government. Cost-based pricing is determined under the FAR and CAS. The FAR and CAS provide guidance on the types of costs that are allowable and allocable in establishing prices for goods and services from U.S. government contracts. For example, costs such as charitable contributions, advertising, interest expense, and public relations are unallowable, and therefore not recoverable through sales. In addition, we may enter into agreements with the U.S. government that address the subjects of allowability and allocability of costs to contracts for specific matters. We closely monitor compliance with and the consistent application of our critical accounting policies related to contract accounting. We review the status of contracts through periodic contract status and performance reviews. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel independent from the business segment performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are reviewed for compliance with regulatory standards by our personnel, and are subject to audit by the DCAA. Accordingly, we record an allowance on our unbilled receivables for amounts of potential contract overhead costs which may not be successfully negotiated and collected. Goodwill Goodwill represents the excess of the purchase price of an acquired enterprise or assets over the fair values of the identifiable assets acquired and liabilities assumed. All of our recorded goodwill resides in the Aerospace and Defense reporting unit. Tests for impairment of goodwill are performed on an annual basis, or at any other time if events occur or circumstances indicate that the carrying amount of goodwill may not be recoverable. Circumstances that could trigger an impairment test include but are not limited to: a significant adverse change in the business climate or legal factors; adverse cash flow trends; an adverse action or assessment by a regulator; unanticipated competition; loss of key personnel; decline in stock price; and results of testing for recoverability of a significant asset group within a reporting unit. We evaluate qualitative factors (including macroeconomic conditions, industry and market considerations, cost factors, and overall financial performance) to determine whether it is necessary to perform the first step of the goodwill test. This step is referred to as the "Step Zero" analysis. If it is determined that it is more likely than not (a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, we will proceed to the quantitative ("Step One") analysis to determine the existence and amount of any goodwill impairment. We may also perform a Step One analysis from time to time to augment our qualitative assessment. We evaluated goodwill using a "Step One" analysis as of October 1, 2018, and determined that goodwill was not impaired. We evaluated goodwill using a "Step Zero" analysis as of October 1, 2017, and determined that goodwill was not impaired. There can be no assurance that our estimates and assumptions made for purposes of our goodwill impairment testing will prove to be accurate predictions of the future. If our assumptions and estimates are incorrect, we may be required to record goodwill impairment charges in future periods. Retirement Benefit Plans We discontinued future benefit accruals for our defined benefit pension plans in 2009. We provide medical and life insurance benefits to certain eligible retired employees, with varied coverage by employee group. Annual charges are made for the cost of the plans, including interest costs on benefit obligations, and net amortization and deferrals, increased or reduced by the return on assets. We also sponsor a defined contribution 401(k) plan and participation in the plan is available to all employees. Retirement benefits are a significant cost of doing business and represent obligations that will be ultimately settled far in the future and therefore are subject to estimates. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there is a lag between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under our U.S. government contracts. Our pension and medical and life insurance benefit obligations and related costs are calculated using actuarial concepts in accordance with GAAP. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine the retirement benefit obligations and expense (income) for the year. The following table presents the assumptions to determine the benefit obligations: The following table presents the assumptions to determine the retirement benefits expense (income): ____ * Not applicable as our medical and life insurance benefits are unfunded. The discount rate represents the current market interest rate used to determine the present value of future cash flows currently expected to be required to settle pension obligations. Based on market conditions, discount rates can experience significant variability. Changes in discount rates can significantly change the liability and, accordingly, the funded status of the pension plan. The assumed discount rate represents the market rate available for investments in high-quality fixed income instruments with maturities matched to the expected benefit payments for pension and medical and life insurance benefit plans. The expected long-term rate of return on assets represents the rate of earnings expected in the funds invested, and funds to be invested, to provide for anticipated benefit payments to plan participants. We evaluated the historical investment performance, current and expected asset allocation, and, with input from our external advisors, developed best estimates of future investment performance. Market conditions and interest rates significantly affect assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This "smoothing" results in the creation of other accumulated income or loss which will be amortized to pension costs in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses in the market-related value of pension assets and all other gains and losses including changes in the discount rate used to calculate the benefit obligation each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual pension costs, future pension costs are impacted by changes in the market value of assets and changes in interest rates. The following table summarizes the effects of a one-percentage-point change in key assumptions on the projected benefit obligations as of December 31, 2018, and on retirement benefits expense for 2018: Contingencies and Litigation We are currently involved in certain legal proceedings and, as required, have accrued our estimate of the probable costs and recoveries for resolution of these claims. These estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in assumptions or the effectiveness of strategies related to these proceedings. See Notes 8(b) and 8(c) in the consolidated financial statements in Item 8 of this Report for more detailed information on litigation exposure. Environmental Reserves and Estimated Recoveries For a discussion of our accounting for environmental remediation obligations and costs and related legal matters, see "Environmental Matters" above and Notes 8(c) and 8(d) in the consolidated financial statements in Item 8 of this Report. We accrue for costs associated with the remediation of environmental contamination when it becomes probable that a liability has been incurred, and when our costs can be reasonably estimated. In most cases, only a range of reasonably probable costs can be estimated. In establishing the reserves, the most probable estimated amount is used when determinable, and the minimum amount is used when no single amount in the range is more probable. Environmental reserves include the costs of completing remedial investigation and feasibility studies, remedial and corrective actions, regulatory oversight costs, the cost of operation and maintenance of the remedial action plan, and employee compensation costs for employees who are expected to devote a significant amount of time to remediation efforts. Calculation of environmental reserves is based on the evaluation of currently available information with respect to each individual environmental site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. Such estimates are based on the expected costs of investigation and remediation and the likelihood that other potentially responsible parties will be able to fulfill their commitments at sites where we may be jointly or severally liable. At the time a liability is recorded for future environmental costs, we record an asset for estimated future recoveries that are estimable and probable. Some of our environmental costs are eligible for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements. We consider the recovery probable based on the Global Settlement, U.S. government contracting regulations, and our long history of receiving reimbursement for such costs. Income Taxes We file a consolidated U.S. federal income tax return for the Company and our 100% owned consolidated subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in the period of the enactment date of the change. The carrying value of our deferred tax assets is dependent upon our ability to generate sufficient taxable income in the future. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence is considered, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, the length of carryback and carryforward periods, and evaluation of potential tax planning strategies. Despite our belief that our tax return positions are consistent with applicable tax laws, we believe that certain positions are likely to be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or some partial adjustment reached through negotiations or litigation. Our tax reserves reflect the difference between the tax benefit claimed on tax returns and the amount recognized in the financial statements. The accounting standards provide guidance for the recognition and measurement in financial statements of uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process, the first step being recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate resolution with a taxing authority. As the examination process progresses with tax authorities, adjustments to tax reserves may be necessary to reflect taxes payable upon settlement. Tax reserve adjustments related to positions impacting the effective tax rate affect the provision for income taxes. Tax reserve adjustments related to positions impacting the timing of deductions impact deferred tax assets and liabilities.

<s>[INST] Overview A summary of the significant financial highlights for 2018, which management uses to evaluate our operating performance and financial condition, is presented below. Net sales for 2018 totaled $1,895.9 million compared with $1,877.2 million for 2017. Net income for 2018 was $137.3 million, or $1.75 diluted income per share ("EPS"), compared with net loss of $(9.2) million, or $(0.13) diluted EPS for 2017. Adjusted Net Income (NonGAAP measure*) for 2018 was $151.5 million, or $1.93 Adjusted EPS (NonGAAP measure*), compared with $76.0 million, or $1.02 Adjusted EPS for 2017. Adjusted EBITDAP (NonGAAP measure*) for 2018 was $304.9 million compared with $222.9 million for 2017. Segment performance before environmental remediation provision adjustments, retirement benefits, net, and unusual items (NonGAAP measure*) was $236.2 million for 2018, compared with $202.9 million for 2017. Cash provided by operating activities in 2018 totaled $252.7 million compared with $212.8 million in 2017. Free cash flow (NonGAAP measure*) in 2018 totaled $209.5 million compared with $183.4 million in 2017. Effective January 1, 2018, we adopted the new revenue recognition guidance. Consistent with the standard, net assets increased by $37.6 million and $578.0 million of net sales were recognized in the cumulative effect at January 1, 2018, with a corresponding reduction to backlog. Total backlog as of December 31, 2018, was $4.1 billion compared with $4.6 billion as of December 31, 2017. _________ * We provide NonGAAP measures as a supplement to financial results presented in accordance with GAAP. A reconciliation of the NonGAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading "Operating Segment Information" and "Use of NonGAAP Financial Measures." In May 2014, the Financial Accounting Standards Board ("FASB") amended the existing accounting standards for revenue recognition. The amendments are based on the principle that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. We adopted the guidance effective January 1, 2018, using the modified retrospective method, with the cumulative effect recognized as of January 1, 2018. All applicable amounts and disclosures for 2018 reflect the impact of adoption. As we elected to use the modified retrospective method, prior periods presented have not been restated to reflect the impact of adoption. Reclassifications have been made where noted for conforming presentation only (see Notes 1(p) and 14 in the consolidated financial statements in Item 8 of this Report). Our business outlook is affected by both increasing complexity in the global security environment and continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, successful implementation of our cost reduction plans, environmental matters, capital structure, underfunded retirement benefit plans, and information technology and cyber security. Major Customers The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and [/INST] Negative. </s>

AEROJET ROCKETDYNE HOLDINGS, INC.

2020-02-19

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8 of this Report, the risk factors appearing in Item 1A of this Report, and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1 of this Report. We have elected to omit discussion of the earliest of the three years covered by the consolidated financial statements presented. Refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations located in our Form 10-K for the fiscal year ended December 31, 2018, filed with the SEC on February 19, 2019, for the discussion of the year ended December 31, 2017, the earliest of the three fiscal years presented. Overview A summary of the significant financial highlights for 2019, which management uses to evaluate our operating performance and financial condition, is presented below. • Net sales for 2019 totaled $1,981.5 million compared with $1,895.9 million for 2018. • Net income for 2019 was $141.0 million, or $1.69 diluted EPS, compared with $137.3 million, or $1.75 diluted EPS for 2018. • Adjusted Net Income (Non-GAAP measure*) for 2019 was $130.1 million, or $1.56 Adjusted EPS (Non-GAAP measure*), compared with $151.5 million, or $1.93 Adjusted EPS for 2018. • Adjusted EBITDAP (Non-GAAP measure*) for 2019 was $271.7 million compared with $304.9 million for 2018. • Cash provided by operating activities in 2019 totaled $261.2 million compared with $252.7 million in 2018. • Free cash flow (Non-GAAP measure*) in 2019 totaled $218.3 million compared with $209.5 million in 2018. • Total backlog as of December 31, 2019, was $5.4 billion compared with $4.1 billion as of December 31, 2018. _________ * We provide Non-GAAP measures as a supplement to financial results presented in accordance with GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading "Use of Non-GAAP Financial Measures." Our business outlook is affected by both increasing complexity in the global security environment and continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, successful implementation of our cost reduction plans, environmental matters, capital structure, underfunded retirement benefit plans, and information technology and cyber security. Major Customers The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, MDA, and the prime contractors that serve these agencies, exercise independent purchasing power within "budget top-line" limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. The following table summarizes net sales to the U.S. government and its agencies, including net sales to significant customers disclosed below: The following table summarizes net sales by principal end user in 2019: The following table summarizes the percentages of net sales for significant programs, all of which are included in the U.S. government sales and are comprised of multiple contracts: The following table summarizes customers that represented more than 10% of net sales, each of which involves sales of several product lines and programs: Industry Update Information concerning our industry appears in Part I, Item 1. Business under the caption "Industry Overview." Competitive Improvement Program During 2015, we initiated Phase I of our CIP comprised of activities and initiatives aimed at reducing costs in order for us to continue to compete successfully. Phase I was comprised of three major components: (i) facilities optimization and footprint reduction; (ii) product affordability; and (iii) reduced administrative and overhead costs. On April 6, 2017, the Board of Directors approved Phase II of our previously announced CIP. Pursuant to Phase II, we expanded CIP and further consolidated our Sacramento, California, and Gainesville, Virginia sites, while we centralized and expanded our existing presence in Huntsville, Alabama. When fully implemented, we anticipate that the CIP will result in annual costs that are $230.0 million below levels anticipated prior to the CIP. We currently estimate that we will incur restructuring and related costs of the Phase I and II programs of approximately $197.0 million (including approximately $60.5 million of capital expenditures), which is down $38.0 million compared with our initial cost estimate of $235.0 million. Our current estimate of $197.0 million has decreased from the prior year primarily due to continued efficiencies in program transitions and lower than expected employee costs. We have incurred $170.4 million of such costs through December 31, 2019, including $53.5 million in capital expenditures. Environmental Matters Our current and former business operations are subject to, and affected by, federal, state, and local environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. See Notes 9(b) and 9(c) in the consolidated financial statements in Item 8 of this Report and "Environmental Matters" below for summary of our environmental reserve activity. Capital Structure We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of December 31, 2019, we had $637.0 million of debt outstanding. Retirement Benefits As of the last measurement date at December 31, 2019, the pension assets, projected benefit obligations, and unfunded pension obligation were $932.5 million, $1,349.8 million, and $417.3 million, respectively. We estimate that 83% of our unfunded pension obligation as of December 31, 2019, is related to our U.S. government contracting business, Aerojet Rocketdyne. We expect to make contributions of approximately $46.0 million to our tax-qualified defined benefit pension plan in 2020, including $13.9 million of cash and $32.1 million of prepayment credits. We generally are able to recover contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there are differences between when we contribute to our tax-qualified defined benefit pension plan under pension funding rules and when it is recoverable under CAS. Information Technology and Cyber Security We routinely defend against various cyber and other security threats against our defenses to protect the confidentiality, integrity and availability of our information technology infrastructure, supply chain, business or customer information and other threats. We are also subject to similar security threats at customer sites that we operate and manage as a contractual requirement. The threats we face range from attacks common to most industries to more advanced and persistent, highly organized adversaries, insider threats and other threat vectors targeting us and other defense and aerospace companies; because we protect national security information. In addition, cyber threats are evolving, growing in their frequency and include, but are not limited to, malicious software, destructive malware, attempts to gain unauthorized access to data, disruption or denial of service attacks, and other electronic security breaches that could lead to disruptions in mission critical systems, unauthorized release of confidential, personal or otherwise protected information (ours or that of our employees, customers or partners), and corruption of data, networks or systems. We also could be impacted by cyber threats or other disruptions or vulnerabilities found in products we use or in our partners’ or customers’ systems that are used in connection with our business. We continue to assess our information technology systems and are engaged in cooperative efforts with our customers, suppliers, and subcontractors to seek to minimize the impact of cyber threats, other security threats or business disruptions. Results of Operations: Net Sales: Primary reason for change. The increase in net sales was primarily due to an increase of $120.6 million in defense program sales primarily driven by the PAC-3, GMLRS, and hypersonic booster programs. The increase in net sales was partially offset by a decrease of $34.7 million in space program sales primarily driven by lower sales in the RS-68 program and the anticipated wind-down of the AJ-60 solid rocket motor program partially offset by growth in the RS-25 program. Cost of Sales (exclusive of items shown separately below): Primary reason for change. The decrease in cost of sales as a percentage of net sales was primarily driven by improved performance on the Commercial Crew Development program partially offset by lower risk retirements in 2019 on the RS-68, RL10, and THAAD programs. Selling, General and Administrative Expense ("SG&A"): Primary reason for change. The increase in SG&A expense was primarily driven by stock-based compensation as a result of increases in the fair value of the stock appreciation rights in the current period. See Note 10(d) in the consolidated financial statements in Item 8 of this Report for additional information. Depreciation and Amortization: Primary reason for change. The increase in depreciation expense was primarily due to the completion of the facilities located in Huntsville, Alabama in early 2019. Other Expense (Income), Net: Primary reason for change. The change in other expense (income), net was primarily due to a one-time benefit of $43.0 million during 2018 in environmental remediation provision adjustments as a result of reaching a determination with the U.S. government that certain environmental expenditures are reimbursable under the Global Settlement (see discussion of "Environmental Matters" below). Interest Income: Primary reason for change. The increase in interest income was due to higher average cash balances and interest rates. Interest Expense: Primary reason for change. The increase in interest expense was primarily due to higher finance lease obligations associated with the Huntsville, Alabama facilities in the current period partially offset by lower average obligations and variable interest rates on our Senior Credit Facility. Income Tax Provision: In 2019, our effective tax rate was 26.5%. Our effective tax rate is higher than the 21% statutory federal income tax rate primarily due to state income taxes and uncertain tax positions, offset by R&D credits and excess tax benefits related to our stock-based compensation. In 2018, our effective tax rate was 27.2%. Our effective tax rate differed from the 21% statutory federal income tax rate primarily due to an increase from state income taxes and unfavorable adjustments to uncertain tax positions partially offset by R&D credits. As of December 31, 2019, the liability for uncertain income tax positions was $49.1 million. Due to the uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. Retirement Benefits Expense: Primary reason for change. The decrease in retirement benefits expense was primarily due to a decrease in the amortization of net actuarial losses in 2019 primarily as a result of an increase in the discount rate used to determine our pension obligation at December 31, 2018. We estimate that our retirement benefits expense will be approximately $37 million in 2020. Additionally, we estimate the CAS recoverable amounts related to the Company's retirement benefits plans to be approximately $48 million in 2020. See "Critical Accounting Policies - Retirement Benefit Plans" for more information about our accounting practices with respect to retirement benefits. Operating Segment Information: We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance represents net sales less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, and unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our operational performance. Aerospace and Defense Segment Primary reason for change. The increase in net sales was primarily due to an increase of $120.6 million in defense program sales primarily driven by the PAC-3, GMLRS, and hypersonic booster programs. The increase in net sales was partially offset by a decrease of $34.7 million in space program sales primarily driven by lower sales in the RS-68 program and the anticipated wind-down of the AJ-60 solid rocket motor program partially offset by growth in the RS-25 program. After adjusting for a one-time benefit of $43.0 million in 2018 as a result of reaching a determination with the U.S. government that certain environmental expenditures are reimbursable under the Global Settlement, segment margin increased 1.9 percentage points to 13.6% primarily due to improved performance on the Commercial Crew Development program in 2019 and lower retirement benefits expense. Despite a $4.6 million headwind in the fourth quarter of 2019 primarily from overhead rate adjustments, we realized $38.4 million of net favorable changes in contract estimates on income before income taxes for the full year 2019 compared with favorable changes of $59.1 million during 2018. The overhead rate adjustments were driven by a combination of minor downward revisions to base from small program cancellations and schedule shifts, and more cost associated with facility investments in support of future work. The 2019 net favorable changes in contract estimates on income before income taxes were primarily driven by improved performance and risk retirements on the THAAD and PAC-3 programs and are net of the impact of overhead rate adjustments made in the fourth quarter of 2019. The 2018 net favorable changes in contract estimates on income before income taxes were primarily driven by risk retirements on the THAAD, RS-68, and RL10 programs and favorable overhead rate performance, partially offset by cost growth and performance issues on the Commercial Crew Development program. Real Estate Segment During 2019, net sales and segment performance consisted primarily of rental property operations. In 2018, we recognized net sales of $1.4 million from a land sale of 57 acres of the Sacramento Land. Backlog: As of December 31, 2019, our total remaining performance obligations, also referred to as backlog, totaled $5.4 billion, compared with $4.1 billion as of December 31, 2018. The increase in backlog was primarily due to large multi-year awards on the Standard Missile and THAAD programs. We expect to recognize approximately 36%, or $2.0 billion, of the remaining performance obligations as sales over the next twelve months, an additional 23% the following twelve months, and 41% thereafter. The following table summarizes backlog: Total backlog includes both funded backlog (unfilled orders for which funding is authorized, appropriated and contractually obligated by the customer) and unfunded backlog (firm orders for which funding has not been appropriated). Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. Backlog is subject to funding delays or program restructurings/cancellations which are beyond our control. Use of Non-GAAP Financial Measures: Adjusted EBITDAP, Adjusted Net Income, and Adjusted EPS We provide the Non-GAAP financial measures of our performance called Adjusted EBITDAP, Adjusted Net Income, and Adjusted EPS. We use these metrics to measure our operating and total Company performance. We believe that for management and investors to effectively compare core performance from period to period, the metrics should exclude items that are not indicative of, or are unrelated to, results from our ongoing business operations such as retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the ordinary, ongoing and customary course of our business. Accordingly, we define Adjusted EBITDAP as GAAP net income adjusted to exclude interest expense, interest income, income taxes, depreciation and amortization, retirement benefits net of amounts that are recoverable under our U.S. government contracts, and unusual items which we do not believe are reflective of such ordinary, ongoing and customary activities. Adjusted Net Income and Adjusted EPS exclude retirement benefits net of amounts that are recoverable under our U.S. government contracts and unusual items which we do not believe are reflective of such ordinary, ongoing and customary activities. Adjusted Net Income and Adjusted EPS do not represent, and should not be considered an alternative to, net income or diluted EPS as determined in accordance with GAAP. _________ (1) The income tax impact is calculated using the federal and state statutory rates in the corresponding year. Free Cash Flow We also provide the Non-GAAP financial measure of Free Cash Flow. Free Cash Flow is defined as cash flow from operating activities less capital expenditures. Free Cash Flow should not be considered in isolation as a measure of residual cash flow available for discretionary purposes or as an alternative to cash flows from operations presented in accordance with GAAP. We use Free Cash Flow, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that this financial measure is useful because it provides supplemental information to assist investors in viewing the business using the same tools that management uses to evaluate progress in achieving our goals. The following table summarizes Free Cash Flow: Because our method for calculating these Non-GAAP measures may differ from other companies’ methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures. Environmental Matters: Our policy is to conduct our businesses with due regard for the preservation and protection of the environment. We devote a significant amount of resources and management attention to environmental matters and actively manage our ongoing processes to comply with environmental laws and regulations. We are involved in the remediation of environmental conditions that resulted from generally accepted manufacturing and disposal practices at certain plants in the 1950s and 1960s. In addition, we have been designated a PRP with other companies at third party sites undergoing investigation and remediation. Estimating environmental remediation costs is difficult due to the significant uncertainties inherent in these activities, including the extent of remediation required, changing governmental regulations and legal standards regarding liability, evolving technologies and the long period of time over which most remediation efforts take place. We: • accrue for costs associated with the remediation of environmental pollution when it becomes probable that a liability has been incurred and when our proportionate share of the costs can be reasonably estimated; and • record related estimated recoveries when such recoveries are deemed probable. In addition to the costs associated with environmental remediation discussed above, we incur expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations which totaled $5.3 million and $5.9 million in 2019 and 2018, respectively. The following table summarizes our recoverable amounts, environmental reserves, and range of liability, as of December 31, 2019: _____ (1) Excludes the receivable from Northrop of $52.5 million as of December 31, 2019, related to environmental costs already paid (and therefore not reserved) by us in prior years and reimbursable under our agreement with Northrop. Environmental Reserves We review on a quarterly basis estimated future remediation costs and have an established practice of estimating environmental remediation costs over a fifteen year period, except for those environmental remediation costs with a specific contractual term. Environmental liabilities at the BPOU site are currently estimated through the term of the project agreement, which expires in May 2027. As the period for which estimated environmental remediation costs lengthens, the reliability of such estimates decreases. These estimates consider the investigative work and analysis of engineers, outside environmental consultants, and the advice of legal staff regarding the status and anticipated results of various administrative and legal proceedings. In most cases, only a range of reasonably possible costs can be estimated. In establishing our reserves, the most probable estimate is used when determinable; otherwise, the minimum amount is used when no single amount in the range is more probable. Accordingly, such estimates can change as we periodically evaluate and revise these estimates as new information becomes available. We cannot predict whether new information gained as projects progress will affect the estimated liability accrued. The timing of payment for estimated future environmental costs is influenced by a number of factors, such as the regulatory approval process and the time required designing, constructing, and implementing the remedy. The following table summarizes our environmental reserve activity: The $16.7 million of environmental reserve additions in 2019 was primarily due to the following items: (i) $10.0 million of additional operations and maintenance for treatment facilities; (ii) $4.1 million of remediation related to operable treatment units; (iii) $1.9 million of sampling analysis costs; and (iv) $0.7 million related to other environmental clean-up matters. The $23.3 million of environmental reserve additions in 2018 was primarily due to the following items: (i) $8.8 million of additional operations and maintenance for treatment facilities; (ii) $4.6 million of regulatory oversight costs and fees; (iii) $3.8 million of remediation related to operable treatment units; (iv) $2.2 million of sampling analysis costs; and (v) $3.9 million related to other environmental clean-up matters. The effect of the final resolution of environmental matters and our obligations for environmental remediation and compliance cannot be accurately predicted due to the uncertainty concerning both the amount and timing of future expenditures and due to regulatory or technological changes. We continue our efforts to mitigate past and future costs through pursuit of claims for recoveries from our insurance carriers and other PRPs and continued investigation of new and more cost effective remediation alternatives and associated technologies. Estimated Recoveries Environmental remediation costs are primarily incurred by our Aerospace and Defense segment, and certain of these costs are recoverable from our contracts with the U.S. government. We currently estimate approximately 12% of our future Aerospace and Defense segment environmental remediation costs will not likely be reimbursable and are expensed. Allowable environmental remediation costs are charged to our contracts as the costs are incurred. Because these costs are recovered through forward-pricing arrangements, the ability of Aerojet Rocketdyne to continue recovering these costs from the U.S. government depends on Aerojet Rocketdyne’s sustained business volume from U.S. government contracts and programs. While we are currently seeking an arrangement with the U.S. government to recover environmental expenditures in excess of the reimbursement ceiling identified in the Global Settlement, there can be no assurances that such a recovery will be obtained, or if not obtained, that such unreimbursed environmental expenditures will not have a materially adverse effect on our operating results, financial condition, and/or cash flows. The following table summarizes the activity in the current and non-current recoverable amounts from the U.S. government and Northrop: _____ (1) The adjustment in 2018 was primarily a result of reaching a determination with the U.S. government that certain environmental expenditures are reimbursable under the Global Settlement. See Note 9(c) in the consolidated financial statements in Item 8 of this Report for additional information. The activity for recoveries is commensurate with the activity associated with the environmental reserve activity. Environmental reserves and recoveries impact on the consolidated statements of operations The expenses (benefits) associated with adjustments to the environmental reserves are recorded as a component of other expense (income), net in the consolidated statements of operations. The following table summarizes the impact of environmental reserves and recoveries to the consolidated statements of operations: Recently Adopted Accounting Pronouncements: See Note 1(x) in the consolidated financial statements in Item 8 of this Report for information relating to our discussion of the effects of recent accounting pronouncements. Liquidity and Capital Resources: Net Cash Provided By (Used In) Operating, Investing, and Financing Activities The following table summarizes the change in cash, cash equivalents and restricted cash: Net Cash Provided by Operating Activities The $8.5 million increase in cash provided by operating activities in 2019 compared with 2018 was primarily due to improved operating performance and working capital utilization partially offset by an increase of $43.0 million in income taxes (net of refunds) paid in the current period. Net Cash Used in Investing Activities During 2019 and 2018, we had capital expenditures of $42.9 million and $43.2 million, respectively. During 2018, we received net proceeds of $20.4 million in marketable securities. Net Cash Used in Financing Activities During 2019 and 2018, we had debt cash payments of $20.8 million and $25.3 million, respectively. See a summary of the 2019 debt principal activity below. Additionally, we had net cash usage of $3.3 million in 2019 associated with our equity plans compared with net cash generation of $2.1 million in 2018. Debt Activity The following table summarizes our debt principal activity: Outlook Short-term liquidity requirements consist primarily of recurring operating expenses, including but not limited to costs related to our capital and environmental expenditures, company-funded R&D expenditures, debt service requirements, and retirement benefit plans. We believe that our existing cash and cash equivalents and availability under the Senior Credit Facility coupled with cash generated from our future operations will provide sufficient funds to meet our operating plan for the next twelve months. The operating plan for this period provides for full operation of our businesses, including interest and debt payments. As of December 31, 2019, we had $932.6 million of cash and cash equivalents as well as $620.3 million of available borrowings under our Senior Credit Facility. Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of December 31, 2019. Our failure to comply with these covenants could result in an event of default that, if not cured or waived by the lenders, could result in the acceleration of the Senior Credit Facility and 2¼% Notes. In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility, and in certain cases, would cause a cross default on the 2¼% Notes. We are committed to a cash management strategy that maintains liquidity to adequately support the operation of the business, our growth strategy and to withstand unanticipated business volatility. Our cash management strategy includes maintaining the flexibility to pay down debt and/or repurchase shares depending on economic and other conditions. In connection with the implementation of our cash management strategy, our management may seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for equity securities, in open market purchases, privately negotiated transactions or otherwise if we believe that it is in our best interests. Such repurchases or exchanges, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. Potential future business acquisitions depend, in part, on the availability of financial resources at an acceptable cost of capital. We expect to utilize cash on hand and cash generated by operations, as well as cash available under our Senior Credit Facility, which may involve renegotiation of credit limits to finance any future acquisitions. Other sources of capital could include the issuance of common and/or preferred stock, the placement of debt, or combination of both. We periodically evaluate capital markets and may access such markets when circumstances appear favorable. We believe that sufficient capital resources will be available from one or several of these sources to finance any future acquisitions. However, no assurances can be made that acceptable financing will be available, or that acceptable acquisition candidates will be identified, or that any such acquisitions will be accretive to earnings. As disclosed in Notes 9(a) and 9(b) in the consolidated financial statements in Item 8 of this Report, we have exposure for certain legal and environmental matters. We believe that it is currently not possible to estimate the impact, if any, that the ultimate resolution of certain of these matters will have on our financial position, results of operations, or cash flows. Major factors that could adversely impact our forecasted operating cash flows and our financial condition are described in Part I, Item 1A. Risk Factors. In addition, our liquidity and financial condition will continue to be affected by changes in prevailing interest rates on the portion of debt that bears interest at variable interest rates. Contractual Obligations: We have contractual obligations and commitments in the form of debt obligations, operating leases, certain other liabilities, and other commitments. The following table summarizes our contractual obligations as of December 31, 2019: ________ (1) Holders may convert their 2¼% Notes at their option from January 1, 2020, through March 31, 2020, because our closing stock price exceeded $33.80 for at least 20 days in the 30 day period prior to December 31, 2019. We have a stated intention to cash settle the principal amount of the 2¼% Notes with the conversion premium to be settled in common shares. Accordingly, the 2¼% Notes are classified as a current liability as of December 31, 2019. The classification of the 2¼% Notes as current or noncurrent on the balance sheet is evaluated at each reporting date and may change depending on whether the sale price contingency has been met. See Note 7 in the consolidated financial statements in Item 8 of this Report for additional information. (2) Includes interest on variable debt calculated based on interest rates at December 31, 2019. (3) The payments presented above are expected payments for the next 10 years. The payments for postretirement medical and life insurance benefits reflect the estimated benefit payments of the plans using the provisions currently in effect. The obligation related to postretirement medical and life insurance benefits is actuarially determined on an annual basis. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (4) Purchase obligations represent open purchase orders and other commitments to suppliers, subcontractors, and other outsourcing partners for equipment, materials, and supplies in the normal course of business. These amounts are based on volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers. A substantial portion of these amounts are recoverable through our contracts with the U.S. government. (5) The conditional asset retirement obligations presented are related to our Aerospace and Defense segment and are allowable costs under our contracts with the U.S. government. We expect to make cash contributions of approximately $13.9 million to our tax-qualified defined benefit pension plan in 2020. We generally are able to recover contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there can be differences between when we contribute to our tax-qualified defined benefit pension plan under pension funding rules and recover it under CAS. Arrangements with Off-Balance Sheet Risk: See Note 9(d) in the consolidated financial statements in Item 8 of this Report for information relating to our off-balance sheet risk. Critical Accounting Policies: Our financial statements are prepared in accordance with GAAP that offer acceptable alternative methods for accounting for certain items affecting our financial results, such as determining inventory cost, depreciating long-lived assets, and recognizing revenues. The preparation of financial statements requires the use of estimates, assumptions, judgments, and interpretations that can affect the reported amounts of assets, liabilities, revenues, and expenses, the disclosure of contingent assets and liabilities and other supplemental disclosures. The development of accounting estimates is the responsibility of our management. Although we believe that the positions we have taken with regard to uncertainties are reasonable, others might reach different conclusions and our positions can change over time as more information becomes available. If an accounting estimate changes, its effects are accounted for prospectively and, if significant, disclosed in notes of the consolidated financial statements. The areas most affected by our accounting policies and estimates are revenue recognition, other contract considerations, goodwill, retirement benefit plans, litigation, environmental remediation costs and recoveries, and income taxes. Except for income taxes, which are not allocated to our operating segments, these areas affect the financial results of our business segments. For a discussion of all of our accounting policies, including the accounting policies discussed below, see Note 1 in the consolidated financial statements in Item 8 of this Report. Revenue Recognition In our Aerospace and Defense segment, the majority of our revenue is earned from long-term contracts to design, develop, and manufacture aerospace and defense products, and provide related services, for our customers, including the U.S. government, major aerospace and defense prime contractors, and the commercial sector. Each customer contract defines our distinct performance obligations and the associated transaction price for each obligation. A contract may contain one or multiple performance obligations. In certain circumstances, multiple contracts with a customer are required to be combined in determining the distinct performance obligation. For contracts with multiple performance obligations, we allocate the contracted transaction price to each performance obligation based upon the relative standalone selling price, which represents the price at which we would sell the promised good or service separately to the customer. We determine the standalone selling price based upon the facts and circumstances of each obligated good or service. The majority of our contracts have no observable standalone selling price since the associated products and services are customized to customer specifications. As such, the standalone selling price generally reflects our forecast of the total cost to satisfy the performance obligation plus an appropriate profit margin. Contract modifications are routine in the performance of our long-term contracts. Contracts are often modified to account for changes in contract specifications or requirements. In most instances, contract modifications are for goods or services that are not distinct, and, therefore, are accounted for as part of the existing contract. We recognize revenue as each performance obligation is satisfied. The majority of our aerospace and defense performance obligations are satisfied over time either as the service is provided, or as control transfers to the customer. Transfer of control is evidenced by our contractual right to payment for work performed to date plus a reasonable profit on contracts with highly customized products that we have no alternative use for. We measure progress on substantially all our performance obligations using the cost-to-cost method, which we believe best depicts the transfer of control of goods and services to the customer. Under the cost-to-cost method, we record revenues based upon costs incurred to date relative to the total estimated cost at completion. Contract costs include labor, material, overhead, and general and administrative expenses, as appropriate. Recognition of revenue and profit on long-term contracts requires the use of assumptions and estimates related to the total contract value, the total cost at completion, and the measurement of progress towards completion for each performance obligation. Due to the nature of the programs, developing the estimated total contract value and total cost at completion for each performance obligation requires the use of significant judgment. The contract value of long-term contracts may include variable consideration, such as incentives, awards, or penalties. The value of variable consideration is generally determined by contracted performance metrics, which may include targets for cost, performance, quality, and schedule. We include variable consideration in the transaction price for the respective performance obligation at either estimated value, or most likely amount to be earned, based upon our assessment of expected performance. We record these amounts only to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. We evaluate the contract value and cost estimates for performance obligations at least quarterly and more frequently when circumstances significantly change. Factors considered in estimating the work to be completed include, but are not limited to: labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements, inflationary trends, schedule and performance delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. When our estimate of total costs to be incurred to satisfy a performance obligation exceeds the expected revenue, we recognize the loss immediately. When we determine that a change in estimates has an impact on the associated profit of a performance obligation, we record the cumulative positive or negative adjustment to the statement of operations. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact of the changes in significant contract accounting estimates on our Aerospace and Defense segment operating results: See Note 1(r) in the consolidated financial statements in Item 8 of this Report for additional information. Other Contract Considerations The majority of Aerospace and Defense segment sales are driven by pricing based on costs incurred to produce products and perform services under contracts with the U.S. government. Cost-based pricing is determined under the FAR and CAS. The FAR and CAS provide guidance on the types of costs that are allowable and allocable in establishing prices for goods and services from U.S. government contracts. For example, costs such as charitable contributions, advertising, interest expense, and public relations are unallowable, and therefore not recoverable through sales. In addition, we may enter into agreements with the U.S. government that address the subjects of allowability and allocability of costs to contracts for specific matters. We closely monitor compliance with and the consistent application of our critical accounting policies related to contract accounting. We review the status of contracts through periodic contract status and performance reviews. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel independent from the business segment performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are reviewed for compliance with regulatory standards by our personnel, and are subject to audit by the DCAA. Accordingly, we record an allowance on our unbilled receivables for amounts of potential contract overhead costs which may not be successfully negotiated and collected. Retirement Benefit Plans We discontinued future benefit accruals for our defined benefit pension plans in 2009. We provide medical and life insurance benefits to certain eligible retired employees, with varied coverage by employee group. Annual charges are made for the cost of the plans, including interest costs on benefit obligations, and net amortization and deferrals, increased or reduced by the return on assets. We also sponsor a defined contribution 401(k) plan and participation in the plan is available to all employees. Retirement benefits are a significant cost of doing business and represent obligations that will be ultimately settled far in the future and therefore are subject to estimates. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there is a lag between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under our U.S. government contracts. Our pension and medical and life insurance benefit obligations and related costs are calculated using actuarial concepts in accordance with GAAP. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine the retirement benefit obligations and expense (income) for the year. The following table presents the assumptions to determine the benefit obligations: The following table presents the assumptions to determine the retirement benefits expense (income): ____ * Not applicable as our medical and life insurance benefits are unfunded. The discount rate represents the current market interest rate used to determine the present value of future cash flows currently expected to be required to settle pension obligations. Based on market conditions, discount rates can experience significant variability. Changes in discount rates can significantly change the liability and, accordingly, the funded status of the pension plan. The assumed discount rate represents the market rate available for investments in high-quality fixed income instruments with maturities matched to the expected benefit payments for pension and medical and life insurance benefit plans. The expected long-term rate of return on assets represents the rate of earnings expected in the funds invested, and funds to be invested, to provide for anticipated benefit payments to plan participants. We evaluated the historical investment performance, current and expected asset allocation, and, with input from our external advisors, developed best estimates of future investment performance. Market conditions and interest rates significantly affect assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This "smoothing" results in the creation of other accumulated income or loss which will be amortized to pension costs in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses in the market-related value of pension assets and all other gains and losses including changes in the discount rate used to calculate the benefit obligation each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual pension costs, future pension costs are impacted by changes in the market value of assets and changes in interest rates. The following table summarizes the effects of a one-percentage-point change in key assumptions on the projected benefit obligations as of December 31, 2019, and on retirement benefits expense for 2019: Environmental Reserves and Estimated Recoveries For a discussion of our accounting for environmental remediation obligations and costs and related legal matters, see "Environmental Matters" above and Notes 9(b) and 9(c) in the consolidated financial statements in Item 8 of this Report. We accrue for costs associated with the remediation of environmental contamination when it becomes probable that a liability has been incurred, and when our costs can be reasonably estimated. In most cases, only a range of reasonably probable costs can be estimated. In establishing the reserves, the most probable estimated amount is used when determinable, and the minimum amount is used when no single amount in the range is more probable. Environmental reserves include the costs of completing remedial investigation and feasibility studies, remedial and corrective actions, regulatory oversight costs, the cost of operation and maintenance of the remedial action plan, and employee compensation costs for employees who are expected to devote a significant amount of time to remediation efforts. Calculation of environmental reserves is based on the evaluation of currently available information with respect to each individual environmental site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. Such estimates are based on the expected costs of investigation and remediation and the likelihood that other potentially responsible parties will be able to fulfill their commitments at sites where we may be jointly or severally liable. At the time a liability is recorded for future environmental costs, we record an asset for estimated future recoveries that are estimable and probable. Some of our environmental costs are eligible for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements. We consider the recovery probable based on the Global Settlement, U.S. government contracting regulations, and our long history of receiving reimbursement for such costs. Income Taxes We file a consolidated U.S. federal income tax return for the Company and our 100% owned consolidated subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in the period of the enactment date of the change. The carrying value of our deferred tax assets is dependent upon our ability to generate sufficient taxable income in the future. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence is considered, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, the length of carryback and carryforward periods, and evaluation of potential tax planning strategies. We believe that certain positions may be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or a partial adjustment reached through negotiations or litigation. Our tax reserves reflect the difference between the tax benefit claimed on tax returns and the amount recognized in the financial statements. The accounting standards provide guidance for the recognition and measurement in financial statements of uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process, the first step being recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate resolution with a taxing authority. As the examination process progresses with tax authorities, adjustments to tax reserves may be necessary to reflect taxes payable upon settlement. Tax reserve adjustments related to positions impacting the effective tax rate affect the provision for income taxes. Tax reserve adjustments related to positions impacting the timing of deductions impact deferred tax assets and liabilities.

<s>[INST] Overview A summary of the significant financial highlights for 2019, which management uses to evaluate our operating performance and financial condition, is presented below. Net sales for 2019 totaled $1,981.5 million compared with $1,895.9 million for 2018. Net income for 2019 was $141.0 million, or $1.69 diluted EPS, compared with $137.3 million, or $1.75 diluted EPS for 2018. Adjusted Net Income (NonGAAP measure*) for 2019 was $130.1 million, or $1.56 Adjusted EPS (NonGAAP measure*), compared with $151.5 million, or $1.93 Adjusted EPS for 2018. Adjusted EBITDAP (NonGAAP measure*) for 2019 was $271.7 million compared with $304.9 million for 2018. Cash provided by operating activities in 2019 totaled $261.2 million compared with $252.7 million in 2018. Free cash flow (NonGAAP measure*) in 2019 totaled $218.3 million compared with $209.5 million in 2018. Total backlog as of December 31, 2019, was $5.4 billion compared with $4.1 billion as of December 31, 2018. _________ * We provide NonGAAP measures as a supplement to financial results presented in accordance with GAAP. A reconciliation of the NonGAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading "Use of NonGAAP Financial Measures." Our business outlook is affected by both increasing complexity in the global security environment and continuing worldwide economic pressures. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business. Some of the significant challenges we face are as follows: dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, successful implementation of our cost reduction plans, environmental matters, capital structure, underfunded retirement benefit plans, and information technology and cyber security. Major Customers The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, MDA, and the prime contractors that serve these agencies, exercise independent purchasing power within "budget topline" limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer. The following table summarizes net sales to the U.S. government and its agencies, including net sales to significant customers disclosed below: The following table summarizes net sales by principal end user in 2019: The following table summarizes the percentages of net sales for significant programs, all of which are included in the U.S. government sales and are comprised of multiple contracts: The following table summarizes customers that represented more than 10% of net sales, each of which involves sales of several product lines and programs: Industry Update Information concerning our industry appears in Part I, Item 1. Business under the caption "Industry Overview." Competitive Improvement Program During 2015, we initiated Phase I of our CIP comprised of activities and initiatives aimed at reducing costs in order for us to continue to compete successfully. Phase I was comprised of three major components: (i) facilities optimization and footprint reduction; (ii) product affordability; and (iii) reduced administrative and overhead costs. On April 6, 2017, the Board of Directors approved Phase II of our previously announced CIP [/INST] Positive. </s>

TEJON RANCH CO

2015-03-16

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See Part I, "Forward Looking Statements" for our cautionary statement regarding forward-looking information. Overview We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in four business segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; and farming. Our commercial/industrial real estate development segment generates revenues from building, grazing, and land lease activities, land and building sales, and ancillary land management activities. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active developments are TMV, Centennial, and the Grapevine Development Area, or Grapevine. During the first quarter of 2013 we began land planning activities and the first steps of gathering information to prepare an environmental impact report to entitle Grapevine, which is an approximately 15,315-acre potential development area located on the San Joaquin Valley floor area of our lands, adjacent to TRCC. We are currently focusing on approximately 8,010 acres within Grapevine for a mixed use development to include housing, retail, and commercial components. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. During 2014, we continued to expand our water operations to not only manage water infrastructure and water assets but to also sell water on an annual basis to third parties, as we did during the first quarter of 2014. We determined during the third quarter of 2014 that water assets and water management fit most appropriately with our other resource assets and activities and will now be included in the mineral resources segment. As a result of this, the Company has reclassified prior year amortization associated with the purchase of water contracts from corporate expenses into mineral resources expenses on the consolidated statements of operations to conform to the current year presentation. The prior year amortization reclassification was $815,000 and $708,000, respectively for 2013 and 2012. For 2014 we had net income attributable to common stockholders of $5,655,000 compared to net income attributable to common stockholders of $4,165,000 for 2013. This improvement is driven by an increase in revenue, primarily from mineral resources revenue, as a result of 2014 water sales and improved equity in earnings of unconsolidated joint ventures of $1,288,000. These increases in revenue were partially offset by an increase in operating expenses of $4,964,000 largely driven by $4,523,000 in water cost of sales. During 2014, farming revenue declined due to lower quantities of orchard crops being sold. Revenues improved slightly in the commercial/industrial segment due primarily to the sale of a convenience store/gas station site and higher development fees. Equity in earnings of unconsolidated joint ventures improved primarily due to the earnings growth within the TA/Petro and Rockefeller joint ventures. For 2013 we had net income attributable to common stockholders of $4,165,000 compared to net income attributable to common stockholders of $4,441,000 for 2012. This decline was driven by a reduction in revenue, primarily from mineral resources revenue, which was partially offset by improved equity in earnings of unconsolidated joint ventures of $1,471,000 and a reduction in income taxes. During 2013, farming had another excellent revenue year and revenues improved in the commercial/industrial segment due to higher hunting permit revenues. Equity in earnings of unconsolidated joint ventures improved primarily due to the earnings growth within the TA/Petro joint venture. During 2015, we will continue to invest funds toward the achievement of entitlements for our land and for master project infrastructure and vertical development within our active commercial and industrial developments. Securing entitlements for our land is a long, arduous process that can take several years and often involves litigation. During the next few years, our net income will fluctuate from year-to-year based upon commodity prices, production within our farming segment, and the timing of sales of land and the leasing of land within our industrial developments. This Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a narrative discussion of our results of operations. It contains the results of operations for each operating segment of the business and is followed by a discussion of our financial position. It is useful to read the business segment information in conjunction with Note 16, Business Segment of the Notes to Consolidated Financial Statements. Critical Accounting Policies The preparation of our consolidated financial statements in accordance with generally accepted accounting principles, or “GAAP,” requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimates that are likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, impairment of long-lived assets, capitalization of costs, profit recognition related to land sales, stock compensation, our future ability to utilize deferred tax assets, and defined benefit retirement plans. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact on our financial statements. See also Note 1, Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements, which discusses accounting policies that we have selected from acceptable alternatives. We believe the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements: Revenue Recognition - The Company’s revenue is primarily derived from lease revenue from our rental portfolio, royalty revenue from mineral leases, sales of farm crops, sales of water, and land sales. Revenue from leases with rent concessions or fixed escalations is recognized on a straight-line basis over the initial term of the related lease unless there is a considerable risk as to collectibility. The financial terms of leases are contractually defined. Lease revenue is not accrued when a tenant vacates the premises and ceases to make rent payments or files for bankruptcy. Royalty revenues are contractually defined as to the percentage of royalty and are tied to production and market prices. Our royalty arrangements generally require payment on a monthly basis with the payment based on the previous month’s activity. We accrue monthly royalty revenues based upon estimates and adjust to actual as we receive payments. From time to time the Company sells easements over its land. The easements are either in the form of rights of access granted for such things as utility corridors or are in the form of conservation easements that generally require the Company to divest its rights to commercially develop a portion of its land, but do not result in a change in ownership of the land or restrict the Company from continuing other revenue generating activities on the land. Sales of conservation easements are accounted for in accordance with Staff Accounting Bulletin Topic 13 - Revenue Recognition, or SAB Topic 13. Since conservation easements generally do not impose any significant continuing performance obligations on the Company, revenue from conservation easement sales have been recognized when the four criteria outlined in SAB Topic 13 have been met, which generally occurs in the period the sale has closed and consideration has been received. In recognizing revenue from land sales, the Company follows the provisions in Accounting Standards Codification 976, or ASC 976, “Real Estate - Retail Land” to record these sales. ASC 976 provides specific sales recognition criteria to determine when land sales revenue can be recorded. For example, ASC 976 requires a land sale to be consummated with a sufficient down payment of at least 20% to 25% of the sales price depending upon the type and timeframe for development of the property sold, and that any receivable from the sale cannot be subject to future subordination. In addition, the seller cannot retain any material continuing involvement in the property sold or be required to develop the property in the future. At the time farm crops are harvested, contracted, and delivered to buyers and revenues can be estimated, revenues are recognized and any related inventoried costs are expensed, which traditionally occurs during the third and fourth quarters of each year. It is not unusual for portions of our almond or pistachio crop to be sold in the year following the harvest. Orchard (almond and pistachio) revenues are based upon the contract settlement price or estimated selling price, whereas vineyard revenues are typically recognized at the contracted selling price. Estimated prices for orchard crops are based upon the quoted estimate of what the final market price will be by marketers and handlers of the orchard crops. These market price estimates are updated through the crop payment cycle as new information is received as to the final settlement price for the crop sold. These estimates are adjusted to actual upon receipt of final payment for the crop. This method of recognizing revenues on the sale of orchard crops is a standard practice within the agribusiness community. Actual final crop selling prices are not determined for several months following the close of our fiscal year due to supply and demand fluctuations within the orchard crop markets. Adjustments for differences between original estimates and actual revenues received are recorded during the period in which such amounts become known. Capitalization of Costs - The Company capitalizes direct construction and development costs, including predevelopment costs, interest, property taxes, insurance, and indirect project costs that are clearly associated with the acquisition, development, or construction of a project. Costs currently capitalized that in the future would be related to any abandoned development opportunities will be written off if we determine such costs do not provide any future benefits. Should development activity decrease, a portion of interest, property taxes, and insurance costs would no longer be eligible for capitalization, and would be expensed as incurred. Allocation of Costs Related to Land Sales and Leases - When we sell or lease land within one of our real estate developments and we have not completed all infrastructure development related to the total project, we follow ASC 976 to determine the appropriate costs of sales for the sold land and the timing of recognition of the sale. In the calculation of cost of sales or allocations to leased land, we use estimates and forecasts to determine total costs at completion of the development project. These estimates of final development costs can change as conditions in the market and costs of construction change. In preparing these estimates, we use internal budgets, forecasts, and engineering reports to help us estimate future costs related to infrastructure that has not been completed. These estimates become more accurate as the development proceeds forward, due to historical cost numbers and to the continued refinement of the development plan. These estimates are updated periodically throughout the year so that, at the ultimate completion of development, all costs have been allocated. Any increases to our estimates in future years will negatively impact net profits and liquidity due to an increased need for funds to complete development. If, however, this estimate decreases, net profits as well as liquidity will improve. We believe that the estimates used related to cost of sales and allocations to leased land are critical accounting estimates and will become even more significant as we continue to move forward as a real estate development company. The estimates used are very susceptible to change from period to period, due to the fact that they require management to make assumptions about costs of construction, absorption of product, and timing of project completion, and changes to these estimates could have a material impact on the recognition of profits from the sale of land within our developments. Impairment of Long-Lived Assets - We evaluate our property and equipment and development projects for impairment when events or changes in circumstances indicate that the carrying value of assets contained in our financial statements may not be recoverable. The impairment calculation compares the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows (discounted). We recognize an impairment loss equal to the amount by which the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited. We currently operate in four segments, commercial/industrial real estate development, resort/residential real estate development, mineral resources, and farming. At this time, there are no assets within any of our segments that we believe are in danger of being impaired due to market conditions. We believe that the accounting estimate related to asset impairment is a critical accounting estimate because it is very susceptible to change from period to period; it requires management to make assumptions about future prices, production, and costs, and the potential impact of a loss from impairment could be material to our earnings. Management’s assumptions regarding future cash flows from real estate developments and farming operations have fluctuated in the past due to changes in prices, absorption, production and costs and are expected to continue to do so in the future as market conditions change. In estimating future prices, absorption, production, and costs, we use our internal forecasts and business plans. We develop our forecasts based on recent sales data, historical absorption and production data, input from marketing consultants, as well as discussions with commercial real estate brokers and potential purchasers of our farming products. If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed to impairment losses that could be material to our results of operations. Defined Benefit Retirement Plans - The plan obligations and related assets of our defined benefit retirement plan are presented in Note 15 Retirement Plans of the Notes to Consolidated Financial Statements. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using level one and level two indicators, which are quoted prices in active markets and quoted prices for similar types of assets in active markets for the investments. Pension benefit obligations and the related effects on operations are calculated using actuarial models. The estimation of our pension obligations, costs and liabilities requires that we make use of estimates of present value of the projected future payments to all participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. These assumptions may have an effect on the amount and timing of future contributions. The assumptions used in developing the required estimates include the following key factors: • Discount rates; • Salary growth; • Retirement rates; • Expected contributions; • Inflation; • Expected return on plan assets; and • Mortality rates The discount rate enables us to state expected future cash flows at a present value on the measurement date. In determining the discount rate, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments. Salary increase assumptions are based upon historical experience and anticipated future management actions. To determine the expected long-term rate of return on pension plan assets, we consider the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. At December 31, 2014, the weighted-average actuarial assumption of the Company’s defined benefit plan consisted of a discount rate of 4.3%, a long-term rate of return on plan assets of 7.5%, and assumed salary increases of 3.5%. The effects of actual results differing from our assumptions and the effects of changing assumptions are recognized as a component of other comprehensive income, net of tax. Amounts recognized in accumulated other comprehensive income are adjusted as they are subsequently recognized as components of net periodic benefit cost. If we were to assume a 50 basis point change in the discount rate used, our projected benefit obligation would change approximately $800,000. Stock-Based Compensation - We apply the recognition and measurement principles of ASC 718, “Compensation - Stock Compensation” in accounting for long-term stock-based incentive plans. Our stock-based compensation plans include both restricted stock units and restricted stock grants. We have not issued any stock options to employees or directors since January 2003, and our 2014 financial statements do not reflect any compensation expenses for stock options. All stock options issued in the past have been exercised or forfeited. We make stock awards to employees based upon time-based criteria and through the achievement of performance-related objectives. Performance-related objectives are either stratified into threshold, target, and maximum goals or based on the achievement of a milestone event. These stock awards are currently being expensed over the expected vesting period based on each performance criterion. We make estimates as to the number of shares that will actually be granted based upon estimated ranges of success in meeting the defined performance measures. If our estimates of performance shares vesting were to change by 25%, stock compensation expense would increase or decrease by approximately $200,000 depending on whether the change in estimate increased or decreased shares vesting. See Note 11, Stock Compensation - Restricted Stock and Performance Share Grants, of the Notes to Consolidated Financial Statement for total 2014 stock compensation expense related to stock grants. Fair Value Measurements - The Financial Accounting Standards Board's (FASB) authoritative guidance for fair value measurements of certain financial instruments defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Fair value is defined as the exchange (exit) price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance establishes a three-level hierarchy for fair value measurements based upon the inputs to the valuation of an asset or liability. Observable inputs are those which can be easily seen by market participants while unobservable inputs are generally developed internally, utilizing management’s estimates and assumptions: • Level 1 - Valuation is based on quoted prices in active markets for identical assets and liabilities. • Level 2 - Valuation is determined from quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market. • Level 3 - Valuation is derived from model-based techniques in which at least one significant input is unobservable and based on our own estimates about the assumptions that market participants would use to value the asset or liability. When available, we use quoted market prices in active markets to determine fair value. We consider the principal market and nonperformance risk associated with our counterparties when determining the fair value measurement. Fair value measurements are used for marketable securities, investments within the pension plan and hedging instruments. Recent Accounting Pronouncements For discussion of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements. Results of Operations by Segment We evaluate the performance of our operating segments separately to monitor the different factors affecting financial results. Each segment is subject to review and evaluation as we monitor current market conditions, market opportunities, and available resources. The performance of each segment is discussed below: Real Estate - Commercial/Industrial During 2014, our commercial/industrial segment losses were relatively flat when compared to 2013. Commercial/industrial segment revenues increased $231,000, or 2% during 2014 compared to 2013 primarily due to a land sale to our TA/Petro unconsolidated joint venture partner of which $458,000 was recognized during 2014 with the remaining $687,000 deferred until the time we exit the joint venture or the joint venture is terminated. The increase in commercial/industrial segment revenues was also attributed to an increase of $587,000 in development fees mainly related to the construction of the Outlets at Tejon. This increase was partially offset by a $788,000 reduction in Calpine power plant percentage rent resulting from lower 2014 prices and to a one-time credit of $467,000 that is the result of an amendment to the lease executed in the second quarter of 2014 and retroactive to January 2013. The amendment is related to percentage rent paid by Calpine on the collection of greenhouse gas assessment taxes that are now included in the energy revenue component of the percentage rent. The percentage rent calculation has been modified to exclude these taxes that are collected by Calpine and passed on to the State of California. The retroactive amendment resulted in a credit of $467,000 that will be applied over time to future earned percentage rent. At December 31, 2014, the outstanding amount of the credit was $68,000. Our expectations are that percentage rent from this lease will continue to range between $400,000 and $600,000 as it has traditionally done. The decrease in commercial/industrial segment revenues was also attributed to a decrease of $151,000 in cattle grazing range leases and other ancillary commercial revenues. Commercial/industrial real estate segment expenses were $13,204,000 during 2014, an increase of $302,000 or 2% compared to the same period in 2013, primarily due to a $587,000 increase in general and administrative allocations in line with higher corporate expenses, a $147,000 decrease in costs capitalized to construction in progress as a result of increased activity within our joint ventures, such as the Tejon/Rock Outlet Center LLC, and $161,000 higher employee compensation including stock compensation expense and bonus incentives associated with growth in this segment. These increases were partially offset by a $447,000 decrease in assessments from Tejon-Castac Water District, a $93,000 decrease in depreciation, a decline in professional service fees, and a $129,000 decrease in marketing expense, as our marketing efforts have been directed to the Outlets at Tejon, where costs are shared with our joint venture partner. During 2013, our commercial/industrial segment profits improved $576,000 compared to 2012. Commercial/industrial segment revenues increased $1,207,000 during 2013 compared to 2012 primarily due to a $1,036,000 increase in hunting revenues. The hunting program re-opened in September 2012 after an eight month closure. Additionally, percentage rent from our Calpine power plant increased $551,000. Percentage rent is based on a spark spread arrangement that is tied to the price of electricity and natural gas. These increases were partially offset by a $648,000 decrease in land sale revenue recognized in the first half of 2012 related to the deferred gain from the land sale to Caterpillar that occurred in December of 2011. We will continue to focus our efforts for TRCC-East and TRCC-West on the labor and logistical benefits of our site and success that current tenants and owners within our development have experienced to capture more of the warehouse distribution market. Our strategy fits within the logistics model that many companies are using, which favors larger single-site buildings rather than a number of decentralized smaller distribution centers. The world class logistics operators located within TRCC have demonstrated success in serving all of California and the western United States through utilization of large centralized distribution centers which have been strategically located to maximize outbound efficiencies. We believe that our ability to provide fully entitled shovel-ready land parcels to support buildings of 1.0 million square feet or larger can provide us with a potential marketing advantage in the future. We are also increasing our marketing efforts to industrial users in the Santa Clarita Valley of northern Los Angeles County and the northern part of the San Fernando Valley due to the limited availability of new product and the high real estate costs in these locations. Tenants in these geographic areas are typically users of smaller square footage products. A potential disadvantage to our development strategy is our distance from the ports of Los Angeles and Long Beach in comparison to the warehouse/distribution centers located in the Inland Empire, a large industrial area located east of Los Angeles which continues its expansion eastward beyond Riverside and San Bernardino to include Perris, Moreno Valley, and Beaumont. Strong demand for large distribution facilities is driving development farther east in a search for large entitled parcels. During 2015, vacancy rates in the Inland Empire were comparable to 2014, primarily due to an increase in the development of buildings for lease. Without this increase in new development the vacancy rate would have declined. The low vacancy rates have also led to an improvement in lease rates within the Inland Empire. As lease rates increase in the Inland Empire, we may begin to have greater pricing advantages due to our lower land basis. We expect the commercial/industrial segment to continue to experience costs, net of amounts capitalized, primarily related to professional service fees, marketing costs, commissions, planning costs, and staffing costs as we continue to pursue development opportunities. These costs are expected to remain consistent with current levels of expense with any variability in the future tied to specific absorption transactions in any given year. The actual timing and completion of development is difficult to predict due to the uncertainties of the market. Infrastructure development and marketing activities and costs could continue over several years as we develop our land holdings. We will also continue to evaluate land resources to determine the highest and best uses for our land holdings. Future sales of land are dependent on market circumstances and specific opportunities. Our goal in the future is to increase land value and create future revenue growth through planning and development of commercial and industrial properties. Real Estate - Resort/Residential The resort/residential segment reported revenues decreased $155,000, or 46%, to $183,000 during 2014 compared to $338,000 during 2013 primarily due to a $132,000 decrease in management fees from the TMV project, as a result of our purchase of full ownership of the TMV joint venture. Resort/residential segment expenses increased $377,000 primarily due to a $460,000 increase in compensation expense. The increase in compensation expense is primarily due to the reversal of previously recorded stock compensation expense in 2013 related to the forfeiture unvested awards of an executive who left the Company and a change in estimate in 2012 of a performance condition tied to the TMV and Centennial projects. The resort/residential segment reported revenues increased to $338,000 during 2013 from no revenues during 2012 primarily due to a $312,000 increase in management fees from the TMV project. Resort/residential segment expenses decreased $1,466,000 primarily due to a $1,425,000 decrease in compensation expense. The decrease in compensation expense is primarily due to the reversal of previously recorded stock compensation expense related to the forfeiture unvested awards of an executive who left the Company and a change in estimate in 2012 of a performance condition tied to the TMV and Centennial projects. These changes in activity between 2013 and 2012 resulted in a segment loss of $1,893,000 for 2013, an improvement of $1,804,000 from the segment loss reported in 2012. Our resort/residential segment activities include land planning and entitlement activities related to our potential residential developments, which include the Centennial master-planned community, the Grapevine Development Area and TMV. Centennial is being developed through a joint venture in which we have 74.05% of the ownership and is consolidated in our financial statements. We expect near-term activities within this segment to be focused on preparation and submission of a specific plan for phase one development for the Centennial project, pre-development activity at TMV to include Board of Directors approval of a development business plan, and the entitlement process within the Grapevine Development Area. The resort/residential segment will continue to incur costs in the future related to professional service fees, public relations costs, and staffing costs as we continue forward with entitlement and permitting activities for the above communities and continue to meet our obligations under the Conservation Agreement. We expect these expenses to remain consistent with current years cost in the near term and only begin to increase as we move forward with development. The actual timing and completion of entitlement-related activities and the beginning of development is difficult to predict due to the uncertainties of the approval process, the possibility of litigation upon approval of our entitlements in the future, and the status of the economy. We will also continue to evaluate land resources to determine the highest and best use for our land holdings. Our long-term goal through this process is to increase the value of our land and create future revenue opportunities through resort and residential development. Since we are in the process of achieving entitlements for the Centennial and the Grapevine communities, we do not have a fully approved project and therefore we do not have inventory for sale in the current market for these communities. For TMV, we have a fully permitted and entitled project and, we are in the process of finalizing market research, land plans and engineering studies in preparation for development in the future as the economy improves and the second home market improves. We are continuously monitoring the markets in order to identify the appropriate time in the future to begin infrastructure improvements and lot sales. Our long-term business plan of developing the communities of TMV, Centennial, and Grapevine remains unchanged. As the economy improves we believe the perception of land values will also begin to improve and the long-term fundamentals that support housing demand in our region, primarily California population growth and household formation will also improve. See Item 1, “Business - Real Estate Operations” for a further discussion of real estate development activities. Mineral Resources Revenues from our mineral resources segment increased $6,013,000, or 59%, to $16,255,000 during 2014 compared to 2013. As noted earlier, management determined that our water resources will be managed within the mineral resources segment. Prior year water resource activity has been reclassified to this segment for comparability purposes. See Note 1 (Summary of Significant Account Policies Reclassifications) of the Notes to Consolidated Financial Statements for further detail regarding these reclassifications. The $6,013,000 increase is primarily due to the sale of 6,250 acre-feet of water totaling $7,702,000. During the first quarter of 2014, we determined we had excess water supply for our 2014 needs, and in the first half of 2014 we sold 6,250 acre-feet of the 6,693 acre-feet of 2014 water we purchased. Additionally, cement and rock and aggregate royalties increased $476,000 due to expanded production driven by improved construction activity in the region led by new road construction. These increases were partially offset by a $1,606,000 decrease in oil royalty revenues resulting from a 7% drop in production due to lower production from older wells, the timing of new wells coming on-line during the year and the timing of completion of the expansion of lessees' production facilities. The average price per barrel of oil decreased approximately 10% when compared to the same period of 2013 to approximately $90 per barrel, however by the end of the fourth quarter of 2014 prices had fallen to approximately $50 per barrel of oil. This will negatively impact our revenues in future months. Leasehold and related fee payments also decreased $586,000 due to a tenant entering the drilling phase of their lease. Please refer to Item 1 - Business - Mineral Resources for a discussion of oil and gas activities and the status of the Sojitz lease. Mineral resources expenses increased $5,141,000 primarily due to the sale of 6,250 acre feet of water with a respective cost of sales of $4,523,000 and an increase of $535,000 in water cost amortization associated with the Nickel water purchase in late 2013. Revenues from our mineral resources segment decreased $3,770,000, or 27%, to $10,242,000 during 2013 compared to 2012, primarily due to a $3,401,000 decrease in oil royalty revenues. The decline in oil royalty revenues is because of a decrease in production of 31% resulting from temporary closures of existing wells for maintenance, expansion of lessees' production facilities, and regulatory permitting management, which reduced the number of new wells being drilled. In addition, the price per barrel of oil decreased by 3% when compared to the 2012. Leasehold payments also declined during the year. These unfavorable oil royalty and lease payments were partially offset by $105,000 of improvements in rock and aggregate royalties and in production at the National Cement lease. These improvements were driven by improved construction activity in our region. Oil and gas production numbers and average pricing for the last three-years is as follows: Please refer to Item 1, "Business - Mineral Resources" for additional information regarding oil barrels per day production. As oil prices declined during the fourth quarter of 2014, and continued to decline during the first two months of 2015, we saw a pullback in the start of new drilling activity from our largest tenant, California Resources Corporation, or CRC. CRC has approved permits and drill sites on our land and has delayed the start of drilling as it evaluates the market. A positive aspect of our lease with CRC is that the approved drill sites are in an area of the ranch where the development and production costs are moderate due to the depths being drilled. We will continue to see a decline in year-over-year royalty revenue in 2015 due to the over 50% decline in prices for oil from our leases. There continues to be interest from tenants to enhance their oil production activities over time on our land. As the market allows, we anticipate new activity on our land. The timing of this activity and the respective speed of occurrence we cannot predict at this time. Since we only receive royalties based on tenant production and market prices and do not produce oil, we do not have information as to the potential size of oil reserves. Our royalty revenues are contractually defined and based on a percentage of production and are received in cash. Royalty revenues fluctuate based on changes in market price for oil, gas, rock and aggregate, and Portland cement. In addition, royalty revenue is impacted by new production, the inevitable decline in production in existing wells and rock and limestone quarries, and the cost of development and production. Farming During 2014, farming revenues decreased $175,000 compared to 2013. The decline in farming revenue was primarily driven by lower almond revenues. With the 2014 crop harvest complete, production figures reflected a decrease in production within our orchard crops resulting from various weather conditions such as a mild winter that reduced the tree and vine dormant time and early hot summer weather. As a result, almond revenue decreased $821,000 compared to the same period in 2013, which was driven by a 27% decrease in almond pounds sold. This decrease in almond pounds sold was partially offset by a 27% increase in average price for the sale of our prior year almond crop inventory as well as sales for our current 2014 crop. Pistachio revenues were fairly flat for the year due primarily to pricing, which increased approximately 19% offsetting a 16% decrease in pounds sold. Wine grape revenues decreased $116,000 as a result of an average price per ton decrease of 14% during 2014. This decrease in average price per ton for wine grapes was partially offset by an increase of 9% in tons sold. Pricing for our orchard crops improved throughout 2014 due to strong worldwide demand for product and lower inventory levels. The decreases in wine grape and almond revenue were partially offset by an increase of $433,000 in hay sales due to improved pricing. During the fourth quarter of 2014, the Company determined hay crop sales previously recorded in the resort/residential revenues segment related to farming activities within Centennial, fit most appropriately with our farming revenues segment. As a result, the Company has reclassified prior period hay crop sales into farming revenue on the consolidated statements of operations to conform to the current year presentation. The amounts reclassified for the twelve months ended December 31, 2014, December 31, 2013, and December 31, 2012 were $1,361,000, $928,000, and $583,000, respectively. Farming expenses increased $324,000, or 2% during 2014 compared to 2013, primarily due to a $1,032,000 increase in fixed water costs when compared to the prior year, resulting from adjustments received in the third quarter of 2013 from WRMWSD for prior year reconciliations for which we received a cash refund of approximately $1,100,000 during the fourth quarter of 2013. Farming expenses also increased by $270,000 during 2014 when compared to 2013 as a result of general increases in operating expenses related to power costs and repair costs. This increase was partially offset by decreases in cost of sales of $426,000, $126,000 and $313,000 for almonds, wine grapes and pistachios, respectively. During 2013, farming revenues increased $474,000 compared to 2012. Farming revenue activities consisted of higher almond revenues, an increase in other farming revenue, lower pistachio revenues, and lower grape revenues. This improvement in almond revenue compared to the same period in 2012 is driven by a 45% increase in average price for the sale of our prior year almond crop inventory as well as sales for our current 2013 crop. This increase in pricing was slightly offset by a 17% decrease in almond pounds sold. Hay crop sales also experienced an increase of $345,000 when compared to 2012 due to rising prices. During the summer, high winds damaged all of our crops at varying degrees resulting in lower production levels for all crops. Pistachio revenues decreased $1,107,000 resulting from a 26% decrease in pounds sold, as a result of this being a down production cycle year coupled with the wind damage. Average price per pound of pistachios increased 9%. Wine grape revenues decreased $1,042,000 resulting from a 22% decrease in tons sold, as a result of a 25% reduction of the French Columbard variety due removal of old vines, coupled with the wind damage. The price per ton of wine grapes increased 3% during 2013. Farming expenses increased $1,539,000, or 11% during 2013 compared to 2012, primarily due to increases in cost of sales of $847,000, $349,000 and $129,000 for almonds, wine grapes and pistachios, respectively. The increases were due to cost of sales of 2012 almond carry-over inventory sold in 2013, higher variable water costs due to drought conditions and cost to repair damage caused by the high winds. The following table reflects crop revenues in thousands for the last three years by variety of product and crop year. Quantity of almonds and pistachios are stated in thousands of pounds and quantity of wine grapes is stated in thousands of tons. Average prices are stated on a per pound basis for almonds, and pistachios, and average prices are stated on a per ton basis for wine grapes. Thus far in 2015, the price for our crops has remained consistent with 2014 pricing due to the level of industry inventories and stable demand in U.S. and world markets. All of our crops are sensitive to the size of each year’s world crop. Large crops in California and abroad can depress prices. Our long-term projection is that crop production, especially of almonds and pistachios will continue to increase on a statewide basis over time because of new plantings, which could negatively impact future prices if the growth in demand does not keep pace with production. While demand for product continues to be strong and growing, the increase in the relative strength of the U.S. dollar along with slow global economic growth, primarily in Europe, could have a negative impact on the markets. As we move into the 2015 crop year we have had a relatively mild winter thus far, which could possibly impact our almond and pistachio production due to a low level of dormant hours. Dormant hours allow the trees to rest, which enhances the growth of the tree and production. It is too early to project 2015 crop yields and what impact that may have on prices later in 2015. Water delivery and water availability continues to be a long-term concern within California. Any limitation of delivery of SWP water and the absence of available alternatives during drought periods could potentially cause permanent damage to orchards and vineyards throughout California. While this could impact us, we believe we have sufficient water resources available to meet our requirements in 2015. Please see our discussion on water in Item 2, "Properties - Water Operations." The DWR announced its early 2015 estimated water supply delivery at 20% of full entitlement. We expect 2015 to be a difficult water year due to the continuing drought in California. The current 20% allocation of SWP water is not enough for us to farm our crops, but our additional water resources, such as groundwater and surface sources, and those of the water districts we are in should allow us to have sufficient water for our farming needs. It is too early in the year to determine the impact of low water supplies and the drought on 2015 California crop production for almonds, pistachios, and wine grapes, but it could be detrimental. See Note 6, Long Term Water Assets, of the Notes to our Consolidated Financial Statements for additional information regarding our water assets. For further discussion of the farming operations, refer to Item I “Business-Farming Operations.” Investment Income Investment income declined $245,000, or 26%, during 2014 when compared to 2013. Investment income also declined $301,000, or 24% during 2013 when compared to 2012. The decline in both periods is primarily attributable to lower average investment balances and a decline in overall yield on the portfolio as higher yielding securities matured through the year. The above interest income relates to our marketable securities portfolio as further disclosed in Note 3, Marketable Securities of the Notes to Consolidated Financial Statements. Corporate Expenses Corporate general and administrative costs decreased $1,180,000, or 10%, during 2014 compared 2013. The decrease in costs is driven by $528,000 in lower professional service fees due to costs in 2013 related to the hiring of a new CEO, the warrant dividend program, IT professional services and a $1,014,000 increase in cost allocations to our business operating segments. We also saw a decrease in donations of $198,000 during 2014. These improvements were partially offset by an increase in staffing costs of $1,293,000 when compared to 2013 staffing costs. This increase is tied to the reversal of stock compensation expense in 2013 tied to performance grants that would not vest upon the prior Chief Executive Officer’s retirement in December 2013. Corporate general and administrative costs decreased $738,000, or 6%, during 2013 compared to the same period in 2012, primarily due to a $1,544,000 decrease in total compensation, mainly stock compensation, due to the reversal of expense associated with grants that did not vest upon the Chief Executive Officer's retirement in December 2013, coupled with a change in estimate in the second quarter of 2012 of a performance condition tied to the TMV project. In addition, there was a $913,000 increase in cost allocations to our business operating segments. These decreases were partially offset by a $1,139,000 increase in professional services primarily related to general business consulting, costs related to hiring a new CEO, the warrant dividend program, and consulting services in preparation for increased business activity from the outlet center. Other expenses that increased are stock compensation to the board of directors, higher licensing fees for IT software and an increase in charitable donations. Equity in Earnings of Unconsolidated Joint Ventures Equity in earnings of unconsolidated joint ventures is an important and growing component of our commercial/industrial activities and in the future, equity in earnings of unconsolidated joint ventures will become a significant part of our operational activity within the resort/residential segment. As we expand our current ventures and add new joint ventures, these investments will become a growing revenue source for the Company. Internally, we manage and evaluate our commercial/industrial and resort/residential segments by including the appropriate equity in earnings from joint ventures to each segment. We do this because it provides us with an overall view of the operations and profitability of our real estate activities. As an example, with equity in earnings of joint ventures included in our commercial/industrial segment our commercial/industrial activities produced operating profits of $3,504,000 in 2014 compared to $2,311,000 in 2013. Refer to Note 16 Business Segments, and Note 17 Investment in Unconsolidated and Consolidated Joint Ventures, of the Notes to Consolidated Financial Statements for additional detail regarding our current joint ventures. During 2014, equity in earnings of unconsolidated joint ventures grew to $5,294,000, or an increase of $1,288,000, compared to 2013 primarily due to $1,012,000 of higher income from our TA/Petro joint venture mainly due to increasing gasoline sales, higher net margins from diesel and gasoline sales and lower interest expense as a result of reduced interest rates. Equity in earnings of unconsolidated joint ventures also improved due to an increase in the minimum rent and tenant reimbursements along with a decline in interest expense due to lower interest rates within the Five West Parcel joint venture. Income Taxes For the twelve months ended December 31, 2014, the Company incurred a net income tax expense of $2,697,000 compared to a net income tax expense of $2,086,000 for the twelve months ended December 31, 2013. These represent effective income tax rates of approximately 32% and 31% for the twelve months ended December 31, 2014 and, 2013, respectively. The effective tax rate is impacted by the noncontrolling interest held in the Centennial joint venture and the impact of depletion allowances. During 2014, permanent tax differences declined due to lower depletion allowances. Depletion allowances declined due to a reduction in oil and gas revenues. As of December 31, 2014 we had an income tax payable of $1,703,000 and on December 31, 2013, we had no tax payable. As of December 31, 2014, we had net deferred tax assets of $4,576,000. Our largest deferred tax assets were made up of temporary differences related to the capitalization of costs, pension adjustments, and stock grant expense. Deferred tax liabilities consist of depreciation, deferred gains, cost of sale allocations, and straight-line rent. Due to the nature of most of our deferred tax assets, we believe they will be used in future years and an allowance is not necessary. The Company classifies interest and penalties incurred on tax payments as income tax expenses. The Company made total income tax payments of $1,100,000 in 2014 and $15,000 during 2013. The Company received federal refunds of $3,484,000 in 2014 and zero in 2013. Liquidity and Capital Resources Cash Flow and Liquidity. Our financial position allows us to pursue our strategies of land entitlement, development, and conservation. Accordingly, we have established well-defined priorities for our available cash, including investing in core business segments to achieve profitable future growth. We have historically funded our operations with cash flows from operating activities, cash and investments, and short-term borrowings from our bank credit facilities. In the past, we have also issued common stock and used the proceeds for capital investment activities. In 2014, our use of debt to raise capital increased significantly. To enhance shareholder value, we will continue to make investments in our real estate segments to secure land entitlement approvals, build infrastructure for our developments, ensure adequate future water supplies, and provide funds for general land development activities. Within our farming segment, we will make investments as needed to improve efficiency and add capacity to its operations when it is profitable to do so. Our cash, cash equivalents and marketable securities totaled approximately $47,778,000 at December 31, 2014, a decrease of $16,689,000, or 26%, from the corresponding amount at the end of 2013. Cash, cash equivalents and marketable securities decreased during 2014 due to property and equipment expenditures that included infrastructure development and land entitlement costs, investment in joint ventures, and the purchase of our former joint venture partner's membership interest in TMV. These investments were partially offset by an increase in long-term and short-term debt. The following table summarizes the cash flow activities for the last three years: During 2014, our operations provided $13,218,000 of cash primarily attributable to operating results mainly from farming revenues, mineral resources revenues, investment income, a decline in other current assets related to income tax receivables and add back of non-cash expenses. During 2013, our operations provided $9,536,000 of cash primarily attributable to operating results mainly from farming revenues, mineral resources revenues, investment income, and add back of non-cash expenses. Supplementing operations was a reduction in receivables and inventory, both of which are tied to farming activities. During 2014, investing activities used $92,592,000 of cash primarily as a result of the purchase of DMB TMV LLC's interest in TMV for $70,000,000, $24,775,000 in capital expenditures and $9,656,000 of investment in our unconsolidated joint ventures. The investment in unconsolidated joint ventures consisted of an $8,500,000 contribution to the TRCC/Rock Outlet Center LLC joint venture and $1,112,000 to TMV prior to the membership interest buyout. These expenditures were partially offset by net proceeds of $12,319,000 from marketable securities. Included in the $24,775,000 of capital expenditures during 2014 was $1,128,000 related to TMV, $2,437,000 related to Centennial Founders LLC, and $6,352.000 related to Grapevine. The remaining capital expenditures consisted of $14,625,000 of investments in TRCC infrastructure related to roads, utilities, and water infrastructure to support new development and capital investment in farming equipment replacements and crop development. During 2013, investing activities used $7,611,000 of cash primarily as a result of the $21,558,000 in capital expenditures, $9,635,000 in water investments and $3,415,000 net investment in our unconsolidated joint ventures of which $3,400,000 was contributed to TMV. These expenditures were partially offset by net proceeds of $8,387,000 from marketable securities, a $17,809,000 reimbursement for public infrastructure costs through the East CFD and $512,000 in reimbursements for outlet center costs incurred prior to the formation of the joint venture. Included in the $21,558,000 of capital expenditures during 2013 was $2,619,000 related to Centennial Founders LLC. The remaining capital expenditures consisted of $18,939,000 of investments in TRCC infrastructure, primarily associated with the development of the outlet center on land at TRCC-East and ordinary capital expenditures such as farm equipment replacements and crop development. Our estimated capital investment for 2015 is primarily related to our real estate projects as it was in 2014. These estimated investments include approximately $9,800,000 of infrastructure development at TRCC-East and West to support continued commercial retail and industrial development and to expand water facilities to support future anticipated absorption. We are also investing approximately $1,800,000 to complete development of a new grape vineyard and begin development of a new almond orchard. The farm investments are part of a long-term farm management program to redevelop declining orchards and vineyards to maintain and improve future farm revenues. We expect to possibly invest up to $17,000,000 for land planning, entitlement activities, and development activities at TMV, Centennial, and Grapevine during 2015. The timing of these investments is dependent on our coordination efforts with Kern County and Los Angeles County regarding entitlement efforts for Grapevine and Centennial. Our plans also call for the potential investment of up to $4,800,000 in water infrastructure to include the drilling of water wells and as opportunities arise to help secure additional water assets for real estate, farming, and as an investment. We are also planning to potentially invest up to $2,500,000 in the normal replacement of operating equipment, such as farm and ranch equipment, and updates to our information technology systems. During 2014, financing activities provided $75,981,000 in cash. This growth in financing activities is largely tied to the increase in long-term debt of $70,000,000, a ten-year term loan, which is funding the purchase of DMB TMV LLC’s membership interest in TMV. We also saw a net increase in the use of our line-of-credit to fund infrastructure development as we were waiting on the timing of reimbursement from the East CFD. During January 2015, we received a reimbursement for public infrastructure from the East CFD of $4,971,000. During 2013, financing activities used $113,000 in cash. This use of cash was tied to the buyback of stock at time of the vesting of stock grants for the payment of payroll taxes. This cash usage was offset by a $4,750,000 increase in long-term debt during 2013 and the exercise of stock options. At December 31, 2013, there was no outstanding balance on our line of credit. It is difficult to accurately predict cash flows due to the nature of our businesses and fluctuating economic conditions. Our earnings and cash flows will be affected from period to period by the commodity nature of our farming operations, the timing of sales and leases of property within our development projects, and the beginning of development within our residential projects. The timing of sales and leases within our development projects is difficult to predict due to the time necessary to complete the development process and negotiate sales or lease contracts. Often, the timing aspect of land development can lead to particular years or periods having more or less earnings than comparable periods. Based on our experience, we believe we will have adequate cash flows and cash balances over the next twelve months to fund internal operations. Capital Structure and Financial Condition. At December 31, 2014, total capitalization at book value was $398,792,000 consisting of $74,459,000 of debt and $324,333,000 of equity, resulting in a debt-to-total-capitalization ratio of approximately 18.7%, which is a significant increase when compared to the debt-to-total-capitalization ratio of 1.45% at December 31, 2013. The increase in the use of debt in 2014 is primarily tied to the purchase of our former partner's membership interest in TMV LLC and is not indicative of a trend to materially increase the use of long-term debt. On October 13, 2014, the Company as borrower, entered into an Amended and Restated Credit Agreement, a Term Note and a Revolving Line of Credit Note, with Wells Fargo, or collectively the New Credit Facility. The New Credit Facility amends and restates our existing credit facility dated as of November 5, 2010 and extended on December 4, 2013. The New Credit Facility adds a $70,000,000 term loan, or Term Loan, to the existing $30,000,000 revolving line of credit, or RLC. Funds from the Term Loan were used to finance the Company's purchase of DMB TMV LLC’s interest in TMV as disclosed in the Current Report on Form 8-K filed on July 16, 2014. Any future borrowings under the RLC will be used for ongoing working capital requirements and other general corporate purposes. To maintain availability of funds under the RLC, undrawn amounts under the RLC will accrue a commitment fee of 10 basis points per annum. The Company's ability to borrow additional funds in the future under the RLC is subject to compliance with certain financial covenants and making certain representations and warranties. At the Company’s option, the interest rate on the RLC can float at 1.50% over a selected LIBOR rate or can be fixed at 1.50% above LIBOR for a fixed rate term. During the term of this credit facility (which matures in September 2019), we can borrow at any time and partially or wholly repay any outstanding borrowings and then re-borrow, as necessary. At December 31, 2014, the RLC had an outstanding balance of $6,850,000 and no outstanding balance at December 31, 2013. The interest rate per annum applicable to the Term Loan is LIBOR (as defined in the Term Note) plus a margin of 170 basis points. The interest rate for the term of the note has been fixed through the use of an interest rate swap at a rate of 4.11%. We utilize an interest rate swap agreement to hedge our exposure to variable interest rates associated with our term loan. The Term Loan requires interest only payments for the first two years of the term and thereafter requires monthly amortization payments pursuant to a schedule set forth in the Term Note, with the final outstanding principal amount due October 5, 2024. TRC may make voluntary prepayments on the Term Loan at any time without penalty (excluding any applicable LIBOR or interest rate swap breakage costs). Each optional prepayment will be applied to reduce the most remote principal payment then unpaid. The New Credit Facility is secured by TRC’s farmland and farm assets, which include equipment, crops and crop receivables and the Calpine power plant lease and lease site, and related accounts and other rights to payment and inventory. The New Credit Facility requires compliance with three financial covenants: (a) total liabilities divided by tangible net worth not greater than 0.75 to 1.0 at each quarter end; (b) a debt service coverage ratio not less than 1.25 to 1.00 as of each quarter end on a rolling four quarter basis; and (c) maintain liquid assets equal to or greater than $20,000,000. At December 31, 2014, we were in compliance with the financial covenants. The New Credit Facility also contains customary negative covenants that limit the ability of TRC to, among other things, make capital expenditures, incur indebtedness and issue guaranties, consummate certain assets sales, acquisitions or mergers, make investments, pay dividends or repurchase stock, or incur liens on any assets. The New Credit Facility contains customary events of default, including: failure to make required payments; failure to comply with terms of the New Credit Facility; bankruptcy and insolvency; and a change in control without consent of bank (which consent will not be unreasonably withheld). The New Credit Facility contains other customary terms and conditions, including representations and warranties, which are typical for credit facilities of this type. During the third quarter of 2013, we entered into a promissory note agreement to pay a principal amount of $4,750,000 with principal and interest due monthly starting on October 1, 2013. The interest rate on this promissory note is 4.25% per annum, with principal and interest payments ending on September 1, 2028. The proceeds from this promissory note were used to eliminate debt that had been previously used to provide long-term financing for a building being leased to Starbucks and provide additional working capital for future investment. Our current and future capital resource requirements will be provided primarily from current cash and marketable securities, cash flow from on-going operations, proceeds from the sale of developed and undeveloped parcels, potential sales of assets, additional use of debt, proceeds from the reimbursement of public infrastructure costs through CFD bond debt (described below under “Off-Balance Sheet Arrangements”), and the issuance of common stock. During October 2012, we filed a shelf registration statement on Form S-3 that went effective in May 2013. Under the shelf registration statement, we may offer and sell in the future one or more offerings, common stock, preferred stock, debt securities, warrants or any combination of the foregoing. The shelf registration allows for efficient and timely access to capital markets and when combined with our other potential funding sources just noted, provides us with a variety of capital funding options that can then be used and appropriately matched to the funding need. On August 7, 2013, the Company announced that its Board of Directors declared a dividend of 3,000,000 warrants to purchase shares of Company common stock, par value $0.50 per share, or Warrants, to holders of record of Common Stock as of August 21, 2013, the Record Date. The Warrants were distributed to shareholders on August 28, 2013. Each Warrant will entitle the holder to purchase one share of Common Stock at an initial exercise price of $40.00 per share and will be exercisable through August 31, 2016, subject to the Company's right to accelerate the expiration date under certain circumstances when the Warrants are in-the-money. Each holder of Common Stock as of the Record Date received a number of Warrants equal to the number of shares held multiplied by 0.14771, rounded to the nearest whole number. No cash or other consideration was paid in respect of any fractional Warrants that were rounded down. The Company issued the Warrants pursuant to a Warrant Agreement, dated as of August 7, 2013, between the Company, Computershare, Inc. and Computershare Trust Company, N.A., as warrant agent. Proceeds received from the exercise of the Warrants will be used to provide additional working capital for generate corporate purposes, including development activities within the Company's industrial and residential projects and to continue its investments into water assets and water facilities. As noted above, at December 31, 2014, we had $47,778,000 in cash and securities and as of the filing date of this Form 10-K, we have $23,150,000 available on credit lines to meet any short-term liquidity needs. We continue to expect that substantial future investments will be required in order to develop our land assets. In order to meet these long-term capital requirements, we may need to secure additional debt financing and continue to renew our existing credit facilities. In addition to debt financing, we will use other capital alternatives such as joint ventures with financial partners, sales of assets, and the issuance of common stock. We will use a combination of the above funding sources to properly match funding requirements with the assets or development project being funded. There is no assurance that we can obtain financing or that we can obtain financing at favorable terms. We believe we have adequate capital resources to fund our cash needs and our capital investment requirements as described earlier in the cash flow and liquidity discussions. Contractual Cash Obligations. The following table summarizes our contractual cash obligations and commercial commitments as of December 31, 2014, to be paid over the next five years: The categories above include purchase obligations and other long-term liabilities reflected on our balance sheet under GAAP. A “purchase obligation” is defined in Item 303(a)(5)(ii)(D) of Regulation S-K as “an agreement to purchase goods or services that is enforceable and legally binding the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.” Based on this definition, the table above includes only those contracts that include fixed or minimum obligations. It does not include normal purchases, which are made in the ordinary course of business. Our financial obligations to the Tejon Ranch Conservancy are prescribed in the Conservation Agreement. Our advances to the Tejon Ranch Conservancy are dependent on the occurrence of certain events and their timing, and are therefore subject to change in amount and period. The amounts included above are the minimum amounts we anticipate contributing through the year 2021. As discussed in Note 15 (Retirement Plans) of the Notes to Unaudited Consolidated Financial Statements, we have long-term liabilities for deferred employee compensation, including pension and supplemental retirement plans. Payments in the above table reflect estimates of future defined benefit plan contributions from the Company to the plan trust, estimates of payments to employees from the plan trust, and estimates of future payments to employees from the Company that are in the SERP program. During 2014, we made $650,000 in pension contributions and estimate that we will contribute approximately $600,000 to the pension plan over the next twelve months. Our cash contract commitments consist of contracts in various stages of completion related to infrastructure development within our industrial developments and entitlement costs related to our industrial and residential development projects. Also, included in the cash contract commitments are estimated fees earned during the second quarter of 2014 by a consultant, related to the entitlement of the Grapevine Development Area. The Company exited a consulting contract during the second quarter of 2014 related to the Grapevine Development and is obligated to pay an earned incentive fee at the time of successful receipt of project entitlements and at a value measurement date five-years after entitlements have been achieved for Grapevine. The final amount of the incentive fees will not be finalized until the future payment dates. The Company believes that net savings from exiting the contract over this future time period will more than offset the incentive payment costs. Estimated water payments include SWP contracts with Wheeler Ridge Maricopa Water Storage District, Tejon-Castac Water District, Tulare Lake Basin Water Storage District, and Dudley-Ridge Water Storage District. These contracts for the supply of future water run through 2035. The Tulare Lake Basin Water Storage District and Dudley-Ridge Water Storage District SWP contracts have now been transferred to AVEK for our use in the Antelope Valley. Beginning in 2014, payments related to these contracts are now paid to AVEK. In addition, in late 2013 we purchased the assignment of a contract to purchase water. The assigned water contract is with Nickel Family, LLC and obligates us to purchase 6,693 acre-feet of water starting in 2014 and running through 2044. Please refer to Note 6 (Long Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding water assets. Our operating lease obligations are for office equipment, several vehicles, and a temporary trailer providing office space and average approximately $25,000 per month. At the present time, we do not have any capital lease obligations or purchase obligations outstanding. Off-Balance Sheet Arrangements The following table shows contingent obligations we have with respect to the CFDs. TRPFFA, is a joint powers authority formed by Kern County and TCWD to finance public infrastructure within the Company’s Kern County developments. TRPFFA created two CFDs, the West CFD and the East CFD. The West CFD has placed liens on 420 acres of the Company’s land to secure payment of special taxes related to $28,620,000 of bond debt sold by TRPFFA for TRCC-West. The East CFD has placed liens on 1,931 acres of the Company’s land to secure payments of special taxes related to $39,750,000 of bond debt sold by TRPFFA for TRCC-East. At TRCC-West, the West CFD has no additional bond debt approved for issuance. At TRCC-East, the East CFD has approximately $80,250,000 of additional bond debt authorized by TRPFFA. In connection with the sale of bonds there is a standby letter of credit for $5,426,000 related to the issuance of East CFD bonds. The standby letter of credit is in place to provide additional credit enhancement and cover approximately two year's worth of interest on the outstanding bonds. This letter of credit will not be drawn upon unless the Company, as the largest landowner in the CFD, fails to make its property tax payments. As development occurs within TRCC-East there is a mechanism in the bond documents to reduce the amount of the letter of credit. The Company believes that the letter of credit will never be drawn upon. This letter of credit is for a two-year period of time and will be renewed in two-year intervals as necessary. The annual cost related to the letter of credit is approximately $83,000. The assessment of each individual property sold or leased within each CFD is not determinable at this time because it is based on current tax rate and the assessed value of the property at the time of sale or on its assessed value at the time it is leased to a third-party. Accordingly, the Company is not required to recognize an obligation at December 31, 2014.

<s>[INST] See Part I, "Forward Looking Statements" for our cautionary statement regarding forwardlooking information. Overview We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in four business segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; and farming. Our commercial/industrial real estate development segment generates revenues from building, grazing, and land lease activities, land and building sales, and ancillary land management activities. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active developments are TMV, Centennial, and the Grapevine Development Area, or Grapevine. During the first quarter of 2013 we began land planning activities and the first steps of gathering information to prepare an environmental impact report to entitle Grapevine, which is an approximately 15,315acre potential development area located on the San Joaquin Valley floor area of our lands, adjacent to TRCC. We are currently focusing on approximately 8,010 acres within Grapevine for a mixed use development to include housing, retail, and commercial components. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. During 2014, we continued to expand our water operations to not only manage water infrastructure and water assets but to also sell water on an annual basis to third parties, as we did during the first quarter of 2014. We determined during the third quarter of 2014 that water assets and water management fit most appropriately with our other resource assets and activities and will now be included in the mineral resources segment. As a result of this, the Company has reclassified prior year amortization associated with the purchase of water contracts from corporate expenses into mineral resources expenses on the consolidated statements of operations to conform to the current year presentation. The prior year amortization reclassification was $815,000 and $708,000, respectively for 2013 and 2012. For 2014 we had net income attributable to common stockholders of $5,655,000 compared to net income attributable to common stockholders of $4,165,000 for 2013. This improvement is driven by an increase in revenue, primarily from mineral resources revenue, as a result of 2014 water sales and improved equity in earnings of unconsolidated joint ventures of $1,288,000. These increases in revenue were partially offset by an increase in operating expenses of $4,964,000 largely driven by $4,523,000 in water cost of sales. During 2014, farming revenue declined due to lower quantities of orchard crops being sold. Revenues improved slightly in the commercial/industrial segment due primarily to the sale of a convenience store/gas station site and higher development fees. Equity in earnings of unconsolidated joint ventures improved primarily due to the earnings [/INST] Negative. </s>

TEJON RANCH CO

2016-03-08

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See Part I, "Forward-Looking Statements" for our cautionary statement regarding forward-looking information. Overview We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five business segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active developments are MV, Centennial, and Grapevine. During the first quarter of 2013 we began land planning activities and the first steps of gathering information to prepare an environmental impact report to entitle Grapevine, which is an approximately 15,315-acre potential development area located on the San Joaquin Valley floor area of our lands, adjacent to TRCC. We are currently focusing on approximately 8,000 acres within Grapevine for a mixed use development to include housing, retail, and commercial components. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. During 2014, we continued to expand our water operations to not only manage water infrastructure and water assets but to also sell water on an annual basis to third parties, as we did during the first quarter of 2014. We determined during the third quarter of 2014 that water assets and water management fit most appropriately within our mineral resources segment. As a result of this, the Company in 2014 reclassified prior year amortization associated with the purchase of water contracts from corporate expenses into mineral resources expenses on the consolidated statements of operations to conform to the current year presentation. The amortization reclassification was $815,000 for 2013. During the fourth quarter of 2015, the Company reclassified revenues and expenses previously classified as commercial/industrial into a new segment called Ranch Operations. Ranch Operations is comprised of grazing leases, game management, and other ancillary services supporting the ranch. For 2015, net income attributable to common stockholders was $2,950,000 compared to $5,655,000 in 2014. The change is driven by a decline in mineral resource revenues of $1,139,000 resulting from deteriorating oil prices in 2015, a $2,162,000 increase in corporate expenses of which a majority relates to pension and staffing costs, and a decline in pistachio revenues of $1,160,000 resulting from the poor yields caused by the mild winter of 2015. Income from our joint ventures increased by $1,030,000, partially offsetting the declines in net income noted above. Our joint venture with TA/Petro largely contributed to this increase which is further discussed in the Results of Operations. For 2014, we had net income attributable to common stockholders of $5,655,000 compared to net income attributable to common stockholders of $4,165,000 for 2013. This improvement is driven by an increase in revenue, primarily from mineral resources revenue, as a result of 2014 water sales and improved equity in earnings of unconsolidated joint ventures of $1,288,000. These increases in revenue were partially offset by an increase in operating expenses of $4,964,000 largely driven by $4,523,000 in water cost of sales. During 2014, farming revenue declined due to lower quantities of orchard crops being sold. Revenues improved slightly in the commercial/industrial segment due primarily to the sale of a convenience store/gas station site and higher development fees. Equity in earnings of unconsolidated joint ventures improved primarily due to the earnings growth within the TA/Petro and Rockefeller joint ventures. For the year ended December 31, 2015 we had no material lease renewals. During 2016, we will continue to invest funds toward the achievement of entitlements for our land and for master project infrastructure and vertical development within our active commercial and industrial developments. Securing entitlements for our land is a long, arduous process that can take several years and often involves litigation. During the next few years, our net income will fluctuate from year-to-year based upon commodity prices, production within our farming segment, and the timing of sales of land and the leasing of land within our industrial developments. This Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a narrative discussion of our results of operations. It contains the results of operations for each operating segment of the business and is followed by a discussion of our financial position. It is useful to read the business segment information in conjunction with Note 16 (Business Segments) of the Notes to Consolidated Financial Statements. Critical Accounting Policies The preparation of our consolidated financial statements in accordance with generally accepted accounting principles, or “GAAP,” requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimates that are likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, impairment of long-lived assets, capitalization of costs, profit recognition related to land sales, stock compensation, our future ability to utilize deferred tax assets, and defined benefit retirement plans. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact on our financial statements. See also Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements, which discusses accounting policies that we have selected from acceptable alternatives. We believe the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements: Revenue Recognition - The Company’s revenue is primarily derived from lease revenue from our rental portfolio, royalty revenue from mineral leases, sales of farm crops, sales of water, and land sales. Revenue from leases with rent concessions or fixed escalations is recognized on a straight-line basis over the initial term of the related lease unless there is a considerable risk as to collectability. The financial terms of leases are contractually defined. Lease revenue is not accrued when a tenant vacates the premises and ceases to make rent payments or files for bankruptcy. Royalty revenues are contractually defined as to the percentage of royalty and are tied to production and market prices. Our royalty arrangements generally require payment on a monthly basis with the payment based on the previous month’s activity. We accrue monthly royalty revenues based upon estimates and adjust to actual as we receive payments. From time to time the Company sells easements over its land. The easements are either in the form of rights of access granted for such things as utility corridors or are in the form of conservation easements that generally require the Company to divest its rights to commercially develop a portion of its land, but do not result in a change in ownership of the land or restrict the Company from continuing other revenue generating activities on the land. Sales of conservation easements are accounted for in accordance with Staff Accounting Bulletin Topic 13 - Revenue Recognition, or SAB Topic 13. Since conservation easements generally do not impose any significant continuing performance obligations on the Company, revenue from conservation easement sales have been recognized when the four criteria outlined in SAB Topic 13 have been met, which generally occurs in the period the sale has closed and consideration has been received. In recognizing revenue from land sales, the Company follows the provisions in Accounting Standards Codification 976, or ASC 976, “Real Estate - Retail Land” to record these sales. ASC 976 provides specific sales recognition criteria to determine when land sales revenue can be recorded. For example, ASC 976 requires a land sale to be consummated with a sufficient down payment of at least 20% to 25% of the sales price depending upon the type and timeframe for development of the property sold, and that any receivable from the sale cannot be subject to future subordination. In addition, the seller cannot retain any material continuing involvement in the property sold or be required to develop the property in the future. At the time farm crops are harvested, contracted, and delivered to buyers and revenues can be estimated, revenues are recognized and any related inventoried costs are expensed, which traditionally occurs during the third and fourth quarters of each year. It is not unusual for portions of our almond or pistachio crop to be sold in the year following the harvest. Orchard (almond and pistachio) revenues are based upon the contract settlement price or estimated selling price, whereas vineyard revenues are typically recognized at the contracted selling price. Estimated prices for orchard crops are based upon the quoted estimate of what the final market price will be by marketers and handlers of the orchard crops. These market price estimates are updated through the crop payment cycle as new information is received as to the final settlement price for the crop sold. These estimates are adjusted to actual upon receipt of final payment for the crop. This method of recognizing revenues on the sale of orchard crops is a standard practice within the agribusiness community. Actual final crop selling prices are not determined for several months following the close of our fiscal year due to supply and demand fluctuations within the orchard crop markets. Adjustments for differences between original estimates and actual revenues received are recorded during the period in which such amounts become known. Capitalization of Costs - The Company capitalizes direct construction and development costs, including predevelopment costs, interest, property taxes, insurance, and indirect project costs that are clearly associated with the acquisition, development, or construction of a project. Costs currently capitalized that in the future would be related to any abandoned development opportunities will be written off if we determine such costs do not provide any future benefits. Should development activity decrease, a portion of interest, property taxes, and insurance costs would no longer be eligible for capitalization, and would be expensed as incurred. Allocation of Costs Related to Land Sales and Leases - When we sell or lease land within one of our real estate developments, currently TRCC, and we have not completed all infrastructure development related to the total project, we follow ASC 976 to determine the appropriate costs of sales for the sold land and the timing of recognition of the sale. This treatment currently applies to sales and leases of land within TRCC. In the calculation of cost of sales or allocations to leased land, we use estimates and forecasts to determine total costs at completion of the development project. These estimates of final development costs can change as conditions in the market and costs of construction change. In preparing these estimates, we use internal budgets, forecasts, and engineering reports to help us estimate future costs related to infrastructure that has not been completed. These estimates become more accurate as the development proceeds forward, due to historical cost numbers and to the continued refinement of the development plan. These estimates are updated periodically throughout the year so that, at the ultimate completion of development, all costs have been allocated. Any increases to our estimates in future years will negatively impact net profits and liquidity due to an increased need for funds to complete development. If, however, this estimate decreases, net profits as well as liquidity will improve. We believe that the estimates used related to cost of sales and allocations to leased land are critical accounting estimates and will become even more significant as we continue to move forward as a real estate development company. The estimates used are very susceptible to change from period to period, due to the fact that they require management to make assumptions about costs of construction, absorption of product, and timing of project completion, and changes to these estimates could have a material impact on the recognition of profits from the sale of land within our developments. Impairment of Long-Lived Assets - We evaluate our property and equipment and development projects for impairment when events or changes in circumstances indicate that the carrying value of assets contained in our financial statements may not be recoverable. The impairment calculation compares the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows (discounted). We recognize an impairment loss equal to the amount by which the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited. We currently operate in five segments, commercial/industrial real estate development, resort/residential real estate development, mineral resources, farming, and ranch operations. At this time, there are no assets within any of our segments that we believe are in danger of being impaired due to market conditions. We believe that the accounting estimate related to asset impairment is a critical accounting estimate because it is very susceptible to change from period to period; it requires management to make assumptions about future prices, production, and costs, and the potential impact of a loss from impairment could be material to our earnings. Management’s assumptions regarding future cash flows from real estate developments and farming operations have fluctuated in the past due to changes in prices, absorption, production and costs and are expected to continue to do so in the future as market conditions change. In estimating future prices, absorption, production, and costs, we use our internal forecasts and business plans. We develop our forecasts based on recent sales data, historical absorption and production data, input from marketing consultants, as well as discussions with commercial real estate brokers and potential purchasers of our farming products. If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed to impairment losses that could be material to our results of operations. Defined Benefit Retirement Plans - The plan obligations and related assets of our defined benefit retirement plan are presented in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using level one and level two indicators, which are quoted prices in active markets and quoted prices for similar types of assets in active markets for the investments. Pension benefit obligations and the related effects on operations are calculated using actuarial models. The estimation of our pension obligations, costs and liabilities requires that we make use of estimates of present value of the projected future payments to all participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. These assumptions may have an effect on the amount and timing of future contributions. The assumptions used in developing the required estimates include the following key factors: • Discount rates; • Salary growth; • Retirement rates; • Expected contributions; • Inflation; • Expected return on plan assets; and • Mortality rates The discount rate enables us to state expected future cash flows at a present value on the measurement date. In determining the discount rate, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments. Salary increase assumptions are based upon historical experience and anticipated future management actions. To determine the expected long-term rate of return on pension plan assets, we consider the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. At December 31, 2015, the weighted-average actuarial assumption of the Company’s defined benefit plan consisted of a discount rate of 4.6%, a long-term rate of return on plan assets of 7.5%, and assumed salary increases of 3.5%. The effects of actual results differing from our assumptions and the effects of changing assumptions are recognized as a component of other comprehensive income, net of tax. Amounts recognized in accumulated other comprehensive income are adjusted as they are subsequently recognized as components of net periodic benefit cost. If we were to assume a 50 basis point change in the discount rate used, our projected benefit obligation would change approximately $800,000. Stock-Based Compensation - We apply the recognition and measurement principles of ASC 718, “Compensation - Stock Compensation” in accounting for long-term stock-based incentive plans. Our stock-based compensation plans include both restricted stock units and restricted stock grants. We have not issued any stock options to employees or directors since January 2003, and our 2015 financial statements do not reflect any compensation expenses for stock options. All stock options issued in the past have been exercised or forfeited. We make stock awards to employees based upon time-based criteria and through the achievement of performance-related objectives. Performance-related objectives are either stratified into threshold, target, and maximum goals or based on the achievement of a milestone event. These stock awards are currently being expensed over the expected vesting period based on each performance criterion. We make estimates as to the number of shares that will actually be granted based upon estimated ranges of success in meeting the defined performance measures. If our estimates of performance shares vesting were to change by 25%, stock compensation expense would increase or decrease by approximately $465,000 depending on whether the change in estimate increased or decreased shares vesting. See Note 11, Stock Compensation - Restricted Stock and Performance Share Grants, of the Notes to Consolidated Financial Statement for total 2015 stock compensation expense related to stock grants. Fair Value Measurements - The Financial Accounting Standards Board's, or FASB, authoritative guidance for fair value measurements of certain financial instruments defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Fair value is defined as the exchange (exit) price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance establishes a three-level hierarchy for fair value measurements based upon the inputs to the valuation of an asset or liability. Observable inputs are those which can be easily seen by market participants while unobservable inputs are generally developed internally, utilizing management’s estimates and assumptions: • Level 1 - Valuation is based on quoted prices in active markets for identical assets and liabilities. • Level 2 - Valuation is determined from quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market. • Level 3 - Valuation is derived from model-based techniques in which at least one significant input is unobservable and based on our own estimates about the assumptions that market participants would use to value the asset or liability. When available, we use quoted market prices in active markets to determine fair value. We consider the principal market and nonperformance risk associated with our counterparties when determining the fair value measurement. Fair value measurements are used for marketable securities, investments within the pension plan and hedging instruments. Recent Accounting Pronouncements For discussion of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements. Non-GAAP Measures EBITDA represents earnings before interest, taxes, depreciation, and amortization, a non-GAAP financial measure, and is used by us and others as a supplemental measure of performance. We use Adjusted EBITDA to assess the performance of our core operations, for financial and operational decision making, and as a supplemental or additional means of evaluating period-to-period comparisons on a consistent basis. Adjusted EBITDA is calculated as EBITDA, excluding stock compensation expense. We believe Adjusted EBITDA provides investors relevant and useful information because it permits investors to view income from our operations on an unleveraged basis before the effects of taxes, depreciation and amortization, and stock compensation expense. By excluding interest expense and income, EBITDA and Adjusted EBITDA allow investors to measure our performance independent of our capital structure and indebtedness and, therefore, allow for a more meaningful comparison of our performance to that of other companies, both in the real estate industry and in other industries. We believe that excluding charges related to share-based compensation facilitates a comparison of our operations across periods and among other companies without the variances caused by different valuation methodologies, the volatility of the expense (which depends on market forces outside our control), and the assumptions and the variety of award types that a company can use. EBITDA and Adjusted EBITDA have limitations as measures of our performance. EBITDA and Adjusted EBITDA do not reflect our historical cash expenditures or future cash requirements for capital expenditures or contractual commitments. While EBITDA and Adjusted EBITDA are relevant and widely used measures of performance, they do not represent net income or cash flows from operations as defined by GAAP, and they should not be considered as alternatives to those indicators in evaluating performance or liquidity. Further, our computation of EBITDA and Adjusted EBITDA may not be comparable to similar measures reported by other companies. Results of Operations by Segment We evaluate the performance of our operating segments separately to monitor the different factors affecting financial results. Each segment is subject to review and evaluation as we monitor current market conditions, market opportunities, and available resources. The performance of each segment is discussed below: Real Estate - Commercial/Industrial During 2015, commercial/industrial segment revenues increased $427,000, or 5% when compared to 2014. This improvement is primarily attributable to an increase of $249,000 relating to percentage and base rent from the power plant lease, specifically related to the expiration in January 2015 of credits issued in 2014 in conjunction with the power plant lease amendment. The amendment related to percentage rent collected on greenhouse gas assessment taxes. The percentage rent calculation was modified to exclude the greenhouse gas assessment taxes that are collected by the tenant and passed on to the State of California and in connection therewith the Company issued the tenant a one-time credit of $467,000 in 2014. In addition, we recognized an additional $215,000 and $412,000 in property management fees and common area maintenance fee reimbursements, respectively, from our joint venture properties, most noticeably the Outlets at Tejon, which opened in August 2014. Lastly, in 2015 we placed into service a land lease with Carl's Jr and operating leases with Pieology and Starbucks at TRCC East, contributing an additional $428,000 in lease revenues. In 2015, we recognized $225,000 in additional landscaping revenues on services rendered to new and existing tenants. The 2015 improvements were partially offset by two non-recurring revenue streams occurring in 2014. In 2014, we sold land to our TA/Petro unconsolidated joint venture partner of which $458,000 was recognized during 2014 with the remaining $687,000 deferred until the time we exit the joint venture or the joint venture is terminated. Additionally, in 2014, we recognized $587,000 in additional development fees from the development of the Outlets at Tejon. Commercial/industrial real estate segment expenses were $6,694,000 during 2015, a decrease of $512,000, or 7%, compared to the same period in 2014, primarily due to a $591,000 decrease in Tejon-Castac Water District, or TCWD, fixed water assessments during 2015. TCWD decreased water assessment taxes as a result of an increase in TCWD water sales to parties outside of the district, which provided additional funds to TCWD. The decrease in commercial/industrial expenses were partially offset by a $173,000 increase in landscape maintenance costs resulting from a full year of operations from the Outlets at Tejon along with our three new tenants discussed above. During 2014, our commercial/industrial segment revenues were relatively flat when compared to 2013. Commercial/industrial segment revenues increased $390,000, or 2% during 2014 compared to 2013 primarily due to a land sale to our TA/Petro unconsolidated joint venture partner as discussed above. The increase in commercial/industrial segment revenues was also attributed to an increase of $587,000 in development fees mainly related to the construction of the Outlets at Tejon. This increase was partially offset by a $788,000 reduction in our PEF power plant percentage rent resulting from lower 2014 prices and to a one-time credit of $467,000 that is discussed above. The amendment is related to percentage rent paid by PEF on the collection of greenhouse gas assessment taxes that are now included in the energy revenue component of the percentage rent. The percentage rent calculation has been modified to exclude these taxes that are collected by PEF and passed on to the State of California. The retroactive amendment resulted in a credit of $467,000 that will be applied over time to future earned percentage rent. At December 31, 2014, the outstanding amount of the credit was $68,000. Our expectations are that percentage rent from this lease will continue to range between $400,000 and $600,000 as it has traditionally done. We will continue to focus our efforts for TRCC-East and TRCC-West on the labor and logistical benefits of our site and the success that current tenants and owners within our development have experienced to capture more of the warehouse distribution market. Our strategy fits within the logistics model that many companies are using, which favors larger single-site buildings rather than a number of decentralized smaller distribution centers. The world class logistics operators located within TRCC have demonstrated success in serving all of California and the western United States through utilization of large centralized distribution centers which have been strategically located to maximize outbound efficiencies. We believe that our ability to provide fully entitled shovel-ready land parcels to support buildings of 1.0 million square feet or larger can provide us with a potential marketing advantage in the future. We are also increasing our marketing efforts to industrial users in the Santa Clarita Valley of northern Los Angeles County and the northern part of the San Fernando Valley due to the limited availability of new product and the high real estate costs in these locations. Tenants in these geographic areas are typically users of relatively smaller facilities. To meet this market we will be developing a building for rent of approximately 250,000 square feet. We estimate this building will be completed in late 2016. A potential disadvantage to our development strategy is our distance from the ports of Los Angeles and Long Beach in comparison to the warehouse/distribution centers located in the Inland Empire, a large industrial area located east of Los Angeles which continues its expansion eastward beyond Riverside and San Bernardino to include Perris, Moreno Valley, and Beaumont. Strong demand for large distribution facilities is driving development farther east in a search for large entitled parcels. During 2015, vacancy rates in the Inland Empire were comparable to 2014 at 4.3%, primarily due to an increase in the development of buildings for lease. Without this increase in new development in the Inland Empire the vacancy rate would have declined in that region. The low vacancy rates have also led to an increase in lease rates of 12% within the Inland Empire from 2014 to 2015. As lease rates increase in the Inland Empire, we may begin to have greater pricing advantages due to our lower land basis. We expect the commercial/industrial segment to continue to experience costs, net of amounts capitalized, primarily related to professional service fees, marketing costs, commissions, planning costs, and staffing costs as we continue to pursue development opportunities. These costs are expected to remain consistent with current levels of expense with any variability in the future tied to specific absorption transactions in any given year. The actual timing and completion of development is difficult to predict due to the uncertainties of the market. Infrastructure development and marketing activities and costs could continue over several years as we develop our land holdings. We will also continue to evaluate land resources to determine the highest and best uses for our land holdings. Future sales of land are dependent on market circumstances and specific opportunities. Our goal in the future is to increase land value and create future revenue growth through planning and development of commercial and industrial properties. Real Estate - Resort/Residential Due to the purchase of the remaining ownership interest in the MV joint venture in 2014, we no longer earn management fees related to the MV joint venture. Resort/residential segment expenses declined $259,000 primarily due to additional capitalization of payroll and benefits more than offsetting the increase in compensation costs. In 2014, we brought in-house full management responsibility for both the MV and Grapevine developments and the full impact of that decision resulted in an increase in compensation costs of $764,000 in 2015. An offsetting benefit to the compensation cost increase from internalizing management was a decrease in professional service fees of $206,000. In 2014, resort/residential segment expenses increased $377,000 primarily due to a $460,000 increase in compensation expense. The increase in compensation expense is primarily due to the reversal of previously recorded stock compensation expense in 2013 related to the forfeiture unvested awards of an executive who left the Company and a change in estimate in 2012 of a performance condition tied to the MV and Centennial projects. Our resort/residential segment activities include land entitlement, land planning and pre-construction engineering and land stewardship and conservation activities. We have three major resort/residential communities within this segment: MV, which has entitlement approvals and is in the tentative tract map process; the Centennial community, which received preliminary zoning within the Antelope Valley Area Plan, or AVAP, and has begun the specific plan process for approvals of phase one entitlement; and the Grapevine community project, which is on land owned within Kern County that is in the entitlement process. The entitlement process precedes the regulatory approvals necessary for land development and routinely takes several years to complete. Since we are in the process of achieving entitlements for the Centennial and the Grapevine communities, which are expected in 2016 or early 2017, we do not have a fully approved project and therefore we do not have inventory for sale in the current market for these communities. For MV, we have a fully permitted and entitled project and, we are in the process of filing tentative tract maps, which we believe will be complete in late 2017, and completing land plans and engineering studies in preparation for development in the future as the economy improves and the second home market improves. The resort/residential segment will continue to incur costs in the future related to professional service fees, public relations costs, and staffing costs as we continue forward with entitlement and permitting activities for the above communities and continue to meet our obligations under the Conservation Agreement. We expect these expenses to remain consistent with current years cost in the near term and only begin to increase as we move forward with development. The actual timing and completion of entitlement-related activities and the beginning of development is difficult to predict due to the uncertainties of the approval process, the possibility of litigation upon approval of our entitlements in the future, and the status of the economy. We will also continue to evaluate land resources to determine the highest and best use for our land holdings. Our long-term goal through this process is to increase the value of our land and create future revenue opportunities through resort and residential development. We are continuously monitoring the markets in order to identify the appropriate time in the future to begin infrastructure improvements and lot sales. Our long-term business plan of developing the communities of MV, Centennial, and Grapevine remains unchanged. As the California economy improves we believe the perception of land values will also begin to improve and the long-term fundamentals that support housing demand in our region, primarily California population growth and household formation will also improve. See Item 1, “Business - Real Estate Operations” for a further discussion of real estate development activities. Mineral Resources Revenues from our mineral resources segment decreased $1,139,000, or 7%, to $15,116,000 during 2015 compared to 2014. The $1,139,000 decrease is primarily due to a decrease in oil royalty revenues driven by lower average prices for a barrel of oil. The average price per barrel of oil decreased by 50% to approximately $45 per barrel during 2015 from approximately $90 per barrel during 2014. The price decline also led to a decrease in production as compared to the same period in 2014. The overall impact was a $3,348,000 decrease in oil royalty revenue. The decrease was partially offset by a $2,323,000 increase in water sales revenue from the sale of 7,922 acre feet of water. During the first quarter of 2015, we determined we had excess water supply for our 2015 needs, thus we sold the entire allotment of the 2015 Nickel water we purchased plus carry forward inventory from 2014. Mineral resources expenses during 2015 increased $978,000 compared to 2014, primarily due to the sale of an additional 1,672 acre feet of water in 2015 increasing water cost of sales by $960,000. Revenues from our mineral resources segment increased $6,013,000, or 59%, to $16,255,000 during 2014 compared to 2013. The $6,013,000 increase was primarily due to the sale of 6,250 acre-feet of water totaling $7,702,000. During the first quarter of 2014, we determined we had excess water supply for our 2014 needs, and in the first half of 2014 we sold 6,250 acre-feet of the 6,693 acre-feet of 2014 water we purchased. Additionally, cement and rock and aggregate royalties increased $476,000 due to expanded production driven by improved construction activity in the region led by new road construction. These increases were partially offset by a $1,606,000 decrease in oil royalty revenues resulting from a 7% drop in production due to lower production from older wells, the timing of new wells coming on-line during the year and the timing of completion of the expansion of lessees' production facilities. The average price per barrel of oil decreased approximately 10% when compared to the same period of 2013 to approximately $90 per barrel, however by the end of the fourth quarter of 2014 prices had fallen to approximately $50 per barrel of oil. This decline negatively impacted our 2015 revenues. Leasehold and related fee payments also decreased $586,000 due to a tenant entering the drilling phase of their lease. Mineral resources expenses during 2014 increased $5,141,000 compared to 2013, primarily due to the sale of 6,250 acre feet of water with a respective cost of sales of $4,523,000 and an increase of $535,000 in water cost amortization associated with the Nickel water purchase in late 2013. Our purchase of the Nickel water in late 2013 allows us to sell excess water once our farming and commercial needs are satisfied. Oil and gas production numbers and average pricing for the last three-years are as follows: Please refer to Item 1, "Business - Mineral Resources" for additional information regarding oil barrels per day production. As oil prices declined during the fourth quarter of 2015, and continued to decline during early 2016, we expect our largest tenant, California Resources Corporation, or CRC, to continue its 2015 program of producing from current active wells at lower levels with no intent to begin new drilling programs until oil prices increase. CRC has approved permits and drill sites on our land and has delayed the start of drilling as it evaluates the market. A positive aspect of our lease with CRC is that the approved drill sites are in an area of the ranch where the development and production costs are moderate due to the depths being drilled. We expect to see a decline in year-over-year royalty revenue in 2016 due to the continued decline in prices for oil from our leases. Since we only receive royalties based on tenant production and market prices and do not produce oil, we do not have information as to the potential size of oil reserves. Our royalty revenues are contractually defined and based on a percentage of production and are received in cash. Royalty revenues fluctuate based on changes in market price for oil, gas, rock and aggregate, and Portland cement. In addition, royalty revenue is impacted by new production, the inevitable decline in production in existing wells and rock and limestone quarries, and the cost of development and production. Farming During 2015, farming revenues increased by $401,000 from $23,435,000 in 2014 to $23,836,000 in 2015. The below table reflects crop revenues in thousands for the previous two years by variety of product and crop year. The revenue increase resulted from a $2,202,000 improvement in almond revenues resulting from an increase in sales price and units sold. Also contributing to the revenue increase was the sale of an additional 1.8 tons of wine grapes, which resulted from improved crop yields. Offsetting the revenue increases was a $1,160,000 decrease in pistachio revenues. Pistachio revenues decreased because our pistachio crop yield was severely impacted by the mild 2015 winter. A mild winter decreases the number of hours the pistachio trees are dormant, adversely impacting the pollination of the pistachio tree. We typically expect 5% - 10% of our crops to produce blanks or hollow shells. However, we experienced blanks in 90% of our pistachio crop, which is unprecedented compared to historical trends. The impact to pistachio production as a result of the mild winter is not a phenomenon specific to Tejon Ranch but has impacted a large majority of the pistachio production in California. We purchased crop insurance to mitigate weather-related catastrophic crop losses which ultimately paid $2,700,000 for losses and partially offset lost revenues. Farming expenses increased $2,734,000, or 17% during 2015 compared to 2014. The drivers of this increase are as follow: • Wine grape cost of sales increased $906,000 which resulted from 1.8 tons in additional wine grape sales. • Almond cost of sales increased $816,000, of which approximately $638,000 relates to a 375,000 pound improvement in current crop year sales. The remainder of the increase, resulted from a 162,000 pound increase in carryover almond sales. • Pistachio cost of sales increased $477,000 which we attribute to the 2015 crop write-off caused by the mild winter discussed above. As a result, there was no carryover crop since all crop costs were recognized during the current fiscal year. • In 2015, fixed water costs paid to WRMWSD increased by $521,000 resulting from increases in state water costs resulting from the drought. During 2014, farming revenues decreased $175,000 from $23,610,000 in 2013 to $23,435,000 in 2014. The below table reflects crop revenues in thousands for the previous two years by variety of product and crop year. During 2014, farming revenues decreased $175,000 compared to 2013. The decline in farming revenue was primarily driven by lower almond revenues. The 2014 almond crop production figures reflected a decrease in production within our orchard crops resulting from various weather conditions such as a mild winter that reduced the tree and vine dormant time and early hot summer weather. As a result, almond revenue decreased $821,000 compared to the same period in 2013, which was driven by a 27% decrease in almond pounds sold. This decrease in almond pounds sold was partially offset by a 27% increase in average price for the sale of our prior year almond crop inventory as well as sales for our current 2014 crop. Pistachio revenues were fairly flat for the year due primarily to pricing, which increased approximately 19% offsetting a 16% decrease in pounds sold. Wine grape revenues decreased $116,000 as a result of an average price per ton decrease of 14% during 2014. This decrease in average price per ton for wine grapes was partially offset by an increase of 13% in tons sold. Pricing for our orchard crops improved throughout 2014 due to strong worldwide demand for product and lower inventory levels. The decreases in wine grape and almond revenue were partially offset by an increase of $433,000 in hay sales due to improved pricing. During the fourth quarter of 2014, the Company determined hay crop sales previously recorded in the resort/residential segment revenues related to farming activities within Centennial, fit most appropriately with our farming segment revenues. As a result, the Company has reclassified prior period hay crop sales into farming revenue on the consolidated statements of operations to conform to the current year presentation. The amounts reclassified for the twelve months ended December 31, 2014, and December 31, 2013 were $1,361,000 and $928,000, respectively. Farming expenses increased $324,000, or 2% during 2014 compared to 2013, primarily due to a $1,032,000 increase in fixed water costs when compared to the prior year, resulting from adjustments received in the third quarter of 2013 from WRMWSD for prior year reconciliations for which we received a cash refund of approximately $1,100,000 during the fourth quarter of 2013. Farming expenses also increased by $270,000 during 2014 when compared to 2013 as a result of general increases in operating expenses related to power costs and repair costs. This increase was partially offset by decreases in cost of sales of $426,000, $126,000 and $313,000 for almonds, wine grapes and pistachios, respectively. Thus far in 2016, the prices for our crops, especially almonds, have seen declines compared to the fourth quarter of 2015. The decline in prices seems to be driven by higher almond inventories, a strong dollar against the Euro, and lower sales throughout Asia and China. All of our crops are sensitive to the size of each year’s world crop. Large crops in California and abroad can depress prices. Our long-term projection is that crop production, especially of almonds and pistachios will continue to increase on a statewide basis over time because of new plantings, which could negatively impact future prices if the growth in demand does not keep pace with production. As we move into the 2016 crop year we have had a relatively mild winter thus far, which could possibly impact our almond and pistachio production due to a low level of dormant hours. Dormant hours allow the trees to rest, which enhances the growth of the tree and production. It is too early to project 2016 crop yields and what impact that may have on prices later in 2016. Water delivery and water availability continues to be a long-term concern within California. Any limitation of delivery of SWP water and the absence of available alternatives during drought periods could potentially cause permanent damage to orchards and vineyards throughout California. While this could impact us, we believe we have sufficient water resources available to meet our requirements in 2016. Please see our discussion on water in Item 2, "Properties - Water Operations." The DWR announced its 2013 estimated water supply delivery at 30% of full entitlement. We expect 2016 to be a difficult water year due to the drought in California, even if we get substantial rains during the first part of 2016, due to the already low water levels within state reservoirs. The current 30% allocation of SWP water is not enough for us to farm our crops, but our additional water resources, such as groundwater and surface sources, and those of the water districts we are in should allow us to have sufficient water for our farming needs. It is too early in the year to determine the impact of water supplies and the impacts of the drought on 2016 California crop production for almonds, pistachios, and wine grapes. See Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding our water assets. For further discussion of the farming operations, refer to Item I “Business-Farming Operations.” Ranch Operations Revenues from ranch operations increased $389,000 from $3,534,000 in 2014 to $3,923,000 in 2015. The increase is attributed to an increase in grazing lease revenues of $330,000. The increase is driven by an overall increase in the price per head of cattle. All other business lines including game management and High Desert Hunt Club remained flat. Ranch operation expenses increased by $114,000 from $5,998,000 in 2014 to $6,112,000 in 2015. The expense increase is comprised of the ongoing costs necessary to maintain the ranch and include items such as payroll, supplies, and other necessary costs. Revenues from ranch operations decreased $159,000 from $3,693,000 in 2013 to $3,534,000 in 2014. The decrease resulted from a drought clause reducing grazing lease revenues from prior year by $277,000. The decrease was partially offset by increased revenues from game management of $96,000 due to events such as Tejon Hounds, a fox hunting club. Investment Income Investment income declined $168,000, or 24%, during 2015 when compared to 2014. Investment income also declined $245,000, or 26% during 2014 when compared to 2013. The decline in both periods is primarily attributable to lower average investment balances and a decline in overall yield on the portfolio as higher yielding securities matured through the year. The above interest income relates to our marketable securities portfolio as further disclosed in Note 3, Marketable Securities of the Notes to Consolidated Financial Statements. Corporate Expenses Corporate general and administrative costs increased $2,162,000, or 20%, during 2015 when compared to 2014. We attribute $2,077,000 of the increase to payroll, severance and benefit costs. In 2015, the Company experienced an increase of $527,000 in workers compensation and health insurance costs. Workers compensation typically increases as total payroll increases while health insurance increased as a result of the Affordable Care Act. Also, during 2015 we recognized a one-time charge related to employee severance of $633,000. Lastly, we experienced an increase in pension and retirement charges of $917,000, included in this amount is a one-time non-cash pension settlement charge of $536,000. Corporate general and administrative costs decreased $1,180,000, or 10%, during 2014 compared 2013. The decrease in costs is driven by $528,000 in lower professional service fees due to costs in 2013 related to the hiring of a new Chief Executive Officer, or CEO, the warrant dividend program, IT professional services and a $1,014,000 increase in cost allocations to our business operating segments. We also saw a decrease in donations of $198,000 during 2014. These improvements were partially offset by an increase in staffing costs of $1,293,000 when compared to 2013 staffing costs. This increase is tied to the reversal of stock compensation expense in 2013 tied to performance grants that would not vest upon the prior CEO's retirement in December 2013. Equity in Earnings of Unconsolidated Joint Ventures Equity in earnings of unconsolidated joint ventures is an important and growing component of our commercial/industrial activities and in the future, equity in earnings of unconsolidated joint ventures will become a significant part of our operational activity within the resort/residential segment. As we expand our current ventures and add new joint ventures, these investments will become a growing revenue source for the Company. During 2015, equity in earnings from unconsolidated joint ventures grew to $6,324,000, or an increase of $1,030,000, compared to 2014. TA/Petro, when compared to 2014, contributed an additional $1,440,000 in earnings from unconsolidated joint ventures. The improvement in operations within the TA/Petro joint venture was driven by an increase in diesel volumes of 2.4 million gallons and gas volumes of 1.2 million gallons. The improvement in the volumes of fuel sales continued to be driven by the growing amount of traffic along Interstate - 5 and the expansion of offerings at TRCC such as the Outlets at Tejon. Due to the addition of a new restaurant at the end of 2014 and the increase in the volume of activity the TA/Petro joint venture also saw an increase in non-fuel revenue margins during 2015. During 2014, equity in earnings of unconsolidated joint ventures grew to $5,294,000, or an increase of $1,288,000, compared to 2013 primarily due to $1,012,000 of higher income from our TA/Petro joint venture mainly due to increasing gasoline sales, higher net margins from diesel and gasoline sales and lower interest expense as a result of reduced interest rates. Equity in earnings of unconsolidated joint ventures also improved due to an increase in the minimum rent and tenant reimbursements along with a decline in interest expense due to lower interest rates within the Five West Parcel joint venture. Income Taxes For the twelve months ended December 31, 2015, the Company incurred a net income tax expense of $1,125,000 compared to a net income tax expense of $2,697,000 for the twelve months ended December 31, 2014. These represent effective income tax rates of approximately 28% and 32% for the twelve months ended December 31, 2015 and, 2014, respectively. The effective tax rate is impacted by the noncontrolling interest held in the Centennial joint venture and the impact of depletion allowances. During 2015, permanent tax differences declined due to lower depletion allowances. Depletion allowances declined due to a reduction in oil and gas revenues. As of December 31, 2015 and 2014 we had an income tax payable of $1,237,000 and $1,703,000, respectively. As of December 31, 2015, we had net deferred tax assets of $4,659,000. Our largest deferred tax assets were made up of temporary differences related to the capitalization of costs, pension adjustments, and stock grant expense. Deferred tax liabilities consist of depreciation, deferred gains, cost of sale allocations, and straight-line rent. Due to the nature of most of our deferred tax assets, we believe they will be used in future years and an allowance is not necessary. The Company classifies interest and penalties incurred on tax payments as income tax expenses. The Company made total income tax payments of $2,100,000 in 2015 and $1,100,000 during 2014. The Company received refunds of $283,000 in 2015 and $3,484,000 in 2014. Liquidity and Capital Resources Cash Flow and Liquidity. Our financial position allows us to pursue our strategies of land entitlement, development, and conservation. Accordingly, we have established well-defined priorities for our available cash, including investing in core business segments to achieve profitable future growth. We have historically funded our operations with cash flows from operating activities, investment proceeds, and short-term borrowings from our bank credit facilities. In the past, we have also issued common stock and used the proceeds for capital investment activities. In 2014, our use of long-term debt to finance capital needs increased significantly. To enhance shareholder value, we will continue to make investments in our real estate segments to secure land entitlement approvals, build infrastructure for our developments, ensure adequate future water supplies, and provide funds for general land development activities. Within our farming segment, we will make investments as needed to improve efficiency and add capacity to its operations when it is profitable to do so. Our cash and cash equivalents and marketable securities totaled approximately $34,745,000 at December 31, 2015, a decrease of $13,033,000, or 27%, from the corresponding amount at the end of 2014. Cash and cash equivalents and marketable securities decreased during 2015 due to the sale and maturity of $24,157,000 in marketable securities of which we reinvested $15,574,000. We used net proceeds from marketable securities sales to pay down our revolving line of credit in addition to financing our real estate development projects at Grapevine, MV, Centennial, and TRCC. The following table summarizes the cash flow activities for the following periods ended December 31: During 2015, our operations provided $16,968,000 of cash primarily attributable to operating results mainly from farming, mineral resource, and leasing revenues. We also received a distribution of $7,200,000 from the TA/Petro joint venture. Please refer to "Results of Operations by Segment" for further discussion on our operating results. During 2014, our operations provided $13,218,000 of cash primarily attributable to operating results mainly from farming revenues, mineral resources revenues, investment income, a decline in other current assets related to income tax receivables and add back of non-cash expenses. During 2015, investing activities used $12,661,000 of cash primarily as a result of $28,048,000 in real estate and equipment expenditures. Of the $28,048,000 we spent $5,317,000, $5,585,000, $5,667,000 on pre-development and entitlement costs on our Centennial, MV, and Grapevine projects, respectively. We used $7,023,000 for the development of two multi-tenant buildings along with supporting infrastructure projects over at TRCC. We invested $2,583,000 into our farming segment for the development of new almond and wine grape crops along with acquiring new farming equipment. We invested $1,199,000 into water related projects including water turnouts and wells that will ultimately support our real estate and farming operations. The remainder of the capital investments primarily relate to capital equipment used as part of our ranch operations and corporate segments. Outside of capital projects, we acquired $15,574,000 in marketable securities. Offsetting our cash outlays are maturities and sales of marketable securities of $24,157,000, distributions from our joint venture partners of $1,100,000, and reimbursements from TRPFFA for qualifying infrastructure projects of $4,971,000, During 2014, investing activities used $92,592,000 of cash primarily as a result of the purchase of DMB TMV LLC's interest in MV for $70,000,000, $24,775,000 in capital expenditures and $9,656,000 of investment in our unconsolidated joint ventures. The investment in unconsolidated joint ventures consisted of an $8,500,000 contribution to the TRCC/Rock Outlet Center LLC joint venture and $1,112,000 to MV prior to the membership interest buyout. These expenditures were partially offset by net proceeds of $12,319,000 from marketable securities. Included in the $24,775,000 of capital expenditures during 2014 was $1,128,000 related to MV, $2,437,000 related to Centennial Founders LLC, and $6,352.000 related to Grapevine. The remaining capital expenditures consisted of $14,625,000 of investments in TRCC infrastructure related to roads, utilities, and water infrastructure to support new development and capital investment in farming equipment replacements and crop development. Our estimated capital investment for 2016 is primarily related to our real estate projects as it was in 2015. These estimated investments include approximately $10,500,000 of infrastructure development at TRCC-East and West to support continued commercial retail and industrial development and to expand water facilities to support future anticipated absorption. We are also investing approximately $1,200,000 to begin development of a new almond orchard and costs related to new developments that are not currently in production. The farm investments are part of a long-term farm management program to redevelop declining orchards and vineyards to maintain and improve future farm revenues. We expect to possibly invest up to $16,000,000 for land planning, entitlement activities, and development activities at MV, Centennial, and Grapevine during 2016. The timing of these investments is dependent on our coordination efforts with Kern County and Los Angeles County regarding entitlement efforts for Grapevine and Centennial and tentative tract maps for MV. Our plans also call for the potential investment of up to $3,900,000 in water infrastructure to include the drilling of water wells and as opportunities arise to help secure additional water assets for real estate, farming, and as an investment. We are also planning to potentially invest up to $2,500,000 in the normal replacement of operating equipment, such as farm and ranch equipment, and updates to our information technology systems. During 2015, financing activities used $8,015,000 resulting from borrowing $17,540,000 on our line of credit offset by payments of $24,390,000 on our line of credit and long-term borrowings. During 2014, financing activities provided $75,981,000 in cash. This growth in financing activities is largely tied to the increase in long-term debt of $70,000,000, a ten-year term loan, which is funding the purchase of DMB TMV LLC’s membership interest in MV. We also saw a net increase in the use of our line-of-credit to fund infrastructure development as we were waiting on the timing of reimbursement from the East CFD. During January 2015, we received a reimbursement for public infrastructure from the East CFD of $4,971,000. It is difficult to accurately predict cash flows due to the nature of our businesses and fluctuating economic conditions. Our earnings and cash flows will be affected from period to period by the commodity nature of our farming and mineral operations, the timing of sales and leases of property within our development projects, and the beginning of development within our residential projects. The timing of sales and leases within our development projects is difficult to predict due to the time necessary to complete the development process and negotiate sales or lease contracts. Often, the timing aspect of land development can lead to particular years or periods having more or less earnings than comparable periods. Based on our experience, we believe we will have adequate cash flows, cash balances, and availability on our line of credit over the next twelve months to fund internal operations. Capital Structure and Financial Condition. At December 31, 2015, total capitalization at book value was $405,346,000 consisting of $74,038,000 of debt, net of deferred financing costs, and $331,308,000 of equity, resulting in a debt-to-total-capitalization ratio of approximately 18.2%, which is a slight decrease when compared to the debt-to-total-capitalization ratio of 18.7% at December 31, 2014. The increase in the use of debt in 2014 is primarily tied to the purchase of our former partner's membership interest in TMV LLC and is not indicative of a trend to materially increase the use of long-term debt. On October 13, 2014, the Company as borrower, entered into an Amended and Restated Credit Agreement, a Term Note and a Revolving Line of Credit Note, with Wells Fargo, or collectively the Credit Facility. The Credit Facility amends and restates our existing credit facility dated as of November 5, 2010 and extended on December 4, 2013. The Credit Facility adds a $70,000,000 term loan, or Term Loan, to the existing $30,000,000 revolving line of credit, or RLC. Funds from the Term Loan were used to finance the Company's purchase of DMB TMV LLC’s interest in MV as disclosed in the Current Report on Form 8-K filed on July 16, 2014. Any future borrowings under the RLC will be used for ongoing working capital requirements and other general corporate purposes. To maintain availability of funds under the RLC, undrawn amounts under the RLC will accrue a commitment fee of 10 basis points per annum. The Company's ability to borrow additional funds in the future under the RLC is subject to compliance with certain financial covenants and making certain representations and warranties. At the Company’s option, the interest rate on the RLC can float at 1.50% over a selected LIBOR rate or can be fixed at 1.50% above LIBOR for a fixed rate term. During the term of this credit facility (which matures in September 2019), we can borrow at any time and partially or wholly repay any outstanding borrowings and then re-borrow, as necessary. The outstanding balance on the RLC was $0 and $6,850,000 as of December 31, 2015 and 2014, respectively. The interest rate per annum applicable to the Term Loan is LIBOR (as defined in the Term Note) plus a margin of 170 basis points. The interest rate for the term of the note has been fixed through the use of an interest rate swap at a rate of 4.11%. We utilize an interest rate swap agreement to hedge our exposure to variable interest rates associated with our term loan. The Term Loan requires interest only payments for the first two years of the term and thereafter requires monthly amortization payments pursuant to a schedule set forth in the Term Note, with the final outstanding principal amount due October 5, 2024. TRC may make voluntary prepayments on the Term Loan at any time without penalty (excluding any applicable LIBOR or interest rate swap breakage costs). Each optional prepayment will be applied to reduce the most remote principal payment then unpaid. The Credit Facility is secured by TRC’s farmland and farm assets, which include equipment, crops and crop receivables and the power plant lease and lease site, and related accounts and other rights to payment and inventory. The Credit Facility requires compliance with three financial covenants: (a) total liabilities divided by tangible net worth not greater than 0.75 to 1.0 at each quarter end; (b) a debt service coverage ratio not less than 1.25 to 1.00 as of each quarter end on a rolling four quarter basis; and (c) maintain liquid assets equal to or greater than $20,000,000. At December 31, 2015, we were in compliance with the financial covenants. The Credit Facility also contains customary negative covenants that limit the ability of TRC to, among other things, make capital expenditures, incur indebtedness and issue guaranties, consummate certain assets sales, acquisitions or mergers, make investments, pay dividends or repurchase stock, or incur liens on any assets. The Credit Facility contains customary events of default, including: failure to make required payments; failure to comply with terms of the Credit Facility; bankruptcy and insolvency; and a change in control without consent of bank (which consent will not be unreasonably withheld). The Credit Facility contains other customary terms and conditions, including representations and warranties, which are typical for credit facilities of this type. We also have a $4,750,000 promissory note agreement with principal and interest due monthly starting on October 1, 2013. The interest rate on this promissory note is 4.25% per annum, with principal and interest payments ending on September 1, 2028. The balance as of December 31, 2015 is $4,215,000. The proceeds from this promissory note were used to eliminate debt that had been previously used to provide long-term financing for a building being leased to Starbucks and provide additional working capital for future investment. Our current and future capital resource requirements will be provided primarily from current cash and marketable securities, cash flow from on-going operations, proceeds from the sale of developed and undeveloped parcels, potential sales of assets, additional use of debt, proceeds from the reimbursement of public infrastructure costs through CFD bond debt (described below under “Off-Balance Sheet Arrangements”), and the issuance of common stock. During October 2012, we filed a shelf registration statement on Form S-3 that went effective in May 2013. Under the shelf registration statement, we may offer and sell in the future one or more offerings, common stock, preferred stock, debt securities, warrants or any combination of the foregoing. The shelf registration allows for efficient and timely access to capital markets and when combined with our other potential funding sources just noted, provides us with a variety of capital funding options that can then be used and appropriately matched to the funding need. We expect to update the shelf registration during 2016. On August 7, 2013, the Company announced that its Board of Directors declared a dividend of 3,000,000 warrants to purchase shares of Company common stock, par value $0.50 per share, or Warrants, to holders of record of Common Stock as of August 21, 2013, the Record Date. The Warrants were distributed to shareholders on August 28, 2013. Each Warrant will entitle the holder to purchase one share of Common Stock at an initial exercise price of $40.00 per share and will be exercisable through August 31, 2016, subject to the Company's right to accelerate the expiration date under certain circumstances when the Warrants are in-the-money. Each holder of Common Stock as of the Record Date received a number of Warrants equal to the number of shares held multiplied by 0.14771, rounded to the nearest whole number. No cash or other consideration was paid in respect of any fractional Warrants that were rounded down. The Company issued the Warrants pursuant to a Warrant Agreement, dated as of August 7, 2013, between the Company, Computershare, Inc. and Computershare Trust Company, N.A., as warrant agent. Proceeds received from the exercise of the Warrants will be used to provide additional working capital for generate corporate purposes, including development activities within the Company's industrial and residential projects and to continue its investments into water assets and water facilities. At the time of this filing we do not expect the warrants to be exercised based on the current price of our stock. On February 26, 2016, the Company received a notice from NYSE MKT indicating that the Warrants are not in compliance with the NYSE MKT's continued listing standard due to the security's abnormally low market value of less than $0.01. Consequently, NYSE notified the Company that it has commenced proceedings to delist the Warrants. For additional information please refer to our Current Report on Form 8-K filed on February 26, 2016. As noted above, at December 31, 2015, we had $34,745,000 in cash and securities and as of the filing date of this Form 10-K, we have $30,000,000 available on credit lines to meet any short-term liquidity needs. We continue to expect that substantial future investments will be required in order to develop our land assets. In order to meet these long-term capital requirements, we may need to secure additional debt financing and continue to renew our existing credit facilities. In addition to debt financing, we will use other capital alternatives such as joint ventures with financial partners, sales of assets, and the issuance of common stock. We will use a combination of the above funding sources to properly match funding requirements with the assets or development project being funded. There is no assurance that we can obtain financing or that we can obtain financing at favorable terms. We believe we have adequate capital resources to fund our cash needs and our capital investment requirements as described earlier in the cash flow and liquidity discussions. Contractual Cash Obligations. The following table summarizes our contractual cash obligations and commercial commitments as of December 31, 2015, to be paid over the next five years: The categories above include purchase obligations and other long-term liabilities reflected on our balance sheet under GAAP. A “purchase obligation” is defined in Item 303(a)(5)(ii)(D) of Regulation S-K as “an agreement to purchase goods or services that is enforceable and legally binding the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.” Based on this definition, the table above includes only those contracts that include fixed or minimum obligations. It does not include normal purchases, which are made in the ordinary course of business. Our financial obligations to the Tejon Ranch Conservancy are prescribed in the Conservation Agreement. Our advances to the Tejon Ranch Conservancy are dependent on the occurrence of certain events and their timing, and are therefore subject to change in amount and period. The amounts included above are the minimum amounts we anticipate contributing through the year 2021, at which time our current contractual obligation terminates. As discussed in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements, we have long-term liabilities for deferred employee compensation, including pension and supplemental retirement plans. Payments in the above table reflect estimates of future defined benefit plan contributions from the Company to the plan trust, estimates of payments to employees from the plan trust, and estimates of future payments to employees from the Company that are in the SERP program. During 2015, we made $450,000 in pension contributions and estimate that we will contribute approximately $450,000 to the pension plan over the next twelve months. Our cash contract commitments consist of contracts in various stages of completion related to infrastructure development within our industrial developments and entitlement costs related to our industrial and residential development projects. Also, included in the cash contract commitments are estimated fees earned during the second quarter of 2014 by a consultant, related to the entitlement of the Grapevine Development Area. The Company exited a consulting contract during the second quarter of 2014 related to the Grapevine Development and is obligated to pay an earned incentive fee at the time of successful receipt of project entitlements and at a value measurement date five-years after entitlements have been achieved for Grapevine. The final amount of the incentive fees will not be finalized until the future payment dates. The Company believes that net savings from exiting the contract over this future time period will more than offset the incentive payment costs. Estimated water payments include SWP contracts with Wheeler Ridge Maricopa Water Storage District, Tejon-Castac Water District, Tulare Lake Basin Water Storage District, and Dudley-Ridge Water Storage District. These contracts for the supply of future water run through 2035. The Tulare Lake Basin Water Storage District and Dudley-Ridge Water Storage District SWP contracts have now been transferred to AVEK for our use in the Antelope Valley. In addition, in late 2013 we purchased the assignment of a contract to purchase water. The assigned water contract is with Nickel Family, LLC and obligates us to purchase 6,693 acre-feet of water starting in 2014 and running through 2044. Please refer to Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding water assets. Our operating lease obligations are for office equipment, several vehicles, and a temporary trailer providing office space and average approximately $25,000 per month. At the present time, we do not have any capital lease obligations or purchase obligations outstanding. Off-Balance Sheet Arrangements The following table shows contingent obligations we have with respect to the CFDs. TRPFFA is a joint powers authority formed by Kern County and TCWD to finance public infrastructure within the Company’s Kern County developments. TRPFFA created two CFDs, the West CFD and the East CFD. The West CFD has placed liens on 420 acres of the Company’s land to secure payment of special taxes related to $28,620,000 of bond debt sold by TRPFFA for TRCC-West. The East CFD has placed liens on 1,931 acres of the Company’s land to secure payments of special taxes related to $55,000,000 of bond debt sold by TRPFFA for TRCC-East. At TRCC-West, the West CFD has no additional bond debt approved for issuance. At TRCC-East, the East CFD has approximately $65,000,000 of additional bond debt authorized by TRPFFA. In connection with the sale of bonds there is a standby letter of credit for $5,426,000 related to the issuance of East CFD bonds. The standby letter of credit is in place to provide additional credit enhancement and cover approximately two year's worth of interest on the outstanding bonds. This letter of credit will not be drawn upon unless the Company, as the largest landowner in the CFD, fails to make its property tax payments. As development occurs within TRCC-East there is a mechanism in the bond documents to reduce the amount of the letter of credit. The Company believes that the letter of credit will never be drawn upon. This letter of credit is for a two-year period of time and will be renewed in two-year intervals as necessary. The annual cost related to the letter of credit is approximately $83,000. The assessment of each individual property sold or leased within each CFD is not determinable at this time because it is based on the current tax rate and the assessed value of the property at the time of sale or on its assessed value at the time it is leased to a third-party. Accordingly, the Company is not required to recognize an obligation at December 31, 2015.

<s>[INST] See Part I, "ForwardLooking Statements" for our cautionary statement regarding forwardlooking information. Overview We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five business segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active developments are MV, Centennial, and Grapevine. During the first quarter of 2013 we began land planning activities and the first steps of gathering information to prepare an environmental impact report to entitle Grapevine, which is an approximately 15,315acre potential development area located on the San Joaquin Valley floor area of our lands, adjacent to TRCC. We are currently focusing on approximately 8,000 acres within Grapevine for a mixed use development to include housing, retail, and commercial components. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. During 2014, we continued to expand our water operations to not only manage water infrastructure and water assets but to also sell water on an annual basis to third parties, as we did during the first quarter of 2014. We determined during the third quarter of 2014 that water assets and water management fit most appropriately within our mineral resources segment. As a result of this, the Company in 2014 reclassified prior year amortization associated with the purchase of water contracts from corporate expenses into mineral resources expenses on the consolidated statements of operations to conform to the current year presentation. The amortization reclassification was $815,000 for 2013. During the fourth quarter of 2015, the Company reclassified revenues and expenses previously classified as commercial/industrial into a new segment called Ranch Operations. Ranch Operations is comprised of grazing leases, game management, and other ancillary services supporting the ranch. For 2015, net income attributable to common stockholders was $2,950,000 compared to $5,655,000 in 2014. The change is driven by a decline in mineral resource revenues of $1,139,000 resulting from deteriorating oil prices in 2015, a $2,162,000 increase in corporate expenses of which a majority relates to pension and staffing costs, and a decline in pistachio revenues of $1,160,000 resulting from the poor yields caused by the mild winter of 2015. Income from our joint ventures increased by $1,030,000, partially offsetting the decl [/INST] Positive. </s>

TEJON RANCH CO

2017-03-13

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See Part I, "Forward-Looking Statements" for our cautionary statement regarding forward-looking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part 1 of this Form 10-K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five operating segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active developments are MV, Centennial, and Grapevine. During the last quarter of 2016, the Kern County Board of Supervisors granted entitlement approval for our land planning activities for Grapevine, which is an approximately 8,010 acre development area located on the San Joaquin Valley floor area of our lands, adjacent to TRCC. These approvals included certification of our final environmental impact report and related findings, approval of associated general plan amendments, and adoption of associated zoning maps. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2016, net income attributable to common stockholders was $558,000 compared to $2,950,000 in 2015. Factors driving the change include: a decline in farming revenues of $5,188,000 resulting from declines in commodity prices and a decline of mineral resource revenues of $963,000 resulting from falling oil prices in 2016. Offsetting the decline in net income were the following factors: an increase in commercial real estate revenues of $1,166,000 resulting from a land sale, and increased rents, a gain on sale of building and land located in Rancho Santa Fe, California of $1,044,000, an overall reduction in total expenses of $860,000, and an increase in income from unconsolidated joint ventures of $774,000. For 2015, net income attributable to common stockholders was $2,950,000 compared to $5,655,000 in 2014. The change was driven by a decline in mineral resource revenues of $1,139,000 resulting from deteriorating oil prices in 2015, a $2,162,000 increase in corporate expenses of which a majority relates to pension and staffing costs, and a decline in pistachio revenues of $1,160,000 resulting from the poor yields caused by the mild winter of 2015. Income from our joint ventures increased by $1,030,000, partially offsetting the declines in net income noted above. Our joint venture with TA/Petro largely contributed to this increase which is further discussed in the Results of Operations. For the year ended December 31, 2016 we had no material lease renewals. During 2017, we will continue to invest funds toward the achievement of entitlements, permits, and maps for our land and for master project infrastructure and vertical development within our active commercial and industrial development. Securing entitlements for our land is a long, arduous process that can take several years and often involves litigation. During the next few years, our net income will fluctuate from year-to-year based upon commodity prices, production within our farming segment, and the timing of sales of land and the leasing of land within our industrial developments. During the fourth quarter of 2015, the Company reclassified revenues and expenses previously classified as commercial/industrial into a new segment called Ranch Operations. Ranch Operations is comprised of grazing leases, game management, and other ancillary services supporting the ranch. This Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a narrative discussion of our results of operations. It contains the results of operations for each operating segment of the business and is followed by a discussion of our financial position. It is useful to read the business segment information in conjunction with Note 16 (Operating Segments and Related Information) of the Notes to Consolidated Financial Statements. Critical Accounting Policies The preparation of our consolidated financial statements in accordance with generally accepted accounting principles, or GAAP, requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimates that are likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, impairment of long-lived assets, capitalization of costs, profit recognition related to land sales, stock compensation, our future ability to utilize deferred tax assets, and defined benefit retirement plans. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact on our financial statements. See also Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements, which discusses accounting policies that we have selected from acceptable alternatives. We believe the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements: Revenue Recognition - The Company’s revenue is primarily derived from lease revenue from our rental portfolio, royalty revenue from mineral leases, sales of farm crops, sales of water, and land sales. Revenue from leases with rent concessions or fixed escalations is recognized on a straight-line basis over the initial term of the related lease unless there is a considerable risk as to collectability. The financial terms of leases are contractually defined. Lease revenue is not accrued when a tenant vacates the premises and ceases to make rent payments or files for bankruptcy. Royalty revenues are contractually defined as to the percentage of royalty and are tied to production and market prices. Our royalty arrangements generally require payment on a monthly basis with the payment based on the previous month’s activity. We accrue monthly royalty revenues based upon estimates and adjust to actual as we receive payments. From time to time the Company sells easements over its land. The easements are either in the form of rights of access granted for such things as utility corridors or are in the form of conservation easements that generally require the Company to divest its rights to commercially develop a portion of its land, but do not result in a change in ownership of the land or restrict the Company from continuing other revenue generating activities on the land. Sales of conservation easements are accounted for in accordance with Staff Accounting Bulletin Topic 13 - Revenue Recognition, or SAB Topic 13. Since conservation easements generally do not impose any significant continuing performance obligations on the Company, revenue from conservation easement sales have been recognized when the four criteria outlined in SAB Topic 13 have been met, which generally occurs in the period the sale has closed and consideration has been received. In recognizing revenue from land sales, the Company follows the provisions in Accounting Standards Codification 976, or ASC 976, “Real Estate - Retail Land” to record these sales. ASC 976 provides specific sales recognition criteria to determine when land sales revenue can be recorded. For example, ASC 976 requires a land sale to be consummated with a sufficient down payment of at least 20% to 25% of the sales price depending upon the type and timeframe for development of the property sold, and that any receivable from the sale cannot be subject to future subordination. In addition, the seller cannot retain any material continuing involvement in the property sold or be required to develop the property in the future. At the time farm crops are harvested, contracted, and delivered to buyers and revenues can be estimated, revenues are recognized and any related inventoried costs are expensed, which traditionally occurs during the third and fourth quarters of each year. It is not unusual for portions of our almond or pistachio crop to be sold in the year following the harvest. Orchard (almond and pistachio) revenues are based upon the contract settlement price or estimated selling price, whereas vineyard revenues are typically recognized at the contracted selling price. Estimated prices for orchard crops are based upon the quoted estimate of what the final market price will be by marketers and handlers of the orchard crops. These market price estimates are updated through the crop payment cycle as new information is received as to the final settlement price for the crop sold. These estimates are adjusted to actual upon receipt of final payment for the crop. This method of recognizing revenues on the sale of orchard crops is a standard practice within the agribusiness community. Actual final crop selling prices are not determined for several months following the close of our fiscal year due to supply and demand fluctuations within the orchard crop markets. Adjustments for differences between original estimates and actual revenues received are recorded during the period in which such amounts become known. Capitalization of Costs - The Company capitalizes direct construction and development costs, including predevelopment costs, interest, property taxes, insurance, and indirect project costs that are clearly associated with the acquisition, development, or construction of a project. Costs currently capitalized that in the future would be related to any abandoned development opportunities will be written off if we determine such costs do not provide any future benefits. Should development activity decrease, a portion of interest, property taxes, and insurance costs would no longer be eligible for capitalization, and would be expensed as incurred. Allocation of Costs Related to Land Sales and Leases - When we sell or lease land within one of our real estate developments, currently TRCC, and we have not completed all infrastructure development related to the total project, we follow ASC 976 to determine the appropriate costs of sales for the sold land and the timing of recognition of the sale. In the calculation of cost of sales or allocations to leased land, we use estimates and forecasts to determine total costs at completion of the development project. These estimates of final development costs can change as conditions in the market and costs of construction change. In preparing these estimates, we use internal budgets, forecasts, and engineering reports to help us estimate future costs related to infrastructure that has not been completed. These estimates become more accurate as the development proceeds forward, due to historical cost numbers and to the continued refinement of the development plan. These estimates are updated periodically throughout the year so that, at the ultimate completion of development, all costs have been allocated. Any increases to our estimates in future years will negatively impact net profits and liquidity due to an increased need for funds to complete development. If, however, this estimate decreases, net profits as well as liquidity will improve. We believe that the estimates used related to cost of sales and allocations to leased land are critical accounting estimates and will become even more significant as we continue to move forward as a real estate development company. The estimates used are very susceptible to change from period to period, due to the fact that they require management to make assumptions about costs of construction, absorption of product, and timing of project completion, and changes to these estimates could have a material impact on the recognition of profits from the sale of land within our developments. Impairment of Long-Lived Assets - We evaluate our property and equipment and development projects for impairment when events or changes in circumstances indicate that the carrying value of assets contained in our financial statements may not be recoverable. The impairment calculation compares the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows (discounted). We recognize an impairment loss equal to the amount by which the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited. We currently operate in five segments, commercial/industrial real estate development, resort/residential real estate development, mineral resources, farming, and ranch operations. At this time, there are no assets within any of our segments that we believe are in danger of being impaired due to market conditions. We believe that the accounting estimate related to asset impairment is a critical accounting estimate because it is very susceptible to change from period to period; it requires management to make assumptions about future prices, production, and costs, and the potential impact of a loss from impairment could be material to our earnings. Management’s assumptions regarding future cash flows from real estate developments and farming operations have fluctuated in the past due to changes in prices, absorption, production and costs and are expected to continue to do so in the future as market conditions change. In estimating future prices, absorption, production, and costs, we use our internal forecasts and business plans. We develop our forecasts based on recent sales data, historical absorption and production data, input from marketing consultants, as well as discussions with commercial real estate brokers and potential purchasers of our farming products. If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed to impairment losses that could be material to our results of operations. Defined Benefit Retirement Plans - The plan obligations and related assets of our defined benefit retirement plan are presented in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using level one and level two indicators, which are quoted prices in active markets and quoted prices for similar types of assets in active markets for the investments. Pension benefit obligations and the related effects on operations are calculated using actuarial models. The estimation of our pension obligations, costs and liabilities requires that we make use of estimates of present value of the projected future payments to all participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. These assumptions may have an effect on the amount and timing of future contributions. The assumptions used in developing the required estimates include the following key factors: • Discount rates; • Salary growth; • Retirement rates; • Expected contributions; • Inflation; • Expected return on plan assets; and • Mortality rates The discount rate enables us to state expected future cash flows at a present value on the measurement date. In determining the discount rate, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments. Salary increase assumptions are based upon historical experience and anticipated future management actions. To determine the expected long-term rate of return on pension plan assets, we consider the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. At December 31, 2016, the weighted-average actuarial assumption of the Company’s defined benefit plan consisted of a discount rate of 4.3%, a long-term rate of return on plan assets of 7.5%, and assumed salary increases of 3.5%. The effects of actual results differing from our assumptions and the effects of changing assumptions are recognized as a component of other comprehensive income, net of tax. Amounts recognized in accumulated other comprehensive income are adjusted as they are subsequently recognized as components of net periodic benefit cost. If we were to assume a 50 basis point change in the discount rate used, our projected benefit obligation would change approximately $900,000. Stock-Based Compensation - We apply the recognition and measurement principles of ASC 718, “Compensation - Stock Compensation” in accounting for long-term stock-based incentive plans. Our stock-based compensation plans include both restricted stock units and restricted stock grants. We have not issued any stock options to employees or directors since January 2003, and our 2016 financial statements do not reflect any compensation expenses for stock options. All stock options issued in the past have been exercised or forfeited. We make stock awards to employees based upon time-based criteria and through the achievement of performance-related objectives. Performance-related objectives are either stratified into threshold, target, and maximum goals or based on the achievement of a milestone event. These stock awards are currently being expensed over the expected vesting period based on each performance criterion. We make estimates as to the number of shares that will actually be granted based upon estimated ranges of success in meeting the defined performance measures. If our estimates of performance shares vesting were to change by 25%, stock compensation expense would increase or decrease by approximately $400,000 depending on whether the change in estimate increased or decreased shares vesting. See Note 11, Stock Compensation - Restricted Stock and Performance Share Grants, of the Notes to Consolidated Financial Statement for total 2016 stock compensation expense related to stock grants. Fair Value Measurements - The Financial Accounting Standards Board's, or FASB, authoritative guidance for fair value measurements of certain financial instruments defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Fair value is defined as the exchange (exit) price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance establishes a three-level hierarchy for fair value measurements based upon the inputs to the valuation of an asset or liability. Observable inputs are those which can be easily seen by market participants while unobservable inputs are generally developed internally, utilizing management’s estimates and assumptions: • Level 1 - Valuation is based on quoted prices in active markets for identical assets and liabilities. • Level 2 - Valuation is determined from quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market. • Level 3 - Valuation is derived from model-based techniques in which at least one significant input is unobservable and based on our own estimates about the assumptions that market participants would use to value the asset or liability. When available, we use quoted market prices in active markets to determine fair value. We consider the principal market and nonperformance risk associated with our counterparties when determining the fair value measurement. Fair value measurements are used for marketable securities, investments within the pension plan and hedging instruments. Recent Accounting Pronouncements For discussion of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements. Results of Operations by Segment We evaluate the performance of our operating segments separately to monitor the different factors affecting financial results. Each segment is subject to review and evaluation as we monitor current market conditions, market opportunities, and available resources. The performance of each segment is discussed below: Real Estate - Commercial/Industrial During 2016, commercial/industrial segment revenues increased $1,166,000, or 14% when compared to 2015. In October 2016, we sold unimproved real property located at TRCC-East for $1,193,000. We recognized $710,000 of the revenues in 2016 and will recognize the remainder upon the completion of certain on-site land improvements, which are expected to be completed during the first half of 2017. Also in 2016, we placed into service a multi-tenant building leased to Baja Fresh and Habit Burger increasing lease revenue by $266,000. Lastly, we recognized additional leasing revenues of $48,000 from Starbucks and Pieology given that they were not placed into service until the latter part of the second quarter of 2015. Commercial/industrial real estate segment expenses were $7,100,000 during 2016, an increase of $406,000, or 6%, compared to the same period in 2015. During 2016, there were increases in professional services and repairs and maintenance of $126,000 and $108,000, respectively. Additionally, the basis in the land sold was $95,000. During 2015, commercial/industrial segment revenues increased $427,000, or 5% when compared to 2014. This improvement is primarily attributable to an increase of $249,000 relating to percentage and base rent from the power plant lease, specifically related to the expiration in January 2015 of credits issued in 2014 in conjunction with the power plant lease amendment. The amendment related to percentage rent collected on greenhouse gas assessment taxes. The percentage rent calculation was modified to exclude the greenhouse gas assessment taxes that are collected by the tenant and passed on to the State of California and in connection therewith the Company issued the tenant a one-time credit of $467,000 in 2014. In addition, we recognized an additional $215,000 and $412,000 in property management fees and common area maintenance fee reimbursements, respectively, from our joint venture properties, most noticeably the Outlets at Tejon, which opened in August 2014. Lastly, in 2015 we placed into service a land lease with Carl's Jr and operating leases with Pieology and Starbucks at TRCC East, contributing an additional $428,000 in lease revenues. In 2015, we recognized $225,000 in additional landscaping revenues on services rendered to new and existing tenants. The 2015 improvements were partially offset by two non-recurring revenue streams occurring in 2014. In 2014, we sold land to our TA/Petro unconsolidated joint venture partner of which $458,000 was recognized during 2014 with the remaining $687,000 deferred until the time we exit the joint venture or the joint venture is terminated. Additionally, in 2014, we recognized $587,000 in additional development fees from the development of the Outlets at Tejon. Commercial/industrial real estate segment expenses were $6,694,000 during 2015, a decrease of $512,000, or 7%, compared to the same period in 2014, primarily due to a $591,000 decrease in Tejon-Castac Water District, or TCWD, fixed water assessments during 2015. TCWD decreased water assessment taxes as a result of an increase in TCWD water sales to parties outside of the district, which provided additional funds to TCWD. The decrease in commercial/industrial expenses was partially offset by a $173,000 increase in landscape maintenance costs resulting from a full year of operations from the Outlets at Tejon along with our three new tenants discussed above. The logistics operators currently located within our Commerce Center have demonstrated success in serving all of California and the western region of the United States, and we are building from their success in our marketing efforts. We will continue to focus our marketing strategy for TRCC-East and TRCC-West on the significant labor and logistical benefits of our site, the pro-business approach of Kern County, and the demonstrated success of the current tenants and owners within our development. Our strategy fits within the logistics model that many companies are using, which favors large, centralized distribution facilities which have been strategically located to maximize the balance of inbound and outbound efficiencies, rather than a number of decentralized smaller distribution centers. The world class logistics operators located within TRCC have demonstrated success through utilization of this model. With access to markets of over 40 million people for next-day delivery service, they are also demonstrating success with e-commerce fulfillment. We believe that our ability to provide fully-entitled, shovel-ready land parcels to support buildings of any size, especially buildings 1.0 million feet or larger, can provide us with a potential marketing advantage in the future. We are also expanding our marketing efforts to include industrial users in the Santa Clarita Valley of northern Los Angeles County, and the northern part of the San Fernando Valley due to the limited availability of new product and high real estate costs in these locations. Tenants in these geographic areas are typically users of relatively smaller facilities. In pursuit of such opportunities, the Company has partnered with Majestic Realty Co. in the speculative development of a 480,000 square foot, state-of-the-art distribution facility. Construction of the facility is underway, and is scheduled to be complete in the late third quarter of 2017. A potential disadvantage to our development strategy is our distance from the ports of Los Angeles and Long Beach in comparison to the warehouse/distribution centers located in the Inland Empire, a large industrial area located east of Los Angeles, which continues its expansion eastward beyond Riverside and San Bernardino, to include Perris, Moreno Valley, and Beaumont. As development in the Inland Empire continues to move east and farther away from the ports, our potential disadvantage of our distance from the ports is being mitigated. Strong demand for large distribution facilities is driving development farther east in a search for large entitled parcels. At year-end 2016, vacancy rates in the Inland Empire approximated 4.1%; primarily due to demand keeping pace with the development of new buildings for lease. Without the increase in new development, the vacancy rate would have declined. As lease rates increase in the Inland Empire and northern Los Angeles County, we may begin to have a greater pricing advantage due to our low land basis. We expect the commercial/industrial segment to continue to experience costs, net of amounts capitalized, primarily related to professional service fees, marketing costs, commissions, planning costs, and staffing costs as we continue to pursue development opportunities. These costs are expected to remain consistent with current levels of expense with any variability in the future tied to specific absorption transactions in any given year. The actual timing and completion of development is difficult to predict due to the uncertainties of the market. Infrastructure development and marketing activities and costs could continue over several years as we develop our land holdings. We will also continue to evaluate land resources to determine the highest and best uses for our land holdings. Future sales of land are dependent on market circumstances and specific opportunities. Our goal in the future is to increase land value and create future revenue growth through planning and development of commercial and industrial properties. Real Estate - Resort/Residential Resort/residential segment expenses declined $719,000 primarily due to additional capitalization of payroll and overhead costs of $475,000 that were identified to be incremental to our master plan development projects. In addition, there were decreases in professional service and fees of $261,000. In 2015, resort/residential segment expenses declined $259,000 primarily due to additional capitalization of payroll and benefits more than offsetting the increase in compensation costs. In 2014, we brought in-house full management responsibility for both the MV and Grapevine developments and the full impact of that decision resulted in an increase in compensation costs of $764,000 in 2015. An offsetting benefit to the compensation cost increase from internalizing management was a decrease in professional service fees of $206,000. Our resort/residential segment activities include land entitlement, land planning and pre-construction engineering and conservation activities. We have three major resort/residential communities within this segment: Centennial, Grapevine, and MV. We are in the process of achieving entitlements and expect to file the EIR and specific plan for Los Angeles County during 2017 for Centennial, we do not have a fully approved project and therefore we do not have inventory for sale. As it relates to Grapevine, we are working with Kern County to defend the approved EIR. The entire litigation and permitting process will take several years and the investment of several million dollars to successfully complete. For MV, we have a fully permitted and entitled project and, we are in the process of getting approval for tentative tract maps, which we believe will be complete in late 2017. We are also completing land plans and engineering studies in preparation for development in the future as the economy improves and the second home market improves. The resort/residential segment will continue to incur costs in the future related to professional service fees, public relations costs, and staffing costs as we continue forward with entitlement and permitting activities for the above communities and continue to meet our obligations under the Conservation Agreement. We expect these expenses to remain consistent with current years cost in the near term and only begin to increase as we move forward with development. The actual timing and completion of entitlement-related activities and the beginning of development is difficult to predict due to the uncertainties of the approval process, the possibility of litigation upon approval of our entitlements in the future, and the status of the economy. We will also continue to evaluate land resources to determine the highest and best use for our land holdings. Our long-term goal through this process is to increase the value of our land and create future revenue opportunities through resort and residential development. We are continuously monitoring the markets in order to identify the appropriate time in the future to begin infrastructure improvements and lot sales. Our long-term business plan of developing the communities of MV, Centennial, and Grapevine remains unchanged. As the California economy continues to improves we believe the perception of land values will also begin to improve and the long-term fundamentals that support housing demand in our region, primarily California population growth and household formation will also improve. California also has a significant housing shortage, which we believe our communities will help ease as the population base within California continues to grow. See Item 1, “Business - Real Estate Development Overview” for a further discussion of real estate development activities. Mineral Resources Revenues from our mineral resources segment decreased $963,000, or 6%, to $14,153,000 in 2016 compared to $15,116,000 in 2015. The decrease is primarily due to a $1,112,000 decrease in oil royalty revenues driven by lower average prices for a barrel of oil, which then led to declines in production. Please refer to below table for current and historical production volume and pricing. Also in 2016, we sold 7,285 acre feet of water compared to 7,922 acre feet in 2015 reducing water revenues by $570,000. Offsetting those amounts were improvements in cement, sand, and rock royalties of $330,000 and reimbursable costs and other of $364,000. We now expect that water sales for 2017 could be significantly lower than 2016, due to the winter rains and snow that are at historical levels. Mineral resources expenses during 2016 increased $400,000 compared to 2015, primarily due to increases in payroll and salaries of $125,000 and fuel costs of $94,000 related to transferring and banking water. The remainder of the increase can be attributed to increases in other expenses including property taxes, professional services, and fees. Revenues from our mineral resources segment decreased $1,139,000, or 7%, to $15,116,000 during 2015 compared to 2014. The $1,139,000 decrease is primarily due to a decrease in oil royalty revenues driven by lower average prices for a barrel of oil. The average price per barrel of oil decreased by 50% to approximately $45 per barrel during 2015 from approximately $90 per barrel during 2014. The price decline also led to a decrease in production as compared to the same period in 2014. The overall impact was a $3,348,000 decrease in oil royalty revenue. The decrease was partially offset by a $2,323,000 increase in water sales revenue from the sale of 7,922 acre feet of water. During the first quarter of 2015, we determined we had excess water supply for our 2015 needs, thus we sold the entire allotment of the 2015 Nickel water we purchased plus carry forward inventory from 2014. Mineral resources expenses during 2015 increased $978,000 compared to 2014, primarily due to the sale of an additional 1,672 acre feet of water in 2015 increasing water cost of sales by $960,000. Oil and gas production numbers and average pricing were as follows for the years ended December 31: Please refer to Item 1, "Business - Mineral Resources" for additional information regarding oil barrels per day production. Although oil prices improved during the fourth quarter of 2016, we expect our largest tenant, California Resources Corporation, or CRC, to continue its 2016 program of producing from current active wells at lower levels with no near term intent to begin new drilling programs until oil prices increase and stabilize at higher levels. CRC has approved permits and drill sites on our land and has delayed the start of drilling as it evaluates the market. A positive aspect of our lease with CRC is that the approved drill sites are in an area of the ranch where the development and production costs are moderate due to the depths being drilled. With the overall improvement in prices, we could see an improvement in royalty revenue. Thus far in 2017, oil prices have improved and are approximately 7% to 10% below West Texas Intermediate pricing. Since we only receive royalties based on tenant production and market prices and do not produce oil, we do not have information as to the potential size of oil reserves. Our royalty revenues are contractually defined and based on a percentage of production and are received in cash. Royalty revenues fluctuate based on changes in market price for oil, gas, rock and aggregate, and Portland cement. In addition, royalty revenue is impacted by new production, the inevitable decline in production in existing wells and rock and limestone quarries, and the cost of development and production. Farming During 2016, farming revenues decreased by $5,188,000 from $23,836,000 in 2015 to $18,648,000 in 2016. The below table reflects crop revenues in thousands for the previous two years by variety of product and crop year. Key highlights include: • An overall reduction in market price for current year almonds along with management's decision to sell more crops in 2015, taking advantage of higher prices, reduced almond revenues by $4,865,000. In 2016, the California almond industry had strong yields, driving prices downward. • We recovered from the mild winter of 2015 that adversely affected our 2015 pistachio crop yields. Total 2016 crop yield was at a recent historical high of 3,200,000 pounds. Despite the robust 2016 yields, a decline in market prices lowered pistachio revenues by $226,000 when compared to 2015 revenues, which were primarily generated through insurance proceeds and market price adjustments. In 2016, the California pistachio industry had strong yields, driving prices downward. • Improvement in other revenues is driven by a new farm land lease and recoverable costs. Farming expenses decreased $311,000, or 2% during 2016 compared to 2015. In 2016, almond costs decreased $1,019,000 or 15% as we spent less time pruning trees, applying pesticides, and removing mummies, all of which are time and labor intensive. The decrease in almond costs were offset by an increase in wine grape costs of $260,000 as a result of a 10% increase in the number of acres farmed and an increase in fixed water costs of $256,000 paid to WRMWSD. During 2015, farming revenues increased by $401,000 from $23,435,000 in 2014 to $23,836,000 in 2015. The below table reflects crop revenues in thousands for the previous two years by variety of product and crop year. The revenue increase resulted from a $2,202,000 improvement in almond revenues resulting from an increase in sales price and units sold. Also contributing to the revenue increase was the sale of an additional 1.8 tons of wine grapes, which resulted from improved crop yields. Offsetting the revenue increases was a $1,160,000 decrease in pistachio revenues. Pistachio revenues decreased because our pistachio crop yield was severely impacted by the mild 2015 winter. A mild winter decreases the number of hours the pistachio trees are dormant, adversely impacting the pollination of the pistachio tree. We typically expect 5% - 10% of our crops to produce blanks or hollow shells. However, we experienced blanks in 90% of our pistachio crop, which is unprecedented compared to historical trends. The impact to pistachio production as a result of the mild winter is not a phenomenon specific to Tejon Ranch but has impacted a large majority of the pistachio production in California. We purchased crop insurance to mitigate weather-related catastrophic crop losses which ultimately paid $2,700,000 for losses and partially offset lost revenues. Farming expenses increased $2,734,000, or 17% during 2015 compared to 2014. The drivers of this increase are as follow: • Wine grape cost of sales increased $906,000 which resulted from 1.8 tons in additional wine grape sales. • Almond cost of sales increased $816,000, of which approximately $638,000 relates to a 375,000 pound improvement in current crop year sales. The remainder of the increase, resulted from a 162,000 pound increase in carryover almond sales. • Pistachio cost of sales increased $477,000 which we attribute to the 2015 crop write-off caused by the mild winter discussed above. As a result, there was no carryover crop since all crop costs were recognized during the current fiscal year. • In 2015, fixed water costs paid to WRMWSD increased by $521,000 resulting from increases in state water costs resulting from the drought. Thus far in 2017, the prices for our crops, especially almonds and pistachios, have seen some stabilization at the lower levels seen at the end of 2016. The decline in prices was driven by higher almond production and larger pistachio inventories. All of our crops are sensitive to the size of each year’s world crop. Large crops in California and abroad can depress prices. Our long-term projection is that crop production, especially of almonds and pistachios will continue to increase on a statewide basis over time because of new plantings, which could negatively impact future prices if the growth in demand does not keep pace with production. An unknown factor related to future statewide production and the continuation of new plantings will be how new state ground water management laws impact the amount of farming land in production over the next five to ten years, which could eventually reduce production. The rains and snow of 2017 are not expected to significantly impact the ground water basins within the Central Valley of California, and therefore could still lead to a reduction in crop production. We are less impacted due to our water sources and the ground water basin we are in. We have had a relatively mild winter thus far, which could possibly impact our almond and pistachio production due to a low level of dormant hours. Dormant hours allow the trees to rest, which enhances the growth of the tree and production. It is too early to project 2017 crop yields and what impact that may have on prices later in 2017. Water delivery and water availability continues to be a long-term concern within California. Any limitation of delivery of SWP water and the absence of available alternatives during drought periods could potentially cause permanent damage to orchards and vineyards throughout California. While this could impact us, we believe we have sufficient water resources available to meet our requirements in 2017. Please see our discussion on water in Item 2, "Properties - Water Operations." The DWR announced its 2017 estimated water supply delivery at 60% of full entitlement. We expect this number to increase by late spring due to continued rains during February 2017. The current 60% allocation of SWP water is not enough for us to farm our crops, but our additional water resources, such as groundwater and surface sources, and those of the water districts we are in should allow us to have sufficient water for our farming needs. See Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding our water assets. For further discussion of the farming operations, refer to Item I “Business-Farming Operations.” Ranch Operations Revenues from ranch operations decreased $585,000 from $3,923,000 in 2015 to $3,338,000 in 2016. The decline is attributed to a $362,000 decrease in game management revenues. The on-going California drought has had an adverse effect on the quality and availability of harvestable game due to shortages in food supplies. Also contributing to the decrease is a drought clause within our grazing leases taking effect amidst the California drought, which reduced revenues by $297,000. Improvements from other revenue sources, such as filming location fees offset the declines noted by $67,000. Ranch operations expenses decreased $378,000 to $5,734,000 in 2016 from $6,112,000 in 2015. The drought as discussed above, has reduced hunt volume in 2016, thus reducing related costs such as payroll, supplies, fuel, and other services. Revenues from ranch operations increased $389,000 from $3,534,000 in 2014 to $3,923,000 in 2015. The increase is attributed to an increase in grazing lease revenues of $330,000. The increase is driven by an overall increase in the price per head of cattle. All other business lines including game management and High Desert Hunt Club remained flat. Ranch operation expenses increased by $114,000 from $5,998,000 in 2014 to $6,112,000 in 2015. The expense increase is comprised of the ongoing costs necessary to maintain the ranch and include items such as payroll, supplies, and other necessary costs. Other Income Total other income increased $750,000 to $1,659,000, or 83%, during 2016 from $909,000 in 2015. In November 2016, we sold building and land located in Rancho Santa Fe California for $4,700,000, recognizing a gain of $1,044,000. Offsetting the gain from Rancho Santa Fe California is a reduction of interest and other income of $294,000. Total other income declined $313,000, or 26%, during 2015 when compared to 2014. Investment income also declined $245,000, or 26% during 2014. The decline in both periods is primarily attributable to lower average investment balances and a decline in overall yield on the portfolio as higher yielding securities matured through the year. The above interest income relates to our marketable securities portfolio as further disclosed in Note 3, Marketable Securities of the Notes to Consolidated Financial Statements. Corporate Expenses Corporate general and administrative costs decreased $258,000, or 2%, during 2016 when compared to 2015. In 2016, we did not recognize a one-time-non-cash pension settlement charge of $536,000 as we did in 2015, which is discussed below. In addition, personnel levels decreased resulting in decreased payroll and salaries of $415,000. Offsetting the decreases include an increase in stock compensation of $532,000 resulting from meeting performance milestones and issuing new performance grants. Corporate general and administrative costs increased $2,162,000, or 20%, during 2015 when compared to 2014. We attribute $2,077,000 of the increase to payroll, severance and benefit costs. In 2015, the Company experienced an increase of $527,000 in workers compensation and health insurance costs. Workers compensation typically increases as total payroll increases while health insurance increased as a result of the Affordable Care Act. Also, during 2015 we recognized a one-time charge related to employee severance of $633,000. Lastly, we experienced an increase in pension and retirement charges of $917,000. Included in this amount is a one-time non-cash pension settlement charge of $536,000. Equity in Earnings of Unconsolidated Joint Ventures Equity in earnings of unconsolidated joint ventures is an important and growing component of our commercial/industrial activities and in the future, equity in earnings of unconsolidated joint ventures will become a significant part of our operational activity within the resort/residential segment. As we expand our current ventures and add new joint ventures, these investments will become a growing revenue source for the Company. During 2016, equity in earnings from unconsolidated joint ventures grew to $7,098,000, or an increase of $774,000, compared to $6,324,000 in 2015. TA/Petro, when compared to 2015, contributed an additional $868,000 in earnings from unconsolidated joint ventures. The improvement in operations within the TA/Petro joint venture was driven by an increase in diesel volumes of 1.5 million gallons and gas volumes of 1.0 million gallons. During 2015, equity in earnings from unconsolidated joint ventures grew to $6,324,000, or an increase of $1,030,000, compared to 2014. TA/Petro, when compared to 2014, contributed an additional $1,440,000 in earnings from unconsolidated joint ventures. The improvement in operations within the TA/Petro joint venture was driven by an increase in diesel volumes of 2.4 million gallons and gas volumes of 1.2 million gallons. Due to the addition of a new restaurant at the end of 2014 and the increase in the volume of activity the TA/Petro joint venture also saw an increase in non-fuel revenue margins during 2015. The improvement in the volumes of fuel sales for 2016 and 2015 continued to be driven by the growing amount of traffic along Interstate 5 and the expansion of offerings at TRCC such as the Outlets at Tejon and new restaurants. We expect the trend of increased volumes of fuel sales to continue into 2017. Income Taxes For the twelve months ended December 31, 2016, the Company incurred a net income tax expense of $336,000 compared to a net income tax expense of $1,125,000 for the twelve months ended December 31, 2015. These represent effective income tax rates of approximately 39% and 28% for the twelve months ended December 31, 2016 and, 2015, respectively. The effective tax rate is impacted by the noncontrolling interest held in the Centennial joint venture and the impact of depletion allowances. During 2016, permanent tax differences declined due to lower depletion allowances. Depletion allowances declined due to a reduction in oil and gas revenues. As of December 31, 2016 and 2015 we had an income tax receivable and payable of $468,000 and $1,237,000, respectively. As of December 31, 2016, we had net deferred tax assets of $2,282,000. Our largest deferred tax assets were made up of temporary differences related to the capitalization of costs, pension adjustments, and stock grant expense. Deferred tax liabilities consist of depreciation, deferred gains, cost of sale allocations, and straight-line rent. Due to the nature of most of our deferred tax assets, we believe they will be used in future years and an allowance is not necessary. The Company classifies interest and penalties incurred on tax payments as income tax expenses. The Company made total income tax payments of $1,750,000 in 2016 and $2,100,000 during 2015. The Company received refunds of $615,000 in 2016 and $283,000 in 2015. Liquidity and Capital Resources Cash Flow and Liquidity Our financial position allows us to pursue our strategies of land entitlement, development, and conservation. Accordingly, we have established well-defined priorities for our available cash, including investing in core operating segments to achieve profitable future growth. We have historically funded our operations with cash flows from operating activities, investment proceeds, and short-term borrowings from our bank credit facilities. In the past, we have also issued common stock and used the proceeds for capital investment activities. In 2014, our use of long-term debt to finance capital needs increased significantly. To enhance shareholder value, we will continue to make investments in our real estate segments to secure land entitlement approvals, build infrastructure for our developments, ensure adequate future water supplies, and provide funds for general land development activities. Within our farming segment, we will make investments as needed to improve efficiency and add capacity to its operations when it is profitable to do so. Our cash and cash equivalents and marketable securities totaled approximately $27,933,000 at December 31, 2016, a decrease of $6,812,000, or 20%, from the corresponding amount at the end of 2015. Cash and cash equivalents and marketable securities decreased during 2016 due to the sale and maturity of $11,750,000 in marketable securities of which we reinvested $5,983,000. We used cash from operations, net proceeds from marketable securities as well as the use of our line-of-credit to finance our real estate development projects at Grapevine, MV, Centennial, and TRCC. The following table summarizes the cash flow activities for the following years ended December 31: During 2016, our operations provided $5,585,000 of cash primarily attributable to operating results from mineral resources, and commercial real estate activities. We also received a $4,500,000 distribution from our TA/Petro joint venture. Please refer to "Results of Operations by Segment" for further discussion on our operating results. During 2015, our operations provided $16,968,000 of cash primarily attributable to operating results mainly from farming, mineral resource, and leasing revenues. We also received a distribution of $7,200,000 from the TA/Petro joint venture. During 2016, investing activities used $10,242,000 of cash primarily as a result of $26,380,000 in real estate and equipment expenditures. Of the $26,380,000 we spent $5,253,000, $5,244,000, $5,516,000 on pre-development and entitlement costs on our Centennial, MV, and Grapevine projects, respectively. At TRCC we used $5,196,000 for supporting infrastructure projects. Our farming segment cash outlay was $2,006,000 for developing new almond crops and acquiring farm equipment. We invested $2,161,000 into our mineral resources division primarily to develop two new water wells. The remainder of the capital investments primarily relate to capital equipment used as part of our ranch operations and corporate segments. Outside of capital projects, we acquired $5,983,000 in marketable securities and contributed $2,000,000 to joint ventures with Majestic. Offsetting our cash outlays are maturities and sales of marketable securities of $11,750,000, distributions from our joint venture partners of $1,600,000, and reimbursements from TRPFFA for qualifying infrastructure projects of $6,155,000, During 2015, investing activities used $12,661,000 of cash primarily as a result of $28,048,000 in real estate and equipment expenditures. Of the $28,048,000 we spent $5,317,000, $5,585,000, $5,667,000 on pre-development and entitlement costs on our Centennial, MV, and Grapevine projects, respectively. We used $7,023,000 for the development of two multi-tenant buildings along with supporting infrastructure projects over at TRCC. We invested $2,583,000 into our farming segment for the development of new almond and wine grape crops along with acquiring new farming equipment. We invested $1,199,000 into water related projects including water turnouts and wells that will ultimately support our real estate and farming operations. The remainder of the capital investments primarily relate to capital equipment used as part of our ranch operations and corporate segments. Outside of capital projects, we acquired $15,574,000 in marketable securities. Offsetting our cash outlays are maturities and sales of marketable securities of $24,157,000, distributions from our joint venture partners of $1,100,000, and reimbursements from TRPFFA for qualifying infrastructure projects of $4,971,000, Our estimated capital investment for 2017 is primarily related to our real estate projects as it was in 2016. These estimated investments include approximately $8,430,000 of infrastructure development at TRCC-East and West to support continued commercial retail and industrial development and to expand water facilities to support future anticipated absorption. It is assumed we will invest up to $1,600,000 into the Majestic joint venture as equity for completion of a new building. We are also investing approximately $1,420,000 to begin development of a new almond orchard and the acquisition of new farming equipment. The farm investments are part of a long-term farm management program to redevelop declining orchards and vineyards to maintain and improve future farm revenues. We expect to possibly invest up to $19,950,000 for land planning, entitlement activities, and development activities at MV, Centennial, and Grapevine during 2017. The timing of these investments is dependent on our coordination efforts with Los Angeles County regarding entitlement efforts for Centennial, litigation and permitting activities for Grapevine, and tentative tract maps for MV. Our plans also call for the potential investment of up to $1,300,000 in water infrastructure and as opportunities arise to help secure additional water assets for real estate, farming, and as an investment. We are also planning to potentially invest up to $900,000 in the normal replacement of operating equipment, such as ranch equipment, and updates to our information technology systems. During 2016, financing activities provided $3,985,000 through $20,700,000 in drawdowns from our line of credit offset by paydowns of $13,815,000 on our line of credit and long-term borrowings. During 2015, financing activities used $8,015,000 resulting from borrowing $17,540,000 on our line of credit offset by payments of $24,390,000 on our line of credit and long-term borrowings. It is difficult to accurately predict cash flows due to the nature of our businesses and fluctuating economic conditions. Our earnings and cash flows will be affected from period to period by the commodity nature of our farming and mineral operations, the timing of sales and leases of property within our development projects, and the beginning of development within our residential projects. The timing of sales and leases within our development projects is difficult to predict due to the time necessary to complete the development process and negotiate sales or lease contracts. Often, the timing aspect of land development can lead to particular years or periods having more or less earnings than comparable periods. Based on our experience, we believe we will have adequate cash flows, cash balances, and availability on our line of credit over the next twelve months to fund internal operations. As we move forward with the completion of the entitlement process for our master planned communities and prepare to move into the development stage, we will need to secure additional funding through the issuance of equity and secure other forms of financing such as joint ventures and possibly debt financing. Capital Structure and Financial Condition At December 31, 2016, total capitalization at book value was $415,873,000 consisting of $81,406,000 of debt, net of deferred financing costs, and $334,467,000 of equity, resulting in a debt-to-total-capitalization ratio of approximately 19.6%, which is an increase when compared to the debt-to-total-capitalization ratio of 18.2% at December 31, 2015. On October 13, 2014, the Company as borrower, entered into an Amended and Restated Credit Agreement, a Term Note and a Revolving Line of Credit Note, with Wells Fargo, or collectively the Credit Facility. The Credit Facility adds a $70,000,000 term loan, or Term Loan, to the existing $30,000,000 revolving line of credit, or RLC. Funds from the Term Loan were used to finance the Company's purchase of DMB TMV LLC’s interest in MV as disclosed in the Current Report on Form 8-K filed on July 16, 2014. The Term Loan had a $69,439,000 balance as of December 31, 2016. Any future borrowings under the RLC will be used for ongoing working capital requirements and other general corporate purposes. To maintain availability of funds under the RLC, undrawn amounts under the RLC will accrue a commitment fee of 10 basis points per annum. The Company's ability to borrow additional funds in the future under the RLC is subject to compliance with certain financial covenants and making certain representations and warranties. At the Company’s option, the interest rate on the RLC can float at 1.50% over a selected LIBOR rate or can be fixed at 1.50% above LIBOR for a fixed rate term. During the term of this credit facility (which matures in September 2019), we can borrow at any time and partially or wholly repay any outstanding borrowings and then re-borrow, as necessary. The outstanding balance on the RLC was $7,700,000 and $0 as of December 31, 2016 and 2015, respectively. The interest rate per annum applicable to the Term Loan is LIBOR (as defined in the Term Note) plus a margin of 170 basis points. The interest rate for the term of the note has been fixed through the use of an interest rate swap at a rate of 4.11%. We utilize an interest rate swap agreement to hedge our exposure to variable interest rates associated with our term loan. The Term Loan requires interest only payments for the first two years of the term and thereafter requires monthly amortization payments pursuant to a schedule set forth in the Term Note, with the final outstanding principal amount due October 5, 2024. TRC may make voluntary prepayments on the Term Loan at any time without penalty (excluding any applicable LIBOR or interest rate swap breakage costs). Each optional prepayment will be applied to reduce the most remote principal payment then unpaid. The Credit Facility is secured by TRC’s farmland and farm assets, which include equipment, crops and crop receivables and the power plant lease and lease site, and related accounts and other rights to payment and inventory. The Credit Facility requires compliance with three financial covenants: (a) total liabilities divided by tangible net worth not greater than 0.75 to 1.0 at each quarter end; (b) a debt service coverage ratio not less than 1.25 to 1.00 as of each quarter end on a rolling four quarter basis; and (c) maintain liquid assets equal to or greater than $20,000,000. At December 31, 2016, we were in compliance with the financial covenants. The Credit Facility also contains customary negative covenants that limit the ability of TRC to, among other things, make capital expenditures, incur indebtedness and issue guaranties, consummate certain assets sales, acquisitions or mergers, make investments, pay dividends or repurchase stock, or incur liens on any assets. The Credit Facility contains customary events of default, including: failure to make required payments; failure to comply with terms of the Credit Facility; bankruptcy and insolvency; and a change in control without consent of bank (which consent will not be unreasonably withheld). The Credit Facility contains other customary terms and conditions, including representations and warranties, which are typical for credit facilities of this type. We also have a $4,750,000 promissory note agreement with principal and interest due monthly starting on October 1, 2013. The interest rate on this promissory note is 4.25% per annum, with principal and interest payments ending on September 1, 2028. The balance as of December 31, 2016 is $3,961,000. The proceeds from this promissory note were used to eliminate debt that had been previously used to provide long-term financing for a building being leased to Starbucks and provide additional working capital for future investment. Our current and future capital resource requirements will be provided primarily from current cash and marketable securities, cash flow from on-going operations, proceeds from the sale of developed and undeveloped parcels, potential sales of assets, additional use of debt, proceeds from the reimbursement of public infrastructure costs through CFD bond debt (described below under “Off-Balance Sheet Arrangements”), and the issuance of common stock. In April 2016, we filed an updated shelf registration statement on Form S-3 that went effective in May 2016. Under the shelf registration statement, we may offer and sell in the future one or more offerings, common stock, preferred stock, debt securities, warrants or any combination of the foregoing. The shelf registration allows for efficient and timely access to capital markets and when combined with our other potential funding sources just noted, provides us with a variety of capital funding options that can then be used and appropriately matched to the funding need. On August 7, 2013, the Company announced that its Board of Directors declared a dividend of 3,000,000 warrants to purchase shares of Company common stock, par value $0.50 per share, or Warrants, to holders of record of Common Stock as of August 21, 2013, the Record Date. The Warrants were distributed to shareholders on August 28, 2013. Each Warrant entitled the holder to purchase one share of Common Stock at an initial exercise price of $40.00 per share and expired unexercised on August 31, 2016. As noted above, at December 31, 2016, we had $27,933,000 in cash and securities and as of the filing date of this Form 10-K, we have $22,300,000 available on credit lines to meet any short-term liquidity needs. We continue to expect that substantial investments will be required in order to develop our land assets. In order to meet these capital requirements, we may need to secure additional debt financing and continue to renew our existing credit facilities. In addition to debt financing, we will use other capital alternatives such as joint ventures with financial partners, sales of assets, and the issuance of common stock. We will use a combination of the above funding sources to properly match funding requirements with the assets or development project being funded. There is no assurance that we can obtain financing or that we can obtain financing at favorable terms. We believe we have adequate capital resources to fund our cash needs and our capital investment requirements in the near-term as described earlier in the cash flow and liquidity discussions. Contractual Cash Obligations The following table summarizes our contractual cash obligations and commercial commitments as of December 31, 2016, to be paid over the next five years: The categories above include purchase obligations and other long-term liabilities reflected on our balance sheet under GAAP. A “purchase obligation” is defined in Item 303(a)(5)(ii)(D) of Regulation S-K as “an agreement to purchase goods or services that is enforceable and legally binding the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.” Based on this definition, the table above includes only those contracts that include fixed or minimum obligations. It does not include normal purchases, which are made in the ordinary course of business. Our financial obligations to the Tejon Ranch Conservancy are prescribed in the Conservation Agreement. Our advances to the Tejon Ranch Conservancy are dependent on the occurrence of certain events and their timing, and are therefore subject to change in amount and period. The amounts included above are the minimum amounts we anticipate contributing through the year 2021, at which time our current contractual obligation terminates. As discussed in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements, we have long-term liabilities for deferred employee compensation, including pension and supplemental retirement plans. Payments in the above table reflect estimates of future defined benefit plan contributions from the Company to the plan trust, estimates of payments to employees from the plan trust, and estimates of future payments to employees from the Company that are in the SERP program. During 2016, we did not make any pension contributions and it is projected that there will be no required contributions in 2017. Our cash contract commitments consist of contracts in various stages of completion related to infrastructure development within our industrial developments and entitlement costs related to our industrial and residential development projects. Also, included in the cash contract commitments are estimated fees earned during the second quarter of 2014 by a consultant, related to the entitlement of the Grapevine Development Area. The Company exited a consulting contract during the second quarter of 2014 related to the Grapevine Development and is obligated to pay an earned incentive fee at the time of successful receipt of litigated project entitlements and at a value measurement date five-years after entitlements have been achieved for Grapevine. The final amount of the incentive fees will not be finalized until the future payment dates. The Company believes that net savings from exiting the contract over this future time period will more than offset the incentive payment costs. Estimated water payments include SWP contracts with Wheeler Ridge Maricopa Water Storage District, Tejon-Castac Water District, Tulare Lake Basin Water Storage District, and Dudley-Ridge Water Storage District. These contracts for the supply of future water run through 2035. In addition, in late 2013 we purchased the assignment of a contract to purchase water. The assigned water contract is with Nickel Family, LLC and obligates us to purchase 6,693 acre-feet of water starting in 2014 and running through 2044. Please refer to Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding water assets. Our operating lease obligations are for office equipment, several vehicles, and a temporary trailer providing office space and average approximately $25,000 per month. At the present time, we do not have any capital lease obligations or purchase obligations outstanding. Off-Balance Sheet Arrangements The following table shows contingent obligations we have with respect to the CFDs. TRPFFA is a joint powers authority formed by Kern County and TCWD to finance public infrastructure within the Company’s Kern County developments. TRPFFA created two CFDs, the West CFD and the East CFD. The West CFD has placed liens on 420 acres of the Company’s land to secure payment of special taxes related to $28,620,000 of bond debt sold by TRPFFA for TRCC-West. The East CFD has placed liens on 1,931 acres of the Company’s land to secure payments of special taxes related to $55,000,000 of bond debt sold by TRPFFA for TRCC-East. At TRCC-West, the West CFD has no additional bond debt approved for issuance. At TRCC-East, the East CFD has approximately $65,000,000 of additional bond debt authorized by TRPFFA. In connection with the sale of bonds there is a standby letter of credit for $4,921,000 related to the issuance of East CFD bonds. The standby letter of credit is in place to provide additional credit enhancement and cover approximately two year's worth of interest on the outstanding bonds. This letter of credit will not be drawn upon unless the Company, as the largest landowner in the CFD, fails to make its property tax payments. As development occurs within TRCC-East there is a mechanism in the bond documents to reduce the amount of the letter of credit. The Company believes that the letter of credit will never be drawn upon. This letter of credit is for a two-year period of time and will be renewed in two-year intervals as necessary. The annual cost related to the letter of credit is approximately $83,000. The assessment of each individual property sold or leased within each CFD is not determinable at this time because it is based on the current tax rate and the assessed value of the property at the time of sale or on its assessed value at the time it is leased to a third-party. Accordingly, the Company is not required to recognize an obligation at December 31, 2015. At December 31, 2016, aggregate outstanding debt of unconsolidated joint ventures was $97,318,000. We guarantee $82,043,000 of this debt, relating to our joint ventures with Rockefeller and Majestic. Because of positive cash flow generation within the Rockefeller and Majestic joint ventures, we do not expect the guarantee to ever be called upon. We do not provide a guarantee on the $15,275,000 of debt related to our joint venture with TA/Petro. Non-GAAP Financial Measures EBITDA represents earnings before interest, taxes, depreciation, and amortization, a non-GAAP financial measure, and is used by us and others as a supplemental measure of performance. We use Adjusted EBITDA to assess the performance of our core operations, for financial and operational decision making, and as a supplemental or additional means of evaluating period-to-period comparisons on a consistent basis. Adjusted EBITDA is calculated as EBITDA, excluding stock compensation expense. We believe Adjusted EBITDA provides investors relevant and useful information because it permits investors to view income from our operations on an unleveraged basis before the effects of taxes, depreciation and amortization, and stock compensation expense. By excluding interest expense and income, EBITDA and Adjusted EBITDA allow investors to measure our performance independent of our capital structure and indebtedness and, therefore, allow for a more meaningful comparison of our performance to that of other companies, both in the real estate industry and in other industries. We believe that excluding charges related to share-based compensation facilitates a comparison of our operations across periods and among other companies without the variances caused by different valuation methodologies, the volatility of the expense (which depends on market forces outside our control), and the assumptions and the variety of award types that a company can use. EBITDA and Adjusted EBITDA have limitations as measures of our performance. EBITDA and Adjusted EBITDA do not reflect our historical cash expenditures or future cash requirements for capital expenditures or contractual commitments. While EBITDA and Adjusted EBITDA are relevant and widely used measures of performance, they do not represent net income or cash flows from operations as defined by GAAP, and they should not be considered as alternatives to those indicators in evaluating performance or liquidity. Further, our computation of EBITDA and Adjusted EBITDA may not be comparable to similar measures reported by other companies. The Company utilizes net operating income (NOI) for its unconsolidated joint ventures as a measure of financial or operating performance that is not specifically defined by GAAP in the United States. We believe NOI of unconsolidated joint ventures provides investors with additional information concerning operating performance of our unconsolidated joint ventures. We also use this measure internally to monitor the operating performance of our unconsolidated joint ventures. Our computation of this non-GAAP measure may not be the same as similar measures reported by other companies. This non-GAAP financial measure should not be considered as an alternative to net income as a measure of the operating performance of our unconsolidated joint ventures or to cash flows computed in accordance with GAAP as a measure of liquidity nor are they indicative of cash flows from operating and financial activities of our unconsolidated joint ventures. The following schedule reconciles net income from unconsolidated joint ventures to NOI.

<s>[INST] See Part I, "ForwardLooking Statements" for our cautionary statement regarding forwardlooking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10K, beginning at page. It also should be read in conjunction with the disclosure under “ForwardLooking Statements” in Part 1 of this Form 10K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five operating segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active developments are MV, Centennial, and Grapevine. During the last quarter of 2016, the Kern County Board of Supervisors granted entitlement approval for our land planning activities for Grapevine, which is an approximately 8,010 acre development area located on the San Joaquin Valley floor area of our lands, adjacent to TRCC. These approvals included certification of our final environmental impact report and related findings, approval of associated general plan amendments, and adoption of associated zoning maps. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2016, net income attributable to common stockholders was $558,000 compared to $2,950,000 in 2015. Factors driving the change include: a decline in farming revenues of $5,188,000 resulting from declines in commodity prices and a decline of mineral resource revenues of $963,000 resulting from falling oil prices in 2016. Offsetting the decline in net income were the following factors: an increase in commercial real estate revenues of $1,166,000 resulting from a land sale, and increased rents, a gain on sale of building and land located in Rancho Santa Fe, California of $1,044,000, an overall reduction in total expenses of $860,000, and an increase in income from unconsolidated joint ventures of $774,000. For 2015, net income attributable to common stock [/INST] Positive. </s>

TEJON RANCH CO

2018-03-12

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See Part I, "Forward-Looking Statements" for our cautionary statement regarding forward-looking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part 1 of this Form 10-K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five operating segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active mixed use master plan developments are MV, Centennial, and Grapevine. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2017, net loss attributable to common stockholders was $1,555,000 compared to net income attributed to common stockholders of $558,000 in 2016. Factors driving the change include: a decline in farming revenues of $2,214,000 resulting from a decline in pistachio production in excess of 2,200,000 pounds, a decline in mineral resource revenues of $8,170,000 resulting from decreased sales opportunities for water in 2017 when compared to 2016, and a decrease in income from unconsolidated joint ventures of $2,871,000. From an expense perspective, expenses decreased $10,282,000 as a result of reduced water sales and our staff rightsizing initiatives. For 2016, net income attributable to common stockholders was $558,000 compared to $2,950,000 in 2015. Factors driving the change include: a decline in farming revenues of $5,188,000 resulting from declines in commodity prices and a decline of mineral resource revenues of $963,000 resulting from falling oil prices in 2016. Offsetting the decline in net income were the following factors: an increase in commercial real estate revenues of $1,166,000 resulting from a land sale, and increased rents, a gain on sale of building and land located in Rancho Santa Fe, California of $1,044,000, an overall reduction in total expenses of $860,000, and an increase in income from unconsolidated joint ventures of $774,000. For the year ended December 31, 2017 we had no material lease renewals. During 2018, we will continue to invest funds toward the achievement of entitlements, permits, and maps for our land and for master project infrastructure and vertical development within our active commercial and industrial development. Securing entitlements for our land is a long, arduous process that can take several years and often involves litigation. During the next few years, our net income will fluctuate from year-to-year based upon, among other factors, commodity prices, production within our farming segment, and the timing of sales of land and the leasing of land within our industrial developments. During the fourth quarter of 2015, the Company reclassified revenues and expenses previously classified as commercial/industrial into a new segment called Ranch Operations. Ranch Operations is comprised of grazing leases, game management, and other ancillary services supporting the ranch. This Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a narrative discussion of our results of operations. It contains the results of operations for each operating segment of the business and is followed by a discussion of our financial position. It is useful to read the business segment information in conjunction with Note 16 (Operating Segments and Related Information) of the Notes to Consolidated Financial Statements. Critical Accounting Policies The preparation of our consolidated financial statements in accordance with generally accepted accounting principles, or GAAP, requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimates that are likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, impairment of long-lived assets, capitalization of costs, allocation of costs related to land sales and leases, stock compensation, our future ability to utilize deferred tax assets, and defined benefit retirement plans. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact on our financial statements. See also Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements, which discusses accounting policies that we have selected from acceptable alternatives. We believe the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements: Revenue Recognition - The Company’s revenue is primarily derived from lease revenue from our rental portfolio, royalty revenue from mineral leases, sales of farm crops, sales of water, and land sales. Revenue from leases with rent concessions or fixed escalations is recognized on a straight-line basis over the initial term of the related lease unless there is a considerable risk as to collectability. The financial terms of leases are contractually defined. Lease revenue is not accrued when a tenant vacates the premises and ceases to make rent payments or files for bankruptcy. Royalty revenues are contractually defined as to the percentage of royalty and are tied to production and market prices. Our royalty arrangements generally require payment on a monthly basis with the payment based on the previous month’s activity. We accrue monthly royalty revenues based upon estimates and adjust to actual as we receive payments. From time to time the Company sells easements over its land. The easements are either in the form of rights of access granted for such things as utility corridors or are in the form of conservation easements that generally require the Company to divest its rights to commercially develop a portion of its land, but do not result in a change in ownership of the land or restrict the Company from continuing other revenue generating activities on the land. Sales of conservation easements are accounted for in accordance with Staff Accounting Bulletin Topic 13 - Revenue Recognition, or SAB Topic 13. Since conservation easements generally do not impose any significant continuing performance obligations on the Company, revenue from conservation easement sales have been recognized when the four criteria outlined in SAB Topic 13 have been met, which generally occurs in the period the sale has closed and consideration has been received. In recognizing revenue from land sales, the Company follows the provisions in Accounting Standards Codification 976, or ASC 976, “Real Estate - Retail Land” to record these sales. ASC 976 provides specific sales recognition criteria to determine when land sales revenue can be recorded. For example, ASC 976 requires a land sale to be consummated with a sufficient down payment of at least 20% to 25% of the sales price depending upon the type and timeframe for development of the property sold, and that any receivable from the sale cannot be subject to future subordination. In addition, the seller cannot retain any material continuing involvement in the property sold or be required to develop the property in the future. At the time farm crops are harvested, contracted, and delivered to buyers and revenues can be estimated, revenues are recognized and any related inventoried costs are expensed, which traditionally occurs during the third and fourth quarters of each year. It is not unusual for portions of our almond or pistachio crop to be sold in the year following the harvest. Orchard (almond and pistachio) revenues are based upon the contract settlement price or estimated selling price, whereas vineyard revenues are typically recognized at the contracted selling price. Estimated prices for orchard crops are based upon the quoted estimate of what the final market price will be by marketers and handlers of the orchard crops. These market price estimates are updated through the crop payment cycle as new information is received as to the final settlement price for the crop sold. These estimates are adjusted to actual upon receipt of final payment for the crop. This method of recognizing revenues on the sale of orchard crops is a standard practice within the agribusiness community. Actual final crop selling prices are not determined for several months following the close of our fiscal year due to supply and demand fluctuations within the orchard crop markets. Adjustments for differences between original estimates and actual revenues received are recorded during the period in which such amounts become known. For a discussion of implementation of Accounting Standards Update (ASU) 2014-09 “Revenue with Contracts from Customers (Topic 606),” see Note 1 (Summary of Significant Accounting Policies) of the Notes to the Consolidated Financial Statements. Capitalization of Costs - The Company capitalizes direct construction and development costs, including predevelopment costs, interest, property taxes, insurance, and indirect project costs that are clearly associated with the acquisition, development, or construction of a project. Costs currently capitalized that in the future would be related to any abandoned development opportunities will be written off if we determine such costs do not provide any future benefits. Should development activity decrease, a portion of interest, property taxes, and insurance costs would no longer be eligible for capitalization, and would be expensed as incurred. Allocation of Costs Related to Land Sales and Leases - When we sell or lease land within one of our real estate developments, as we are currently doing within TRCC, and we have not completed all infrastructure development related to the total project, we follow ASC 976 to determine the appropriate costs of sales for the sold land and the timing of recognition of the sale. In the calculation of cost of sales or allocations to leased land, we use estimates and forecasts to determine total costs at completion of the development project. These estimates of final development costs can change as conditions in the market and costs of construction change. In preparing these estimates, we use internal budgets, forecasts, and engineering reports to help us estimate future costs related to infrastructure that has not been completed. These estimates become more accurate as the development proceeds forward, due to historical cost numbers and to the continued refinement of the development plan. These estimates are updated periodically throughout the year so that, at the ultimate completion of development, all costs have been allocated. Any increases to our estimates in future years will negatively impact net profits and liquidity due to an increased need for funds to complete development. If, however, this estimate decreases, net profits as well as liquidity will improve. We believe that the estimates used related to cost of sales and allocations to leased land are critical accounting estimates and will become even more significant as we continue to move forward as a real estate development company. The estimates used are very susceptible to change from period to period, due to the fact that they require management to make assumptions about costs of construction, absorption of product, and timing of project completion, and changes to these estimates could have a material impact on the recognition of profits from the sale of land within our developments. Impairment of Long-Lived Assets - We evaluate our property and equipment and development projects for impairment when events or changes in circumstances indicate that the carrying value of assets contained in our financial statements may not be recoverable. The impairment calculation compares the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows (discounted). We recognize an impairment loss equal to the amount by which the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited. We currently operate in five segments: commercial/industrial real estate development, resort/residential real estate development, mineral resources, farming, and ranch operations. At this time, there are no assets within any of our segments that we believe are in danger of being impaired due to market conditions. We believe that the accounting estimate related to asset impairment is a critical accounting estimate because it is very susceptible to change from period to period; it requires management to make assumptions about future prices, production, and costs, and the potential impact of a loss from impairment could be material to our earnings. Management’s assumptions regarding future cash flows from real estate developments and farming operations have fluctuated in the past due to changes in prices, absorption, production and costs and are expected to continue to do so in the future as market conditions change. In estimating future prices, absorption, production, and costs, we use our internal forecasts and business plans. We develop our forecasts based on recent sales data, historical absorption and production data, input from marketing consultants, as well as discussions with commercial real estate brokers and potential purchasers of our farming products. If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed to impairment losses that could be material to our results of operations. Defined Benefit Retirement Plans - The plan obligations and related assets of our defined benefit retirement plan are presented in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using level one and level two indicators, which are quoted prices in active markets and quoted prices for similar types of assets in active markets for the investments. Pension benefit obligations and the related effects on operations are calculated using actuarial models. The estimation of our pension obligations, costs and liabilities requires that we make use of estimates of present value of the projected future payments to all participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. These assumptions may have an effect on the amount and timing of future contributions. The assumptions used in developing the required estimates include the following key factors: • Discount rates; • Salary growth; • Retirement rates; • Expected contributions; • Inflation; • Expected return on plan assets; and • Mortality rates The discount rate enables us to state expected future cash flows at a present value on the measurement date. In determining the discount rate, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments. Salary increase assumptions are based upon historical experience and anticipated future management actions. To determine the expected long-term rate of return on pension plan assets, we consider the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. At December 31, 2017, the weighted-average actuarial assumption of the Company’s defined benefit plan consisted of a discount rate of 3.7% and a long-term rate of return on plan assets of 7.5%. For the years beginning with 2017, there are no assumed salary increase factors included in the plan assumptions due to the plan being amended to freeze future benefits. The effects of actual results differing from our assumptions and the effects of changing assumptions are recognized as a component of other comprehensive income, net of tax. Amounts recognized in accumulated other comprehensive income are adjusted as they are subsequently recognized as components of net periodic benefit cost. If we were to assume a 50-basis point change in the discount rate used, our projected benefit obligation would change approximately $800,000. Stock-Based Compensation - We apply the recognition and measurement principles of ASC 718, “Compensation - Stock Compensation” in accounting for long-term stock-based incentive plans. Our stock-based compensation plans include both restricted stock units and restricted stock grants. We have not issued any stock options to employees or directors since January 2003, and our 2017 financial statements do not reflect any compensation expenses for stock options. All stock options issued in the past have been exercised or forfeited. We make stock awards to employees based upon time-based criteria and through the achievement of performance-related objectives. Performance-related objectives are either stratified into threshold, target, and maximum goals or based on the achievement of a milestone event. These stock awards are currently being expensed over the expected vesting period based on each performance criterion. We make estimates as to the number of shares that will actually be granted based upon estimated ranges of success in meeting the defined performance measures. If our estimates of performance shares vesting were to change by 25%, stock compensation expense would increase or decrease by approximately $400,000 depending on whether the change in estimate increased or decreased shares vesting. See Note 11, (Stock Compensation - Restricted Stock and Performance Share Grants), of the Notes to Consolidated Financial Statement for total 2017 stock compensation expense related to stock grants. Fair Value Measurements - The Financial Accounting Standards Board's, or FASB, authoritative guidance for fair value measurements of certain financial instruments defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Fair value is defined as the exchange (exit) price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance establishes a three-level hierarchy for fair value measurements based upon the inputs to the valuation of an asset or liability. Observable inputs are those which can be easily seen by market participants while unobservable inputs are generally developed internally, utilizing management’s estimates and assumptions: • Level 1 - Valuation is based on quoted prices in active markets for identical assets and liabilities. • Level 2 - Valuation is determined from quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market. • Level 3 - Valuation is derived from model-based techniques in which at least one significant input is unobservable and based on our own estimates about the assumptions that market participants would use to value the asset or liability. When available, we use quoted market prices in active markets to determine fair value. We consider the principal market and nonperformance risk associated with our counterparties when determining the fair value measurement. Fair value measurements are used for marketable securities, investments within the pension plan and hedging instruments. Recent Accounting Pronouncements For discussion of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements. Results of Operations by Segment We evaluate the performance of our operating segments separately to monitor the different factors affecting financial results. Each segment is subject to review and evaluation as we monitor current market conditions, market opportunities, and available resources. The performance of each segment is discussed below: Real Estate - Commercial/Industrial During 2017, commercial/industrial segment revenues decreased $35,000, or 0%, when compared to 2016. The Pastoria lease revenues increased $242,000, or 7%, when compared to 2016, we also experienced an increase of $366,000, or 18%, in leasing revenues within TRCC. These increases were offset by a decrease in commercial lease revenues of $354,000, or 22%, as a result of the sale in 2016 of an investment asset. During 2017, we satisfied our performance obligation relating to the land sale which occurred in 2016 and recognized the remaining deferred revenue in 2017. Commercial/industrial real estate segment expenses decreased $571,000, or 8%, from $7,100,000 in 2016 to $6,529,000 during 2017. During 2017, payroll, overhead, and bonuses decreased $269,000 as a result of our staff right sizing. Also contributing to the decrease were reductions in professional services and repairs and maintenance costs of $149,000 and $153,000 respectively. During 2016, commercial/industrial segment revenues increased $1,166,000, or 14% when compared to 2015. In October 2016, we sold unimproved real property located at TRCC-East for $1,193,000. We recognized $710,000 of the revenues in 2016 and recognized the remainder during the first half of 2017 upon completion of the performance obligations. Also in 2016, we placed into service a multi-tenant building leased to Baja Fresh and Habit Burger increasing lease revenue by $266,000. Lastly, we recognized additional leasing revenues of $48,000 from Starbucks and Pieology given that they were not placed into service until the latter part of the second quarter of 2015. Commercial/industrial real estate segment expenses were $7,100,000 during 2016, an increase of $406,000, or 6%, compared to the same period in 2015. During 2016, there were increases in professional services and repairs and maintenance of $126,000 and $108,000, respectively. Additionally, the basis in the land sold was $95,000. The logistics operators currently located within TRCC have demonstrated success in serving all of California and the western region of the United States, and we are building from their success in our marketing efforts. We will continue to focus our marketing strategy for TRCC-East and TRCC-West on the significant labor and logistical benefits of our site, the pro-business approach of Kern County, and the demonstrated success of the current tenants and owners within our development. Our strategy fits within the logistics model that many companies are using, which favors large, centralized distribution facilities which have been strategically located to maximize the balance of inbound and outbound efficiencies, rather than a number of decentralized smaller distribution centers. The world class logistics operators located within TRCC have demonstrated success through utilization of this model. With access to markets of over 40 million people for next-day delivery service, they are also demonstrating success with e-commerce fulfillment. We believe that our ability to provide fully-entitled, shovel-ready land parcels to support buildings of any size, especially buildings 1.0 million square feet or larger, can provide us with a potential marketing advantage in the future. We are also expanding our marketing efforts to include industrial users in the Santa Clarita Valley of northern Los Angeles County, and the northern part of the San Fernando Valley due to the limited availability of new product and high real estate costs in these locations. Tenants in these geographic areas are typically users of relatively smaller facilities. In pursuit of such opportunities, the Company, in 2017, completed development of a 480,480 square foot, state-of-the-art distribution facility with Majestic Realty Co. The Company and Majestic Realty Co. are in the process of fully leasing this industrial building. A potential disadvantage to our development strategy is our distance from the ports of Los Angeles and Long Beach in comparison to the warehouse/distribution centers located in the Inland Empire, a large industrial area located east of Los Angeles, which continues its expansion eastward beyond Riverside and San Bernardino, to include Perris, Moreno Valley, and Beaumont. As development in the Inland Empire continues to move east and farther away from the ports, our potential disadvantage of our distance from the ports is being mitigated. Strong demand for large distribution facilities is driving development farther east in a search for large entitled parcels. During 2017, vacancy rates in the Inland Empire approximated 3.7%, the lowest vacancy rate ever recorded in the Inland Empire. Vacancy is at an all-time low and further declines will be hard to achieve. This is especially true given that 26.1 million square feet remains in the construction pipeline. The low vacancy rates have also led to an increase in lease rates of 7.7% within the Inland Empire. As lease rates increase in the Inland Empire, we may begin to have greater pricing advantages due to our lower land basis. During 2017, vacancy rates in the northern Los Angeles industrial market, which includes the San Fernando Valley and Santa Clarita Valley, approximated 1.7%. This industrial market continues to see available supply remain at extremely low levels, and while new construction has recently been at higher levels, it still has not been enough to keep pace with strong demand, resulting in vacancy remaining at all-time lows and rental rates still rising rapidly. Demand for industrial space in this market will continue to be driven by domestic and global consumption levels. In 2017, the Los Angeles and Long Beach Port container traffic recorded its highest container total ever with 16.89 million Twenty-Foot Equivalent Units, or TEU's, up 8% from 2016 and 7% higher than its second highest year during 2006. TEU is a measure of a ship's cargo carrying capacity. The dimensions of one TEU are equal to that of a standard shipping container measuring 20 feet long by 8 feet tall. We expect the commercial/industrial segment to continue to experience costs, net of amounts capitalized, primarily related to professional service fees, marketing costs, commissions, planning costs, and staffing costs as we continue to pursue development opportunities. These costs are expected to remain consistent with current levels of expense with any variability in the future tied to specific absorption transactions in any given year. The actual timing and completion of development is difficult to predict due to the uncertainties of the market. Infrastructure development and marketing activities and costs could continue over several years as we develop our land holdings. We will also continue to evaluate land resources to determine the highest and best uses for our land holdings. Future sales of land are dependent on market circumstances and specific opportunities. Our goal in the future is to increase land value and create future revenue growth through planning and development of commercial and industrial properties. Real Estate - Resort/Residential In 2017, resort/residential segment expenses increased $325,000 primarily due to reduced capitalization of payroll and overhead costs that in the prior years were identified to be incremental to our mixed use master plan development projects. We are in the preliminary stages of development, hence no revenues are attributed to this segment. In 2016, resort/residential segment expenses declined $719,000 primarily due to additional capitalization of payroll and overhead costs of $475,000 that were identified to be incremental to our master plan development projects. In addition, there were decreases in professional service and fees of $261,000. Our resort/residential segment activities include land entitlement, land planning and pre-construction engineering and conservation activities. We have three major resort/residential communities within this segment: Centennial, Grapevine, and MV. • For Centennial, Los Angeles County is currently reviewing the EIR, the responses will become part of the Final Environmental Impact Report that will be considered first by the Los Angeles County Regional Planning Commission tentatively in April 2018 and later by the Board of Supervisors. • For Grapevine, we are working with Kern County to defend litigation related to the approved EIR. The entire litigation and permitting process will take several years and the investment of several million dollars to successfully complete. • For MV, we have a fully permitted and entitled project and received approval of a Tentative Tract Map for our first phases of development in December 2017. The timing of MV development in the coming years will be dependent on the strength of both the economy and the second home real estate market. In moving the project forward, we will focus on the preparation of engineering leading to the final map for the first phases of MV, consumer and market research studies and fine tuning of development business plans as well as defining the capital funding sources for this development. The resort/residential segment will continue to incur costs in the future related to professional service fees, public relations costs, and staffing costs as we continue forward with entitlement and permitting activities for the above communities and continue to meet our obligations under the Conservation Agreement. We expect these expenses to remain consistent with current years cost in the near term and only begin to increase as we move into the development phase of each project in the future. The actual timing and completion of entitlement-related activities and the beginning of development is difficult to predict due to the uncertainties of the approval process, the possibility of litigation upon approval of our entitlements in the future, and the status of the economy. We will also continue to evaluate land resources to determine the highest and best use for our land holdings. Our long-term goal through this process is to increase the value of our land and create future revenue opportunities through resort and residential development. We are continuously monitoring the markets in order to identify the appropriate time in the future to begin infrastructure improvements and lot sales. Our long-term business plan of developing the communities of MV, Centennial, and Grapevine remains unchanged. As the California economy continues to improve we believe the perception of land values will also begin to improve and the long-term fundamentals that support housing demand in our region, primarily California population growth and household formation will also improve. California also has a significant documented housing shortage, which we believe our communities will help ease as the population base within California continues to grow. See Item 1, “Business - Real Estate Development Overview” for a further discussion of real estate development activities. Mineral Resources 2017 Operational Highlights: • Revenues from our mineral resources segment decreased $8,170,000, or 58%, to $5,983,000 in 2017 compared to $14,153,000 in 2016. During the 2016/2017 winter, California experienced above normal rain fall and snow levels, resulting in a reduction in water market activity throughout the state adversely impacting water sales opportunities. This resulted in an $8,347,000 decline in water sales. The reduced water sales accordingly decreased mineral resources expenses associated with the cost of sales of water by $4,832,000. California has historically experienced decades-long droughts, the rain falls in 2017 do not appear to be repeating in 2018, which leads some to believe the drought may be returning, suggesting water opportunities in 2018 can see improvements. This also lends itself to a volatile water market that can change from year-to-year based on rain and snow levels. • We experienced improvements in cement production as a result of increased demand and pricing during 2017 compared to 2016. The improvement in shipments is due to an increase in road construction activity as compared to the prior years. • Despite falling production, we experienced improvements for oil and gas royalties as a result of improved oil prices. Please refer to above table for current and historical production volume and pricing. 2016 Operational Highlights: • Revenues decreased $963,000, or 6%, to $14,153,000 in 2016 compared to $15,116,000 in 2015. The decrease is primarily due to a $1,112,000 decrease in oil royalty revenues driven by lower average prices for a barrel of oil, which then led to declines in production. • Also in 2016, we sold 7,285 acre-feet of water compared to 7,922 acre-feet in 2015 reducing water revenues by $570,000. Offsetting those amounts were improvements in cement, sand, and rock royalties of $330,000 and reimbursable costs and other of $364,000. • Expenses during 2016 increased $400,000 compared to 2015, primarily due to increases in payroll and salaries of $125,000 and fuel costs of $94,000 related to transferring and banking water. The remainder of the increase can be attributed to increases in other expenses including property taxes, professional services, and fees. Please refer to Item 1, "Business - Mineral Resources" for additional information regarding oil barrels per day production. Although oil prices improved during the fourth quarter of 2017 and throughout the early part of 2018, we expect our largest tenant, California Resources Corporation, or CRC, to continue its program of producing from current active wells at lower levels with no near-term intent to begin new drilling programs until oil prices stabilize at the current higher levels. CRC has approved permits and drill sites on our land and has delayed the start of drilling as it evaluates the market. A positive aspect of our lease with CRC is that the approved drill sites are in an area of the ranch where the development and production costs are moderate due to the depths being drilled. During 2017, CRC executed a new exploration lease with us covering 1,524 acres. With the overall improvement in prices, we could see an improvement in royalty revenue. Thus far in 2018, oil prices have improved and are within 5% of West Texas Intermediate pricing. Since we only receive royalties based on tenant production and market prices and do not produce oil, we do not have information as to the potential size of oil reserves. Our royalty revenues are contractually defined and based on a percentage of production and are received in cash. Royalty revenues fluctuate based on changes in market price for oil, gas, rock and aggregate, and Portland cement. In addition, royalty revenue is impacted by new production, the inevitable decline in production in existing wells, and rock and limestone quarries, and the cost of development and production. Farming 2017 Operational Highlights: • During 2017, farming revenues decreased $2,214,000 from $18,648,000 in 2016 to $16,434,000 in 2017. When compared to 2016, pistachio revenues decreased $1,676,000. In comparison to 2016, which was a near record year in terms of yield, fiscal 2017 was an alternate down bearing year for pistachios. Additionally, the warm winter reduced the number of hours the trees were dormant. We experienced similarly low yields in 2015 as a result of the mild 2015 winter. The Company purchases crop insurance to mitigate weather-related reductions in crop production which mitigated $776,000 of total crop costs. • Almond revenues decreased $1,046,000 as a result of both commodity pricing and overall units sold. Given the timing of 2017 crop sales management will carryforward 472,541 pounds to sell in future periods. In comparison, the Company carried forward 338,845 pounds in 2017. • Farming expenses decreased $2,472,000, or 13% during 2017 compared to 2016. In 2017, we had reduced water costs of $1,584,000 when compared to 2016. The decrease is attributed to heavy rains during the 2017 winter along with credits received from the local water district, through the State Water Project. Despite the reduced revenues discussed above, reduced water and farming costs increased farm operating profits by $258,000 when compared to 2016. • We experienced reduced cost of sales for our wine grapes and almonds of $342,000 and $751,000, respectively, as a result of reduced cultural costs largely tied to lower weed and pest control costs. 2016 Operational Highlights: • During 2016, farming revenues decreased by $5,188,000 from $23,836,000 in 2015 to $18,648,000 in 2016. • An overall reduction in market price for 2016-year almonds along with management's decision to sell more crops in 2015, taking advantage of higher prices, reduced almond revenues by $4,865,000. In 2016, the California almond industry had strong yields, driving prices downward. • We recovered from the mild winter of 2015 that adversely affected our 2015 pistachio crop yields. Total 2016 crop yield was at a recent historical high of 3,200,000 pounds. Despite the robust 2016 yields, a decline in market prices lowered pistachio revenues by $226,000 when compared to 2015 revenues, which were primarily generated through insurance proceeds and market price adjustments. In 2016, the California pistachio industry had strong yields, driving prices downward. • Improvement in other revenues is driven by a new farm land lease and recoverable costs related to the lease. • Farming expenses decreased $311,000, or 2% during 2016 compared to 2015. In 2016, almond costs decreased $1,019,000 or 15% as we spent less time pruning trees, applying pesticides, and removing mummies, all of which are time and labor intensive. The decrease in almond costs were offset by an increase in wine grape costs of $260,000 as a result of a 10% increase in the number of acres farmed and an increase in fixed water costs of $256,000 paid to WRMWSD. Thus far in 2018, the prices for our crops, especially almonds and pistachios, remain consistent with 2017 levels. All of our crops are sensitive to the size of each year’s world crop. Large crops in California and abroad can depress prices. Our long-term projection is that crop production, especially of almonds and pistachios will continue to increase on a statewide basis over time because of new plantings, which could negatively impact future prices if the growth in demand does not keep pace with production. An unknown factor related to future statewide production and the continuation of new plantings will be how new state ground water management laws impact the amount of farming land in production over the next five to ten years, which could eventually reduce production. The rains and snow of 2018 are not expected to significantly impact the ground water basins within the Central Valley of California, and therefore could lead to a reduction in crop production. We are less impacted due to our water sources and the ground water basin we are in. We have had a relatively mild winter thus far, which could possibly impact our almond and pistachio production due to a low level of dormant hours. Dormant hours allow the trees to rest, which enhances the growth of the tree and production. It is too early to project 2018 crop yields and what impact that may have on prices later in 2018. Water delivery and water availability continues to be a long-term concern within California. Any limitation of delivery of SWP water and the absence of available alternatives during drought periods could potentially cause permanent damage to orchards and vineyards throughout California. While this could impact us, we believe we have sufficient water resources available to meet our requirements in 2018. Please see our discussion on water in Item 2, "Properties - Water Operations." The DWR announced its 2018 estimated water supply delivery at 20% of full entitlement. The current 20% allocation of SWP water is not enough for us to farm our crops, but our additional water resources, such as groundwater and surface sources, and those of the water districts we are in should allow us to have sufficient water for our farming needs. See Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding our water assets. For further discussion of the farming operations, refer to Item 1 “Business-Farming Operations.” Ranch Operations Revenues from ranch operations increased $499,000 from $3,338,000 in 2016 to $3,837,000 in 2017. When compared to 2016, we experienced an increase in grazing leases of $490,000 due to the fact that a drought clause was in effect during the 2016 drought. Ranch operations expenses decreased $323,000 to $5,411,000 in 2017 from $5,734,000 in 2016. The decrease is attributed to reduced payroll, overhead, and incentive based compensation of $119,000 primarily a result of a staff rightsizing. The segment also saw a decrease in repairs and maintenance costs of $106,000. Revenues from ranch operations decreased $585,000 from $3,923,000 in 2015 to $3,338,000 in 2016. The decline is attributed to a $362,000 decrease in game management revenues. The on-going California drought has had an adverse effect on the quality and availability of harvestable game due to shortages in food supplies. Also contributing to the decrease is a drought clause within our grazing leases taking effect amidst the California drought, which reduced revenues by $297,000. Improvements from other revenue sources, such as filming location fees offset the declines noted by $67,000. Ranch operations expenses decreased $378,000 to $5,734,000 in 2016 from $6,112,000 in 2015. The drought as discussed above, has reduced hunt volume in 2016, thus reducing related costs such as payroll, supplies, fuel, and other services. Other Income Total other income decreased $1,044,000 to $615,000, or 63%, during 2017 from $1,659,000 in 2016. The change resulted from the fact that in November 2016, we sold building and land located in Rancho Santa Fe, California for $4,700,000, recognizing a gain of $1,044,000. Total other income increased $750,000 to $1,659,000, or 83%, during 2016 from $909,000 in 2015, primarily as a result of the gain from the Rancho Santa Fe sale of $1,044,000. Offsetting the gain from Rancho Santa Fe, California is a reduction of interest and other income of $294,000. Corporate Expenses Corporate general and administrative costs decreased $2,409,000, or 19%, during 2017 when compared to 2016. In 2017, we had a reduction in payroll, overhead, and incentive based compensation (both share-based and cash bonus) of $1,603,000 which was primarily a result of a staff rightsizing that occurred during the second quarter of 2017. We also benefited from savings of $924,000 as a result of reduced legal and information technology related professional services costs. Corporate general and administrative costs decreased $258,000, or 2%, during 2016 when compared to 2015. In 2016, we did not recognize a one-time-non-cash pension settlement charge of $536,000 as we did in 2015, as a result of lump sum payment to retired former employees. which is discussed below. In addition, personnel levels decreased resulting in decreased payroll and salaries of $415,000. Offsetting the decreases include an increase in stock compensation of $532,000 resulting from meeting performance milestones and issuing new performance grants. Equity in Earnings of Unconsolidated Joint Ventures Equity in earnings of unconsolidated joint ventures is an important and growing component of our commercial/industrial activities and in the future, equity in earnings of unconsolidated joint ventures will become a significant part of our operational activity within the resort/residential segment. As we expand our current ventures and add new joint ventures, these investments will become a growing revenue source for the Company. During 2017, equity in earnings from unconsolidated joint ventures decreased $2,871,000 to $4,227,000 when compared to $7,098,000 in 2016. • There was a $995,000 decrease in our share of earnings from our TA/Petro joint venture. The decline was driven by increased operating costs and depreciation associated with new offerings at TA/Petro, a one time charge of $200,000 related to a workers' compensation claim, and a decline in gas fuel margins. • There was a $989,000 decrease in our share of earnings from our TRCC/Rock Outlet joint venture. The decrease was attributable to write-off of tenant allowances and other leasing costs associated with lease terminations. The departing tenants have struggled nationally in recent years as a result of the retail slump and do not represent the overall performance of The Outlets at Tejon. ◦ During 2017, sales per occupied square foot increased 13% as compared to 2016 as a result of increased tour bus traffic and improved conversion rates from shoppers. The conversion rate is the percentage of users who take a desired action. Operationally, The Outlets at Tejon is continually identifying new and desirable tenants to better serve its target demographic. ◦ During the second quarter, Express, a nationally recognized brand focusing on men's and women's fashion commenced operations occupying a space approximating 7,828 square feet. On July 14, 2017, TRCC/Rock Outlets executed a lease with Old Navy for a space approximating 12,500 square feet. On July 21, 2017, Samsonite, a worldwide leader in superior travel bags and luggage, took possession of a vacated unit and immediately commenced operations. • TRC-MRC 2, a joint venture which was formed during the third quarter of 2016, had an additional $839,000 loss as compared to 2016. The increase in loss was driven by non-cash GAAP losses stemming from purchase accounting adjustments, despite generating positive net operating income. Please refer to "Non-GAAP Measures" for further financial discussion on our joint ventures. During 2016, equity in earnings from unconsolidated joint ventures grew to $7,098,000, or an increase of $774,000, compared to $6,324,000 in 2015. TA/Petro, when compared to 2015, contributed an additional $868,000 in earnings from unconsolidated joint ventures. The improvement in operations within the TA/Petro joint venture was driven by an increase in diesel volumes of 1.5 million gallons and gas volumes of 1.0 million gallons. Income Taxes On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as U.S. Tax Reform. U.S. Tax Reform makes broad and complex changes to the U.S. tax code, including, but not limited to, (i) reducing the U.S. federal statutory tax rate from 35% to 21%; (ii) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (iii) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (iv) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; (v) eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized; (vi) creating the base erosion anti-abuse tax (BEAT), a new minimum tax; (vii) creating a new limitation on deductible interest expense; (viii) changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017, and (ix) modifying the officer’s compensation limitation. The provision for income taxes for fiscal year 2017 includes a $54,000 estimated tax expense as a result of the revaluation of U.S. federal net deferred tax assets from 34% to 21% due to the enactment of U.S. Tax Reform. The final impact of U.S. Tax Reform may differ from these estimates, due to, among other things, changes in interpretations, analysis and assumptions made by management, additional guidance that may be issued by the U.S. Department of the Treasury and the Internal Revenue Service, and any updates or changes to estimates we have utilized to calculate the transition impact. Therefore, our accounting for the elements of U.S. Tax Reform is incomplete. However, we were able to make reasonable estimates of the effects of U.S. Tax Reform. For the twelve months ended December 31, 2017, the Company incurred a net income tax benefit of $1,123,000 compared to a net income tax expense of $336,000 for the twelve months ended December 31, 2016. These represent effective income tax rates of approximately 42% and 39% for the twelve months ended December 31, 2017 and, 2016, respectively. Our effective income tax rate for the year ended December 31, 2017 was higher than the federal statutory rate in the United States primarily due to effects of recent tax law changes, state taxes, and other permanent differences. The effective tax rate was impacted by the aforementioned revaluation of net deferred assets related to the U.S. Tax Reform. As of December 31, 2017 and 2016 we had an income tax receivable of $1,804,000 and $468,000, respectively. For more detail, see Note 5, Income Taxes, of the Notes to Consolidated Financial Statements, included this Annual Report on Form 10-K. As of December 31, 2017 (and after the aforementioned revaluation), we had net deferred tax assets of $1,562,000. Our largest deferred tax assets were made up of temporary differences related to the capitalization of costs, pension adjustments, and stock grant expense. Deferred tax liabilities consist of depreciation, deferred gains, cost of sale allocations, and straight-line rent. Due to the nature of most of our deferred tax assets, we believe they will be used in future years and an allowance is not necessary. The Company classifies interest and penalties incurred on tax payments as income tax expenses. The Company made total income tax payments of $0 in 2017 and $$1,750,000 during 2016. The Company received refunds of $124,000 in 2017 and $615,000 in 2016. Liquidity and Capital Resources Cash Flow and Liquidity Our financial position allows us to pursue our strategies of land entitlement, development, and conservation. Accordingly, we have established well-defined priorities for our available cash, including investing in core operating segments to achieve profitable future growth. We have historically funded our operations with cash flows from operating activities, investment proceeds, and short-term borrowings from our bank credit facilities. In the past, we have also issued common stock and used the proceeds for capital investment activities. To enhance shareholder value, we will continue to make investments in our real estate segments to secure land entitlement approvals, build infrastructure for our developments, ensure adequate future water supplies, and provide funds for general land development activities. Within our farming segment, we will make investments as needed to improve efficiency and add capacity to its operations when it is profitable to do so. On October 4, 2017, the Company commenced a rights offering to common shareholders whereby proceeds will be used to provide additional working capital for general corporate purposes, including to fund general infrastructure costs and the development of buildings at TRCC, to continue forward with entitlement and permitting programs for the Centennial and Grapevine communities and costs related to the preparation of the development of MV. The rights offering concluded on October 27, 2017, with the Company raising $89,867,000, net of offering costs, from the sale of 5,000,000 shares at $18.00 per share. Our cash and cash equivalents and marketable securities totaled approximately $90,975,000 at December 31, 2017, an increase of $63,042,000, or 226%, from the corresponding amount at the end of 2016. The following table summarizes the cash flow activities for the following years ended December 31: Cash flows provided by operating activities are primarily dependent upon the rental rates of our leases, the collectability of rent and recovery of operating expenses from our tenants, distributions from joint ventures, the success of our crops and commodity prices within our mineral resource segment. During 2017, our operations provided $9,830,000 of cash primarily attributable to operating results from mineral resources, and commercial real estate activities. We also received a $7,200,000 distribution from our TA/Petro joint venture. Please refer to "Results of Operations by Segment" for further discussion on our operating results. During 2016, our operations provided $5,585,000 of cash primarily attributable to operating results from mineral resources, and commercial real estate activities. We also received a $4,500,000 distribution from our TA/Petro joint venture. Please refer to "Results of Operations by Segment" for further discussion on our operating results. During 2017, investing activities used $68,214,000. During 2017, we invested a portion of our proceeds from the rights offering, totaling $52,716,000, into marketable securities. We also had $21,709,000 in capital expenditures associated with real estate and farm crop development. Of the $21,709,000 we spent $5,462,000 on tentative tract maps for MV, $4,831,000, on entitlement, and land planning activities for Centennial, and $3,938,000 on litigation defense and permitting activities for the Grapevine project. At TRCC we used $4,638,000 on continued expansion and infrastructure related to Wheeler Ridge Road and indirect costs supporting all ongoing infrastructure projects, such as expansion of water treatment facilities. Our farming segment had cash outlays of $2,129,000 for developing new almond orchards and purchase of replacement farm equipment. Lastly, we purchased water through our annual water contracts, using $4,717,000. Offsetting our cash outlays were maturity of marketable securities of $8,126,000, and distributions from our joint venture partners of $3,114,000. During 2016, investing activities used $10,242,000 of cash primarily as a result of $26,380,000 in real estate and equipment expenditures. Of the $26,380,000 we spent $5,253,000, $5,244,000, $5,516,000 on pre-development and entitlement costs on our Centennial, MV, and Grapevine projects, respectively. At TRCC we used $5,196,000 for supporting infrastructure projects. Our farming segment cash outlay was $2,006,000 for developing new almond crops and acquiring farm equipment. We invested $2,161,000 into our mineral resources division primarily to develop two new water wells. The remainder of the capital investments primarily relate to capital equipment used as part of our ranch operations and corporate segments. Outside of capital projects, we acquired $5,983,000 in marketable securities and contributed $2,000,000 to joint ventures with Majestic. Offsetting our cash outlays are maturities and sales of marketable securities of $11,750,000, distributions from our joint venture partners of $1,600,000, and reimbursements from TRPFFA for qualifying infrastructure projects of $6,155,000, Our estimated capital investment for 2018 is primarily related to our real estate projects as it was in 2017. These estimated investments include approximately $8,110,000 of infrastructure development at TRCC-East and West to support continued commercial retail and industrial development and to expand water facilities to support future anticipated absorption. It is assumed we will invest up to $800,000 into the Majestic joint venture as equity for tenant improvement and lease-up purposes. We are also investing approximately $3,624,000 to begin development of new almond orchards and acquiring new farming equipment. The farm investments are part of a long-term farm management program to redevelop declining orchards and vineyards to maintain and improve future farm revenues. We expect to possibly invest up to $18,462,000 for land planning, entitlement activities, litigation related to entitlement approvals, federal and state agency permitting activities, and development activities at MV, Centennial, and Grapevine during 2018. The timing of these investments is dependent on our coordination efforts with Los Angeles County regarding entitlement efforts for Centennial, litigation and permitting activities for Grapevine, and final maps for MV. Our plans also include $6,224,000 for payment of annual water infrastructure and water related investments. We are also planning to potentially invest up to $300,000 in the normal replacement of operating equipment, such as ranch equipment, and updates to our information technology systems. We capitalize interest cost as a cost of the project only during the period for which activities necessary to prepare an asset for its intended use are ongoing, provided that expenditures for the asset have been made and interest cost has been incurred. Capitalized interest for the years ended December 31, 2017 and 2016, of $3,478,000 and $3,381,000, respectively, is classified in real estate development. We also capitalized payroll costs related to development, pre-construction, and construction projects which aggregated $2,809,000 and $2,656,000 for the years ended December 31, 2017 and 2016, respectively. Expenditures for repairs and maintenance are expensed as incurred. During 2017, financing activities provided $77,233,000 through the rights offering discussed previously. A portion of the proceeds from the Rights Offering were used to payoff $17,000,0000 outstanding on our line-of-credit. During 2016, financing activities provided $3,985,000 through $20,700,000 in drawdowns from our line-of-credit offset by paydowns of $13,815,000 on our line-of-credit and long-term borrowings. It is difficult to accurately predict cash flows due to the nature of our businesses and fluctuating economic conditions. Our earnings and cash flows will be affected from period to period by the commodity nature of our farming and mineral operations, the timing of sales and leases of property within our development projects, and the beginning of development within our residential projects. The timing of sales and leases within our development projects is difficult to predict due to the time necessary to complete the development process and negotiate sales or lease contracts. Often, the timing aspect of land development can lead to particular years or periods having more or less earnings than comparable periods. Based on our experience, we believe we will have adequate cash flows, cash balances, and availability on our line of credit over the next twelve months to fund internal operations. As we move forward with the completion of the entitlement process for our master planned communities and prepare to move into the development stage, we will need to secure additional funding through the issuance of equity and secure other forms of financing such as joint ventures and possibly debt financing. Capital Structure and Financial Condition At December 31, 2017, total capitalization at book value was $496,630,000 consisting of $69,820,000 of debt, net of deferred financing costs, and $426,810,000 of equity, resulting in a debt-to-total-capitalization ratio of approximately 14.0%, representing a decrease when compared to the debt-to-total-capitalization ratio of 19.6% at December 31, 2016. On October 13, 2014, the Company as borrower, entered into an Amended and Restated Credit Agreement, a Term Note and a Revolving Line of Credit Note, with Wells Fargo, or collectively the Credit Facility. The Credit Facility adds a $70,000,000 term loan, or Term Loan, to the existing $30,000,000 revolving line of credit, or RLC. Funds from the Term Loan were used to finance the Company's purchase of DMB TMV LLC’s interest in MV as disclosed in the Current Report on Form 8-K filed on July 16, 2014. The Term Loan had a $66,046,000 balance as of December 31, 2017. Any future borrowings under the RLC will be used for ongoing working capital requirements and other general corporate purposes. To maintain availability of funds under the RLC, undrawn amounts under the RLC will accrue a commitment fee of 10 basis points per annum. The Company's ability to borrow additional funds in the future under the RLC is subject to compliance with certain financial covenants and making certain representations and warranties. At the Company’s option, the interest rate on the RLC can float at 1.50% over a selected LIBOR rate or can be fixed at 1.50% above LIBOR for a fixed rate term. During the term of this credit facility (which matures in September 2019), we can borrow at any time and partially or wholly repay any outstanding borrowings and then re-borrow, as necessary. The outstanding balance on the RLC was $0 and $7,700,000 as of December 31, 2017 and 2016, respectively. The interest rate per annum applicable to the Term Loan is LIBOR (as defined in the Term Note) plus a margin of 170 basis points. The interest rate for the term of the note has been fixed through the use of an interest rate swap at a rate of 4.11%. We utilize an interest rate swap agreement to hedge our exposure to variable interest rates associated with our term loan. The Term Loan required interest only payments for the first two years of the term and thereafter requires monthly amortization payments pursuant to a schedule set forth in the Term Note, with the final outstanding principal amount due October 5, 2024. TRC may make voluntary prepayments on the Term Loan at any time without penalty (excluding any applicable LIBOR or interest rate swap breakage costs). Each optional prepayment will be applied to reduce the most remote principal payment then unpaid. The Credit Facility is secured by TRC’s farmland and farm assets, which include equipment, crops and crop receivables and the power plant lease and lease site, and related accounts and other rights to payment and inventory. The Credit Facility requires compliance with three financial covenants: (a) total liabilities divided by tangible net worth not greater than 0.75 to 1.0 at each quarter end; (b) a debt service coverage ratio not less than 1.25 to 1.00 as of each quarter end on a rolling four quarter basis; and (c) maintain liquid assets equal to or greater than $20,000,000. At December 31, 2017, we were in compliance with the financial covenants. The Credit Facility also contains customary negative covenants that limit the ability of TRC to, among other things, make capital expenditures, incur indebtedness and issue guaranties, consummate certain assets sales, acquisitions or mergers, make investments, pay dividends or repurchase stock, or incur liens on any assets. The Credit Facility contains customary events of default, including: failure to make required payments; failure to comply with terms of the Credit Facility; bankruptcy and insolvency; and a change in control without consent of bank (which consent will not be unreasonably withheld). The Credit Facility contains other customary terms and conditions, including representations and warranties, which are typical for credit facilities of this type. We also have a $4,750,000 promissory note agreement with principal and interest due monthly starting on October 1, 2013. The interest rate on this promissory note is 4.25% per annum, with principal and interest payments ending on September 1, 2028. The balance as of December 31, 2017 is $3,695,000. The proceeds from this promissory note were used to eliminate debt that had been previously used to provide long-term financing for a building being leased to Starbucks and provide additional working capital for future investment. Our current and future capital resource requirements will be provided primarily from current cash and marketable securities, cash flow from on-going operations, distributions from joint ventures, proceeds from the sale of developed and undeveloped parcels, potential sales of assets, additional use of debt, proceeds from the reimbursement of public infrastructure costs through CFD bond debt (described below under “Off-Balance Sheet Arrangements”), and the issuance of common stock. In April 2016, we filed an updated shelf registration statement on Form S-3 that went effective in May 2016. Under the shelf registration statement, we may offer and sell in the future one or more offerings, common stock, preferred stock, debt securities, warrants or any combination of the foregoing. The shelf registration allows for efficient and timely access to capital markets and when combined with our other potential funding sources just noted, provides us with a variety of capital funding options that can then be used and appropriately matched to the funding need. On August 7, 2013, the Company announced that its Board of Directors declared a dividend of 3,000,000 warrants to purchase shares of Company common stock, par value $0.50 per share, or Warrants, to holders of record of Common Stock as of August 21, 2013, the Record Date. The Warrants were distributed to shareholders on August 28, 2013. Each Warrant entitled the holder to purchase one share of Common Stock at an initial exercise price of $40.00 per share and expired unexercised on August 31, 2016. As noted above, at December 31, 2017, we had $90,975,000 in cash and securities and as of the filing date of this Form 10-K, we have $30,000,000 available on credit lines to meet any short-term liquidity needs. We continue to expect that substantial investments will be required in order to develop our land assets. In order to meet these capital requirements, we may need to secure additional debt financing and continue to renew our existing credit facilities. In addition to debt financing, we will use other capital alternatives such as joint ventures with financial partners, sales of assets, and the issuance of common stock. We will use a combination of the above funding sources to properly match funding requirements with the assets or development project being funded. There is no assurance that we can obtain financing or that we can obtain financing at favorable terms. We believe we have adequate capital resources to fund our cash needs and our capital investment requirements in the near-term as described earlier in the cash flow and liquidity discussions. Contractual Cash Obligations The following table summarizes our contractual cash obligations and commercial commitments as of December 31, 2017, to be paid over the next five years: The categories above include purchase obligations and other long-term liabilities reflected on our balance sheet under GAAP. A “purchase obligation” is defined in Item 303(a)(5)(ii)(D) of Regulation S-K as “an agreement to purchase goods or services that is enforceable and legally binding the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.” Based on this definition, the table above includes only those contracts that include fixed or minimum obligations. It does not include normal purchases, which are made in the ordinary course of business. Our financial obligations to the Tejon Ranch Conservancy are prescribed in the Conservation Agreement. Our advances to the Tejon Ranch Conservancy are dependent on the occurrence of certain events and their timing, and are therefore subject to change in amount and period. The amounts included above are the minimum amounts we anticipate contributing through the year 2021, at which time our current contractual obligation terminates. As discussed in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements, we have long-term liabilities for deferred employee compensation, including pension and supplemental retirement plans. Payments in the above table reflect estimates of future defined benefit plan contributions from the Company to the plan trust, estimates of payments to employees from the plan trust, and estimates of future payments to employees from the Company that are in the SERP program. During 2017, we made pension contributions of $165,000 and it is projected that we will make a similar contribution in 2018. Our cash contract commitments consist of contracts in various stages of completion related to infrastructure development within our industrial developments and entitlement costs related to our industrial and residential development projects. Also, included in the cash contract commitments are estimated fees earned during the second quarter of 2014 by a consultant, related to the entitlement of the Grapevine Development Area. The Company exited a consulting contract during the second quarter of 2014 related to the Grapevine Development and is obligated to pay an earned incentive fee at the time of successful receipt of litigated project entitlements and at a value measurement date five-years after entitlements have been achieved for Grapevine. The final amount of the incentive fees will not be finalized until the future payment dates. The Company believes that net savings from exiting the contract over this future time period will more than offset the incentive payment costs. Estimated water payments include the Nickel water contract, which obligates us to purchase 6,693 acre-feet of water annually through 2044 and SWP contracts with Wheeler Ridge Maricopa Water Storage District, Tejon-Castac Water District, Tulare Lake Basin Water Storage District, and Dudley-Ridge Water Storage District. These contracts for the supply of future water run through 2035. Please refer to Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding water assets. Our operating lease obligations are for office equipment, several vehicles, and a temporary trailer providing office space and average approximately $25,000 per month. At the present time, we do not have any capital lease obligations or purchase obligations outstanding. Off-Balance Sheet Arrangements The following table shows contingent obligations we have with respect to the CFDs. TRPFFA is a joint powers authority formed by Kern County and TCWD to finance public infrastructure within the Company’s Kern County developments. TRPFFA created two CFDs, the West CFD and the East CFD. The West CFD has placed liens on 420 acres of the Company’s land to secure payment of special taxes related to $28,620,000 of bond debt sold by TRPFFA for TRCC-West. The East CFD has placed liens on 1,931 acres of the Company’s land to secure payments of special taxes related to $55,000,000 of bond debt sold by TRPFFA for TRCC-East. At TRCC-West, the West CFD has no additional bond debt approved for issuance. At TRCC-East, the East CFD has approximately $65,000,000 of additional bond debt authorized by TRPFFA. In connection with the sale of bonds there is a standby letter of credit for $4,921,000 related to the issuance of East CFD bonds. The standby letter of credit is in place to provide additional credit enhancement and cover approximately two year's worth of interest on the outstanding bonds. This letter of credit will not be drawn upon unless the Company, as the largest landowner in the CFD, fails to make its property tax payments. As development occurs within TRCC-East there is a mechanism in the bond documents to reduce the amount of the letter of credit. The Company believes that the letter of credit will never be drawn upon. This letter of credit is for a two-year period of time and will be renewed in two-year intervals as necessary. The annual cost related to the letter of credit is approximately $83,000. The assessment of each individual property sold or leased within each CFD is not determinable at this time because it is based on the current tax rate and the assessed value of the property at the time of sale or on its assessed value at the time it is leased to a third-party. Accordingly, the Company is not required to recognize an obligation at December 31, 2015. At December 31, 2017, aggregate outstanding debt of unconsolidated joint ventures was $114,272,000. We guarantee $98,993,000 of this debt, relating to our joint ventures with Rockefeller and Majestic. Because of positive cash flow generation within the Rockefeller and Majestic joint ventures, we do not expect the guarantee to ever be called upon. We do not provide a guarantee on the $15,279,000 of debt related to our joint venture with TA/Petro. Non-GAAP Financial Measures EBITDA represents earnings before interest, taxes, depreciation, and amortization, a non-GAAP financial measure, and is used by us and others as a supplemental measure of performance. We use Adjusted EBITDA to assess the performance of our core operations, for financial and operational decision making, and as a supplemental or additional means of evaluating period-to-period comparisons on a consistent basis. Adjusted EBITDA is calculated as EBITDA, excluding stock compensation expense. We believe Adjusted EBITDA provides investors relevant and useful information because it permits investors to view income from our operations on an unleveraged basis before the effects of taxes, depreciation and amortization, and stock compensation expense. By excluding interest expense and income, EBITDA and Adjusted EBITDA allow investors to measure our performance independent of our capital structure and indebtedness and, therefore, allow for a more meaningful comparison of our performance to that of other companies, both in the real estate industry and in other industries. We believe that excluding charges related to share-based compensation facilitates a comparison of our operations across periods and among other companies without the variances caused by different valuation methodologies, the volatility of the expense (which depends on market forces outside our control), and the assumptions and the variety of award types that a company can use. EBITDA and Adjusted EBITDA have limitations as measures of our performance. EBITDA and Adjusted EBITDA do not reflect our historical cash expenditures or future cash requirements for capital expenditures or contractual commitments. While EBITDA and Adjusted EBITDA are relevant and widely used measures of performance, they do not represent net income or cash flows from operations as defined by GAAP. Further, our computation of EBITDA and Adjusted EBITDA may not be comparable to similar measures reported by other companies. Net operating income (NOI) is a non-GAAP financial measure calculated as operating income, the most directly comparable financial measure calculated and presented in accordance with GAAP, excluding general and administrative expenses, interest expense, depreciation and amortization, and gain or loss on sales of real estate. We believe NOI provides useful information to investors regarding our financial condition and results of operations because it primarily reflects those income and expense items that are incurred at the property level. Therefore, we believe NOI is a useful measure for evaluating the operating performance of our real estate assets. The Company utilizes net operating income (NOI) of unconsolidated joint ventures as a measure of financial or operating performance that is not specifically defined by GAAP in the United States. We believe net operating income of unconsolidated joint ventures provides investors with additional information concerning operating performance of our unconsolidated joint ventures. We also use this measure internally to monitor the operating performance of our unconsolidated joint ventures. Our computation of this non-GAAP measure may not be the same as similar measures reported by other companies. This non-GAAP financial measure should not be considered as an alternative to net income as a measure of the operating performance of our unconsolidated joint ventures or to cash flows computed in accordance with GAAP as a measure of liquidity nor are they indicative of cash flows from operating and financial activities of our unconsolidated joint ventures. The following schedule reconciles net income from unconsolidated joint ventures to net operating income of unconsolidated joint ventures.

<s>[INST] See Part I, "ForwardLooking Statements" for our cautionary statement regarding forwardlooking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10K, beginning at page. It also should be read in conjunction with the disclosure under “ForwardLooking Statements” in Part 1 of this Form 10K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five operating segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through joint venture entities. Within our resort/residential segment, the three active mixed use master plan developments are MV, Centennial, and Grapevine. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2017, net loss attributable to common stockholders was $1,555,000 compared to net income attributed to common stockholders of $558,000 in 2016. Factors driving the change include: a decline in farming revenues of $2,214,000 resulting from a decline in pistachio production in excess of 2,200,000 pounds, a decline in mineral resource revenues of $8,170,000 resulting from decreased sales opportunities for water in 2017 when compared to 2016, and a decrease in income from unconsolidated joint ventures of $2,871,000. From an expense perspective, expenses decreased $10,282,000 as a result of reduced water sales and our staff rightsizing initiatives. For 2016, net income attributable to common stockholders was $558,000 compared to $2,950,000 in 2015. Factors driving the change include: a decline in farming revenues of $5,188,000 resulting from declines in commodity prices and a decline of mineral resource revenues of $963,000 resulting from falling oil prices in 2016. Offsetting the decline in net income were the following factors: an increase in commercial real [/INST] Positive. </s>

TEJON RANCH CO

2019-03-01

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See Part I, "Forward-Looking Statements" for our cautionary statement regarding forward-looking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part 1 of this Form 10-K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five reporting segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through a joint venture. Within our resort/residential segment, the three active mixed use master plan developments are MV, Centennial, and Grapevine. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2018, net income attributable to common stockholders was $4,255,000 compared to net loss attributed to common stockholders of $1,797,000 in 2017. Factors driving the change include an increase in mineral resource revenues of $8,412,000 resulting from more sales opportunities for water in 2018 when compared to 2017, and an increase in farming revenues of $2,129,000 resulting from improved pistachio sales. From an expense perspective, expenses increased $2,410,000 mainly as a result of an increase in costs of $3,100,000 stemming from increased water sales. For 2017, net loss attributable to common stockholders was $1,797,000 compared to net income attributed to common stockholders of $800,000 in 2016. Factors driving the change include: a decline in farming revenues of $2,214,000 resulting from a decline in pistachio production in excess of 2,200,000 pounds, a decline in mineral resource revenues of $8,170,000 resulting from decreased sales opportunities for water in 2017 when compared to 2016, and a decrease in income from unconsolidated joint ventures of $2,871,000. In addition, 2016 included a land sale to a third party of $1,039,000, whereas 2017 did not have any land sales. From an expense perspective, expenses decreased $10,282,000 as a result of reduced water sales and our staff rightsizing initiatives. For the year ended December 31, 2018, we had no material lease renewals. During 2019, we will continue to invest funds toward the achievement of entitlements, permits, and maps for our land and for master project infrastructure and vertical development within our active commercial and industrial development. Securing entitlements for our land is a long, arduous process that can take several years and often involves litigation. During the next few years, our net income will fluctuate from year-to-year based upon, among other factors, commodity prices, production within our farming segment, the timing of land sales and the leasing of land and/or industrial space within our industrial developments, and equity in earnings realized from our unconsolidated joint ventures. This Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a narrative discussion of our results of operations. It contains the results of operations for each operating segment of the business and is followed by a discussion of our financial position. It is useful to read the business segment information in conjunction with Note 16 (Reporting Segments and Related Information) of the Notes to Consolidated Financial Statements. Critical Accounting Policies The preparation of our consolidated financial statements in accordance with generally accepted accounting principles in the United States, or GAAP, requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimates that are likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, impairment of long-lived assets, capitalization of costs, allocation of costs related to land sales and leases, stock compensation, our future ability to utilize deferred tax assets, and defined benefit retirement plans. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact on our financial statements. See also Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements, which discusses accounting policies that we have selected from acceptable alternatives. We believe the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements: Revenue Recognition - The Company’s revenue is primarily derived from lease revenue from our rental portfolio, royalty revenue from mineral leases, sales of farm crops, sales of water, and land sales. Revenue from leases with rent concessions or fixed escalations is recognized on a straight-line basis over the initial term of the related lease unless there is a considerable risk as to collectability. The financial terms of leases are contractually defined. Lease revenue is not accrued when a tenant vacates the premises and ceases to make rent payments or files for bankruptcy. Royalty revenues are contractually defined as to the percentage of royalty and are tied to production and market prices. Our royalty arrangements generally require payment on a monthly basis with the payment based on the previous month’s activity. We accrue monthly royalty revenues based upon estimates and adjust to actual as we receive payments. From time to time the Company sells easements over its land. The easements are either in the form of rights of access granted for such things as utility corridors or are in the form of conservation easements that generally require the Company to divest its rights to commercially develop a portion of its land, but do not result in a change in ownership of the land or restrict the Company from continuing other revenue generating activities on the land. Sales of conservation easements are accounted for in accordance with the five-step model under Accounting Standards Codification Topic 606, or ASC 606. The five-step model requires that we (i) identify the contract with the customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, including variable consideration to the extent that it is probable that a significant future reversal will not occur, (iv) allocate the transaction price to the respective performance obligations in the contract, and (v) recognize revenue when (or as) we satisfy the performance obligation. Since conservation easements generally do not impose any significant continuing performance obligations on the Company, revenue from conservation easement sales are generally recognized in the period the sale has closed and consideration has been received. In recognizing revenue from land sales, the Company follows ASC 606 to achieve the core principle that an entity recognizes revenue to depict the transfer of goods or services to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The adoption of ASC 606 on January 1, 2018 impacted our accounting for land sales. Upon the adoption of ASC 606, for any future land sales with multiple performance obligations, the standard generally requires the Company to allocate the transaction price to the performance obligations in proportion to their standalone selling prices (i.e., on a relative standalone selling price basis) not total costs. At the time farm crops are harvested, contracted, and delivered to buyers and revenues can be estimated, revenues are recognized and any related inventoried costs are expensed, which traditionally occurs during the third and fourth quarters of each year. It is not unusual for portions of our almond or pistachio crop to be sold in the year following the harvest. Orchard (almond and pistachio) revenues are based upon the contract settlement price or estimated selling price, whereas vineyard revenues are typically recognized at the contracted selling price. Estimated prices for orchard crops are based upon the quoted estimate of what the final market price will be by marketers and handlers of the orchard crops. These market price estimates are updated through the crop payment cycle as new information is received as to the final settlement price for the crop sold. These estimates are adjusted to actual upon receipt of final payment for the crop. This method of recognizing revenues on the sale of orchard crops is a standard practice within the agribusiness community. Actual final crop selling prices are not determined for several months following the close of our fiscal year due to supply and demand fluctuations within the orchard crop markets. Adjustments for differences between original estimates and actual revenues received are recorded during the period in which such amounts become known. Capitalization of Costs - The Company capitalizes direct construction and development costs, including predevelopment costs, interest, property taxes, insurance, and indirect project costs that are clearly associated with the acquisition, development, or construction of a project. Costs currently capitalized that in the future would be related to any abandoned development opportunities will be written off if we determine such costs do not provide any future benefits. Should development activity decrease, a portion of interest, property taxes, and insurance costs would no longer be eligible for capitalization, and would be expensed as incurred. Allocation of Costs Related to Land Sales and Leases - When we sell or lease land within one of our real estate developments, as we are currently doing within TRCC, and we have not completed all infrastructure development related to the total project, we determine the appropriate costs of sales for the sold land and the timing of recognition of the sale. In the calculation of cost of sales or allocations to leased land, we use estimates and forecasts to determine total costs at completion of the development project. These estimates of final development costs can change as conditions in the market and costs of construction change. In preparing these estimates, we use internal budgets, forecasts, and engineering reports to help us estimate future costs related to infrastructure that has not been completed. These estimates become more accurate as the development proceeds forward, due to historical cost numbers and to the continued refinement of the development plan. These estimates are updated periodically throughout the year so that, at the ultimate completion of development, all costs have been allocated. Any increases to our estimates in future years will negatively impact net profits and liquidity due to an increased need for funds to complete development. If, however, this estimate decreases, net profits as well as liquidity will improve. We believe that the estimates used related to cost of sales and allocations to leased land are critical accounting estimates and will become even more significant as we continue to move forward as a real estate development company. The estimates used are very susceptible to change from period to period, due to the fact that they require management to make assumptions about costs of construction, absorption of product, and timing of project completion, and changes to these estimates could have a material impact on the recognition of profits from the sale of land within our developments. Impairment of Long-Lived Assets - We evaluate our property and equipment and development projects for impairment when events or changes in circumstances indicate that the carrying value of assets contained in our financial statements may not be recoverable. The impairment calculation compares the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows (discounted). We recognize an impairment loss equal to the amount by which the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited. We currently operate in five reporting segments: commercial/industrial real estate development, resort/residential real estate development, mineral resources, farming, and ranch operations. At this time, there are no assets within any of our reporting segments that we believe are at risk of being impaired due to market conditions nor have we identified any impairment indicators. We believe that the accounting estimate related to asset impairment is a critical accounting estimate because it is very susceptible to change from period to period; it requires management to make assumptions about future prices, production, and costs, and the potential impact of a loss from impairment could be material to our earnings. Management’s assumptions regarding future cash flows from real estate developments and farming operations have fluctuated in the past due to changes in prices, absorption, production and costs and are expected to continue to do so in the future as market conditions change. In estimating future prices, absorption, production, and costs, we use our internal forecasts and business plans. We develop our forecasts based on recent sales data, historical absorption and production data, input from marketing consultants, as well as discussions with commercial real estate brokers and potential purchasers of our farming products. If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed to impairment losses that could be material to our results of operations. Defined Benefit Retirement Plans - The plan obligations and related assets of our defined benefit retirement plan are presented in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using level one and level two indicators, which are quoted prices in active markets and quoted prices for similar types of assets in active markets for the investments. Pension benefit obligations and the related effects on operations are calculated using actuarial models. The estimation of our pension obligations, costs and liabilities requires that we make use of estimates of present value of the projected future payments to all participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. These assumptions may have an effect on the amount and timing of future contributions. The assumptions used in developing the required estimates include the following key factors: • Discount rates; • Retirement rates; • Expected contributions; • Inflation; • Expected return on plan assets; and • Mortality rates. The discount rate enables us to state expected future cash flows at a present value on the measurement date. In determining the discount rate, the Company utilizes the yield on high-quality, fixed-income investments currently available with maturities corresponding to the anticipated timing of the benefit payments. To determine the expected long-term rate of return on pension plan assets, we consider the current and expected asset allocations, as well as historical and expected returns on various categories of plan assets. At December 31, 2018, the weighted-average actuarial assumption of the Company’s defined benefit plan consisted of a discount rate of 4.2% and a long-term rate of return on plan assets of 7.5%. For the years beginning with 2017, there are no assumed salary increase factors included in the plan assumptions due to the plan being amended to freeze future benefits. The effects of actual results differing from our assumptions and the effects of changing assumptions are recognized as a component of other comprehensive income, net of tax. Amounts recognized in accumulated other comprehensive income are adjusted as they are subsequently recognized as components of net periodic benefit cost. If we were to assume a 50-basis point change in the discount rate used, our projected benefit obligation would change approximately $700,000. Stock-Based Compensation - We apply the recognition and measurement principles of ASC 718, “Compensation - Stock Compensation” in accounting for long-term stock-based incentive plans. Our stock-based compensation plans include both restricted stock units and restricted stock grants. We have not issued any stock options to employees or directors since January 2003, and our 2018 financial statements do not reflect any compensation expenses for stock options. All stock options issued in the past have been exercised or forfeited. We make stock awards to employees based upon time-based criteria and through the achievement of performance-related objectives. Performance-related objectives are either stratified into threshold, target, and maximum goals or based on the achievement of a milestone event. These stock awards are currently being expensed over the expected vesting period based on each performance criterion. We make estimates as to the number of shares that will actually be granted based upon estimated ranges of success in meeting the defined performance measures. If our estimates of performance shares vesting were to change by 25%, stock compensation expense would increase or decrease by approximately $725,000 depending on whether the change in estimate increased or decreased shares vesting. See Note 11. (Stock Compensation - Restricted Stock and Performance Share Grants), of the Notes to Consolidated Financial Statement for total 2018 stock compensation expense related to stock grants. Fair Value Measurements - The Financial Accounting Standards Board's, or FASB, authoritative guidance for fair value measurements of certain financial instruments defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Fair value is defined as the exchange (exit) price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance establishes a three-level hierarchy for fair value measurements based upon the inputs to the valuation of an asset or liability. Observable inputs are those which can be easily seen by market participants while unobservable inputs are generally developed internally, utilizing management’s estimates and assumptions: • Level 1 - Valuation is based on quoted prices in active markets for identical assets and liabilities. • Level 2 - Valuation is determined from quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market. • Level 3 - Valuation is derived from model-based techniques in which at least one significant input is unobservable and based on our own estimates about the assumptions that market participants would use to value the asset or liability. When available, we use quoted market prices in active markets to determine fair value. We consider the principal market and nonperformance risk associated with our counterparties when determining the fair value measurement. Fair value measurements are used for marketable securities, investments within the pension plan and hedging instruments. Recent Accounting Pronouncements For discussion of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements. Results of Operations by Segment We evaluate the performance of our reporting segments separately to monitor the different factors affecting financial results. Each reporting segment is subject to review and evaluation as we monitor current market conditions, market opportunities, and available resources. The performance of each reporting segment is discussed below: Real Estate - Commercial/Industrial During 2018, commercial/industrial segment revenues decreased $31,000, or 0.3%, from $9,001,000 in 2017 to $8,970,000. The reduction was primarily attributable to land sale revenues of $73,000 in 2017, whereas we did not have any land sales in 2018. Commercial/industrial real estate segment expenses decreased $283,000, or 4.3%, from $6,529,000 in 2017 to $6,246,000 in 2018. During 2018, payroll, overhead, stock compensation and bonuses decreased $887,000, due to reassignment of resources within the Company, while professional services also decreased $194,000. The above reductions were partially offset by increases in TCWD fixed water assessments of $727,000 and fees of $107,000. TCWD's higher water assessment taxes were a result of declining TCWD water sales to third parties outside of the district. During 2017, commercial/industrial segment revenues decreased $839,000, or 9%, from $9,840,000 in 2016 to $9,001,000 in 2017. The decrease was driven by a land sale in 2016 of $1,039,000 versus land sales of $73,000 in 2017. The decline was offset by a $242,000 increase in lease revenues from the Pastoria Energy Facility. Please refer to Note 1 (Summary of Significant Accounting Policies) of the Notes to the Consolidated Financial Statements for further discussion on adopting ASC 606, and its impact on the recognition of land sales revenue in 2017 and 2016. Commercial/industrial real estate segment expenses decreased $571,000, or 8%, from $7,100,000 in 2016 to $6,529,000 during 2017. During 2017, payroll, overhead, and bonuses decreased $269,000 as a result of our staff rightsizing. Also contributing to the decrease were reductions in professional services and repairs and maintenance costs of $149,000 and $153,000 respectively. The logistics operators currently located within TRCC have demonstrated success in serving all of California and the western region of the United States, and we are building from their success in our marketing efforts. We will continue to focus our marketing strategy for TRCC-East and TRCC-West on the significant labor and logistical benefits of our site, the pro-business approach of Kern County, and the demonstrated success of the current tenants and owners within our development. Our strategy fits within the logistics model that many companies are using, which favors large, centralized distribution facilities which have been strategically located to maximize the balance of inbound and outbound efficiencies, rather than a number of decentralized smaller distribution centers. The world class logistics operators located within TRCC have demonstrated success through utilization of this model. With access to markets of over 40 million people for next-day delivery service, they are also demonstrating success with e-commerce fulfillment. We believe that our ability to provide fully-entitled, shovel-ready land parcels to support buildings of any size, especially buildings 1.0 million square feet or larger, can provide us with a potential marketing advantage in the future. We are also expanding our marketing efforts to include industrial users in the Santa Clarita Valley of northern Los Angeles County, and the northern part of the San Fernando Valley due to the limited availability of new product and high real estate costs in these locations. Tenants in these geographic areas are typically users of relatively smaller facilities. In pursuit of such opportunities, the Company is in process of constructing a 579,040 square foot distribution facility with Majestic. The Company and Majestic have successfully leased 67% of this distribution facility prior to its completion, with the tenant taking occupancy in Q4 of 2019. This new construction is building on the success in 2018 of fully leasing a 480,000 square foot building in a partnership with Majestic. A potential disadvantage to our development strategy is our distance from the ports of Los Angeles and Long Beach in comparison to the warehouse/distribution centers located in the Inland Empire, a large industrial area located east of Los Angeles, which continues its expansion eastward beyond Riverside and San Bernardino, to include Perris, Moreno Valley, and Beaumont. As development in the Inland Empire continues to move east and farther away from the ports, our potential disadvantage of our distance from the ports is being mitigated. Strong demand for large distribution facilities is driving development farther east in a search for large entitled parcels. During 2018, vacancy rates in the Inland Empire stayed flat at 3.9% compared to 3.7% in 2017. This industrial market continues to see available supply remain at historic low levels. Construction declined slightly during the fourth quarter with 20.5 million square feet under construction compared to 20.7 million in 2017. This new supply is currently meeting growing industrial demand. The low vacancy rates have led to a year-over-year increase in lease rates of 7.3% within the Inland Empire. As lease rates increase in the Inland Empire, we may begin to have greater pricing advantages due to our lower land basis. During 2018, vacancy rates in the northern Los Angeles industrial market, which includes the San Fernando Valley and Santa Clarita Valley, approximated 1.6%. Rents have been increasing for the past six years and will likely continue to rise in future years as the vacancy rate is at historic lows and quality industrial space remains hard to find. During 2018, average asking rents increased 8.5% compared with 2017, which have surpassed the historical peak which was seen in late 2007. Industrial demand remains high and infill industrial demand remains higher still. Future quarters will likely see greater construction activity as rents hit new highs and vacancy rates are at historic lows. Demand for industrial space in this market will also continue to be driven by domestic and global consumption levels. As industrial vacancy rates are at historic lows, industrial users seeking larger spaces are having to go further north into neighboring Kern County and particularly, the TRCC which has attracted increased attention as market conditions continue to tighten. In 2018, the Los Angeles and Long Beach Port container traffic recorded its highest container total ever with 17.54 million Twenty-Foot Equivalent Units, or TEU's, up 3.8% from 2017. TEU is a measure of a ship's cargo carrying capacity. The dimensions of one TEU are equal to that of a standard shipping container measuring 20 feet long by 8 feet tall. We expect the commercial/industrial segment to continue to experience costs, net of amounts capitalized, primarily related to professional service fees, marketing costs, commissions, planning costs, and staffing costs as we continue to pursue development opportunities. These costs are expected to remain consistent with current levels of expense with any variability in the future tied to specific absorption transactions in any given year. The actual timing and completion of development is difficult to predict due to the uncertainties of the market. Infrastructure development and marketing activities and costs could continue over several years as we develop our land holdings. We will also continue to evaluate land resources to determine the highest and best uses for our land holdings. Future sales of land are dependent on market circumstances and specific opportunities. Our goal in the future is to increase land value and create future revenue growth through planning and development of commercial and industrial properties. Real Estate - Resort/Residential We are in the preliminary stages of development; hence, no revenues are attributed to this segment for these reporting periods. In 2018, resort/residential segment expenses decreased $425,000 to $1,530,000, or 22%, when compared to $1,955,000 in 2017. The reassignment of resources within the Company translated to increases in qualifying costs, including payroll and overhead costs within resort/residential which in turn translated to an increase in costs being capitalized into our real estate development projects by $250,000 when compared to 2017. In addition, we experienced savings in professional services of $163,000 in 2018. In 2017, resort/residential segment expenses increased $325,000 primarily due to reduced capitalization of payroll and overhead costs that in the prior years were identified to be incremental to our mixed use master plan development projects. Our resort/residential segment activities in include land entitlement, land planning and pre-construction engineering and conservation activities. We have three major resort/residential communities within this segment: Centennial, Grapevine, and MV. • For Centennial, the Board of Supervisors in December 2018, by a vote of 4-1, affirmed the recommendation of the Los Angeles County Regional Planning Commission and Department of Regional Planning that Centennial be approved. • For Grapevine, we are currently working with Kern County to defend litigation related to the approved EIR. For a more complete discussion of the litigation and approval process, please see Note 14 (Commitments and Contingencies) to the Notes to Consolidated Financial Statements. • For MV, we have a fully entitled project and received approval of Tentative Tract Map 1 for our first four phases of development. The timing of MV development in the coming years will be dependent on the strength of both the economy and the real estate market including both primary and second home markets. In moving the project forward, we will focus on the preparation of engineering leading to the final map for the first phases of MV, consumer and market research studies and fine tuning of development business plans as well as defining the possible capital funding sources for this development. We also obtained approval on the Farm Village commercial site plan from Kern County. Farm Village will serve as the commercial center and community gathering place for MV residents and visitors as well as the gateway to MV. The resort/residential segment will continue to incur costs in the future related to professional service fees, public relations costs, and staffing costs as we continue forward with entitlement and permitting activities for the above communities and continue to meet our obligations under the Conservation Agreement. We expect these expenses to remain consistent with current years cost in the near term and only begin to increase as we move into the development phase of each project in the future. The actual timing and completion of entitlement-related activities and the beginning of development is difficult to predict due to the uncertainties of the approval process, the possibility of litigation upon approval of our entitlements in the future, and the status of the economy. We will also continue to evaluate land resources to determine the highest and best use for our land holdings. Our long-term goal through this process is to increase the value of our land and create future revenue opportunities through resort and residential development. We are continuously monitoring the markets in order to identify the appropriate time in the future to begin infrastructure improvements and lot sales. Our long-term business plan of developing the communities of MV, Centennial, and Grapevine remains unchanged. As the California economy continues to improve we believe the perception of land values will also begin to improve and the long-term fundamentals that support housing demand in our region, primarily California population growth and household formation will also improve. California also has a significant documented housing shortage, which we believe our communities will help ease as the population base within California continues to grow. See Item 1, “Business - Real Estate Development Overview” for a further discussion of real estate development activities. Mineral Resources 2018 Operational Highlights: • Revenues from our mineral resources segment increased $8,412,000, or 141%, to $14,395,000 in 2018 when compared to $5,983,000 in 2017. This increase was primarily attributed to water sales of $9,142,000 in 2018, representing a $7,888,000 increase over last year, as a result of moderate drought conditions in Kern County. The improved water sales accordingly increased mineral resources expenses largely due to the cost of sales of water by $3,259,000. • We experienced improvements for oil and gas royalties as a result of improved oil prices. Please refer to above table for current and historical production volume and pricing. 2017 Operational Highlights: • Revenues from our mineral resources segment decreased $8,170,000, or 58%, to $5,983,000 in 2017 compared to $14,153,000 in 2016. During the 2016/2017 winter, California experienced above normal rain fall and snow levels, resulting in a reduction in water market activity throughout the state, adversely impacting water sales opportunities. This resulted in an $8,347,000 decline in water sales. The reduced water sales accordingly decreased mineral resources expenses associated with the cost of sales of water by $4,832,000. • We experienced improvements in cement production as a result of increased demand and pricing during 2017 compared to 2016. The improvement in shipments was due to an increase in road construction activity as compared to the prior years. • Despite falling production, we experienced improvements for oil and gas royalties as a result of improved oil prices. Please refer to above table for current and historical production volume and pricing. Although oil prices improved throughout 2018, we currently expect our largest tenant, California Resources Corporation, or CRC, to continue its program of producing from current active wells at lower levels with no near-term intent to begin new drilling programs until oil prices reach higher levels. CRC has approved permits and drill sites on our land and has delayed the start of drilling as it evaluates the market. A positive aspect of our lease with CRC is that the approved drill sites are in an area of the ranch where the development and production costs are moderate due to the depths being drilled. During 2017, CRC executed a new exploration lease with us covering 1,524 acres. Thus far in 2019, oil prices are within 10% of West Texas Intermediate pricing. Since we only receive royalties based on tenant production and market prices and do not produce oil, we do not have information as to the potential size of oil reserves. Our royalty revenues are contractually defined and based on a percentage of production and are received in cash. Royalty revenues fluctuate based on changes in market price for oil, gas, rock and aggregate, and Portland cement. In addition, royalty revenue is impacted by new production, the inevitable decline in production in existing wells, and rock and limestone quarries, and the cost of development and production. Farming 2018 Operational Highlights: • During 2018, farming revenues increased $2,129,000, or 13%, from $16,434,000 in 2017 to $18,563,000 in 2018. When compared to 2017, pistachio revenues increased $3,357,000 resulting from record high pistachio yields. • Almond revenues decreased $583,000 due to lower almond crop yields that was driven by a combination of unfavorable weather conditions along with a 165 acres reduction in the number of acres in production. The reduction was the result of the Company's decision to redevelop existing almond units. • Farming expenses decreased $173,000, or 1%, to $16,028,000 when compared to $16,201,000 in 2017. The decrease was primarily attributed to reduced cost allocations to all crops. 2017 Operational Highlights: • During 2017, farming revenues decreased $2,214,000 from $18,648,000 in 2016 to $16,434,000 in 2017. When compared to 2016, pistachio revenues decreased $1,676,000. In comparison to 2016, which was a near record year in terms of yield, fiscal 2017 was an alternate down bearing year for pistachios. Additionally, the warm winter reduced the number of hours the trees were dormant. We experienced similarly low yields in 2015 as a result of the mild 2015 winter. The Company purchases crop insurance to mitigate weather-related reductions in crop production, which mitigated $776,000 of total crop costs. • Almond revenues decreased $1,046,000 as a result of both commodity pricing and overall units sold. Given the timing of 2017 crop sales, management carried forward 472,541 pounds to sell in future periods. In comparison, the Company carried forward 338,845 pounds in 2016. • Farming expenses decreased $2,472,000, or 13% during 2017 compared to 2016. In 2017, we had reduced water costs of $1,584,000 when compared to 2016. The decrease is attributed to heavy rains during the 2017 winter along with credits received from the local water district, through the SWP. Despite the reduced revenues discussed above, reduced water and farming costs increased farm operating profits by $258,000 when compared to 2016. • We experienced reduced cost of sales for our wine grapes and almonds of $342,000 and $751,000, respectively, as a result of reduced cultural costs largely tied to lower weed and pest control costs. Thus far in 2019, the prices for our crops, especially almonds and pistachios, remain consistent with 2018 levels. All of our crops are sensitive to global crop production levels. Large crops in California and abroad can depress prices. Our long-term projection is that crop production, especially for almonds and pistachios will continue to increase on a statewide basis over time because of new plantings, which could negatively impact future prices if the growth in demand does not keep pace with production. It is too early to project 2019 crop yields and what impact that may have on prices later in 2019. Additionally, increased tariffs from China and India which are major customers of almonds and pistachios, can make American products less competitive and push customers to switch to another producing country. The impact of new state ground water management laws on new plantings and continuing crop production is also currently unknown. Water delivery and water availability continues to be a long-term concern within California. Any limitation of delivery of SWP water and the absence of available alternatives during drought periods could potentially cause permanent damage to orchards and vineyards throughout California. While this could impact us, we believe we have sufficient water resources available to meet our requirements in 2019. Please see our discussion on water in Item 2, "Properties - Water Operations." The DWR announced its 2019 estimated water supply delivery at 35% of full entitlement. The current 35% allocation of SWP water is not enough for us to farm our crops, but our additional water resources, such as groundwater and surface sources, and those of the water districts we are in should allow us to have sufficient water for our farming needs. See Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding our water assets. For further discussion of the farming operations, refer to Item 1 “Business-Farming Operations.” Ranch Operations Revenues from ranch operations decreased $146,000, or 4%, from $3,837,000 in 2017 to $3,691,000 in 2018. The decrease is primarily attributed to reduced grazing lease revenues of $157,000. Ranch operations expenses increased $40,000, or 1%, to $5,451,000 in 2018 from $5,411,000 in 2017. The increase was mainly attributed to an increase in property taxes of $34,000. Revenues from ranch operations increased $499,000 from $3,338,000 in 2016 to $3,837,000 in 2017. When compared to 2016, we experienced an increase in grazing leases of $490,000 due to the fact that a drought clause was in effect during the 2016 drought. Ranch operations expenses decreased $323,000 to $5,411,000 in 2017 from $5,734,000 in 2016. The decrease is attributed to reduced payroll, overhead, and incentive based compensation of $119,000 primarily a result of a staff rightsizing. The segment also saw a decrease in repairs and maintenance costs of $106,000. Other Income Total other income increased $1,098,000 to $1,285,000, or 587%, during 2018 from $187,000 in 2017. In October of 2017, the Company invested a majority of its rights offering proceeds into marketable securities which contributed to an increase in interest income. Total other income decreased $733,000 to $187,000, or 80%, during 2017 from $920,000 in 2016. The change resulted from the fact that in November 2016, we sold building and land located in Rancho Santa Fe, California for $4,700,000, recognizing a gain of $1,044,000. The decrease was offset by reductions in non employee service related costs associated with our retirement plans of $311,000. Corporate Expenses Corporate general and administrative costs decreased $8,000, or 0.1%, to $9,705,000 during 2018 when compared to $9,713,000 in 2017. We managed to maintain cost savings during 2018 following the staff rightsizing that occurred during the second quarter of 2017. Corporate general and administrative costs decreased $2,098,000, or 18%, during 2017 when compared to 2016. In 2017, we had a reduction in payroll, overhead, and incentive based compensation (both share-based and cash bonus) of $1,603,000 which was primarily a result of a staff rightsizing. We also benefited from savings of $924,000 as a result of reduced legal and information technology related professional services costs. Equity in Earnings of Unconsolidated Joint Ventures Equity in earnings of unconsolidated joint ventures is an important and growing component of our commercial/industrial activities and in the future, equity in earnings of unconsolidated joint ventures will become a significant part of our operational activity within the resort/residential segment. As we expand our current ventures and add new joint ventures, these investments will become a growing revenue source for the Company. During 2018, equity in earnings from unconsolidated joint ventures decreased $393,000 to $3,834,000 when compared to $4,227,000 in 2017. • Despite seeing a 3.7% increase in sales per occupied square foot and an 8.3% increase in monthly sales per vehicle, equity in earnings from our TRCC/Rock Outlet joint venture decreased $1,150,000. The decrease was primarily attributed to accelerating amortization of lease intangibles driven by removing poor performing tenants along with modifying lease terms to reflect the current brick and mortar retail environment. The Outlets at Tejon is continually identifying new and desirable tenants to better serve a wider demographic. In 2018, the Outlets at Tejon attracted new tenants such as Kate Spade, Bath and Body Works, and Journeys. • There was a $448,000 decrease in our share of earnings from our TA/Petro joint venture. The decline was driven by lower fuel margins of 6.7% when compared to the prior year. Comparative fuel sales data are as follow: ◦ Diesel sales volumes were 16.6 million and 16.4 million gallons, or 1.1% increase, as of December 31, 2018 and 2017, respectively. ◦ Gasoline sales volumes were 13.9 million and 13.7 million gallons, or 2.0% increase, as of December 31, 2018 and 2017, respectively. • We incurred a $250,000 loss on our TRC-MRC 1 joint venture due to the fact that it was not fully occupied until the fourth quarter. • The above decreases in equity in earnings were partially offset by an increase in equity in earnings of TRC-MRC 2, a joint venture formed with Majestic in 2016. Equity in earnings improved $1,518,000 in 2018 given that throughout 2017, TRC-MRC 2 incurred significant non-cash GAAP accounting losses that did not reoccur in 2018. During 2017, equity in earnings from unconsolidated joint ventures decreased $2,871,000 to $4,227,000 when compared to $7,098,000 in 2016. • There was a $995,000 decrease in our share of earnings from our TA/Petro joint venture. The decline was driven by increased operating costs and depreciation associated with new offerings at TA/Petro, a one time charge of $200,000 related to a workers' compensation claim, and a decline in gas fuel margins. • There was a $989,000 decrease in our share of earnings from our TRCC/Rock Outlet joint venture. The decrease was attributable to write-off of tenant allowances and other leasing costs associated with lease terminations. The departing tenants have struggled nationally in recent years as a result of the retail slump and do not represent the overall performance of The Outlets at Tejon. ◦ During 2017, sales per occupied square foot increased 13% as compared to 2016 as a result of increased tour bus traffic and improved conversion rates from shoppers. The conversion rate is the percentage of users who take a desired action. Operationally, The Outlets at Tejon is continually identifying new and desirable tenants to better serve its target demographic. ◦ During the second quarter, Express, a nationally recognized brand focusing on men's and women's fashion commenced operations occupying a space approximating 7,828 square feet. On July 14, 2017, TRCC/Rock Outlets executed a lease with Old Navy for a space approximating 12,500 square feet. On July 21, 2017, Samsonite, a worldwide leader in superior travel bags and luggage, took possession of a vacated unit and immediately commenced operations. • TRC-MRC 2, a joint venture which was formed during the third quarter of 2016, had an additional $839,000 loss as compared to 2016. The increase in loss was driven by non-cash GAAP losses stemming from purchase accounting adjustments, despite generating positive net operating income. Please refer to "Non-GAAP Measures" for further financial discussion on our joint ventures. Income Taxes On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as U.S. Tax Reform. U.S. Tax Reform made broad and complex changes to the U.S. tax code, including, but not limited to, (i) reducing the U.S. federal statutory tax rate from 35% to 21%; (ii) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (iii) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (iv) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; (v) eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized; (vi) creating the base erosion anti-abuse tax, a new minimum tax; (vii) creating a new limitation on deductible interest expense; (viii) changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017, and (ix) modifying the officer’s compensation limitation. The provision for income taxes for fiscal year 2017 includes a $54,000 estimated tax expense as a result of the revaluation of U.S. federal net deferred tax assets from 34% to 21% due to the enactment of U.S. Tax Reform. During 2018, the Company completed its analysis of the impacts of the U.S. Tax Reform and no additional expense was warranted. Other provisions of the U.S. Tax Reform did not have a material effect on our effective tax rate for 2018. For the twelve months ended December 31, 2018, the Company's net income tax expense was $1,320,000 compared to a net income tax benefit of $1,283,000 for the twelve months ended December 31, 2017. These represent effective income tax rates of approximately 24% and 41% for the twelve months ended December 31, 2018 and, 2017, respectively. Our effective income tax rate for the year ended December 31, 2018 was higher than the federal statutory rate in the United States, a result of state taxes and other permanent differences. As of December 31, 2018 and 2017 we had an income tax receivable of $277,000 and $1,804,000, respectively. For more detail, see Note 12. (Income Taxes), of the Notes to Consolidated Financial Statements, included this Annual Report on Form 10-K. As of December 31, 2018 (and after the aforementioned revaluation), we had net deferred tax assets of $1,229,000. Our largest deferred tax assets were made up of temporary differences related to the capitalization of costs, pension adjustments, and stock compensation. Deferred tax liabilities consist of depreciation, deferred gains, cost of sale allocations, and straight-line rent. Due to the nature of most of our deferred tax assets, we believe they will be used in future years and an allowance is not necessary. The Company classifies interest and penalties incurred on tax payments as income tax expenses. The Company did not make any income tax payments during 2018 and 2017. The Company received refunds of $164,000 in 2018 and $124,000 in 2017. Liquidity and Capital Resources Cash Flow and Liquidity Our financial position allows us to pursue our strategies of land entitlement, development, and conservation. Accordingly, we have established well-defined priorities for our available cash, including investing in core operating segments to achieve profitable future growth. We have historically funded our operations with cash flows from operating activities, investment proceeds, and short-term borrowings from our bank credit facilities. In the past, we have also issued common stock and used the proceeds for capital investment activities. To enhance shareholder value, we will continue to make investments in our real estate segments to secure land entitlement approvals, build infrastructure for our developments, ensure adequate future water supplies, and provide funds for general land development activities. Within our farming segment, we will make investments as needed to improve efficiency and add capacity to its operations when it is profitable to do so. On October 4, 2017, the Company commenced a rights offering to common shareholders for additional working capital for general corporate purposes, including to fund general infrastructure costs and the development of buildings at TRCC, to continue forward with entitlement and permitting programs for the Centennial and Grapevine communities and costs related to the preparation of the development of MV. The rights offering concluded on October 27, 2017, with the Company raising $89,701,000, net of offering costs, from the sale of 5,000,000 shares at $18.00 per share. Our cash and cash equivalents and marketable securities totaled approximately $79,657,000 at December 31, 2018, a decrease of $11,318,000, or 12%, from the corresponding amount at the end of 2017. The following table summarizes the cash flow activities for the following years ended December 31: Cash flows provided by operating activities are primarily dependent upon the rental rates of our leases, the collectability of rent and recovery of operating expenses from our tenants, distributions from joint ventures, the success of our crops and commodity prices within our mineral resource segment. During 2018, our operations provided $14,354,000 of cash primarily attributable to strong operating results from our farming and mineral resources segments. We also received a $4,800,000 distribution from our TA/Petro joint venture. Please refer to "Results of Operations by Segment" for further discussion on our operating results. During 2017, our operations provided $9,830,000 of cash primarily attributable to operating results from mineral resources, and commercial real estate activities. We also received a $7,200,000 distribution from our TA/Petro joint venture. During 2018, investing activities used $13,246,000 which was partially attributed to reinvesting marketable security maturities of $28,392,000. We also had $22,580,000 in capital expenditures associated with real estate and farm crop development. Of the $22,580,000 we spent $5,204,000 on tentative tract maps, engineering and the design of Farm Village for MV, $5,295,000 on the approval of the specific plan for Centennial, and $2,960,000 on regulatory permits and litigation for Grapevine. At TRCC we used $5,225,000 on continued expansion and infrastructure, and indirect costs supporting all ongoing infrastructure projects, such as expansion of water treatment facilities and relocation of gas line. Our farming segment had cash outlays of $3,166,000 for developing new almond orchards and replacing old farm equipment. Lastly, we purchased water through our annual water contracts, using $3,844,000. Offsetting our cash outlays were marketable securities maturities of $35,219,000 and distributions from our joint venture partners of $2,815,000. During 2017, investing activities used $68,214,000. During 2017, we invested a portion of our proceeds from the rights offering, totaling $52,716,000, into marketable securities. We also had $21,709,000 in capital expenditures associated with real estate and farm crop development. Of the $21,709,000 we spent $5,462,000 on tentative tract maps for MV, $4,831,000, on entitlement, and land planning activities for Centennial, and $3,938,000 on litigation defense and permitting activities for the Grapevine project. At TRCC we used $4,638,000 on continued expansion and infrastructure related to Wheeler Ridge Road and indirect costs supporting all ongoing infrastructure projects, such as expansion of water treatment facilities. Our farming segment had cash outlays of $2,129,000 for developing new almond orchards and purchase of replacement farm equipment. Lastly, we purchased water through our annual water contracts, using $4,717,000. Offsetting our cash outlays were maturity of marketable securities of $8,126,000, and distributions from our joint venture partners of $3,114,000. Our estimated capital investment for 2019 is primarily related to our real estate projects as it was in 2018. These estimated investments include approximately $10,724,000 of infrastructure development at TRCC-East to support continued commercial retail and industrial development and to expand water facilities to support future anticipated absorption. We are also investing approximately $3,216,000 to continue development of new almond orchards and replacing old farming equipment. The farm investments are part of a long-term farm management program to redevelop declining orchards and vineyards to maintain and improve future farm revenues. We expect to possibly invest up to $17,304,000 for land planning, entitlement activities, litigation related to entitlement approvals, federal and state agency permitting activities, and development activities at MV, Centennial, and Grapevine during 2019. The timing of these investments is dependent on our coordination efforts with Los Angeles County regarding litigation efforts for Centennial, litigation and permitting activities for Grapevine, and final maps for MV. Our plans also include $3,230,000 for payment of annual water inventory and water related investments. We are also planning to potentially invest up to $139,000 in the normal replacement of operating equipment, such as ranch equipment, and vehicles. We capitalize interest cost as a cost of the project only during the period for which activities necessary to prepare an asset for its intended use are ongoing, provided that expenditures for the asset have been made and interest cost has been incurred. Capitalized interest for the years ended December 31, 2018 and 2017, of $2,954,000 and $3,478,000, respectively, is classified in real estate development. We also capitalized payroll costs related to development, pre-construction, and construction projects which aggregated $4,171,000 and $2,809,000 for the years ended December 31, 2018 and 2017, respectively. Expenditures for repairs and maintenance are expensed as incurred. During 2018, financing activities used $5,307,000 primarily through repayments of long-term debt of $4,046,000 and taxes on vested stock grants of $1,095,000. During 2017, financing activities provided $77,233,000 through the rights offering discussed previously. A portion of the proceeds from the Rights Offering were used to pay off $17,000,0000 outstanding on our line of credit. It is difficult to accurately predict cash flows due to the nature of our businesses and fluctuating economic conditions. Our earnings and cash flows will be affected from period to period by the commodity nature of our farming and mineral operations, the timing of sales and leases of property within our development projects, and the beginning of development within our residential projects. The timing of sales and leases within our development projects is difficult to predict due to the time necessary to complete the development process and negotiate sales or lease contracts. Often, the timing aspect of land development can lead to particular years or periods having more or less earnings than comparable periods. Based on our experience, we believe we will have adequate cash flows, cash balances, and availability on our line of credit over the next twelve months to fund internal operations. As we move forward with the completion of the litigation, permitting and engineering design for our master planned communities and prepare to move into the development stage, we will need to secure additional funding through the issuance of equity and secure other forms of financing such as joint ventures and possibly debt financing. Capital Structure and Financial Condition At December 31, 2018, total capitalization at book value was $500,470,000 consisting of $65,798,000 of debt, net of deferred financing costs, and $434,672,000 of equity, resulting in a debt-to-total-capitalization ratio of approximately 13.1%, representing a decrease when compared to the debt-to-total-capitalization ratio of 14.0% at December 31, 2017. On October 13, 2014, the Company as borrower, entered into an Amended and Restated Credit Agreement, a Term Note and a Revolving Line of Credit Note, with Wells Fargo, or collectively the Credit Facility. The Credit Facility adds a $70,000,000 term loan, or Term Loan, to the existing $30,000,000 revolving line of credit, or RLC. Funds from the Term Loan were used to finance the Company's purchase of DMB TMV LLC’s interest in MV as disclosed in the Current Report on Form 8-K filed on July 16, 2014. The Term Loan had a $62,483,000 balance as of December 31, 2018. Any future borrowings under the RLC will be used for ongoing working capital requirements and other general corporate purposes. To maintain availability of funds under the RLC, undrawn amounts under the RLC will accrue a commitment fee of 10 basis points per annum. The Company's ability to borrow additional funds in the future under the RLC is subject to compliance with certain financial covenants and making certain representations and warranties, which is typical for this type of instrument. At the Company’s option, the interest rate on the RLC can float at 1.50% over a selected LIBOR rate or can be fixed at 1.50% above LIBOR for a fixed rate term. During the term of this credit facility (which matures in September 2019), we can borrow at any time and partially or wholly repay any outstanding borrowings and then re-borrow, as necessary. The Company expects to renew the RLC in September 2019 under similar terms. There were no outstanding balances on the RLC as of December 31, 2018 and 2017. The interest rate per annum applicable to the Term Loan is LIBOR (as defined in the Term Note) plus a margin of 170 basis points. The interest rate for the term of the note has been fixed through the use of an interest rate swap at a rate of 4.11%. We utilize an interest rate swap agreement to hedge our exposure to variable interest rates associated with our term loan. The Term Loan required interest only payments for the first two years of the term and thereafter requires monthly amortization payments pursuant to a schedule set forth in the Term Note, with the final outstanding principal amount due October 5, 2024. TRC may make voluntary prepayments on the Term Loan at any time without penalty (excluding any applicable LIBOR or interest rate swap breakage costs). Each optional prepayment will be applied to reduce the most remote principal payment then unpaid. The Credit Facility is secured by TRC’s farmland and farm assets, which include equipment, crops and crop receivables and the power plant lease and lease site, and related accounts and other rights to payment and inventory. The Credit Facility requires compliance with three financial covenants: (a) total liabilities divided by tangible net worth not greater than 0.75 to 1.0 at each quarter end; (b) a debt service coverage ratio not less than 1.25 to 1.00 as of each quarter end on a rolling four quarter basis; and (c) maintain liquid assets equal to or greater than $20,000,000. At December 31, 2018, we were in compliance with the financial covenants. The Credit Facility also contains customary negative covenants that limit the ability of TRC to, among other things, make capital expenditures, incur indebtedness and issue guaranties, consummate certain assets sales, acquisitions or mergers, make investments, pay dividends or repurchase stock, or incur liens on any assets. The Credit Facility contains customary events of default, including: failure to make required payments; failure to comply with terms of the Credit Facility; bankruptcy and insolvency; and a change in control without consent of bank (which consent will not be unreasonably withheld). The Credit Facility contains other customary terms and conditions, including representations and warranties, which are typical for credit facilities of this type. We also have a $4,750,000 promissory note agreement with principal and interest due monthly starting on October 1, 2013. The interest rate on this promissory note is 4.25% per annum, with principal and interest payments ending on September 1, 2028. The balance as of December 31, 2018 is $3,418,000. The proceeds from this promissory note were used to eliminate debt that had been previously used to provide long-term financing for a building being leased to Starbucks and provide additional working capital for future investment. Our current and future capital resource requirements will be provided primarily from current cash and marketable securities, cash flow from on-going operations, distributions from joint ventures, proceeds from the sale of developed and undeveloped parcels, potential sales of assets, additional use of debt or draw downs against our line-of-credit, proceeds from the reimbursement of public infrastructure costs through CFD bond debt (described below under “Off-Balance Sheet Arrangements”), and the issuance of common stock. In April 2016, we filed an updated shelf registration statement on Form S-3 that went effective in May 2016. Under the shelf registration statement, we may offer and sell in the future one or more offerings, common stock, preferred stock, debt securities, warrants or any combination of the foregoing. The shelf registration allows for efficient and timely access to capital markets and when combined with our other potential funding sources just noted, provides us with a variety of capital funding options that can then be used and appropriately matched to the funding needs of the Company. As noted above, at December 31, 2018, we had $79,657,000 in cash and securities and as of the filing date of this Form 10-K, we had $30,000,000 available on credit lines to meet any short-term liquidity needs. We continue to expect that substantial investments will be required in order to develop our land assets. In order to meet these capital requirements, we may need to secure additional debt financing and continue to renew our existing credit facilities. In addition to debt financing, we will use other capital alternatives such as joint ventures with financial partners, sales of assets, and the issuance of common stock. We will use a combination of the above funding sources to properly match funding requirements with the assets or development project being funded. There is no assurance that we can obtain financing or that we can obtain financing at favorable terms. We believe we have adequate capital resources to fund our cash needs and our capital investment requirements in the near-term as described earlier in the cash flow and liquidity discussions. Contractual Cash Obligations The following table summarizes our contractual cash obligations and commercial commitments as of December 31, 2018, to be paid over the next five years: The categories above include purchase obligations and other long-term liabilities reflected on our balance sheet under GAAP. A “purchase obligation” is defined in Item 303(a)(5)(ii)(D) of Regulation S-K as “an agreement to purchase goods or services that is enforceable and legally binding the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.” Based on this definition, the table above includes only those contracts that include fixed or minimum obligations. It does not include normal purchases, which are made in the ordinary course of business. Our financial obligations to the Tejon Ranch Conservancy are prescribed in the Conservation Agreement. Our advances to the Tejon Ranch Conservancy are dependent on the occurrence of certain events and their timing, and are therefore subject to change in amount and period. The amounts included above are the minimum amounts we anticipate contributing through the year 2021, at which time our current contractual obligation terminates. As discussed in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements, we have long-term liabilities for deferred employee compensation, including pension and supplemental retirement plans. Payments in the above table reflect estimates of future defined benefit plan contributions from the Company to the plan trust, estimates of payments to employees from the plan trust, and estimates of future payments to employees from the Company that are in the SERP program. During 2018, we made pension contributions of $165,000 and it is projected that we will make a similar contribution in 2019. Our cash contract commitments consist of contracts in various stages of completion related to infrastructure development within our industrial developments and entitlement costs related to our industrial and residential development projects. Also, included in the cash contract commitments are estimated fees earned during the second quarter of 2014 by a consultant, related to the entitlement of the Grapevine Development Area. The Company exited a consulting contract during the second quarter of 2014 related to the Grapevine Development and is obligated to pay an earned incentive fee at the time of successful receipt of litigated project entitlements and at a value measurement date five-years after entitlements have been achieved for Grapevine. The final amount of the incentive fees will not be finalized until the future payment dates. The Company believes that net savings from exiting the contract over this future time period will more than offset the incentive payment costs. Estimated water payments include the Nickel water contract, which obligates us to purchase 6,693 acre-feet of water annually through 2044 and SWP contracts with Wheeler Ridge Maricopa Water Storage District, Tejon-Castac Water District, Tulare Lake Basin Water Storage District, and Dudley-Ridge Water Storage District. These contracts for the supply of future water run through 2035. Please refer to Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding water assets. Our operating lease obligations are for office equipment. At the present time, we do not have any capital lease obligations or purchase obligations outstanding. Off-Balance Sheet Arrangements The following table shows contingent obligations we have with respect to the CFDs. The Tejon Ranch Public Facilities Financing Authority, or TRPFFA, is a joint powers authority formed by Kern County and TCWD to finance public infrastructure within the Company’s Kern County developments. TRPFFA created two CFD's, the West CFD and the East CFD. The West CFD has placed liens on 420 acres of the Company’s land to secure payment of special taxes related to $28,620,000 of bond debt sold by TRPFFA for TRCC-West. The East CFD has placed liens on 1,931 acres of the Company’s land to secure payments of special taxes related to $55,000,000 of bond debt sold by TRPFFA for TRCC-East. At TRCC-West, the West CFD has no additional bond debt approved for issuance. At TRCC-East, the East CFD has approximately $65,000,000 of additional bond debt authorized by TRPFFA. In connection with the sale of bonds there is a standby letter of credit for $4,468,000 related to the issuance of East CFD bonds. The standby letter of credit is in place to provide additional credit enhancement and cover approximately two years' worth of interest on the outstanding bonds. This letter of credit will not be drawn upon unless the Company, as the largest landowner in the CFD, fails to make its property tax payments. As development occurs within TRCC-East there is a mechanism in the bond documents to reduce the amount of the letter of credit. The Company believes that the letter of credit will never be drawn upon. This letter of credit is for a two-year period of time and will be renewed in two-year intervals as necessary. The annual cost related to the letter of credit is approximately $68,000. The assessment of each individual property sold or leased within each CFD is not determinable at this time because it is based on the current tax rate and the assessed value of the property at the time of sale or on its assessed value at the time it is leased to a third-party. Accordingly, the Company is not required to recognize an obligation at December 31, 2018. At December 31, 2018, aggregate outstanding debt of unconsolidated joint ventures was $121,326,000. We guarantee $106,043,000 of this debt, relating to our joint ventures with Rockefeller and Majestic. Because of positive cash flow generation within the Rockefeller and Majestic joint ventures, we do not expect the guarantee to ever be called upon. We do not provide a guarantee on the $15,283,000 of debt related to our joint venture with TA/Petro. Non-GAAP Financial Measures EBITDA represents earnings before interest, taxes, depreciation, and amortization, a non-GAAP financial measure, and is used by us and others as a supplemental measure of performance. We use Adjusted EBITDA to assess the performance of our core operations, for financial and operational decision making, and as a supplemental or additional means of evaluating period-to-period comparisons on a consistent basis. Adjusted EBITDA is calculated as EBITDA, excluding stock compensation expense. We believe Adjusted EBITDA provides investors relevant and useful information because it permits investors to view income from our operations on an unleveraged basis before the effects of taxes, depreciation and amortization, and stock compensation expense. By excluding interest expense and income, EBITDA and Adjusted EBITDA allow investors to measure our performance independent of our capital structure and indebtedness and, therefore, allow for a more meaningful comparison of our performance to that of other companies, both in the real estate industry and in other industries. We believe that excluding charges related to share-based compensation facilitates a comparison of our operations across periods and among other companies without the variances caused by different valuation methodologies, the volatility of the expense (which depends on market forces outside our control), and the assumptions and the variety of award types that a company can use. EBITDA and Adjusted EBITDA have limitations as measures of our performance. EBITDA and Adjusted EBITDA do not reflect our historical cash expenditures or future cash requirements for capital expenditures or contractual commitments. While EBITDA and Adjusted EBITDA are relevant and widely used measures of performance, they do not represent net income or cash flows from operations as defined by GAAP. Further, our computation of EBITDA and Adjusted EBITDA may not be comparable to similar measures reported by other companies. Net operating income (NOI) is a non-GAAP financial measure calculated as operating income, the most directly comparable financial measure calculated and presented in accordance with GAAP, excluding general and administrative expenses, interest expense, depreciation and amortization, and gain or loss on sales of real estate. We believe NOI provides useful information to investors regarding our financial condition and results of operations because it primarily reflects those income and expense items that are incurred at the property level. Therefore, we believe NOI is a useful measure for evaluating the operating performance of our real estate assets. The Company utilizes NOI of unconsolidated joint ventures as a measure of financial or operating performance that is not specifically defined by GAAP. We believe NOI of unconsolidated joint ventures provides investors with additional information concerning operating performance of our unconsolidated joint ventures. We also use this measure internally to monitor the operating performance of our unconsolidated joint ventures. Our computation of this non-GAAP measure may not be the same as similar measures reported by other companies. This non-GAAP financial measure should not be considered as an alternative to net income as a measure of the operating performance of our unconsolidated joint ventures or to cash flows computed in accordance with GAAP as a measure of liquidity nor are they indicative of cash flows from operating and financial activities of our unconsolidated joint ventures. The following schedule reconciles net income from unconsolidated joint ventures to NOI of unconsolidated joint ventures.

<s>[INST] See Part I, "ForwardLooking Statements" for our cautionary statement regarding forwardlooking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10K, beginning at page. It also should be read in conjunction with the disclosure under “ForwardLooking Statements” in Part 1 of this Form 10K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five reporting segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through a joint venture. Within our resort/residential segment, the three active mixed use master plan developments are MV, Centennial, and Grapevine. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2018, net income attributable to common stockholders was $4,255,000 compared to net loss attributed to common stockholders of $1,797,000 in 2017. Factors driving the change include an increase in mineral resource revenues of $8,412,000 resulting from more sales opportunities for water in 2018 when compared to 2017, and an increase in farming revenues of $2,129,000 resulting from improved pistachio sales. From an expense perspective, expenses increased $2,410,000 mainly as a result of an increase in costs of $3,100,000 stemming from increased water sales. For 2017, net loss attributable to common stockholders was $1,797,000 compared to net income attributed to common stockholders of $800,000 in 2016. Factors driving the change include: a decline in farming revenues of $2,214,000 resulting from a decline in pistachio production in excess of 2,200,000 pounds, a decline in mineral resource revenues of $8,170,000 resulting from decreased sales opportunities for water in 2017 when compared to 2016, and a decrease in income from unconsolidated joint vent [/INST] Negative. </s>

TEJON RANCH CO

2020-03-10

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS See Part I, "Forward-Looking Statements" for our cautionary statement regarding forward-looking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part 1 of this Form 10-K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five reporting segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through a joint venture. Within our resort/residential segment, the three active mixed use master plan developments are MV, Centennial, and Grapevine. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2019, net income attributable to common stockholders was $10,580,000 compared to net income attributed to common stockholders of $4,255,000 in 2018. Over the comparative period, commercial/industrial segment revenues and results from our commercial joint ventures improved $7,822,000 and $12,741,000, respectively. Improvements in commercial revenues were attributed to land and building contributions to two joint ventures, while our joint ventures improved because of improved fuel and non fuel margins within our TA/Petro joint venture along with recognizing a substantial gain stemming from the sale of the building and land previously held by our Five West Parcel joint venture. These improvements were offset by reduced mineral resources revenues of $4,604,000 resulting from a lack of water sales opportunities due to the wet 2019 winter rain season, an increase in commercial/industrial expenses of $6,715,000 as a result of land and building costs associated with the joint venture contributions discussed earlier, and a $1,765,000 increase in other losses associated with the abandonment of a wine grape vineyard that will no longer be farmed and pension related expenses. For 2018, net income attributable to common stockholders was $4,255,000 compared to net loss attributed to common stockholders of $1,797,000 in 2017. Factors driving the change include an increase in mineral resource revenues of $8,412,000 resulting from more sales opportunities for water in 2018 when compared to 2017, and an increase in farming revenues of $2,129,000 resulting from improved pistachio sales. From an expense perspective, expenses increased $2,410,000 mainly as a result of an increase in costs of $3,100,000 stemming from increased water sales. For the year ended December 31, 2019, we had no material lease renewals. During 2020, we will continue to invest funds towards litigation defense, permits, and maps for our master plan mixed use developments and for master project infrastructure and vertical development within our active commercial and industrial development. Securing entitlements for our land is a long, arduous process that can take several years and involves litigation. During the next few years, our net income will fluctuate from year-to-year based upon, among other factors, commodity prices, production within our farming segment, the timing of land sales and the leasing of land and/or industrial space within our industrial developments, and equity in earnings realized from our unconsolidated joint ventures. This Management’s Discussion and Analysis of Financial Condition and Results of Operations provides a narrative discussion of our results of operations. It contains the results of operations for each operating segment of the business and is followed by a discussion of our financial position. It is useful to read the business segment information in conjunction with Note 16 (Reporting Segments and Related Information) of the Notes to Consolidated Financial Statements. Critical Accounting Policies The preparation of our consolidated financial statements in accordance with generally accepted accounting principles in the United States, or GAAP, requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We consider an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (2) changes in the estimates that are likely to occur from period to period, or use of different estimates that we reasonably could have used in the current period, would have a material impact on our financial condition or results of operations. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, impairment of long-lived assets, capitalization of costs, allocation of costs related to land sales and leases, stock compensation, our future ability to utilize deferred tax assets, and defined benefit retirement plans. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the foregoing disclosure. In addition, there are other items within our financial statements that require estimation, but are not deemed critical as defined above. Changes in estimates used in these and other items could have a material impact on our financial statements. See also Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements, which discusses accounting policies that we have selected from acceptable alternatives. We believe the following critical accounting policies reflect our more significant judgments and estimates used in the preparation of the consolidated financial statements: Revenue Recognition - The Company’s revenue is primarily derived from lease revenue from our rental portfolio, royalty revenue from mineral leases, sales of farm crops, sales of water, and land sales. Revenue from leases with rent concessions or fixed escalations is recognized on a straight-line basis over the initial term of the related lease unless there is a considerable risk as to collectability. The financial terms of leases are contractually defined. Lease revenue is not accrued when a tenant vacates the premises and ceases to make rent payments or files for bankruptcy. Royalty revenues are contractually defined as to the percentage of royalty and are tied to production and market prices. Our royalty arrangements generally require payment on a monthly basis with the payment based on the previous month’s activity. We accrue monthly royalty revenues based upon estimates and adjust to actual as we receive payments. From time to time the Company sells easements over its land. The easements are either in the form of rights of access granted for such things as utility corridors or are in the form of conservation easements that generally require the Company to divest its rights to commercially develop a portion of its land, but do not result in a change in ownership of the land or restrict the Company from continuing other revenue generating activities on the land. Sales of easements are accounted for in accordance with the five-step model under Accounting Standards Codification Topic 606, or ASC 606. The five-step model requires that we (i) identify the contract with the customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, including variable consideration to the extent that it is probable that a significant future reversal will not occur, (iv) allocate the transaction price to the respective performance obligations in the contract, and (v) recognize revenue when (or as) we satisfy the performance obligation. Since easements generally do not impose any significant continuing performance obligations on the Company, revenue from easement sales are generally recognized in the period the sale has closed and consideration has been received. In recognizing revenue from land sales, the Company follows ASC 606 to achieve the core principle that an entity recognizes revenue to depict the transfer of goods or services to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The adoption of ASC 606 on January 1, 2018 impacted our accounting for land sales. Upon the adoption of ASC 606, for any future land sales with multiple performance obligations, the standard generally requires the Company to allocate the transaction price to the performance obligations in proportion to their standalone selling prices (i.e., on a relative standalone selling price basis) not total costs. At the time farm crops are harvested, contracted, and delivered to buyers and revenues can be estimated, revenues are recognized and any related inventoried costs are expensed, which traditionally occurs during the third and fourth quarters of each year. It is not unusual for portions of our almond or pistachio crop to be sold in the year following the harvest. Orchard (almond and pistachio) revenues are based upon the contract settlement price or estimated selling price, whereas vineyard revenues are typically recognized at the contracted selling price. Estimated prices for orchard crops are based upon the quoted estimate of what the final market price may be by marketers and handlers of the orchard crops. These market price estimates are updated through the crop payment cycle as new information is received as to the final settlement price for the crop sold. These estimates are adjusted to actual upon receipt of final payment for the crop. This method of recognizing revenues on the sale of orchard crops is a standard practice within the agribusiness community. Actual final crop selling prices are not determined for several months following the close of our fiscal year due to supply and demand fluctuations within the orchard crop markets. Adjustments for differences between original estimates and actual revenues received are recorded during the period in which such amounts become known. Impairment of Long-Lived Assets - We evaluate our property and equipment and development projects for impairment when events or changes in circumstances indicate that the carrying value of assets contained in our financial statements may not be recoverable. The impairment calculation compares the carrying value of the asset to the asset’s estimated future cash flows (undiscounted). If the estimated future cash flows are less than the carrying value of the asset, we calculate an impairment loss. The impairment loss calculation compares the carrying value of the asset to the asset’s estimated fair value, which may be based on estimated future cash flows (discounted). We recognize an impairment loss equal to the amount by which the asset’s carrying value exceeds the asset’s estimated fair value. If we recognize an impairment loss, the adjusted carrying amount of the asset will be its new cost basis. For a depreciable long-lived asset, the new cost basis will be depreciated (amortized) over the remaining useful life of that asset. Restoration of a previously recognized impairment loss is prohibited. We currently operate in five reporting segments: commercial/industrial real estate development, resort/residential real estate development, mineral resources, farming, and ranch operations. At this time, there are no assets within any of our reporting segments that we believe are at risk of being impaired due to market conditions nor have we identified any impairment indicators. We believe that the accounting estimate related to asset impairment is a critical accounting estimate because it is very susceptible to change from period to period; it requires management to make assumptions about future prices, production, and costs, and the potential impact of a loss from impairment could be material to our earnings. Management’s assumptions regarding future cash flows from real estate developments and farming operations have fluctuated in the past due to changes in prices, absorption, production and costs and are expected to continue to do so in the future as market conditions change. In estimating future prices, absorption, production, and costs, we use our internal forecasts and business plans. We develop our forecasts based on recent sales data, historical absorption and production data, input from marketing consultants, as well as discussions with commercial real estate brokers and potential purchasers of our farming products. If actual results are not consistent with our assumptions and judgments used in estimating future cash flows and asset fair values, we may be exposed to impairment losses that could be material to our results of operations. Capitalization of Costs - The Company capitalizes direct construction and development costs, including predevelopment costs, interest, property taxes, insurance, and indirect project costs that are clearly associated with the acquisition, development, or construction of a project. Costs currently capitalized that in the future would be related to any abandoned development opportunities will be written off if we determine such costs do not provide any future benefits. Should development activity decrease, a portion of interest, property taxes, and insurance costs would no longer be eligible for capitalization, and would be expensed as incurred. Allocation of Costs Related to Land Sales and Leases - When we sell or lease land within one of our real estate developments, as we are currently doing within TRCC, and we have not completed all infrastructure development related to the total project, we determine the appropriate costs of sales for the sold land and the timing of recognition of the sale. In the calculation of cost of sales or allocations to leased land, we use estimates and forecasts to determine total costs at completion of the development project. These estimates of final development costs can change as conditions in the market and costs of construction change. In preparing these estimates, we use internal budgets, forecasts, and engineering reports to help us estimate future costs related to infrastructure that has not been completed. These estimates become more accurate as the development proceeds forward, due to historical cost numbers and to the continued refinement of the development plan. These estimates are updated periodically throughout the year so that, at the ultimate completion of development, all costs have been allocated. Any increases to our estimates in future years will negatively impact net profits and liquidity due to an increased need for funds to complete development. If, however, this estimate decreases, net profits as well as liquidity will improve. We believe that the estimates used related to cost of sales and allocations to leased land are critical accounting estimates and will become even more significant as we continue to move forward as a real estate development company. The estimates used are very susceptible to change from period to period, due to the fact that they require management to make assumptions about costs of construction, absorption of product, and timing of project completion, and changes to these estimates could have a material impact on the recognition of profits from the sale of land within our developments. Stock-Based Compensation - We apply the recognition and measurement principles of ASC 718, “Compensation - Stock Compensation” in accounting for long-term stock-based incentive plans. Our stock-based compensation plans include both restricted stock units and restricted stock grants. We have not issued any stock options to employees or directors since January 2003, and our 2019 financial statements do not reflect any compensation expenses for stock options. All stock options issued in the past have been exercised or forfeited. We make stock awards to employees based upon time-based criteria and through the achievement of performance-related objectives. Performance-related objectives are either stratified into threshold, target, and maximum goals or based on the achievement of a milestone event. These stock awards are currently being expensed over the expected vesting period based on each performance criterion. We make estimates as to the number of shares that will actually be granted based upon estimated ranges of success in meeting the defined performance measures. If our estimates of performance shares vesting were to change by 25%, stock compensation expense would increase or decrease by approximately $1,220,000 depending on whether the change in estimate increased or decreased shares vesting. The Company also has performance share grants that contain both performance-based and market-based conditions. Compensation cost for these awards is recognized based on either the achievement of the performance-based conditions, if they are considered probable, or if they are not considered probable, on the achievement of the market-based condition. Failure to satisfy the threshold performance conditions will result in the forfeiture of shares. Forfeiture of share awards with service conditions or performance-based restrictions results in a reversal of previously recognized share-based compensation expense. Forfeiture of share awards with market-based restrictions does not result in a reversal of previously recognized share-based compensation expense. See Note 11. (Stock Compensation - Restricted Stock and Performance Share Grants), of the Notes to Consolidated Financial Statement for total 2019 stock compensation expense related to stock grants. Fair Value Measurements - The Financial Accounting Standards Board's, or FASB, authoritative guidance for fair value measurements of certain financial instruments defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Fair value is defined as the exchange (exit) price that would be received for an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This guidance establishes a three-level hierarchy for fair value measurements based upon the inputs to the valuation of an asset or liability. Observable inputs are those which can be easily seen by market participants while unobservable inputs are generally developed internally, utilizing management’s estimates and assumptions: • Level 1 - Valuation is based on quoted prices in active markets for identical assets and liabilities. • Level 2 - Valuation is determined from quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market. • Level 3 - Valuation is derived from model-based techniques in which at least one significant input is unobservable and based on our own estimates about the assumptions that market participants would use to value the asset or liability. When available, we use quoted market prices in active markets to determine fair value. We consider the principal market and nonperformance risk associated with our counterparties when determining the fair value measurement. Fair value measurements are used for marketable securities, investments within the pension plan and hedging instruments. Recent Accounting Pronouncements For discussion of recent accounting pronouncements, see Note 1 (Summary of Significant Accounting Policies) of the Notes to Consolidated Financial Statements. Results of Operations by Segment We evaluate the performance of our reporting segments separately to monitor the different factors affecting financial results. Each reporting segment is subject to review and evaluation as we monitor current market conditions, market opportunities, and available resources. The performance of each reporting segment is discussed below: Real Estate - Commercial/Industrial 2019 Operational Highlights: • During 2019, commercial/industrial segment revenues increased $7,822,000, or 87.2%, from $8,970,000 in 2018 to $16,792,000. The increase was primarily attributable to revenues of $6,621,000 recognized as a result of asset contributions to unconsolidated joint ventures of 1) land, and 2) land and building. We contributed 34.85 acres to TRC-MRC 3, with recognized revenues of $4,317,000, and a 4,900 square-foot multi-tenant building and land to our TA-Petro joint venture, with recognized revenues of $2,303,000. Please refer to Note 17 (Investment in Unconsolidated and Consolidated Joint Ventures) for additional discussion. • Also contributing to the increase in commercial/industrial revenues was a $517,000 increase in PEF revenues which was primarily associated with a catch-up of its 2018 spark spread revenues that were above original estimates. • Commercial/industrial real estate segment expenses increased $6,715,000, or 107.5%, from $6,246,000 in 2018 to $12,961,000 in 2019. During 2019, as a result of the two land and building contributions mentioned above, the Company recorded cost of land and building sale of $4,748,000. Additionally, the Company also experienced an increase in fixed water assessments of $1,958,000. 2018 Operational Highlights: • During 2018, commercial/industrial segment revenues decreased $31,000, or 0.3%, from $9,001,000 in 2017 to $8,970,000. The reduction was primarily attributable to land sale revenues of $73,000 in 2017, whereas we did not have any land sales in 2018. The Company noted a decrease in TRCC management fees as a result of not earning a developer fee from the construction of an industrial building within its TRC-MRC 1 joint venture as it had in 2017. • Commercial/industrial real estate segment expenses decreased $283,000, or 4.3%, from $6,529,000 in 2017 to $6,246,000 in 2018. During 2018, payroll, overhead, stock compensation and bonuses decreased $887,000, due to reassignment of resources within the Company, while professional services also decreased $194,000. The above reductions were partially offset by increases in fixed water assessments of $727,000 and fees of $107,000. For 2020, we expect the commercial/industrial segment to continue to experience costs, net of amounts capitalized, primarily related to professional service fees, marketing costs, commissions, planning costs, and staffing costs as we continue to pursue development opportunities. These costs, as well as fixed water assessments, are expected to remain consistent with current levels of expense with any variability in the future tied to specific absorption transactions in any given year. The actual timing and completion of development is difficult to predict due to the uncertainties of the market. Infrastructure development and marketing activities and costs could continue over several years as we develop our land holdings. We will also continue to evaluate land resources to determine the highest and best uses for our land holdings. Future sales of land are dependent on market circumstances and specific opportunities. Our goal in the future is to increase land value and create future revenue growth through planning and development of commercial and industrial properties. See Item 1, “Business - Real Estate Development Overview” for discussion of the market outlook for the next year. Real Estate - Resort/Residential Our resort/residential segment activities in include defending entitlements, land planning and pre-construction engineering and conservation activities for our Centennial, Grapevine, and MV projects. We are in the preliminary stages of development; hence, no revenues are attributed to this segment for these reporting periods. 2019 Operational Highlights: • In 2019, resort/residential segment expenses increased $717,000 to $2,247,000, or 47%, when compared to $1,530,000 in 2018. The higher expenses were attributable to an increase in professional services of $720,000 associated with strategic planning efforts. 2018 Operational Highlights: • In 2018, resort/residential segment expenses decreased $425,000 to $1,530,000, or 22%, when compared to $1,955,000 in 2017. The reassignment of resources within the Company translated to increases in qualifying costs, including payroll and overhead costs within resort/residential which in turn translated to an increase in costs being capitalized into our real estate development projects by $250,000 when compared to 2017. In addition, we experienced savings in professional services of $163,000 in 2018. The resort/residential segment will continue to incur costs in the future related to professional service fees, public relations costs, and staffing costs as we continue forward with permitting activities for the above communities and continue to meet our obligations under the Conservation Agreement. We expect these expenses to remain consistent with current years cost in the near term and only begin to increase as we move into the development phase of each project in the future. The actual timing and completion of entitlement-related activities and the beginning of development is difficult to predict due to the uncertainties of the approval process, the length of time related to litigation defense, and the status of the economy. We will also continue to evaluate land resources to determine the highest and best use for our land holdings. Our long-term goal through this process is to increase the value of our land and create future revenue opportunities through resort and residential development. We are continuously monitoring the markets in order to identify the appropriate time in the future to begin infrastructure improvements and lot sales. Our long-term business plan of developing the communities of MV, Centennial, and Grapevine remains unchanged. As the California economy continues to improve we believe the perception of land values will also begin to improve and the long-term fundamentals that support housing demand in our region, primarily California population growth and household formation will also improve. California also has a significant documented housing shortage, which we believe our communities will help ease as the population base within California continues to grow. See Item 1, “Business - Real Estate Development Overview” for a further discussion of real estate development activities. Mineral Resources 2019 Operational Highlights: • Revenues from our mineral resources segment decreased $4,604,000, or 32%, to $9,791,000 in 2019 when compared to $14,395,000 in 2018. This decrease was primarily attributed to fewer water sale opportunities after the wet 2019 winter rain season which reduced revenues by $5,145,000 in 2019. • Oil and gas royalties decreased $436,000 as a result of lower production driven by a lower price per barrel of oil overall for the year. • Offsetting the revenue declines were increases in rock aggregate and cement royalties of $324,000 and $213,000, respectively, as a result of an increase in regional construction. • Mineral resource expense decreased $405,000, or 7%, to $5,818,000 in 2019 when compared to $6,223,000 in 2018, which is a direct result of the reduced water sales previously discussed. 2018 Operational Highlights: • Revenues from our mineral resources segment increased $8,412,000, or 141%, to $14,395,000 in 2018 when compared to $5,983,000 in 2017. This increase was primarily attributed to water sales of $9,142,000 in 2018, representing a $7,888,000 increase over last year, as a result of moderate drought conditions in Kern County. The improved water sales accordingly increased mineral resources expenses largely due to the cost of sales of water by $3,259,000. We experienced improvements for oil and gas royalties as a result of improved oil prices. We currently expect our largest tenant, California Resources Corporation, or CRC, to continue its program of producing from current active wells at lower levels with no near-term intent to begin new drilling programs until oil prices reach higher levels. CRC has approved permits and drill sites on our land and has delayed the start of drilling as it evaluates the market. A positive aspect of our lease with CRC is that the approved drill sites are in an area of the ranch where the development and production costs are moderate due to the depths being drilled. Thus far in 2020, oil prices are within 4% of West Texas Intermediate pricing. Since we only receive royalties based on tenant production and market prices and do not produce oil, we do not have information as to the potential size of oil reserves. Our royalty revenues are contractually defined and based on a percentage of production and are received in cash. Royalty revenues fluctuate based on changes in market price for oil, gas, rock and aggregate, and Portland cement. In addition, royalty revenue is impacted by new production, the inevitable decline in production in existing wells, and rock and limestone quarries, and the cost of development and production. Farming 2019 Operational Highlights: • During 2019, farming revenues increased $768,000, or 4%, from $18,563,000 in 2018 to $19,331,000 in 2019. When compared to 2018, almond revenues increased by $1,566,000 primarily from improved 2019 almond crop yields, which increased the amount of inventory available for sale. • Offsetting the increased almond sales were reductions in pistachio revenues of $414,000, which is a result of having lower yields during the 2019 down bearing cycle. Although the Company received insurance proceeds for the loss and a one-time price adjustment on the 2018 pistachio crop, they were not enough to recuperate lost revenues. Also contributing to the decline in farming revenues were declines in other farming revenues of $612,000 which were primarily a result of having fewer water use reimbursements from a farm land lease as a result of having fewer acres leased. • Farming expenses decreased $777,000, or 5%, to $15,251,000 when compared to $16,028,000 in 2018. The decrease was primarily attributed to reductions in WRMWSD water holding costs of $1,642,000 as a result of the wet 2019 rain season offset by an increase in pruning costs of $460,000, harvest costs of $313,000, and hulling costs of $281,000. 2018 Operational Highlights: • During 2018, farming revenues increased $2,129,000, or 13%, from $16,434,000 in 2017 to $18,563,000 in 2018. When compared to 2017, pistachio revenues increased $3,357,000 from record high pistachio yields. • Almond revenues decreased $583,000 due to lower almond crop yields that were driven by a combination of unfavorable weather conditions and a 165 acre reduction in the number of acres in production. The reduction was the result of the Company's decision to redevelop existing almond units. • Farming expenses decreased $173,000, or 1%, to $16,028,000 when compared to $16,201,000 in 2017. The decrease was primarily attributed to reduced cost allocations to all crops. Thus far in 2020, the prices for our crops, especially almonds and pistachios, remain consistent with 2019 levels. All of our crops are sensitive to global crop production levels. Large crops in California and abroad can depress prices. Our long-term projection is that crop production, especially for almonds and pistachios will continue to increase on a statewide basis over time because of new plantings, which could negatively impact future prices if the growth in demand does not keep pace with production. It is too early to project 2020 crop yields and what impact that may have on prices later in 2020. Additionally, the coronavirus outbreak may disrupt the flow of trade associated with our crops. It is currently too early to determine what impact, if any, the coronavirus may have on the almond and pistachio industry. The impact of state ground water management laws on new plantings and continuing crop production is also currently unknown. Water delivery and water availability continues to be a long-term concern within California. Any limitation of delivery of SWP water and the absence of available alternatives during drought periods could potentially cause permanent damage to orchards and vineyards throughout California. While this could impact us, we believe we have sufficient water resources available to meet our requirements in 2020 and beyond. Please see our discussion on water in Item 2, "Properties - Water Operations." The DWR announced its 2020 estimated water supply delivery at 15% of full entitlement. The current 15% allocation of SWP water is not enough for us to farm our crops, but our additional water resources, such as groundwater and surface sources, and those of the water districts we are in should allow us to have sufficient water for our farming needs. See Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding our water assets. For further discussion of the farming operations, refer to Item 1 “Business-Farming Operations.” Ranch Operations 2019 Operational Highlights: • Revenues from ranch operations decreased $82,000, or 2%, from $3,691,000 in 2018 to $3,609,000 in 2019. The decrease is primarily attributed to reduced membership revenues of $143,000, partially offset by an increase in grazing lease revenues of $69,000. • Ranch operations expenses decreased $135,000, or 2%, to $5,316,000 in 2019 from $5,451,000 in 2018. The decrease was mainly attributed to reduced payroll expense of $183,000, partially offset by an increase in repair and maintenance expense of $49,000. 2018 Operational Highlights: • Revenues from ranch operations decreased $146,000, or 4%, from $3,837,000 in 2017 to $3,691,000 in 2018. The decrease is primarily attributed to reduced grazing lease revenues of $157,000. • Ranch operations expenses increased $40,000, or 1%, to $5,451,000 in 2018 from $5,411,000 in 2017. The increase was mainly attributed to an increase in property taxes of $34,000. Other Income Total other income decreased $1,870,000, or 146%, from $1,285,000 in 2018 to a loss of $585,000 in 2019. This was mainly attributable to asset abandonment costs of $1,604,000 that were overwhelmingly related to the abandonment of a wine grape vineyard, consisting of 313 acres, that will no longer be farmed. Total other income increased $1,098,000 to $1,285,000, or 587%, during 2018 from $187,000 in 2017. In October of 2017, the Company invested a majority of its rights offering proceeds into marketable securities which contributed to an increase in interest income. Corporate Expenses Corporate general and administrative costs decreased $344,000, or 3.5%, to $9,361,000 during 2019 when compared to $9,705,000 in 2018. The decrease was primarily attributable to a decrease in depreciation and amortization of $231,000 and software licenses of $149,000. Corporate general and administrative costs decreased $8,000, or 0.1%, to $9,705,000 during 2018 when compared to $9,713,000 in 2017. We managed to maintain cost savings during 2018 following the staff rightsizing that occurred during the second quarter of 2017. Equity in Earnings of Unconsolidated Joint Ventures Equity in earnings of unconsolidated joint ventures is an important and growing component of our commercial/industrial activities and in the future, equity in earnings of unconsolidated joint ventures can become a significant part of our operations within the resort/residential segment. As we expand our current ventures and add new joint ventures, these investments will become a growing revenue source for the Company. 2019 Operational Highlights: During 2019, equity in earnings from unconsolidated joint ventures increased $12,741,000 to $16,575,000 when compared to $3,834,000 in 2018. • Five West Parcel, LLC had the most significant increase in equity in earnings at $8,730,000, resulting from the gain on sale of a building and land previously held by the joint venture. The joint venture had owned and leased a 606,000 square foot building, the joint venture's primary asset, to Dollar General, and the building was sold to a third party in November 2019 for a purchase price of $29,088,000, realizing a gain of $17,537,000 at the joint venture level. • There was a $3,007,000 increase in our share of earnings from our TA/Petro joint venture. The improvement was mainly driven by a 38% increase in fuel margins resulting from lower cost of fuel sales when compared to the prior year. • Our share of the loss within the TRCC/Rock Outlet joint venture decreased $402,000 due to the continuing improvement in average sales per vehicle. In addition, the joint venture also had less accelerated amortization on tenant allowances in 2019. The Outlets at Tejon is continually identifying new and desirable tenants to better serve a wider demographic. In 2019, the Outlets at Tejon attracted new tenants such as The Children's Place and Cosmetics Company Store. 2018 Operational Highlights: During 2018, equity in earnings from unconsolidated joint ventures decreased $393,000 to $3,834,000 when compared to $4,227,000 in 2017. • Despite seeing a 3.7% increase in sales per occupied square foot and an 8.3% increase in monthly sales per vehicle, equity in earnings from our TRCC/Rock Outlet joint venture decreased $1,150,000 compared to 2017. The decrease was primarily attributed to accelerating amortization of lease intangibles driven by removing poor performing tenants along with modifying lease terms to reflect the brick and mortar retail environment at the time. In 2018, the Outlets at Tejon attracted new tenants such as Kate Spade, Bath and Body Works, and Journeys. • There was a $448,000 decrease in our share of earnings from our TA/Petro joint venture. The decline was driven by lower fuel margins of 6.7% when compared to the prior year. • We incurred a $250,000 loss on our TRC-MRC 1 joint venture due to the fact that it was not fully occupied until the fourth quarter of 2018. • The above decreases in equity in earnings were partially offset by an increase in equity in earnings of TRC-MRC 2, a joint venture formed with Majestic in 2016. Equity in earnings improved $1,518,000 in 2018 given that throughout 2017, TRC-MRC 2 incurred significant non-cash GAAP accounting losses that did not reoccur in 2018. Income Taxes On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as U.S. Tax Reform. U.S. Tax Reform made broad and complex changes to the U.S. tax code, including, but not limited to, (i) reducing the U.S. federal statutory tax rate from 35% to 21%; (ii) requiring companies to pay a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries; (iii) generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; (iv) requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; (v) eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized; (vi) creating the base erosion anti-abuse tax, a new minimum tax; (vii) creating a new limitation on deductible interest expense; (viii) changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017, and (ix) modifying the officer’s compensation limitation. The provision for income taxes for fiscal year 2017 included a $54,000 estimated tax expense as a result of the revaluation of U.S. federal net deferred tax assets from 34% to 21% due to the enactment of U.S. Tax Reform. During 2018, the Company completed its analysis of the impacts of the U.S. Tax Reform and no additional expense was warranted. Other provisions of the U.S. Tax Reform did not have a material effect on our effective tax rate for 2018. For the twelve months ended December 31, 2019, the Company's net income tax expense was $3,980,000 compared to a net income tax expense of $1,320,000 for the twelve months ended December 31, 2018. These represent effective income tax rates of approximately 27% and 24% for the twelve months ended December 31, 2019 and, 2018, respectively. Our effective income tax rate for the year ended December 31, 2019 was higher than the federal statutory rate in the United States, a result of state taxes and other permanent differences. As of December 31, 2019 and 2018 we had an income tax receivable of $856,000 and $277,000, respectively. For more detail, see Note 12. (Income Taxes), of the Notes to Consolidated Financial Statements, included this Annual Report on Form 10-K. As of December 31, 2019, we had net deferred tax assets of $713,000. Our largest deferred tax assets were made up of temporary differences related to the capitalization of costs, pension adjustments, and stock compensation. Deferred tax liabilities consist of depreciation, deferred gains, cost of sale allocations, and straight-line rent. Due to the nature of most of our deferred tax assets, we believe they will be used in future years and an allowance is not necessary. The Company classifies interest and penalties incurred on tax payments as income tax expenses. The Company made income tax payments of $4,645,000 during 2019 and did not make any payments in 2018. The Company received refunds of $1,345,000 in 2019 and $164,000 in 2018. Liquidity and Capital Resources Cash Flow and Liquidity Our financial position allows us to pursue our strategies of land entitlement, development, and conservation. Accordingly, we have established well-defined priorities for our available cash, including investing in core operating segments to achieve profitable future growth. We have historically funded our operations with cash flows from operating activities, investment proceeds, and short-term borrowings from our bank credit facilities. In the past, we have also issued common stock and used the proceeds for capital investment activities. To enhance shareholder value, we will continue to make investments in our real estate segments to secure land entitlement approvals, build infrastructure for our developments, ensure adequate future water supplies, and provide funds for general land development activities. Within our farming segment, we will make investments as needed to improve efficiency and add capacity to its operations when it is profitable to do so. On October 4, 2017, the Company commenced a rights offering to common shareholders for additional working capital for general corporate purposes, including to fund general infrastructure costs and the development of buildings at TRCC, to continue forward with entitlement and permitting programs for the Centennial and Grapevine communities and costs related to the preparation of the development of MV. The rights offering concluded on October 27, 2017, with the Company raising $89,701,000, net of offering costs, from the sale of 5,000,000 shares at $18.00 per share. Our cash and cash equivalents and marketable securities totaled approximately $66,190,000 at December 31, 2019, a decrease of $13,467,000, or 17%, from the corresponding amount at the end of 2018. The following table summarizes the cash flow activities for the following years ended December 31: Cash flows provided by operating activities are primarily dependent upon the rental rates of our leases, the collectability of rent and recovery of operating expenses from our tenants, distributions from joint ventures, the success of our crops and commodity prices within our mineral resource segment. During 2019, our operations provided $16,045,000 in cash primarily attributable to strong results from our commercial joint ventures. We received total distributions of $15,381,000 from our Five West Parcel, TA/Petro and Majestic joint ventures. During 2018, our operations provided $14,354,000 of cash primarily attributable to strong operating results from our farming and mineral resources segments. We also received a $4,800,000 distribution from our TA/Petro joint venture. During 2019, investing activities provided $828,000, which was largely attributed to marketable securities maturities of $53,418,000, reimbursements from the community financing district of $4,180,000, and distributions from our unconsolidated joint ventures of $3,457,000. Offsetting the increase were investments in marketable securities of $28,219,000 and capital expenditures of $25,222,000. Of the $25,222,000, we spent $4,691,000 on planning and permitting for MV, $4,403,000 on the final approval of the specific plan for Centennial, and $3,717,000 on re-entitlement and litigation for Grapevine. At TRCC, we used $8,690,000 on continued expansion of water infrastructure at TRCC and construction of a new multi-tenant building that was subsequently contributed to our TA/Petro joint venture. All real estate capital expenditures are inclusive of capitalized interest, payroll and overhead. Our farming segment had cash outlays of $3,362,000 for developing new almond orchards and replacing old farm equipment. Lastly, we purchased water through our annual water contracts, using $3,686,000 and invested $3,100,000 into our unconsolidated joint ventures. During 2018, investing activities used $13,246,000 which was partially attributed to reinvesting marketable security maturities of $28,392,000. We also had $22,580,000 in capital expenditures associated with real estate and farm crop development. Of the $22,580,000 we spent $5,204,000 on tentative tract maps, engineering and the design of Farm Village for MV, $5,295,000 on the approval of the specific plan for Centennial, and $2,960,000 on regulatory permits and litigation for Grapevine. At TRCC we used $5,225,000 on continued expansion and infrastructure, and indirect costs supporting all ongoing infrastructure projects, such as expansion of water treatment facilities and relocation of gas line. Our farming segment had cash outlays of $3,166,000 for developing new almond orchards and replacing old farm equipment. Lastly, we purchased water through our annual water contracts, using $3,844,000. Offsetting our cash outlays were marketable securities maturities of $35,219,000 and distributions from our joint venture partners of $2,815,000. Our estimated capital investment for 2020 is primarily related to our real estate projects as it was in 2019. These estimated investments include approximately $6,033,000 of infrastructure development at TRCC-East to support continued commercial retail and industrial development and expanding water facilities to support future anticipated absorption. We are also investing approximately $3,510,000 to continue developing new almond orchards and replacing old farming equipment. The farm investments are part of a long-term farm management program to redevelop declining orchards and vineyards allowing the Company to maintain and improve future farm revenues. We expect to possibly invest up to $10,492,000 for permitting activities, litigation defense, predevelopment activities and land planning design at MV, Centennial, and Grapevine during 2020. The timing of these investments is dependent on our coordination efforts with Los Angeles County regarding litigation efforts for Centennial, litigation and permitting activities for Grapevine, and final maps for MV. Our plans also include $3,180,000 for payment of annual water inventory and water related investments. We are also planning to potentially invest up to $218,000 in the normal replacement of operating equipment, such as ranch equipment, and vehicles. We capitalize interest cost as a cost of the project only during the period for which activities necessary to prepare an asset for its intended use are ongoing, provided that expenditures for the asset have been made and interest cost has been incurred. Capitalized interest for the years ended December 31, 2019 and 2018, of $2,818,000 and $2,954,000, respectively, is classified in real estate development. We also capitalized payroll costs related to development, pre-construction, and construction projects which aggregated $3,706,000 and $4,171,000 for the years ended December 31, 2019 and 2018, respectively. Expenditures for repairs and maintenance are expensed as incurred. During 2019, financing activities used $5,675,000 primarily through repayments of long-term debt of $4,004,000 and tax payments on vested stock grants of $1,671,000. During 2018, financing activities used $5,307,000 primarily through repayments of long-term debt of $4,046,000 and taxes on vested stock grants of $1,095,000. It is difficult to accurately predict cash flows due to the nature of our businesses and fluctuating economic conditions. Our earnings and cash flows will be affected from period to period by the commodity nature of our farming and mineral operations, the timing of sales and leases of property within our development projects, and the beginning of development within our residential projects. The timing of sales and leases within our development projects is difficult to predict due to the time necessary to complete the development process and negotiate sales or lease contracts. Often, the timing aspect of land development can lead to particular years or periods having more or less earnings than comparable periods. Based on our experience, we believe we will have adequate cash flows, cash balances, and availability on our line of credit over the next twelve months to fund internal operations. As we move forward with the completion of the litigation, permitting and engineering design for our master planned communities and prepare to move into the development stage, we will need to secure additional funding through the issuance of equity and secure other forms of financing such as joint ventures and possibly debt financing. Capital Structure and Financial Condition At December 31, 2019, total capitalization at book value was $507,282,000 consisting of $61,658,000 of debt, net of deferred financing costs, and $445,624,000 of equity, resulting in a debt-to-total-capitalization ratio of approximately 12.2%, representing a decrease when compared to the debt-to-total-capitalization ratio of 13.1% at December 31, 2018. On October 13, 2014, the Company as borrower, entered into an Amended and Restated Credit Agreement, a Term Note and a Revolving Line of Credit Note, with Wells Fargo, or collectively the Credit Facility. The Credit Facility added a $70,000,000 term loan, or Term Loan, to the then existing $30,000,000 revolving line of credit, or RLC. In August 2019, the Company amended the Term Note (Amended Term Note) and extended its maturity to June 2029 and amended the RLC to expand the capacity from $30,000,000 to $35,000,000 and extend the maturity to October 2024. The Amended Term Loan had a $58,768,000 balance as of December 31, 2019, whereas the Term Note had an outstanding balance of $62,483,000 as of December 31, 2018. The interest rate per annum applicable to the Amended Term Note is LIBOR (as defined in the Term Note) plus a margin of 170 basis points. The interest rate for the Amended Term Note has been fixed at 4.16% through the use of an interest rate swap agreement. The Amended Term Note requires monthly amortization payments, with the outstanding principal amount due June 5, 2029. The Amended Term Note is secured by the Company's farmland and farm assets, which include equipment, crops and crop receivables; the PEF power plant lease and lease site; and related accounts and other rights to payment and inventory. The RLC had no outstanding balance at December 31, 2019 and December 31, 2018. At the Company’s option, the interest rate on this line of credit can float at 1.50% over a selected LIBOR rate or can be fixed at 1.50% above LIBOR for a fixed rate term. During the term of this RLC, the Company can borrow at any time and partially or wholly repay any outstanding borrowings and then re-borrow, as necessary. Any future borrowings under the RLC will be used for ongoing working capital requirements and other general corporate purposes. To maintain availability of funds under the RLC, undrawn amounts under the RLC will accrue a commitment fee of 10 basis points per annum. The Company's ability to borrow additional funds in the future under the RLC is subject to compliance with certain financial covenants and making certain representations and warranties, which are typical in this type of borrowing arrangement. The Amended Note and RLC, collectively the Amended Credit Facility, requires compliance with three financial covenants: (i) total liabilities divided by tangible net worth not greater than 0.75 to 1.0 at each quarter end; (ii) a debt service coverage ratio not less than 1.25 to 1.00 as of each quarter end on a rolling four quarter basis; and (iii) maintain liquid assets equal to or greater than $20,000,000, including availability on the RLC. At December 31, 2019 and December 31, 2018, the Company was in compliance with all financial covenants. The Amended Credit Facility also contains customary negative covenants that limit the ability of the Company to, among other things, make capital expenditures, incur indebtedness and issue guaranties, consummate certain assets sales, acquisitions or mergers, make investments, pay dividends or repurchase stock, or incur liens on any assets. The Amended Credit Facility contains customary events of default, including: failure to make required payments; failure to comply with terms of the Amended Credit Facility; bankruptcy and insolvency; and a change in control without consent of the bank (which consent will not be unreasonably withheld). The Amended Credit Facility contains other customary terms and conditions, including representations and warranties, which are typical for credit facilities of this type. We also have a $4,750,000 promissory note agreement with principal and interest due monthly. The interest rate on this promissory note is 4.25% per annum, with principal and interest payments ending on September 1, 2028. The balance as of December 31, 2019 is $3,129,000. The proceeds from this promissory note were used to eliminate debt that had been previously used to provide long-term financing for a building being leased to Starbucks and provide additional working capital for future investment. Our current and future capital resource requirements will be provided primarily from current cash and marketable securities, cash flow from on-going operations, distributions from joint ventures, proceeds from the sale of developed and undeveloped parcels, potential sales of assets, additional use of debt or draw downs against our line-of-credit, proceeds from the reimbursement of public infrastructure costs through CFD bond debt (described below under “Off-Balance Sheet Arrangements”), and the issuance of common stock. In May 2019, we filed an updated shelf registration statement on Form S-3 that went effective in May 2019. Under the shelf registration statement, we may offer and sell in the future one or more offerings, common stock, preferred stock, debt securities, warrants or any combination of the foregoing. The shelf registration allows for efficient and timely access to capital markets and when combined with our other potential funding sources just noted, provides us with a variety of capital funding options that can then be used and appropriately matched to the funding needs of the Company. As noted above, at December 31, 2019, we had $66,190,000 in cash and securities and as of the filing date of this Form 10-K, we had $35,000,000 available on credit lines to meet any short-term liquidity needs. We continue to expect that substantial investments will be required in order to develop our land assets. In order to meet these capital requirements, we may need to secure additional debt financing and continue to renew our existing credit facilities. In addition to debt financing, we will use other capital alternatives such as joint ventures with financial partners, sales of assets, and the issuance of common stock. We will use a combination of the above funding sources to properly match funding requirements with the assets or development project being funded. There is no assurance that we can obtain financing or that we can obtain financing at favorable terms. We believe we have adequate capital resources to fund our cash needs and our capital investment requirements in the near-term as described earlier in the cash flow and liquidity discussions. Contractual Cash Obligations The following table summarizes our contractual cash obligations and commercial commitments as of December 31, 2019, to be paid over the next five years: The categories above include purchase obligations and other long-term liabilities reflected on our balance sheet under GAAP A “purchase obligation” is defined in Item 303(a)(5)(ii)(D) of Regulation S-K as “an agreement to purchase goods or services that is enforceable and legally binding the registrant that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.” Based on this definition, the table above includes only those contracts that include fixed or minimum obligations. It does not include normal purchases, which are made in the ordinary course of business. Our financial obligations to the Tejon Ranch Conservancy are prescribed in the Conservation Agreement. Our advances to the Tejon Ranch Conservancy are dependent on the occurrence of certain events and their timing, and are therefore subject to change in amount and period. The amounts included above are the minimum amounts we anticipate contributing through the year 2021, at which time our current contractual obligation terminates. As discussed in Note 15 (Retirement Plans) of the Notes to Consolidated Financial Statements, we have long-term liabilities for deferred employee compensation, including pension and supplemental retirement plans. Payments in the above table reflect estimates of future defined benefit plan contributions from the Company to the plan trust, estimates of payments to employees from the plan trust, and estimates of future payments to employees from the Company that are in the SERP program. During 2019, we made pension contributions of $165,000 and it is projected that we will make a similar contribution in 2020. Our cash contract commitments consist of contracts in various stages of completion related to infrastructure development within our industrial developments and entitlement costs related to our industrial and residential development projects. Also, included in the cash contract commitments are estimated fees earned during the second quarter of 2014 by a consultant, related to the entitlement of the Grapevine Development Area. The Company exited a consulting contract during the second quarter of 2014 related to the Grapevine Development and is obligated to pay an earned incentive fee at the time of successful receipt of litigated project entitlements and at a value measurement date five-years after entitlements have been achieved for Grapevine. The final amount of the incentive fees will not be finalized until the future payment dates. The Company believes that net savings from exiting the contract over this future time period will more than offset the incentive payment costs. Estimated water payments include the Nickel water contract, which obligates us to purchase 6,693 acre-feet of water annually through 2044 and SWP contracts with Wheeler Ridge Maricopa Water Storage District, Tejon-Castac Water District, Tulare Lake Basin Water Storage District, and Dudley-Ridge Water Storage District. These contracts for the supply of future water run through 2035. Please refer to Note 6 (Long-Term Water Assets) of the Notes to Consolidated Financial Statements for additional information regarding water assets. Off-Balance Sheet Arrangements The following table shows contingent obligations we have with respect to the CFDs. The Tejon Ranch Public Facilities Financing Authority, or TRPFFA, is a joint powers authority formed by Kern County and TCWD to finance public infrastructure within the Company’s Kern County developments. TRPFFA created two CFD's, the West CFD and the East CFD. The West CFD has placed liens on 420 acres of the Company’s land to secure payment of special taxes related to $28,620,000 of bond debt sold by TRPFFA for TRCC-West. The East CFD has placed liens on 1,931 acres of the Company’s land to secure payments of special taxes related to $55,000,000 of bond debt sold by TRPFFA for TRCC-East. At TRCC-West, the West CFD has no additional bond debt approved for issuance. At TRCC-East, the East CFD has approximately $65,000,000 of additional bond debt authorized by TRPFFA. In connection with the sale of bonds there is a standby letter of credit for $4,468,000 related to the issuance of East CFD bonds. The standby letter of credit is in place to provide additional credit enhancement and cover approximately two years' worth of interest on the outstanding bonds. This letter of credit will not be drawn upon unless the Company, as the largest landowner in the CFD, fails to make its property tax payments. As development occurs within TRCC-East there is a mechanism in the bond documents to reduce the amount of the letter of credit. The Company believes that the letter of credit will never be drawn upon. This letter of credit is for a two-year period of time and will be renewed in two-year intervals as necessary. The annual cost related to the letter of credit is approximately $68,000. The assessment of each individual property sold or leased within each CFD is not determinable at this time because it is based on the current tax rate and the assessed value of the property at the time of sale or on its assessed value at the time it is leased to a third-party. Accordingly, the Company is not required to recognize an obligation at December 31, 2019. At December 31, 2019, aggregate outstanding debt of unconsolidated joint ventures was $131,254,000. We guarantee $115,967,000 of this debt, relating to our joint ventures with Rockefeller and Majestic. Because of positive cash flow generation within the Rockefeller and Majestic joint ventures, we do not expect the guarantee to ever be called upon. We do not provide a guarantee on the $15,287,000 of debt related to our joint venture with TA/Petro. Non-GAAP Financial Measures EBITDA represents earnings before interest, taxes, depreciation, and amortization, a non-GAAP financial measure, and is used by us and others as a supplemental measure of performance. We use Adjusted EBITDA to assess the performance of our core operations, for financial and operational decision making, and as a supplemental or additional means of evaluating period-to-period comparisons on a consistent basis. Adjusted EBITDA is calculated as EBITDA, excluding stock compensation expense and asset abandonment charges. We believe Adjusted EBITDA provides investors relevant and useful information because it permits investors to view income from our operations on an unleveraged basis before the effects of taxes, depreciation and amortization, stock compensation expense, and abandonment charges. By excluding interest expense and income, EBITDA and Adjusted EBITDA allow investors to measure our performance independent of our capital structure and indebtedness and, therefore, allow for a more meaningful comparison of our performance to that of other companies, both in the real estate industry and in other industries. We believe that excluding charges related to share-based compensation facilitates a comparison of our operations across periods and among other companies without the variances caused by different valuation methodologies, the volatility of the expense (which depends on market forces outside our control), and the assumptions and the variety of award types that a company can use. EBITDA and Adjusted EBITDA have limitations as measures of our performance. EBITDA and Adjusted EBITDA do not reflect our historical cash expenditures or future cash requirements for capital expenditures or contractual commitments. While EBITDA and Adjusted EBITDA are relevant and widely used measures of performance, they do not represent net income or cash flows from operations as defined by GAAP. Further, our computation of EBITDA and Adjusted EBITDA may not be comparable to similar measures reported by other companies. Net operating income (NOI) is a non-GAAP financial measure calculated as operating income, the most directly comparable financial measure calculated and presented in accordance with GAAP, excluding general and administrative expenses, interest expense, depreciation and amortization, and gain or loss on sales of real estate. We believe NOI provides useful information to investors regarding our financial condition and results of operations because it primarily reflects those income and expense items that are incurred at the property level. Therefore, we believe NOI is a useful measure for evaluating the operating performance of our real estate assets. The Company utilizes NOI of unconsolidated joint ventures as a measure of financial or operating performance that is not specifically defined by GAAP. We believe NOI of unconsolidated joint ventures provides investors with additional information concerning operating performance of our unconsolidated joint ventures. We also use this measure internally to monitor the operating performance of our unconsolidated joint ventures. Our computation of this non-GAAP measure may not be the same as similar measures reported by other companies. This non-GAAP financial measure should not be considered as an alternative to net income as a measure of the operating performance of our unconsolidated joint ventures or to cash flows computed in accordance with GAAP as a measure of liquidity nor are they indicative of cash flows from operating and financial activities of our unconsolidated joint ventures. The following schedule reconciles net income from unconsolidated joint ventures to NOI of unconsolidated joint ventures.

<s>[INST] See Part I, "ForwardLooking Statements" for our cautionary statement regarding forwardlooking information. This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10K, beginning at page. It also should be read in conjunction with the disclosure under “ForwardLooking Statements” in Part 1 of this Form 10K. When this report uses the words “we,” “us,” “our,” “Tejon,” “TRC,” and the “Company,” they refer to Tejon Ranch Co. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending December 31. OVERVIEW Our Business We are a diversified real estate development and agribusiness company committed to responsibly using our land and resources to meet the housing, employment, and lifestyle needs of Californians and to create value for our shareholders. In support of these objectives, we have been investing in land planning and entitlement activities for new industrial and residential land developments and in infrastructure improvements within our active industrial development. Our prime asset is approximately 270,000 acres of contiguous, largely undeveloped land that, at its most southerly border, is 60 miles north of Los Angeles and, at its most northerly border, is 15 miles east of Bakersfield. Our business model is designed to create value through the entitlement and development of land for commercial/industrial and resort/residential uses while at the same time protecting significant portions of our land for conservation purposes. We operate our business near one of the country’s largest population centers, which is expected to continue to grow well into the future. We currently operate in five reporting segments: commercial/industrial real estate development; resort/residential real estate development; mineral resources; farming; and ranch operations. Our commercial/industrial real estate development segment generates revenues from building, land lease activities, and land and building sales. The primary commercial/industrial development is TRCC. The resort/residential real estate development segment is actively involved in the land entitlement and development process internally and through a joint venture. Within our resort/residential segment, the three active mixed use master plan developments are MV, Centennial, and Grapevine. Our mineral resources segment generates revenues from oil and gas royalty leases, rock and aggregate mining leases, a lease with National Cement and sales of water. The farming segment produces revenues from the sale of wine grapes, almonds, and pistachios. Lastly, the ranch operation segment consists of game management revenues and ancillary land uses such as grazing leases and filming. Financial Highlights For 2019, net income attributable to common stockholders was $10,580,000 compared to net income attributed to common stockholders of $4,255,000 in 2018. Over the comparative period, commercial/industrial segment revenues and results from our commercial joint ventures improved $7,822,000 and $12,741,000, respectively. Improvements in commercial revenues were attributed to land and building contributions to two joint ventures, while our joint ventures improved because of improved fuel and non fuel margins within our TA/Petro joint venture along with recognizing a substantial gain stemming from the sale of the building and land previously held by our Five West Parcel joint venture. These improvements were offset by reduced mineral resources revenues of $4,604,000 resulting from a lack of water sales opportunities due to the wet 2019 winter rain season, an increase in commercial/industrial expenses of $6,715,000 as a result of land and building costs associated with the joint venture contributions discussed earlier, and a $1,765,000 increase in other losses associated with the abandonment of a wine grape vineyard that will no longer be farmed and pension related expenses. For 2018, net income attributable to common stockholders was $4,255,000 compared to net loss attributed to common stockholders [/INST] Positive. </s>

CTS CORP

2016-02-24

2015-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview CTS Corporation ("CTS", "we", "our", "us" or the "Company") is a global manufacturer of electronic components and sensors used primarily in the transportation, communications, defense and aerospace, medical, industrial, and information technology markets. CTS' vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. CTS provides components and modules for electronic systems that are organized under the categories of Sense, Connect, Move. Our Sense products provide vital inputs to electronic systems. Our Connect products allow systems to function in sync with other systems. Our Move products ensure required movements are effectively and accurately executed. CTS is committed to invest in the development and supply of products and technologies that Sense, Connect, and Move to fulfill its vision. There is an increasing proliferation of sensing and motion products in various markets served by CTS, including automotive, industrial and other applications. In addition, increasing connectivity of various devices to the internet, communication bandwidth usage, and data storage requirements create opportunities for CTS and its connectivity product portfolio. The Company's success is dependent on its ability to execute this strategy. CTS is subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2015 versus Fourth Quarter 2014 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2015 and December 31, 2014: (1) Cost of goods sold includes restructuring-related charges of $187 in 2015 and $531 in 2014. Sales of $93,282 in the fourth quarter of 2015 decreased $7,096 or 7.1% from the fourth quarter of 2014. Sales to automotive markets decreased $3,933 partly due to lower volumes of older automotive products and partly due to foreign currency impact of approximately $1,600. Other sales were $3,163 lower in the fourth quarter of 2015 driven by weak demand in communications and HDD markets. Gross margin as a percent of sales was 32.3% in the fourth quarter of 2015 compared to 32.9% in the fourth quarter of 2014. The decrease in gross margin was largely related to lower volumes. Selling, general and administrative expenses were $13,805 or 14.8% of sales in the fourth quarter of 2015 versus $15,783 or 15.7% of sales in the comparable quarter of 2014. The decrease was primarily due to continued efficiency gains from restructuring projects, cost containment efforts, and timing of certain expenses. CTS CORPORATION 19 Research and development expenses were $6,083 or 6.5% of sales in the fourth quarter of 2015 compared to $5,798 or 5.8% of sales in the comparable quarter of 2014. The increase was related to continued investment in new products to drive organic growth. Research and development expenses are focused on expanded applications of existing products and new product development as well as current product and process enhancements. Restructuring and impairment charges in the fourth quarter of 2015 totaled $9,335 and consisted of a non-cash charge for unamortized losses related to the windup of CTS’ U.K. pension plan in the amount of $8,280 and other costs incurred in connection with CTS' previously announced 2013 and 2014 restructuring plans. The fourth quarter 2014 restructuring charges totaled $1,135 and consisted primarily of accruals related to the consolidation of CTS’ Canadian operation in Streetsville, Ontario into other CTS facilities and costs in other locations related to the 2013 and 2014 restructuring plans. Operating earnings were $931 or 1.0% of sales in the fourth quarter of 2015 compared to $10,310 or 10.3% of sales in the comparable quarter of 2014 as a result of the items discussed above. Other (expense) income items are summarized in the following table: Interest expense increased slightly in the fourth quarter of 2015 versus 2014 as a result of higher borrowings and a slightly higher interest rate. Interest income declined slightly due to the impact of lower interest rates on higher cash balances in China. Other expense in the fourth quarter of 2015 and 2014 was driven by foreign currency translation losses as the U.S. Dollar appreciated during the quarter compared to the Chinese Renminbi. The effective income tax rate for the fourth quarter of 2015 was (1,910.8%), which includes the impact of restructuring charges and one-time items. In the fourth quarter of 2015, CTS determined that as a result of changes in the business, the foreign earnings of its Canadian and U.K. subsidiaries were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. In addition, although CTS plans to permanently reinvest the earnings of its Chinese operations outside the U.S., CTS has determined that it will not maintain those earnings in China in order to mitigate future currency risk. As a result of these changes, CTS recorded a tax expense of $7,461. CTS recorded additional discrete tax items related to valuation allowances, foreign earnings, and other discrete items in the fourth quarter of 2015, which increased income tax expense by $4,912. Since the shutdown of manufacturing facilities in the U.K. and Canada, CTS does not anticipate generating future profits in these countries. Therefore, the change in permanent reinvestment assertion for these two countries is not expected to have an ongoing impact on the Company's effective tax rate. CTS will continue to record tax expense for withholding taxes (currently 10%) on earnings in China that are not anticipated to be maintained in China. This expense will increase the Company's ongoing effective tax rate. The effective income tax rate for the fourth quarter of 2014 was 20.5%, which included the impact of restructuring charges and one-time items. Tax adjustments related to restructuring decreased the rate by 1.3% in the fourth quarter of 2014. Discrete tax items reduced the rate by 8.4%. The 2014 effective rate reflected a change in the mix of earnings by jurisdiction. The net loss was $13,653 or $0.42 per share in the fourth quarter of 2015 compared to net earnings of $6,964 or $0.21 per diluted share in the comparable quarter of 2014. 20 CTS CORPORATION Results of Operations: Year Ended December 31, 2015 versus Year Ended December 31, 2014 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the years Ended December 31, 2015 and December 31, 2014: (1) Cost of goods sold includes restructuring related charges of $631 in 2015 and $1,935 in 2014. N/M = not meaningful Sales of $382,310 for the year ended December 31, 2015 decreased $21,711 or 5.4% from 2014. Sales to automotive markets declined $14,941 partly due to lower volumes of older automotive products and partly due to an unfavorable currency impact of approximately $7,800. Other sales were down $6,770 driven by weak demand in communications and HDD markets. Gross margin as a percent of sales was 33.2% in 2015 versus 32.2% in 2014. The increase in gross margin resulted from cost savings from continued efficiency gains, material and labor productivity projects, and savings from restructuring projects. CTS realized a substantial portion of anticipated savings from the shift of production from Canada to lower cost locations. In addition, foreign exchange rates had a favorable impact on manufacturing costs as the U.S. Dollar appreciated against various local currencies in countries in which CTS has manufacturing operations. Selling, general and administrative expenses were $57,430 or 15.0% of sales for the year ended December 31, 2015 versus $59,136 or 14.6% of sales in the comparable period of 2014. The decrease was attributable to restructuring actions, cost containment efforts, and the timing of certain expenses. Research and development expenses were $22,461 or 5.9% of sales in 2015 compared to $22,563 or 5.6% of sales in 2014. The decrease was driven by a re-prioritization of spending on specific projects and timing of projects. Research and development expenses are primarily focused on expanded applications of existing products and new product development as well as current product and process enhancements. A non-recurring environmental charge of $14,541 was recorded in the third quarter of 2015 related to a site in Asheville, North Carolina. The charge recorded included both the interim remediation costs proposed by CTS and accepted by the Environmental Protection Agency (“EPA”) and anticipated future remediation costs and monitoring for a final site-wide remediation. Restructuring and impairment charges for the year ended December 31, 2015 totaled $14,564 and consisted largely of a non-cash charge for unamortized losses related to the windup of CTS’ U.K. pension plan in the amount of $8,280 as well as severance and other costs incurred in connection with the 2013 and 2014 restructuring plans. Restructuring CTS CORPORATION 21 charges for the year ended December 31, 2014 totaled $5,941 and consisted primarily of severance costs related to the consolidation of CTS’ Canadian operation into other CTS facilities, lease impairment cost in the U.K., asset impairment costs related to the sale of the Carol Stream facility, and costs in other locations related to the 2013 and 2014 restructuring plans. Operating earnings were $18,113 or 4.7% of sales in 2015 compared to $42,323 or 10.5% of sales in 2014 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense increased in the year ended December 31, 2015 versus the comparable period in 2014 as a result of higher borrowings in 2015. The higher borrowings were primarily to fund share buybacks in 2015. Interest income increased primarily due to higher cash balances. Other expense in the years ended December 31, 2015 and December 31, 2014 was primarily due to the unfavorable foreign exchange impact related to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. The effective income tax rate in 2015 was 43.3%, which included the impact of restructuring charges and one-time items. In 2015, CTS determined that as a result of changes in the business, the foreign earnings of its Canadian and U.K. subsidiaries were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. In addition, although CTS plans to permanently reinvest the earnings of its Chinese operations outside the U.S., CTS has determined that it will not maintain those earnings in China in order to mitigate future currency risk. As a result of these changes, CTS recorded a tax expense of $7,461. CTS recorded a benefit of $16,305 related to the change in the treatment of foreign taxes for U.S. federal income tax purposes. CTS recorded additional discrete tax items in 2015 which increased income tax expense by $10,157 related to uncertain tax positions on certain foreign taxes, valuation allowances, foreign earnings, and other discrete items. The effective tax rate in 2014 was 32.6%, which included the impact of restructuring charges and one-time items. Tax adjustments related to restructuring increased the rate by 2.9% in 2014. Discrete tax items reduced the rate by 1.6%. The 2014 effective rate reflected higher profits, primarily from a change in the mix of earnings by jurisdiction. Net earnings were $6,954 or $0.21 per diluted share for the year ended December 31, 2015 compared to earnings of $26,522 or $0.78 per diluted share in the comparable period of 2014. 22 CTS CORPORATION Results of Operations: Year Ended December 31, 2014 versus Year Ended December 31, 2013 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the Year Ended December 31, 2014 and December 31, 2013: (1) Cost of goods sold includes restructuring related charges of $1,935 in 2014 and $1,317 in 2013. N/M = not meaningful Sales of $404,021 for the year ended December 31, 2014 decreased $5,440 or 1.3% from 2013. Sales to automotive markets increased $2,783. Other sales were $8,223 lower driven by lower shipments of electronic components, mainly frequency, filter and HDD products, which were partially offset by higher shipments of piezo products. Sales in 2013 included a special order of $5,491 to an automotive customer. Excluding this special order, sales in 2014 were approximately equal to sales in 2013. Gross margin as a percent of sales was 32.2% in 2014 versus 29.6% in 2013. The increase in gross margin resulted from cost savings from restructuring actions, productivity improvements, product mix and favorable foreign exchange impact. Selling, general and administrative expenses were $59,136 or 14.6% of sales for the year ended December 31, 2014 versus $69,989 or 17.1% of sales in the comparable period of 2013. The decrease is attributable to restructuring actions, cost containment efforts in 2014, costs for CTS’ CEO transition of $4,138 in 2013, and lower pension expense in 2014 compared to 2013. These reductions were partially offset by an increase in selling and marketing expenses to drive growth initiatives. Research and development expenses were $22,563 or 5.6% of sales in 2014 compared to $23,222 or 5.7% of sales in 2013. The decrease was driven by higher non-recurring engineering funding from customers, timing of projects, cost reductions related to restructuring actions, and a repositioning of CTS’ spending on various projects. Research and development expenses are primarily focused on expanded applications of existing products and new product development as well as current product and process enhancements. CTS CORPORATION 23 Restructuring and impairment charges declined in the year ended December 31, 2014 versus 2013. Charges for the year ended December 31, 2014 totaled $5,941 and consist primarily of severance costs related to the consolidation of CTS’ Canadian operation in Streetsville, Ontario into other CTS facilities, severance costs in China, Mexico and the U.K. and at CTS’ corporate office, lease impairment costs in the U.K. as well as asset impairment costs related to the sale of the Carol Stream facility. Restructuring charges for the year ended December 31, 2013 totaled $10,455 and consist primarily of severance, asset impairments, legal and administrative costs related to the June 2013 Restructuring Plan (“June 2013 Plan”). The June 2013 Restructuring Plan consolidated our U.K. manufacturing facility into the Czech Republic facility, consolidated our Carol Stream, Illinois manufacturing facility into the Juarez, Mexico facility, discontinued manufacturing at our Singapore facility and restructured our corporate office. Operating earnings were $42,323 or 10.5% of sales in 2014 compared to $17,687 or 4.3% of sales in 2013 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense decreased in the year ended December 31, 2014 versus the comparable period in 2013 as a result of lower borrowings enabled by the proceeds from the EMS divestiture in the fourth quarter of 2013. Interest income increased primarily due to higher cash balances. Other expense in the year ended December 31, 2014 is primarily due to the unfavorable foreign exchange impact related to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. In 2013, the U.S. Dollar depreciated compared to these currencies, driving a considerable foreign exchange gain. The effective income tax rate in 2014 was 32.6%, which includes the impact of restructuring charges and one-time items. Tax adjustments related to restructuring increased the rate by 2.9% in 2014. Discrete tax items reduced the rate by 1.6%. The 2014 effective rate reflects higher profits, primarily from a change in the mix of earnings by jurisdiction. The 2013 effective tax rate was 89.0% and reflects $10,800 of tax expense related to a $30,000 cash repatriation from Singapore to the U.S. as a result of the Singapore restructuring and tax expense of $1,000 for the write-off of deferred tax assets in the U.K. related to the June 2013 Restructuring Plan. A $1,632 discrete tax benefit is also included in 2013 associated with the retroactive application of the U.S. research tax credit signed into law during January 2013 and granting of the China high technology incentive tax credit in the first quarter of 2013. In 2014, CTS recognized a $594 tax benefit in its 2014 tax provision due to U.S. tax extender legislation. Net earnings from continuing operations were $26,522 or $0.78 per diluted share for the year ended December 31, 2014 compared to earnings from continuing operations of $1,997 or $0.06 per diluted share in the comparable period of 2013. The loss from discontinued operations in 2013 represents the results from the CTS EMS business, which was divested in the fourth quarter of 2013. Liquidity and Capital Resources (Amounts in thousands, except percentages and per share amounts): Cash and cash equivalents were $156,928 at December 31, 2015 and $134,508 at December 31, 2014, of which $156,310 and $131,152, respectively, were held outside the United States. The increase in cash and cash equivalents was driven by cash generated from operations which exceeded the cash used for investing and financing activities. 24 CTS CORPORATION Total debt as of December 31, 2015 and December 31, 2014 was $90,700 and $75,000, respectively. Total debt as a percentage of total capitalization, defined as the sum of notes payable and long-term debt as a percentage of total debt and shareholders’ equity, was 24.4% at December 31, 2015 compared to 20.6% at December 31, 2014. Working capital decreased by $9,791 from December 31, 2014 to December 31, 2015, primarily due to a $22,420 increase in cash and cash equivalents and a $28,549 increase in accrued liabilities. Cash Flows from Operating Activities Net cash provided by operating activities was $38,624 during the year ended December 31, 2015. Components of net cash provided by operating activities included net earnings of $6,954; depreciation and amortization expense of $16,254; net changes totaling $24,399 for non-cash items such as equity-based compensation, restructuring-related charges, amortization of retirement benefits, non-recurring environmental expense, deferred income taxes and gain on sale of assets; and a net cash use due to changes in current assets and current liabilities of $8,983. The net changes in current assets and liabilities were due to a net decrease in various accrued and other liabilities which were partially offset by a decrease in accounts receivable, inventory and other current assets. Cash Flows from Investing Activities Net cash used in investing activities for year ended December 31, 2015 was $9,130 which consisted of $9,723 of capital expenditures, $1,878 in proceeds from the sale of fixed assets and $1,285 paid for the acquisition of Filter Sensing Technologies, net of cash acquired and a working capital adjustment to be paid in 2016. Cash Flows from Financing Activities Net cash used in financing activities for the year ended December 31, 2015 was $7,302. The primary drivers for the cash outflow from financing activities were $18,088 paid to purchase shares of CTS common stock and $5,291 of dividend payments, which were partially offset by net proceeds on long-term debt of $15,700. Capital Resources CTS has an unsecured revolving credit facility; which has an extended term through January 10, 2020. Long-term debt was comprised of the following: The revolving credit facility requires, among other things, that CTS comply with a maximum total leverage ratio and a minimum fixed charge coverage ratio. Failure of CTS to comply with these covenants could reduce the borrowing availability under the revolving credit facility. CTS was in compliance with all debt covenants at December 31, 2015. CTS uses interest rate swaps to convert the line of credit’s variable rate of interest into a fixed rate on a portion of the debt. In the second quarter of 2012, CTS entered into four separate interest rate swap agreements to fix interest rates on $50,000 of long-term debt for the periods January 2013 to January 2017. In the third quarter of 2012, CTS entered into four separate interest rate swap agreements to fix interest rates on $25,000 of long-term debt for the periods January 2013 to January 2017. The difference paid or received under the terms of the swap agreements is recognized as an adjustment to interest expense for the related line of credit when settled. During the year ended December 31, 2015, CTS repurchased 984,382 shares of its common stock at a total cost of $18,088 or an average price of $18.37 per share. CTS CORPORATION 25 Generally, CTS' practice and intention is to reinvest the earnings of its non-U.S. subsidiaries in those operations. However, CTS determined during 2015 that as a result of changes in the business, the foreign earnings of its subsidiaries in Canada and the U.K. were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. Any repatriation may not result in significant cash income tax payments as the taxable event would likely be offset by the utilization of the then available tax credits, resulting in no net cash taxes being incurred. CTS does not provide for U.S. income taxes on undistributed earnings of its foreign subsidiaries that are intended to be permanently reinvested. We have historically funded our capital and operating needs primarily through cash flows from operating activities, supported by available credit under our credit agreements. We believe that cash flows from operating activities and available borrowings under our current credit agreements will be adequate to fund our working capital, capital expenditures and debt service requirements for at least the next twelve months. However, we may choose to pursue additional equity and debt financing or repatriate cash held in foreign locations to provide additional liquidity or to fund acquisitions. Critical Accounting Policies and Estimates Management prepared the consolidated financial statements of CTS under accounting principles generally accepted in the United States of America. These principles require the use of estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions we used are reasonable, based upon the information available. Our estimates and assumptions affect the reported amounts in our financial statements. The following accounting policies comprise those that we believe are the most critical in understanding and evaluating CTS' reported financial results. Revenue Recognition Product revenue is recognized once four criteria are met: (1) we have persuasive evidence that an arrangement exists; (2) delivery has occurred and title has passed to the customer, which generally happens at the point of shipment, provided that no significant obligations remain; (3) the price is fixed and determinable; and (4) collectability is reasonably assured. Accounts Receivable We have standardized credit granting and review policies and procedures for all customer accounts, including: • Credit reviews of all new customer accounts, • Ongoing credit evaluations of current customers, • Credit limits and payment terms based on available credit information, • Adjustments to credit limits based upon payment history and the customer's current credit worthiness, • An active collection effort by regional credit functions, reporting directly to the corporate financial officers, and • Limited credit insurance on the majority of our international receivables. We reserve for estimated credit losses based upon historical experience and specific customer collection issues. Over the last three years, accounts receivable reserves have been approximately 0.2% of total accounts receivable. We believe our reserve level is appropriate considering the quality of the portfolio. While credit losses have historically been within expectations and the reserves established, we cannot guarantee that our credit loss experience will continue to be consistent with historical experience. Inventories We value our inventories at the lower of the actual cost to purchase or manufacture using the first-in, first-out ("FIFO") method, or the current estimated market value. We review inventory quantities on hand and record a provision for excess and obsolete inventory based on forecasts of product demand and production requirements. Over the last three years, our reserves for excess and obsolete inventories have ranged from 12.5% to 20.1% of gross inventory. We believe our reserve level is appropriate considering the quantities and quality of the inventories. 26 CTS CORPORATION Retirement Plans Actuarial assumptions are used in determining pension income and expense and our pension benefit obligation. We utilize actuaries from consulting companies in each applicable country to develop our discount rates that match high-quality bonds currently available and expected to be available during the period to maturity of the pension benefit in order to provide the necessary future cash flows to pay the accumulated benefits when due. After considering the recommendations of our actuaries, we have assumed a discount rate, expected rate of return on plan assets and a rate of compensation increase in determining our annual pension income and expense and the projected benefit obligation. During the fourth quarter of each year, we review our actuarial assumptions in light of current economic factors to determine if the assumptions need to be adjusted. Changes in the actuarial assumptions could have a material effect on our results of operations. Valuation of Goodwill Goodwill of a reporting unit is tested for impairment annually, or more frequently if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include: • Significant decline in market capitalization relative to net book value, • Significant adverse change in legal factors or in the business climate, • Adverse action or assessment by a regulator, • Unanticipated competition, • More-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, • Testing for recoverability of a significant asset group within a reporting unit, and • Allocation of a portion of goodwill to a business to be disposed. If CTS believes that one or more of the above indicators of impairment have occurred, we performs an impairment test. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. We generally determine the fair value of our reporting units using two valuation methods: "Income Approach - Discounted Cash Flow Method" and "Market Approach - Guideline Public Company Method". The approach defined below is based upon our last impairment test conducted as of December 31, 2015. Under the "Income Approach - Discounted Cash Flow Method", the key assumptions consider sales, cost of sales and operating expenses projected through the year 2020. These assumptions were determined by management utilizing our internal operating plan and assuming growth rates for revenues, operating expenses, and gross margin assumptions. The fourth key assumption under this approach is the discount rate which is determined by looking at current risk-free rates, current market interest rates and the evaluation of risk premium relevant to the business segment. If our assumptions relative to growth rates were to change or were incorrect, our fair value calculation may change which could result in impairment. Under the "Market Approach - Guideline Public Company Method", we identified eight publicly traded companies, including CTS, which we believe have significant relevant similarities. For these eight companies, we calculated the mean ratio of invested capital to revenues and invested capital to EBITDA. Similar to the Income approach discussed above, sales, cost of sales, operating expenses and their respective growth rates were the key assumptions utilized. The market prices of CTS and other guideline company shares are also key assumptions. If these market prices increase, the estimated market value would increase. If the market prices decrease, the estimated market value would decrease. The results of these two methods are weighted based upon management's determination. The Market approach is based upon historical and current economic conditions, which might not reflect the long-term prospects or opportunities for CTS' business being evaluated. CTS CORPORATION 27 If the carrying amount of a reporting unit exceeds the reporting unit's fair value, we perform the second step of the goodwill impairment test to determine the amount of impairment loss, which involves comparing the implied fair value of the affected reporting unit's goodwill with the carrying value of that goodwill. There have not been any significant changes to our impairment testing methodology other than updates to the assumptions to reflect the current market environment. As discussed above, key assumptions used in the first step of the goodwill impairment test were determined by management utilizing the internal operating plan. The key assumptions utilized include forecasted growth rates for revenues and operating expenses as well as a discount rate which is determined by looking at current risk-free rates of capital, current market interest rates and the evaluation of a risk premium relevant to the business segment. CTS will monitor future results and will perform a test if indicators trigger an impairment review. We test the impairment of goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Based upon our latest assessment, we determined that our goodwill was not impaired as of December 31, 2015. Valuation of Long-Lived and Other Intangible Assets We evaluate the impairment of identifiable intangibles and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered that may trigger an impairment review consist of: • Significant underperformance relative to expected historical or projected future operating results, • Significant changes in the manner of use of the acquired assets or the strategy for the overall business, • Significant negative industry or economic trends, • Significant decline in CTS' stock price for a sustained period, and • Significant decline in market capitalization relative to net book value. If CTS believes that one or more of the above indicators of impairment have occurred and the undiscounted cash flow test failed in the case of amortizable assets, it measures impairment based on projected discounted cash flows using a discount rate that incorporates the risk inherent in the cash flows. Income Taxes CTS identified, evaluated, and measured the amount of income tax benefits to be recognized for all of our income tax positions. Included in deferred tax assets are amounts related to federal, state and foreign net operating losses. CTS intends to utilize these net operating loss carryforwards to offset future income taxes. CTS' practice is to recognize interest and penalties related to income tax matters as part of income tax expense. CTS earns a significant amount of its operating income outside of the U.S., which is generally deemed to be permanently reinvested in foreign jurisdictions. However, CTS determined during 2015 that as a result of changes in the business, the foreign earnings of its subsidiaries in Canada and the U.K. were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. CTS does not intend to repatriate funds beyond the amount from its Canadian and U.K. subsidiaries; however, should CTS require more capital in the U.S. than is generated by our domestic operations, CTS could elect to repatriate funds held in foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. Repatriation would result in a higher effective tax rate. Borrowing in the U.S. would result in increased interest expense. 28 CTS CORPORATION Contractual Obligations CTS' contractual obligations as of December 31, 2015 were: We have no off-balance sheet arrangements, except for operating leases, that have a material current effect or are reasonably likely to have a material future effect on our financial condition or changes in our financial condition. Management believes that existing capital resources and funds generated from operations are sufficient to finance anticipated capital requirements. Forward-Looking Statements This document contains statements that are, or may be deemed to be, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, any financial or other guidance, statements that reflect our current expectations concerning future results and events, and any other statements that are not based solely on historical fact. Forward-looking statements are based on management's expectations, certain assumptions and currently available information. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof and are based on various assumptions as to future events, the occurrence of which necessarily are subject to uncertainties. These forward-looking statements are made subject to certain risks, uncertainties and other factors, which could cause our actual results, performance or achievements to differ materially from those presented in the forward-looking statements. Examples of factors that may affect future operating results and financial condition include, but are not limited to: changes in the economy generally and in respect to the business in which CTS operates; unanticipated issues in integrating acquisitions; the results of actions to reposition our business; rapid technological change; general market conditions in the automotive, communications, and computer industries, as well as conditions in the industrial, defense and aerospace, and medical markets; reliance on key customers; unanticipated natural disasters or other events; the ability to protect our intellectual property; pricing pressures and demand for our products; and risks associated with our international operations, including trade and tariff barriers, exchange rates and political and geopolitical risks. Many of these and other risks and uncertainties are discussed in further detail in Item 1A. of this Annual Report on Form 10-K for the fiscal year ended December 31, 2015. We undertake no obligation to publicly update our forward-looking statements to reflect new information or events or circumstances that arise after the date hereof, including market or industry changes. ***** CTS CORPORATION 29

<s>[INST] CTS Corporation ("CTS", "we", "our", "us" or the "Company") is a global manufacturer of electronic components and sensors used primarily in the transportation, communications, defense and aerospace, medical, industrial, and information technology markets. CTS' vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. CTS provides components and modules for electronic systems that are organized under the categories of Sense, Connect, Move. Our Sense products provide vital inputs to electronic systems. Our Connect products allow systems to function in sync with other systems. Our Move products ensure required movements are effectively and accurately executed. CTS is committed to invest in the development and supply of products and technologies that Sense, Connect, and Move to fulfill its vision. There is an increasing proliferation of sensing and motion products in various markets served by CTS, including automotive, industrial and other applications. In addition, increasing connectivity of various devices to the internet, communication bandwidth usage, and data storage requirements create opportunities for CTS and its connectivity product portfolio. The Company's success is dependent on its ability to execute this strategy. CTS is subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2015 versus Fourth Quarter 2014 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2015 and December 31, 2014: (1) Cost of goods sold includes restructuringrelated charges of $187 in 2015 and $531 in 2014. Sales of $93,282 in the fourth quarter of 2015 decreased $7,096 or 7.1% from the fourth quarter of 2014. Sales to automotive markets decreased $3,933 partly due to lower volumes of older automotive products and partly due to foreign currency impact of approximately $1,600. Other sales were $3,163 lower in the fourth quarter of 2015 driven by weak demand in communications and HDD markets. Gross margin as a percent of sales was 32.3% in the fourth quarter of 2015 compared to 32.9% in the fourth quarter of 2014. The decrease in gross margin was largely related to lower volumes. Selling, general and administrative expenses were $13,805 or 14.8% of sales in the fourth quarter of 2015 versus $15,783 or 15.7% of sales in the comparable quarter of 2014. The decrease was primarily due to continued efficiency gains from restructuring projects, cost containment efforts, and timing of certain expenses. CTS CORPORATION 19 Research and development expenses were $6,083 or 6.5% of sales in the fourth quarter of 2015 compared to $5,798 or 5.8% of sales in the comparable quarter of 2014. The increase was related to continued investment in new products to drive organic growth. Research and development expenses are focused on expanded applications of existing products and new product development as well as current product and process enhancements. Restructuring and impairment charges in the fourth quarter of 2015 totaled $9,335 and consisted of a noncash charge for unamortized losses related to the windup of CTS’ U.K. pension plan in the amount of $8,280 and other costs incurred in connection with CTS' previously announced 2013 and 2014 restructuring plans. The fourth quarter 2014 restructuring charges totaled $1,135 and consisted primarily of accruals related to the consolidation of CTS’ Canadian operation in Streetsville, Ontario into other CTS facilities and costs in other locations related to the 2013 and 2014 restructuring plans. Operating earnings were $931 or [/INST] Negative. </s>

CTS CORP

2017-02-24

2016-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, electronic components, and actuators in North America, Europe, and Asia, and supply them to OEMs and distributors serving the transportation, industrial, medical, information technology, defense and aerospace, and communications markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2016 versus Fourth Quarter 2015 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2016, and December 31, 2015: (1) Cost of goods sold includes restructuring-related charges of $0 in 2016 and $187 in 2015. Sales of $101,584 in the fourth quarter of 2016 increased $8,302 or 8.9% from the fourth quarter of 2015. Sales to automotive end-markets increased $3,487. Higher sensor and actuator volumes were partially offset by an unfavorable foreign exchange impact. Sales to other end-markets increased $4,815 including sales from the single crystal acquisition. Changes in foreign exchange rates reduced sales by $1,049 year-over-year due to the U.S. Dollar appreciating compared to the Chinese Renminbi and Euro. Gross margin as a percent of sales was 35.3% in the fourth quarter of 2016 compared to 32.3% in the fourth quarter of 2015. The increase in gross margin resulted from cost savings from continued efficiency gains, material and labor productivity projects, savings from restructuring projects, favorable mix, and the addition of sales from the single crystal acquisition. In addition, foreign exchange rates had a favorable impact on manufacturing costs due to the strengthening of the U.S. Dollar compared to the Mexican Peso. CTS CORPORATION 19 Selling, general and administrative expenses were $15,165 or 14.9% of sales in the fourth quarter of 2016 versus $15,917 or 17.1% of sales in the comparable quarter of 2015. The decrease is primarily attributable to timing of certain expenses. The fourth quarter of 2016 includes added costs as a result of the single crystal acquisition, including amortization of intangibles. Research and development expenses were $5,626 or 5.5% of sales in the fourth quarter of 2016 compared to $6,083 or 6.5% of sales in the comparable quarter of 2015. The decrease is related to timing of certain expenses. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring and impairment charges in the fourth quarter of 2016 totaled $873 for severance and other costs in connection with our 2016 restructuring plan. These costs in the fourth quarter 2015 totaled $9,335 and consisted of a non-cash charge for unamortized losses related to the windup of our U.K. pension plan in the amount of $8,280 and other costs incurred in connection with our previously announced 2013 and 2014 restructuring plans. Operating earnings were $14,146 or 13.9% of sales in the fourth quarter of 2016 compared to $931 or 1.0% of sales in the comparable quarter of 2015 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense increased in the fourth quarter of 2016 versus 2015 due to higher interest rates, higher commitment fees as a result of increasing the revolving credit facility from $200,000 to $300,000, and amortization of a contingent earnout liability associated with our Filter Sensing Technologies acquisition. Interest income declined due to lower cash balances in China. Other expense in the fourth quarter of 2016 and 2015 was driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi. The effective income tax rate for the fourth quarter of 2016 was 26.9%, which includes the impact of restructuring charges, one-time items, the tax impact of non-recurring stock compensation changes, and adjustments to valuation allowances. The effective income tax rate for the fourth quarter of 2015 was (1,910.8%), which included the impact of restructuring charges and one-time items. In the fourth quarter of 2015, we determined that as a result of changes in the business, the foreign earnings of our Canadian and U.K. subsidiaries were no longer permanently reinvested and a provision for the expected taxes on repatriation of those earnings was recorded. In addition, although we plan to permanently reinvest the earnings of our Chinese operations outside the U.S., we determined that we will not maintain those earnings in China in order to mitigate future currency risk. As a result of these changes, we recorded a tax expense of $7,461. We recorded additional discrete tax items related to valuation allowances, foreign earnings, and other discrete items in the fourth quarter of 2015, which increased income tax expense by $4,912. Since the shutdown of manufacturing facilities in the U.K. and Canada, we do not anticipate generating future profits in these countries. Therefore, the change in permanent reinvestment assertion for these two countries is not expected to have an ongoing impact on the Company's effective tax rate. We continue to record tax expense for withholding taxes (currently 10%) on earnings in China that are not anticipated to be maintained in China. Net earnings were $8,310, or $0.25 per diluted share, in the fourth quarter of 2016 compared to a net loss of $(13,653), or $(0.42) per diluted share, in the comparable quarter of 2015. 20 CTS CORPORATION Results of Operations: Years Ended December 31, 2016, versus Year Ended December 31, 2015 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2016, and December 31, 2015: (1) Cost of goods sold includes restructuring related charges of $0 in 2016 and $631 in 2015. N/M = not meaningful Sales of $396,679 for the year ended December 31, 2016, increased $14,369, or 3.8% from 2015. Sales to automotive end-markets increased $5,198. Higher sensor volumes were partially offset by an unfavorable foreign exchange impact. Sales to other end-markets increased $9,171 including the addition of sales from our single crystal acquisition. Sales of components for high-density disk drives ("HDD") declined 30% year-over-year. Changes in foreign exchange rates reduced sales by $2,746 year-over-year as the U.S. Dollar appreciated compared to the Chinese Renminbi and other currencies. Gross margin as a percent of sales was 35.4% in 2016 versus 33.2% in 2015. The increase in gross margin resulted from cost savings from continued efficiency gains, material and labor productivity projects, savings from restructuring projects, favorable mix, and the addition of sales from our single crystal acquisition. In addition, foreign exchange rates had a favorable impact on manufacturing costs primarily due to the strengthening of the U.S. Dollar against the Mexican Peso. Selling, general and administrative expenses were $61,624, or 15.5% of sales for the year ended December 31, 2016, versus $59,586 or 15.6% of sales in the comparable period of 2015. Expenses in 2016 include added costs as a result of our single crystal acquisition, including amortization of intangibles. In addition, we paid an early termination fee related to a leased facility in Lisle, Illinois in anticipation of a move in the 2017/2018 time frame to another leased facility in the same area, which will consolidate the Bolingbrook and Lisle, Illinois sites into one facility and reduce ongoing expenses. Research and development expenses were $24,040 or 6.1% of sales in 2016 compared to $22,461 or 5.9% of sales in 2015. The increase was related to continued investment in new products to drive organic growth and expenses from our single crystal acquisition. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. A non-recurring environmental charge of $14,541 was recorded in the third quarter of 2015 related to a site in Asheville, North Carolina. The charge recorded included both the interim remediation costs we proposed, which was accepted by the Environmental Protection Agency (“EPA”), and anticipated future remediation and monitoring costs. Restructuring and impairment charges for the year ended December 31, 2016, totaled $3,048 and consisted largely of severance, production line move and legal costs in connection with the 2016 restructuring plan. Restructuring and impairment charges for the year ended December 31, 2015, totaled $14,564 and consisted largely of a non-cash charge for unamortized losses related to CTS CORPORATION 21 the windup of our U.K. pension plan in the amount of $8,280 as well as severance and other costs incurred in connection with the 2013 and 2014 restructuring plans. The 2016 gain on sale of assets of $11,450 is driven principally by a gain on the sale of our former manufacturing facility in Canada in June 2016. Operating earnings were $63,166, or 15.9% of sales in 2016, compared to $18,113, or 4.7% of sales in 2015 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense increased in the year ended December 31, 2016, versus the comparable period in 2015 as a result of higher average debt balances related to our single crystal acquisition, higher interest rates, higher commitment fees as a result of increasing the revolving credit facility from $200,000 to $300,000, and amortization of a contingent earnout liability associated with our Filter Sensing Technologies acquisition. Interest income decreased due to lower cash balances in China. Other expense, net in the year ended December 31, 2016, was driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi. Other expense, net in the year ended December 31, 2015, was also driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Renminbi and the Euro. The effective income tax rate in 2016 was 39.9%, which includes the impact of restructuring charges and one-time items. The tax rate in 2016 reflects an increase in valuation allowances recorded against certain state net operating losses and tax credits and the revaluation of U.S. deferred taxes as a result of the June 2016 restructuring activities discussed in Note 7, "Costs Associated with Exit and Restructuring Activities", in this Annual Report on Form 10-K. The rate also reflects an increase in the valuation allowance on certain non-U.S. losses as a result of changes in the expectation of our ability to utilize those losses, changes in the mix of earnings by jurisdiction, our decision to no longer permanently reinvest the earnings of our Canadian and U.K. subsidiaries, tax expense for withholding taxes on earnings in China that are not anticipated to be maintained in China, and various other discrete items. The effective income tax rate in 2015 was 43.3%, which included the impact of restructuring charges and one-time items. In 2015, we determined that as a result of changes in the business, the foreign earnings of our Canadian and U.K. subsidiaries were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. In addition, although we plan to permanently reinvest the earnings of our Chinese operations outside the U.S., we have determined that we will not maintain those earnings in China in order to mitigate future currency risk. As a result of these changes, we recorded a tax expense of $7,461. We recorded a benefit of $16,305 related to a change in the treatment of foreign taxes for U.S. federal income tax purposes. We also recorded additional discrete tax items in 2015 which increased income tax expense by $10,157 related to uncertain tax positions on certain foreign taxes, valuation allowances, foreign earnings, and other discrete items. Net earnings were $34,380 or $1.03 per diluted share for the year ended December 31, 2016, compared to earnings of $6,954 or $0.21 per diluted share in the comparable period of 2015. 22 CTS CORPORATION Results of Operations: Years Ended December 31, 2015, versus Year Ended December 31, 2014 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2015, and December 31, 2014: (1) Cost of goods sold includes restructuring related charges of $631 in 2015 and $1,935 in 2014. N/M = not meaningful Sales of $382,310 for the year ended December 31, 2015, decreased $21,711 or 5.4% from 2014. Sales to automotive markets declined $14,941 partly due to lower volumes of older automotive products and partly due to an unfavorable currency impact of approximately $7,800. Other sales were down $6,770 driven by weak demand in communications and HDD markets. Gross margin as a percent of sales was 33.2% in 2015 versus 32.2% in 2014. The increase in gross margin resulted from cost savings from continued efficiency gains, material and labor productivity projects, and savings from restructuring projects. We realized a substantial portion of anticipated savings from the shift of production from Canada to lower cost locations. In addition, foreign exchange rates had a favorable impact on manufacturing costs as the U.S. Dollar appreciated against various local currencies in countries in which we have manufacturing operations. Selling, general and administrative expenses were $59,586 or 15.6% of sales for the year ended December 31, 2015, versus $61,051 or 15.1% of sales in the comparable period of 2014. The decrease was attributable to restructuring actions, cost containment efforts, and the timing of certain expenses. Research and development expenses were $22,461 or 5.9% of sales in 2015 compared to $22,563 or 5.6% of sales in 2014. The decrease was driven by a re-prioritization of spending on specific projects and timing of projects. Research and development expenses are primarily focused on expanded applications of existing products and new product development as well as current product and process enhancements. A non-recurring environmental charge of $14,541 was recorded in the third quarter of 2015 related to a site in Asheville, North Carolina. The charge recorded included both the interim remediation costs we proposed, which were accepted by the EPA, and anticipated future remediation and monitoring costs. Restructuring and impairment charges for the year ended December 31, 2015, totaled $14,564 and consisted largely of a non-cash charge for unamortized losses related to the windup of our U.K. pension plan in the amount of $8,280 as well as severance and other costs incurred in connection with the 2013 and 2014 restructuring plans. Restructuring charges for the year ended December 31, 2014, totaled $5,941 and consisted primarily of severance costs related to the consolidation of our Canadian operation into other facilities, lease impairment costs in the U.K., asset impairment costs related to the sale of our Carol Stream facility, and costs in other locations related to the 2013 and 2014 restructuring plans. CTS CORPORATION 23 Operating earnings were $18,113, or 4.7% of sales in 2015, compared to $42,323, or 10.5% of sales in 2014 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense increased in the year ended December 31, 2015, versus the comparable period in 2014 as a result of higher borrowings in 2015. The higher borrowings were primarily to fund share buybacks in 2015. Interest income increased primarily due to higher cash balances. Other expense in the years ended December 31, 2015, and December 31, 2014, was primarily due to the unfavorable foreign exchange impact related to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. The effective income tax rate in 2015 was 43.3%, which included the impact of restructuring charges and one-time items. In 2015, we determined that as a result of changes in the business, the foreign earnings of our Canadian and U.K. subsidiaries were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. In addition, although we plan to permanently reinvest the earnings of our Chinese operations outside the U.S., we have determined that we will not maintain those earnings in China in order to mitigate future currency risk. As a result of these changes, we recorded a tax expense of $7,461. We recorded a benefit of $16,305 related to a change in the treatment of foreign taxes for U.S. federal income tax purposes. We recorded additional discrete tax items in 2015, which increased income tax expense by $10,157 related to uncertain tax positions on certain foreign taxes, valuation allowances, foreign earnings, and other discrete items. The effective tax rate in 2014 was 32.6%, which included the impact of restructuring charges and one-time items. Tax adjustments related to restructuring increased the rate by 2.9% in 2014. Discrete tax items reduced the rate by 1.6%. The 2014 effective rate reflected higher profits, primarily from a change in the mix of earnings by jurisdiction. Net earnings were $6,954 or $0.21 per diluted share for the year ended December 31, 2015, compared to earnings of $26,522 or $0.78 per diluted share in the comparable period of 2014. Liquidity and Capital Resources (Amounts in thousands, except percentages and per share amounts): Cash and cash equivalents were $113,805 at December 31, 2016, and $156,928 at December 31, 2015, of which $112,736 and $156,310, respectively, were held outside the United States. The decrease in cash and cash equivalents of $43,123 was driven by a payment for a business acquisition in the amount of $73,063, capital expenditures of $20,500, dividends paid of $5,234, and other net cash outflows of $3,824, which were partially offset by cash generated from operations of $47,202 and proceeds from the sale of assets of $12,296. Total debt as of December 31, 2016, and December 31, 2015, was $89,100 and $90,700, respectively. Total debt as a percentage of total capitalization, defined as the sum of notes payable and long-term debt as a percentage of total debt and shareholders’ equity, was 22.1% at December 31, 2016, compared to 24.4% at December 31, 2015. Working capital decreased by $33,756 from December 31, 2015, to December 31, 2016, primarily due to the aforementioned $43,123 decrease in cash and cash equivalents, partially offset by a $8,049 increase in accounts receivable, net. Cash Flows from Operating Activities Net cash provided by operating activities was $47,202 during the year ended December 31, 2016. Components of net cash provided by operating activities included net earnings of $34,380, depreciation and amortization expense of $18,992, and other net non-cash items totaling $2,998 (gains on sales of assets and foreign currency hedges, deferred income taxes, restructuring charges, stock-based compensation, and pension and other post-retirement plan adjustments), which were offset by net changes in assets and liabilities of $9,168. 24 CTS CORPORATION Cash Flows from Investing Activities Net cash used in investing activities for the year ended December 31, 2016, was $81,267, which includes $20,500 of capital expenditures, $12,296 in proceeds from the sale of fixed assets, and $73,063 paid for a business acquisition. Cash Flows from Financing Activities Net cash used in financing activities for the year ended December 31, 2016, was $8,643, which includes $5,234 of dividend payments, $1,600 of net payments on long-term debt, and $1,809 of taxes paid on behalf of equity award participants. Capital Resources We have an unsecured revolving credit facility; which has a term through January 10, 2020. Long-term debt was comprised of the following: On August 10, 2015, we entered into a new five-year credit agreement (“Revolving Credit Facility”) with a group of banks in order to support our financing needs. The Revolving Credit Facility originally provided for a credit line of $200,000. On May 23, 2016, we requested and received a $100,000 increase in the aggregate revolving credit commitments under our existing credit agreement, which increased the credit line from $200,000 to $300,000. The Revolving Credit Facility requires, among other things, that we comply with a maximum total leverage ratio and a minimum fixed charge coverage ratio. Failure to comply with these covenants could reduce the borrowing availability under the Revolving Credit Facility. We were in compliance with all debt covenants at December 31, 2016. We use interest rate swaps to convert the Revolving Credit Facility’s variable rate of interest into a fixed rate on a portion of our debt balance. In the second quarter of 2012, we entered into four separate interest rate swap agreements to fix interest rates on $50,000 of long-term debt for the periods January 2013 to January 2017. In the third quarter of 2012, we entered into four additional interest rate swap agreements to fix interest rates on $25,000 of long-term debt for the periods January 2013 to January 2017. In the third quarter of 2016, we entered into three additional forward-starting interest rate swap agreements to fix interest rates on $50,000 of long-term debt for the periods August 2017 to August 2020. The difference to be paid or received under the terms of the swap agreements will be recognized as an adjustment to interest expense when settled. Generally, our practice and intention is to reinvest the earnings of our non-U.S. subsidiaries outside the U.S. However, we determined during 2015 that as a result of changes in the business, the foreign earnings of our subsidiaries in Canada and the U.K. were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded at that time. Any repatriation may not result in significant cash income tax payments as the taxable event would likely be offset by the utilization of the then available tax credits, resulting in no significant net cash taxes being incurred. We do not provide for U.S. income taxes on undistributed earnings of our foreign subsidiaries that are intended to be permanently reinvested. We have historically funded our capital and operating needs primarily through cash flows from operating activities, supported by available credit under our Revolving Credit Facility. We believe that cash flows from operating activities and available borrowings under our Revolving Credit Facility will be adequate to fund our working capital, capital expenditures and debt service requirements for at least the next twelve months. However, we may choose to pursue additional equity and debt financing to provide additional liquidity or to fund acquisitions. CTS CORPORATION 25 Critical Accounting Policies and Estimates Management prepared the consolidated financial statements under accounting principles generally accepted in the United States of America. These principles require the use of estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions we used are reasonable, based upon the information available. Our estimates and assumptions affect the reported amounts in our financial statements. The following accounting policies comprise those that we believe are the most critical in understanding and evaluating our reported financial results. Revenue Recognition Product revenue is recognized once four criteria are met: (1) we have persuasive evidence that an arrangement exists; (2) delivery has occurred and title has passed to the customer, which generally happens at the point of shipment, provided that no significant obligations remain; (3) the price is fixed and determinable; and (4) collectability is reasonably assured. Product Warranties Provisions for estimated warranty expenses related to our automotive products are made at the time products are sold. These estimates are established using a quoted industry rate. We adjust our warranty reserve for any known or anticipated warranty claims as new information becomes available. We evaluate our warranty obligations at least quarterly and adjust our accruals if it is probable that future costs will be different than our current reserve. Over the last three years, product warranty reserves have ranged from 0.5% to 0.7% of total sales. We believe our reserve level is appropriate considering the quality of our products. Accounts Receivable We have standardized credit granting and review policies and procedures for all customer accounts, including: • Credit reviews of all new significant customer accounts, • Ongoing credit evaluations of current customers, • Credit limits and payment terms based on available credit information, • Adjustments to credit limits based upon payment history and the customer's current creditworthiness, • An active collection effort by regional credit functions, reporting directly to the corporate financial officers, and • Limited credit insurance on the majority of our international receivables. We reserve for estimated credit losses based upon historical experience and specific customer collection issues. Over the last three years, accounts receivable reserves have ranged from 0.2% to 0.3% of total accounts receivable. We believe our reserve level is appropriate considering the quality of the portfolio. While credit losses have historically been within expectations and the reserves established, we cannot guarantee that our credit loss experience will continue to be consistent with historical experience. Inventories We value our inventories at the lower of the actual cost to purchase or manufacture using the first-in, first-out ("FIFO") method, or net realizable value. We review inventory quantities on hand and record a provision for excess and obsolete inventory based on forecasts of product demand and production requirements. Over the last three years, our reserves for excess and obsolete inventories have ranged from 17.6% to 20.1% of gross inventory. We believe our reserve level is appropriate considering the quantities and quality of the inventories. Retirement Plans Actuarial assumptions are used in determining pension income and expense and our pension benefit obligation. We utilize actuaries from consulting companies in each applicable country to develop our discount rates, matching high-quality bonds currently available and expected to be available during the period to maturity of the pension benefit in order to provide the necessary future cash flows to pay the accumulated benefits when due. After considering the recommendations of our actuaries, we have assumed a discount rate, expected rate of return on plan assets, and a rate of compensation increase in determining our annual pension income and expense and the projected benefit obligation. During the fourth quarter of each year, we review our actuarial assumptions in light of current economic factors to determine if the assumptions need to be adjusted. Changes in the actuarial assumptions could have a material effect on our results of operations. 26 CTS CORPORATION Valuation of Goodwill Goodwill of a reporting unit is tested for impairment annually, or more frequently, if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant adverse change in legal factors or in the business climate, • Adverse action or assessment by a regulator, • Unanticipated competition, • More-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, • Testing for recoverability of a significant asset group within a reporting unit, and • Allocation of a portion of goodwill to a business to be disposed. If we believe that one or more of the above indicators of impairment have occurred, we perform an impairment test. The test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. We generally determine the fair value of our reporting units using two valuation methods: "Income Approach - Discounted Cash Flow Method" and "Market Approach - Guideline Public Company Method". The approach defined below is based upon our last impairment test conducted as of October 1, 2016. Under the "Income Approach - Discounted Cash Flow Method", the key assumptions include sales, cost of sales, and operating expense projections through the year 2021. These assumptions were determined by management utilizing our internal operating plan and assuming growth rates for revenues, operating expenses, and gross margin assumptions. The fourth key assumption under this approach is the discount rate, which is determined by looking at current risk-free rates, current market interest rates and the evaluation of risk premium relevant to the business segment. If any of our assumptions were to change or were incorrect, our fair value calculation may change, which could result in impairment. Under the "Market Approach - Guideline Public Company Method", we identified eight publicly traded companies which we believe have significant relevant similarities to CTS. For these eight companies, we calculated a range of EBITDA multiples derived from the ratio of enterprise value to EBITDA and compared these multiples to the corresponding multiples for each of our reporting units. Similar to the income approach discussed above, sales, cost of sales, operating expenses and growth rates were key assumptions utilized in developing projected EBITDA levels for each of our reporting units. The market prices of CTS and the other guideline company's shares are also key assumptions as they are used to calculate enterprise value. The results of these two methods are weighted based upon management's determination. The Market approach is based upon historical and current economic conditions, which might not reflect the long-term prospects or opportunities for our reporting units being evaluated. If the carrying amount of a reporting unit exceeds the reporting unit's fair value, we perform the second step of the goodwill impairment test to determine the amount of impairment loss, if any. This involves comparing the implied fair value of the affected reporting unit's goodwill with the carrying value of that goodwill. There have not been any significant changes to our impairment testing methodology other than updates to the assumptions to reflect the current market environment. Based upon our latest assessment, we determined that our goodwill was not impaired as of October 1, 2016. We will monitor future results and will perform a test if indicators trigger an impairment review. CTS CORPORATION 27 Valuation of Other Intangible and Long-Lived Assets We evaluate the impairment of identifiable intangibles and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered that may trigger an impairment review consist of, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant underperformance relative to expected historical or projected future operating results, • Significant changes in the manner of use of the acquired assets or the strategy for the overall business, • Significant negative industry or economic trends. If we believe that one or more indicators of impairment have occurred, we perform a recoverability test by comparing the carrying amount of an asset or asset group to the sum of the undiscounted cash flows expected to result from the use and the eventual disposition of the asset or asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value. No indicators of impairment were identified as of December 31, 2016. Environmental and Legal Contingencies U.S. GAAP requires a liability to be recorded for contingencies when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Significant judgment is required to determine the existence of a liability as well as the amount to be recorded. We regularly consult with attorneys and consultants to determine the relevant facts and circumstances before we record a liability. Changes in laws, regulatory orders, cost estimates, participation of other parties, timing of payments, input of attorneys and consultants, or other circumstances may have a material impact on the recorded liability. Income Taxes Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgments and estimates are required in the determination of the consolidated income tax expense. Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets in the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. The assumptions about future taxable income require the use of significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across our global operations. ASC 740 states that a tax benefit from an uncertain tax position may be recognized when it is more-likely-than-not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, on the basis of its technical merits. We record unrecognized tax benefits as liabilities in accordance with ASC 740 and adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available. Our practice is to recognize interest and penalties related to income tax matters as part of income tax expense. We earn a significant amount of our operating income outside of the U.S., which is generally deemed to be permanently reinvested in foreign jurisdictions. However, we determined during 2015 that as a result of changes in the business, the foreign earnings of our subsidiaries in Canada and the U.K. were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. We do not intend to repatriate funds beyond the amount from our Canadian and U.K. subsidiaries; however, should we require more capital in the U.S. than is generated by our domestic operations, we could elect to repatriate funds held in foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. Repatriation would result in a higher effective tax rate. Borrowing in the U.S. would result in increased interest expense. 28 CTS CORPORATION Contractual Obligations Our contractual obligations as of December 31, 2016, were: We have no off-balance sheet arrangements, except for operating leases, that have a material current effect or are reasonably likely to have a material future effect on our financial condition or changes in our financial condition. Management believes that existing capital resources and funds generated from operations are sufficient to finance anticipated capital requirements. CTS CORPORATION 29

<s>[INST] CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, electronic components, and actuators in North America, Europe, and Asia, and supply them to OEMs and distributors serving the transportation, industrial, medical, information technology, defense and aerospace, and communications markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2016 versus Fourth Quarter 2015 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2016, and December 31, 2015: (1) Cost of goods sold includes restructuringrelated charges of $0 in 2016 and $187 in 2015. Sales of $101,584 in the fourth quarter of 2016 increased $8,302 or 8.9% from the fourth quarter of 2015. Sales to automotive endmarkets increased $3,487. Higher sensor and actuator volumes were partially offset by an unfavorable foreign exchange impact. Sales to other endmarkets increased $4,815 including sales from the single crystal acquisition. Changes in foreign exchange rates reduced sales by $1,049 yearoveryear due to the U.S. Dollar appreciating compared to the Chinese Renminbi and Euro. Gross margin as a percent of sales was 35.3% in the fourth quarter of 2016 compared to 32.3% in the fourth quarter of 2015. The increase in gross margin resulted from cost savings from continued efficiency gains, material and labor productivity projects, savings from restructuring projects, favorable mix, and the addition of sales from the single crystal acquisition. In addition, foreign exchange rates had a favorable impact on manufacturing costs due to the strengthening of the U.S. Dollar compared to the Mexican Peso. CTS CORPORATION 19 Selling, general and administrative expenses were $15,165 or 14.9% of sales in the fourth quarter of 2016 versus $15,917 or 17.1% of sales in the comparable quarter of 2015. The decrease is primarily attributable to timing of certain expenses. The fourth quarter of 2016 includes added costs as a result of the single crystal acquisition, including amortization of intangibles. Research and development expenses were $5,626 or 5.5% of sales in the fourth quarter of 2016 compared to $6,083 or 6.5% of sales in the comparable quarter of 2015. The decrease is related to timing of certain expenses. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring and impairment charges in the fourth quarter of 2016 totaled $873 for severance and other costs in connection with our 2016 restructuring plan. These costs in the fourth quarter 2015 totaled $9,335 and consisted of a noncash charge for unamort [/INST] Positive. </s>

CTS CORP

2018-02-23

2017-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, actuators, and electronic components in North America, Europe, and Asia. CTS provides solutions to OEMs in the aerospace, communications, defense, industrial, information technology, medical, and transportation markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2017 versus Fourth Quarter 2016 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2017, and December 31, 2016: Sales of $110,910 in the fourth quarter of 2017 increased $9,326 or 9.2% from the fourth quarter of 2016. Sales to transportation markets increased $4,899 or 7.3%. Other sales increased $4,427 or 12.7%. Our Noliac acquisition, which we completed in May 2017, added $2,987 in sales for the quarter. Changes in foreign exchange rates increased sales by $1,229 year-over-year due to the U.S. Dollar depreciating compared to the Chinese Renminbi and Euro. In the fourth quarter of 2017, we recorded a $13,415 one-time, non-cash pension settlement charge. During 2017, CTS offered its pension participants the opportunity to receive a lump sum payment to settle their future pension benefits. A number of participants elected the lump sum option, and the total lump sum payments distributed to these participants when the offer window closed in the fourth quarter was large enough to trigger a pension settlement charge under U.S. GAAP. This charge was recorded in the amount of $4,796 to cost of goods sold, $6,557 to selling, general and administrative expenses and $2,062 to research and development expenses. Gross margin as a percent of sales was 29.6% in the fourth quarter of 2017 compared to 35.3% in the fourth quarter of 2016. The pension settlement charge impacted gross margin unfavorably by $4,796 or 4.3% of sales. CTS CORPORATION 19 Selling, general and administrative expenses were $24,973 or 22.5% of sales in the fourth quarter of 2017 versus $15,165 or 14.9% of sales in the comparable quarter of 2016. The pension settlement charge impacted selling, general and administrative expenses unfavorably by $6,557 or 5.9% of sales. The remaining increase is primarily attributable to the addition of amortization of intangibles and other operating costs from the Noliac acquisition and timing of certain other expenses. Research and development expenses were $6,714 or 6.1% of sales in the fourth quarter of 2017 compared to $5,626, or 5.5% of sales, in the comparable quarter of 2016. The pension settlement charge impacted research and development expenses unfavorably by $2,062, or 1.9% of sales. The remaining decrease is related to an increase in the reimbursements received from customers for research and development expenses in the fourth quarter of 2017 and timing of certain other expenses. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring and impairment charges were $1,197 in the fourth quarter of 2017. These charges were mainly for building and equipment relocation, severance, and travel costs related to the restructuring of certain operations as part of the 2016 Restructuring Plan. In the fourth quarter 2016, restructuring and impairment charges consisting of severance and other costs totaled $873, which were also in connection with our 2016 Restructuring Plan. Our operating loss was $19, or 0.0% of sales, in the fourth quarter of 2017, compared to operating earnings of $14,146, or 13.9% of sales, in the comparable quarter of 2016 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense increased in the fourth quarter of 2017 versus 2016 due to a one-time charge related to a liability that was settled in 2017. Interest income increased due to higher foreign cash balances. Other income in the fourth quarter of 2017 was driven mainly by foreign currency translation gains due to the appreciation of the Chinese Renminbi compared to the U.S. Dollar. Other expense in the fourth quarter of 2016 was driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi. On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was enacted in the United States, instituting fundamental changes to the tax system. The Tax Act includes changes to the taxation of foreign earnings by implementing a dividend exemption system, expansion of the current anti-deferral rules, a minimum tax on low-taxed foreign earnings, and new measures to deter base erosion. The Tax Act also permanently reduces the corporate tax rate from 35% to 21%, imposes a one-time mandatory transition tax on the historical earnings of foreign affiliates, and implements a territorial style tax system. The impacts of these changes are reflected in tax expense in the fourth quarter of 2017, resulting in a provisional non-cash charge of approximately $18,001. This amount is subject to adjustment in 2018 as we finalize the impact of the Tax Act on our operations. As a result, the effective income tax rate for the fourth quarter of 2017 was 9,493.8%. The effective income tax rate for the fourth quarter of 2016 was 26.9%, which included the impact of restructuring charges, one-time items, the tax impact of non-recurring stock compensation changes, and adjustments to valuation allowances. Net loss was $13,621, or $(0.41) per diluted share, in the fourth quarter of 2017, compared to net earnings of $8,310, or $0.25 per diluted share, in the comparable quarter of 2016. 20 CTS CORPORATION Results of Operations: Year Ended December 31, 2017, versus Year Ended December 31, 2016 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2017, and December 31, 2016: Sales were $422,993 for the year ended December 31, 2017, an increase of $26,314, or 6.6% from 2016. Sales to transportation markets increased $12,586 or 4.8%. Other sales increased $13,728 or 10.2%. The Noliac acquisition added $7,084 in sales in 2017. Gross margin as a percent of sales was 33.2% in 2017 versus 35.4% in 2016. The pension settlement charge recorded in the fourth quarter of 2017 impacted gross margin unfavorably by $4,796, or 1.1% of sales. The remaining decrease in gross margin resulted from costs relating to certain production rework issues that were resolved in 2017 and an unfavorable impact of foreign exchange rate movements. Selling, general and administrative expenses were $71,943, or 17.0% of sales for the year ended December 31, 2017, versus $61,624 or 15.5% of sales in the comparable period of 2016. The pension settlement charge recorded in the fourth quarter of 2017 impacted selling, general and administrative expenses unfavorably by $6,557 or 1.6% of sales. The remaining increase was primarily attributable to an increase in stock-based compensation as well as incremental costs resulting from the Noliac acquisition in 2017 and the single crystal acquisition in 2016, including amortization of intangibles. Research and development expenses were $25,146 or 5.9% of sales in 2017 compared to $24,040 or 6.1% of sales in 2016. The pension settlement charge recorded in the fourth quarter of 2017 impacted research and development expenses unfavorably by $2,062, or 0.5% of sales. The remaining decrease is related to higher reimbursements from customers for research and development costs in 2017 and timing of certain expenses. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring and impairment charges were $4,139 for year ended December 31, 2017. The charges were mainly for building and equipment relocation, severance and travel costs related to the restructuring of certain operations as part of the 2016 Restructuring Plan. Restructuring charges were $3,048 in 2016. The loss on sale of assets in 2017 was driven by a loss on the sale of vacant land at our Hopkinton, Massachusetts facility in September 2017. The 2016 gain on sale of assets of $11,450 is driven principally by a gain on the sale of our former manufacturing facility in Canada in June 2016. Operating earnings were $38,495, or 9.1% of sales in 2017, compared to $63,166, or 15.9% of sales in 2016 as a result of the items discussed above. CTS CORPORATION 21 Other income and expense items are summarized in the following table: Interest expense decreased in the year ended December 31, 2017, versus the same period in 2016 primarily as a result of a reduction in interest related to interest rate swaps. Interest income was down slightly in 2017 versus 2016. Other income in the year ended December 31, 2017, was driven mainly by foreign currency translation gains due to the depreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. Other expense in the year ended December 31, 2016, was driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. The effective income tax rate in 2017 was 64.1%, which was primarily due to a provisional one-time tax expense of $18,001 resulting from the Tax Cuts and Jobs Act, which was enacted on December 22, 2017. The rate also reflects a decrease in the valuation allowance on certain non-U.S. losses as a result of changes in the expectation of our ability to utilize those losses and changes in the mix of earnings by jurisdiction. The effective income tax rate in 2016 was 39.9%, which includes restructuring charges, one-time items, an increase in valuation allowances recorded against certain state net operating losses and tax credits, and the revaluation of U.S. deferred taxes as a result of the June 2016 restructuring activities discussed in Note 7, "Costs Associated with Exit and Restructuring Activities". The rate also reflects an increase in the valuation allowance on certain non-U.S. losses as a result of changes in the expectation of our ability to utilize those losses, changes in the mix of earnings by jurisdiction, our decision to no longer permanently reinvest the earnings of our Canadian and U.K. subsidiaries, tax expense for withholding taxes on earnings in China that are not anticipated to be maintained in China, and various other discrete items. Net earnings were $14,448 or $0.43 per diluted share for the year ended December 31, 2017, compared to earnings of $34,380 or $1.03 per diluted share in the comparable period of 2016. 22 CTS CORPORATION Results of Operations: Years Ended December 31, 2016, versus Year Ended December 31, 2015 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2016, and December 31, 2015: (1) Cost of goods sold includes restructuring related charges of $0 in 2016 and $631 in 2015. N/M = not meaningful Sales of $396,679 for the year ended December 31, 2016, increased $14,369, or 3.8% from 2015. Sales to automotive end-markets increased $5,198. Higher sensor volumes were partially offset by an unfavorable foreign exchange impact. Sales to other end-markets increased $9,171 including the addition of sales from our single crystal acquisition. Sales of components for high-density disk drives ("HDD") declined 30% year-over-year. Changes in foreign exchange rates reduced sales by $2,746 year-over-year as the U.S. Dollar appreciated compared to the Chinese Renminbi and other currencies. Gross margin as a percent of sales was 35.4% in 2016 versus 33.2% in 2015. The increase in gross margin resulted from cost savings from continued efficiency gains, material and labor productivity projects, savings from restructuring projects, favorable mix, and the addition of sales from our single crystal acquisition. In addition, foreign exchange rates had a favorable impact on manufacturing costs primarily due to the strengthening of the U.S. Dollar against the Mexican Peso. Selling, general and administrative expenses were $61,624, or 15.5% of sales for the year ended December 31, 2016, versus $59,586 or 15.6% of sales in the comparable period of 2015. Expenses in 2016 include added costs as a result of our single crystal acquisition, including amortization of intangibles. In addition, we paid an early termination fee related to a leased facility in Lisle, Illinois in anticipation of a move in the 2017/2018 time frame to another leased facility in the same area, which will consolidate the Bolingbrook and Lisle, Illinois sites into one facility and reduce ongoing expenses. Research and development expenses were $24,040 or 6.1% of sales in 2016 compared to $22,461 or 5.9% of sales in 2015. The increase was related to continued investment in new products to drive organic growth and expenses from our single crystal acquisition. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. A non-recurring environmental charge of $14,541 was recorded in the third quarter of 2015 related to a site in Asheville, North Carolina. The charge recorded included both the interim remediation costs we proposed, which was accepted by the Environmental Protection Agency (“EPA”), and anticipated future remediation and monitoring costs. Restructuring and impairment charges for the year ended December 31, 2016, totaled $3,048 and consisted largely of severance, production line move and legal costs in connection with the 2016 restructuring plan. Restructuring and impairment charges for CTS CORPORATION 23 the year ended December 31, 2015, totaled $14,564 and consisted largely of a non-cash charge for unamortized losses related to the windup of our U.K. pension plan in the amount of $8,280 as well as severance and other costs incurred in connection with the 2013 and 2014 restructuring plans. The 2016 gain on sale of assets of $11,450 is driven principally by a gain on the sale of our former manufacturing facility in Canada in June 2016. Operating earnings were $63,166, or 15.9% of sales in 2016, compared to $18,113, or 4.7% of sales in 2015 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense increased in the year ended December 31, 2016, versus the comparable period in 2015 as a result of higher average debt balances related to our single crystal acquisition, higher interest rates, higher commitment fees as a result of increasing the revolving credit facility from $200,000 to $300,000, and amortization of a contingent earnout liability associated with our Filter Sensing Technologies acquisition. Interest income decreased due to lower cash balances in China. Other expense, net in the year ended December 31, 2016, was driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi. Other expense, net in the year ended December 31, 2015, was also driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Renminbi and the Euro. The effective income tax rate in 2016 was 39.9%, which includes the impact of restructuring charges and one-time items. The tax rate in 2016 reflects an increase in valuation allowances recorded against certain state net operating losses and tax credits and the revaluation of U.S. deferred taxes as a result of the June 2016 restructuring activities discussed in Note 7, "Costs Associated with Exit and Restructuring Activities", in this Annual Report on Form 10-K. The rate also reflects an increase in the valuation allowance on certain non-U.S. losses as a result of changes in the expectation of our ability to utilize those losses, changes in the mix of earnings by jurisdiction, our decision to no longer permanently reinvest the earnings of our Canadian and U.K. subsidiaries, tax expense for withholding taxes on earnings in China that are not anticipated to be maintained in China, and various other discrete items. The effective income tax rate in 2015 was 43.3%, which included the impact of restructuring charges and one-time items. In 2015, we determined that as a result of changes in the business, the foreign earnings of our Canadian and U.K. subsidiaries were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. In addition, although we plan to permanently reinvest the earnings of our Chinese operations outside the U.S., we have determined that we will not maintain those earnings in China in order to mitigate future currency risk. As a result of these changes, we recorded a tax expense of $7,461. We recorded a benefit of $16,305 related to a change in the treatment of foreign taxes for U.S. federal income tax purposes. We also recorded additional discrete tax items in 2015 which increased income tax expense by $10,157 related to uncertain tax positions on certain foreign taxes, valuation allowances, foreign earnings, and other discrete items. Net earnings were $34,380 or $1.03 per diluted share for the year ended December 31, 2016, compared to earnings of $6,954 or $0.21 per diluted share in the comparable period of 2015. 24 CTS CORPORATION Liquidity and Capital Resources (Amounts in thousands, except percentages and per share amounts): Cash and cash equivalents were $113,572 at December 31, 2017, and $113,805 at December 31, 2016, of which $112,531 and $112,736, respectively, were held outside the United States. The decrease in cash and cash equivalents of $233 was driven by cash generated from operating activities of $58,048, which was offset by the payment for the Noliac acquisition of $19,121, capital expenditures of $18,094, net debt payments of $13,950, dividends paid of $5,260, and other net payments and foreign currency impacts on cash of $1,856. Total debt as of December 31, 2017, and December 31, 2016, was $76,300 and $90,106, respectively. Total debt as a percentage of total capitalization, defined as the sum of notes payable and long-term debt as a percentage of total debt and shareholders’ equity, was 18.2% at December 31, 2017, compared to 22.1% at December 31, 2016. Working capital increased by $13,619 from December 31, 2016, to December 31, 2017, primarily due to the increase in accounts receivable and inventory as well as the reduction in accrued expenses, which was partially offset by the increase in accounts payable. Cash Flows from Operating Activities Net cash provided by operating activities was $58,048 during the year ended December 31, 2017. Components of net cash provided by operating activities included net earnings of $14,448, depreciation and amortization expense of $20,674, deferred income taxes of $16,710, pension and other post-retirement plan expense of $11,570, stock based compensation of $4,184, and other net non-cash items totaling $802, which were offset by net changes in assets and liabilities of $10,340. Cash Flows from Investing Activities Net cash used in investing activities for the year ended December 31, 2017, was $36,674, driven by the net payment for our Noliac acquisition of $19,121 and capital expenditures of $18,094. Cash Flows from Financing Activities Net cash used in financing activities for the year ended December 31, 2017, was $20,814. These cash outflows were the result of net debt payments of $13,950, dividend payments of $5,260, and taxes paid on behalf of equity award participants of $1,604. Capital Resources We have an unsecured revolving credit facility; which has a term through January 10, 2020. Long-term debt was comprised of the following: On August 10, 2015, we entered into a new five-year credit agreement (“Revolving Credit Facility”) with a group of banks in order to support our financing needs. The Revolving Credit Facility originally provided for a credit line of $200,000. On May 23, 2016, we requested and received a $100,000 increase in the aggregate revolving credit commitments under our existing credit agreement, which increased the credit line from $200,000 to $300,000. The Revolving Credit Facility requires, among other things, that we comply with a maximum total leverage ratio and a minimum fixed charge coverage ratio. Failure to comply with these covenants could reduce the borrowing availability under the Revolving Credit Facility. We were in compliance with all debt covenants at December 31, 2017. We use interest rate swaps to convert the Revolving Credit Facility’s variable rate of interest into a fixed rate on a portion of our debt balance. In the second quarter of 2012, we entered into four separate one-year interest rate swap agreements to fix interest rates on $50,000 of long-term debt for the periods January 2013 to January 2017. In the third quarter of 2012, we entered into four additional one-year interest rate swap agreements to fix interest rates on $25,000 of long-term debt for the periods January CTS CORPORATION 25 2013 to January 2017. In the third quarter of 2016, we entered into three additional one-year interest rate swap agreements to fix interest rates on $50,000 of long-term debt for the periods August 2017 to August 2020. The difference to be paid or received under the terms of the swap agreements will be recognized as an adjustment to interest expense when settled. In general, other than in Canada and the U.K., it has been our historical practice to permanently reinvest the earnings of our non-U.S. subsidiaries in those operations. However, as a result of the Tax Cuts and Jobs Act, we can repatriate our cumulative undistributed foreign earnings to the U.S. when needed with minimal U.S. income tax consequences other than the one-time deemed repatriation charge. We will continue to evaluate whether to repatriate all or a portion of the cumulative undistributed foreign earnings based our business needs. We are still evaluating whether to change our indefinite reinvestment assertion in light of the Act and consider that conclusion to be incomplete under guidance issued by SAB 118. If we subsequently change our assertion during the measurement period, we will account for the change in assertion as a change in estimate related to the enactment of the Act. We have historically funded our capital and operating needs primarily through cash flows from operating activities, supported by available credit under our Revolving Credit Facility. We believe that cash flows from operating activities and available borrowings under our Revolving Credit Facility will be adequate to fund our working capital needs, capital expenditures, and debt service requirements for at least the next twelve months. However, we may choose to pursue additional equity and debt financing to provide additional liquidity or to fund acquisitions. Critical Accounting Policies and Estimates Management prepared the consolidated financial statements under accounting principles generally accepted in the United States of America. These principles require the use of estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions we used are reasonable, based upon the information available. Our estimates and assumptions affect the reported amounts in our financial statements. The following accounting policies comprise those that we believe are the most critical in understanding and evaluating our reported financial results. Revenue Recognition Product revenue is recognized once four criteria are met: (1) we have persuasive evidence that an arrangement exists; (2) delivery has occurred and title has passed to the customer, which generally happens at the point of shipment, provided that no significant obligations remain; (3) the price is fixed and determinable; and (4) collectability is reasonably assured. Product Warranties Provisions for estimated warranty expenses related to our automotive products are made at the time products are sold. These estimates are established using a quoted industry rate. We adjust our warranty reserve for any known or anticipated warranty claims as new information becomes available. We evaluate our warranty obligations at least quarterly and adjust our accruals if it is probable that future costs will be different than our current reserve. Over the last three years, product warranty reserves have ranged from 0.5% to 0.8% of total sales. We believe our reserve level is appropriate considering the quality of our products. Accounts Receivable We have standardized credit granting and review policies and procedures for all customer accounts, including: • Credit reviews of all new significant customer accounts, • Ongoing credit evaluations of current customers, • Credit limits and payment terms based on available credit information, • Adjustments to credit limits based upon payment history and the customer's current creditworthiness, • An active collection effort by regional credit functions, reporting directly to the corporate financial officers, and • Limited credit insurance on the majority of our international receivables. We reserve for estimated credit losses based upon historical experience and specific customer collection issues. Over the last three years, accounts receivable reserves have ranged from 0.2% to 0.5% of total accounts receivable. We believe our reserve level is appropriate considering the quality of the portfolio. While credit losses have historically been within expectations and the reserves established, we cannot guarantee that our credit loss experience will continue to be consistent with historical experience. 26 CTS CORPORATION Inventories We value our inventories at the lower of the actual cost to purchase or manufacture using the first-in, first-out ("FIFO") method, or net realizable value. We review inventory quantities on hand and record a provision for excess and obsolete inventory based on forecasts of product demand and production requirements. Over the last three years, our reserves for excess and obsolete inventories have ranged from 13.7% to 20.1% of gross inventory. We believe our reserve level is appropriate considering the quantities and quality of the inventories. Retirement Plans Actuarial assumptions are used in determining pension income and expense and our defined benefit obligations. We utilize actuaries from consulting companies in each applicable country to develop our discount rates, matching high-quality bonds currently available and expected to be available during the period to maturity of the pension benefit in order to provide the necessary future cash flows to pay the accumulated benefits when due. After considering the recommendations of our actuaries, we have assumed a discount rate, expected rate of return on plan assets, and a rate of compensation increase in determining our annual pension income and expense and the projected benefit obligation. During the fourth quarter of each year, we review our actuarial assumptions in light of current economic factors to determine if the assumptions need to be adjusted. Changes in the actuarial assumptions could have a material effect on our results of operations. Valuation of Goodwill Goodwill of a reporting unit is tested for impairment annually, or more frequently, if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant adverse change in legal factors or in the business climate, • Adverse action or assessment by a regulator, • Unanticipated competition, • More-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, • Testing for recoverability of a significant asset group within a reporting unit, and • Allocation of a portion of goodwill to a business to be disposed. If we believe that one or more of the above indicators of impairment have occurred, we perform an impairment test. The test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. We generally determine the fair value of our reporting units using two valuation methods: "Income Approach - Discounted Cash Flow Method" and "Market Approach - Guideline Public Company Method". The approach defined below is based upon our last impairment test conducted as of October 1, 2017. Under the "Income Approach - Discounted Cash Flow Method", the key assumptions include sales, cost of sales, and operating expense projections through the year 2022. These assumptions were determined by management utilizing our internal operating plan and assuming growth rates for revenues, operating expenses, and gross margin assumptions. The fourth key assumption under this approach is the discount rate, which is determined by looking at current risk-free rates, current market interest rates and the evaluation of risk premium relevant to the business segment. If any of our assumptions were to change or were incorrect, our fair value calculation may change, which could result in impairment. Under the "Market Approach - Guideline Public Company Method", we identified eight publicly traded companies which we believe have significant relevant similarities to CTS. For these eight companies, we calculated a range of EBITDA multiples derived from the ratio of enterprise value to EBITDA and compared these multiples to the corresponding multiples for each of our reporting units. Similar to the income approach discussed above, sales, cost of sales, operating expenses and growth rates were key assumptions utilized in developing projected EBITDA levels for each of our reporting units. The market prices of CTS and the other guideline company's shares are also key assumptions as they are used to calculate enterprise value. CTS CORPORATION 27 The results of these two methods are weighted based upon management's determination. The Market approach is based upon historical and current economic conditions, which might not reflect the long-term prospects or opportunities for our reporting units being evaluated. If the carrying amount of a reporting unit exceeds the reporting unit's fair value, we perform the second step of the goodwill impairment test to determine the amount of impairment loss, if any. This involves comparing the implied fair value of the affected reporting unit's goodwill with the carrying value of that goodwill. There have not been any significant changes to our impairment testing methodology other than updates to the assumptions to reflect the current market environment. Based upon our latest assessment, we determined that our goodwill was not impaired as of October 1, 2017. We will monitor future results and will perform a test if indicators trigger an impairment review. Valuation of Other Intangible and Long-Lived Assets We evaluate the impairment of identifiable intangibles and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered that may trigger an impairment review consist of, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant underperformance relative to expected historical or projected future operating results, • Significant changes in the manner of use of the acquired assets or the strategy for the overall business, • Significant negative industry or economic trends. If we believe that one or more indicators of impairment have occurred, we perform a recoverability test by comparing the carrying amount of an asset or asset group to the sum of the undiscounted cash flows expected to result from the use and the eventual disposition of the asset or asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value. No indicators of impairment were identified as of December 31, 2017. Environmental and Legal Contingencies U.S. GAAP requires a liability to be recorded for contingencies when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Significant judgment is required to determine the existence of a liability as well as the amount to be recorded. We regularly consult with attorneys and consultants to determine the relevant facts and circumstances before we record a liability. Changes in laws, regulatory orders, cost estimates, participation of other parties, timing of payments, input of attorneys and consultants, or other circumstances may have a material impact on the recorded liability. Income Taxes Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgments and estimates are required in the determination of consolidated income tax expense. Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets in the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. The assumptions about future taxable income require the use of significant judgment and are consistent with the plans and estimates we are using to manage our underlying businesses. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across our global operations. ASC 740 states that a tax benefit from an uncertain tax position may be recognized when it is more-likely-than-not that the position will be sustained upon examination, including resolution of any related appeals or litigation processes, on the basis of its technical merits. We record unrecognized tax benefits as liabilities in accordance with ASC 740 and adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available. 28 CTS CORPORATION Our practice is to recognize interest and penalties related to income tax matters as part of income tax expense. We earn a significant amount of our operating income outside of the U.S., which is generally deemed to be permanently reinvested in foreign jurisdictions except in Canada and the U.K. In 2015, as a result of changes in the business, the foreign earnings of these two subsidiaries were no longer permanently reinvested. Therefore, a provision for the expected taxes on repatriation of those earnings was recorded. However, as a result of the Tax Cuts and Jobs Act, we can repatriate our cumulative undistributed foreign earnings back to the U.S. when needed with minimal U.S. income tax consequences other than the one-time deemed repatriation charge. We will continue to evaluate whether to repatriate all or a portion of the cumulative undistributed foreign earnings based on expansion needs and as circumstances change. We are still evaluating whether to change our indefinite reinvestment assertion in light of the Act and consider that conclusion to be incomplete under guidance issued by SAB 118. If we subsequently change our assertion during the measurement period, we will account for the change in assertion as a change in estimate related to enactment of the Act. Contractual Obligations Our contractual obligations as of December 31, 2017, were: We have no off-balance sheet arrangements, except for operating leases, that have a material current effect or are reasonably likely to have a material future effect on our financial condition or changes in our financial condition. Management believes that existing capital resources and funds generated from operations are sufficient to finance anticipated capital requirements. CTS CORPORATION 29

<s>[INST] CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, actuators, and electronic components in North America, Europe, and Asia. CTS provides solutions to OEMs in the aerospace, communications, defense, industrial, information technology, medical, and transportation markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2017 versus Fourth Quarter 2016 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2017, and December 31, 2016: Sales of $110,910 in the fourth quarter of 2017 increased $9,326 or 9.2% from the fourth quarter of 2016. Sales to transportation markets increased $4,899 or 7.3%. Other sales increased $4,427 or 12.7%. Our Noliac acquisition, which we completed in May 2017, added $2,987 in sales for the quarter. Changes in foreign exchange rates increased sales by $1,229 yearoveryear due to the U.S. Dollar depreciating compared to the Chinese Renminbi and Euro. In the fourth quarter of 2017, we recorded a $13,415 onetime, noncash pension settlement charge. During 2017, CTS offered its pension participants the opportunity to receive a lump sum payment to settle their future pension benefits. A number of participants elected the lump sum option, and the total lump sum payments distributed to these participants when the offer window closed in the fourth quarter was large enough to trigger a pension settlement charge under U.S. GAAP. This charge was recorded in the amount of $4,796 to cost of goods sold, $6,557 to selling, general and administrative expenses and $2,062 to research and development expenses. Gross margin as a percent of sales was 29.6% in the fourth quarter of 2017 compared to 35.3% in the fourth quarter of 2016. The pension settlement charge impacted gross margin unfavorably by $4,796 or 4.3% of sales. CTS CORPORATION 19 Selling, general and administrative expenses were $24,973 or 22.5% of sales in the fourth quarter of 2017 versus $15,165 or 14.9% of sales in the comparable quarter of 2016. The pension settlement charge impacted selling, general and administrative expenses unfavorably by $6,557 or 5.9% of sales. The remaining increase is primarily attributable to the addition of amortization of intangibles and other operating costs from the Noliac acquisition and timing of certain other expenses. Research and development expenses were $6,714 or 6.1% of sales in the fourth quarter of 2017 compared to $5,626, or 5.5% of sales, in the comparable quarter of 2016. The pension settlement charge impact [/INST] Negative. </s>

CTS CORP

2019-02-22

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, actuators, and electronic components in North America, Europe, and Asia. CTS provides engineered products to OEMs in the aerospace and defense, industrial, information technology, medical, telecommunications, and transportation markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2018 versus Fourth Quarter 2017 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2018, and December 31, 2017: Sales of $120,073 in the fourth quarter of 2018 increased $9,163 or 8.3% from the fourth quarter of 2017. Sales to transportation markets increased $5,163 or 7.2%. Sales to other end markets increased $4,000 or 10.2%. Changes in foreign exchange rates decreased sales by $880 year-over-year due to the U.S. Dollar appreciating compared to the Chinese Renminbi and Euro. In the fourth quarter of 2017, we recorded a $13,415 one-time, non-cash pension settlement charge. During 2017, CTS offered its pension participants the opportunity to receive a lump sum payment to settle their future pension benefits. A number of participants elected the lump sum option, and the total lump sum payments distributed to these participants when the offer window closed in the fourth quarter was large enough to trigger a pension settlement charge under U.S. GAAP. This charge was recorded in the amount of $4,796 to cost of goods sold, $6,557 to selling, general and administrative expenses and $2,062 to research and development expenses. Gross margin as a percent of sales was 35.5% in the fourth quarter of 2018 compared to 29.6% in the fourth quarter of 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted gross margin unfavorably by $4,796 or 4.3%. The 18 CTS CORPORATION increase in gross margin was primarily driven by savings related to product line transfers associated with the June 2016 Restructuring Plan described in Note 8. Selling, general and administrative expenses were $18,128 or 15.1% of sales in the fourth quarter of 2018 versus $24,973 or 22.5% of sales in the comparable quarter of 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted selling, general and administrative expenses unfavorably by $6,557 or 5.9%. Research and development expenses were $5,804 or 4.8% of sales in the fourth quarter of 2018 compared to $6,714, or 6.1% of sales, in the comparable quarter of 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted research and development expenses unfavorably by $2,062, or 1.9%. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring and impairment charges were $1,698 in the fourth quarter of 2018. These charges were mainly for building and equipment relocation, severance, and travel costs related to the restructuring of certain operations as part of the June 2016 Restructuring Plan. In the fourth quarter 2017, restructuring and impairment charges consisting of severance and other costs totaled $1,197, which were also in connection with our June 2016 Restructuring Plan. Operating earnings were $17,017, or 14.2% of sales in the fourth quarter of 2018, compared to an operating loss of $19, or 0.0% of sales, in the comparable quarter of 2017 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense decreased in the fourth quarter of 2018 versus 2017 due to lower debt balances and a reduction in interest related to interest rate swaps. Interest income increased due to higher interest rates. Other income in the fourth quarter of 2017 was driven mainly by foreign currency translation gains due to the appreciation of the Chinese Renminbi compared to the U.S. Dollar. The effective income tax rate for the fourth quarter of 2018 was (4.1)% compared to 9,493.8% in the fourth quarter of 2017. The tax rate in 2018 was impacted primarily by a discrete one-time rate change benefit related to the Tax Cuts and Jobs Act (“Tax Act”) resulting from the election of tax accounting method changes. The effective income tax rate in the fourth quarter of 2017 was primarily related to the initial application of the Tax Act including the remeasurement of the net deferred tax assets from 35% to 21% and the one-time mandatory transition tax on the historical earnings of foreign affiliates, which resulted in a net non-cash charge of $18,001. Net earnings was $17,564, or $0.52 per diluted share, in the fourth quarter of 2018, compared to a net loss of $13,621, or $0.41 per share, in the comparable quarter of 2017. CTS CORPORATION 19 Results of Operations: Year Ended December 31, 2018, versus Year Ended December 31, 2017 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2018, and December 31, 2017: Sales were $470,483 for the year ended December 31, 2018, an increase of $47,490, or 11.2% from 2017. Sales to transportation markets increased $24,873 or 9.0%. Sales to other end markets increased $22,617 or 15.3%. The Noliac acquisition added $9,463 in sales in 2018 and $7,084 in sales in 2017. Changes in foreign exchange rates increased sales by $3,238 year-over-year due to the U.S. Dollar depreciating compared to the Chinese Renminbi and Euro. Gross margin as a percent of sales was 35.1% in 2018 versus 33.2% in 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted gross margin unfavorably by $4,796, or 1.1% of sales. The increase in gross margin was primarily driven by savings related to product line transfers and a favorable impact of foreign exchange rate movements which were partially offset by material cost increases. Selling, general and administrative expenses were $73,569, or 15.6% of sales for the year ended December 31, 2018, versus $71,943 or 17.0% of sales in the comparable period of 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted selling, general and administrative expenses unfavorably by $6,557 or 1.6% of sales. The increase includes higher stock-based compensation and ERP implementation costs as well as incremental costs resulting from the Noliac acquisition in 2017, including amortization of intangibles. Research and development expenses were $25,304 or 5.4% of sales in 2018 compared to $25,146 or 5.9% of sales in 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted research and development expenses unfavorably by $2,062, or 0.5% of sales. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring and impairment charges were $5,062 for year ended December 31, 2018. The charges were mainly for building and equipment relocation, severance, and travel costs related to the restructuring of certain operations as part of the 2016 Restructuring Plan. Restructuring charges were $4,139 in 2017. The loss on sale of assets in 2017 was driven by a loss on the sale of vacant land at our Hopkinton, Massachusetts facility in September 2017. Operating earnings were $61,038, or 13.0% of sales in 2018, compared to $38,495, or 9.1% of sales in 2017 as a result of the items discussed above. 20 CTS CORPORATION Other income and expense items are summarized in the following table: Interest expense decreased in the year ended December 31, 2018, versus the same period in 2017 primarily due to lower debt balances, a reduction in interest related to interest rate swaps, and a one-time charge related to a liability that was settled in 2017. Interest income increased due to higher interest rates. Other expense in the year ended December 31, 2018, was driven by foreign currency translation losses mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. Other income in the year ended December 31, 2017 was driven mainly by foreign currency translation gains due to the depreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. The effective income tax rate in 2018 was 19.9% compared to 64.1% in the prior year. The tax rate in 2018 was favorably impacted by a discrete one-time rate change benefit related to the Tax Act resulting from the election of tax accounting method changes, partially offset by a one-time withholding tax on repatriation of earnings from one of our foreign subsidiaries that was completed during the year to enable the use of tax credits due to expire in 2018. The tax rate in 2017 was unfavorably impacted by the application of the Tax Act, driven by the remeasurement of the net deferred tax assets from 35% to 21% and the one-time mandatory transition tax on the historical earnings of foreign affiliates, which resulted in a net non-cash charge of $18,001. Net earnings were $46,532 or $1.39 per diluted share for the year ended December 31, 2018, compared to earnings of $14,448 or $0.43 per diluted share in the comparable period of 2017. Results of Operations: Years Ended December 31, 2017, versus Year Ended December 31, 2016 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2017, and December 31, 2016: CTS CORPORATION 21 Sales were $422,993 for the year ended December 31, 2017, an increase of $26,314, or 6.6% from 2016. Sales to transportation markets increased $12,586 or 4.8%. Other sales increased $13,728 or 10.2%. The Noliac acquisition added $7,084 in sales in 2017. Gross margin as a percent of sales was 33.2% in 2017 versus 35.4% in 2016. The pension settlement charge recorded in the fourth quarter of 2017 impacted gross margin unfavorably by $4,796, or 1.1% of sales. The remaining decrease in gross margin resulted from costs relating to certain production rework issues that were resolved in 2017 and an unfavorable impact of foreign exchange rate movements. Selling, general and administrative expenses were $71,943, or 17.0% of sales for the year ended December 31, 2017, versus $61,624 or 15.5% of sales in the comparable period of 2016. The pension settlement charge recorded in the fourth quarter of 2017 impacted selling, general and administrative expenses unfavorably by $6,557 or 1.6% of sales. The remaining increase was primarily attributable to an increase in stock-based compensation as well as incremental costs resulting from the Noliac acquisition in 2017 and the single crystal acquisition in 2016, including amortization of intangibles. Research and development expenses were $25,146 or 5.9% of sales in 2017 compared to $24,040 or 6.1% of sales in 2016. The pension settlement charge recorded in the fourth quarter of 2017 impacted research and development expenses unfavorably by $2,062, or 0.5% of sales. The remaining decrease is related to higher reimbursements from customers for research and development costs in 2017 and timing of certain expenses. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring and impairment charges were $4,139 for year ended December 31, 2017. The charges were mainly for building and equipment relocation, severance and travel costs related to the restructuring of certain operations as part of the 2016 Restructuring Plan. Restructuring charges were $3,048 in 2016. The loss on sale of assets in 2017 was driven by a loss on the sale of vacant land at our Hopkinton, Massachusetts facility in September 2017. The 2016 gain on sale of assets of $11,450 is driven principally by a gain on the sale of our former manufacturing facility in Canada in June 2016. Operating earnings were $38,495, or 9.1% of sales in 2017, compared to $63,166, or 15.9% of sales in 2016 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense decreased in the year ended December 31, 2017, versus the same period in 2016 primarily as a result of a reduction in interest related to interest rate swaps. Interest income was down slightly in 2017 versus 2016. Other income in the year ended December 31, 2017, was driven mainly by foreign currency translation gains due to the depreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. Other expense in the year ended December 31, 2016, was driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. 22 CTS CORPORATION The effective income tax rate in 2017 was 64.1%, which was primarily due to a provisional one-time tax expense of $18,001 resulting from the Tax Cuts and Jobs Act, which was enacted on December 22, 2017. The rate also reflects a decrease in the valuation allowance on certain non-U.S. losses as a result of changes in the expectation of our ability to utilize those losses and changes in the mix of earnings by jurisdiction. The effective income tax rate in 2016 was 39.9%, which includes restructuring charges, one-time items, an increase in valuation allowances recorded against certain state net operating losses and tax credits, and the revaluation of U.S. deferred taxes as a result of the June 2016 restructuring activities discussed in Note 8, "Costs Associated with Exit and Restructuring Activities". The rate also reflects an increase in the valuation allowance on certain non-U.S. losses as a result of changes in the expectation of our ability to utilize those losses, changes in the mix of earnings by jurisdiction, our decision to no longer permanently reinvest the earnings of our Canadian and U.K. subsidiaries, tax expense for withholding taxes on earnings in China that are not anticipated to be maintained in China, and various other discrete items. Net earnings were $14,448 or $0.43 per diluted share for the year ended December 31, 2017, compared to earnings of $34,380 or $1.03 per diluted share in the comparable period of 2016. Liquidity and Capital Resources (Amounts in thousands, except percentages and per share amounts): Cash and cash equivalents were $100,933 at December 31, 2018, and $113,572 at December 31, 2017, of which $96,762 and $112,531, respectively, were held outside the United States. The decrease in cash and cash equivalents of $12,639 was driven principally by cash generated from operating activities of $58,152, which was offset by capital expenditures of $28,488, net debt payments of $26,300, purchase of treasury stock of $9,440, and dividends paid of 5,285. Total debt as of December 31, 2018, and December 31, 2017, was $50,000 and $76,300, respectively. Total debt as a percentage of total capitalization, defined as long-term debt as a percentage of total debt and shareholders’ equity, was 11.7% at December 31, 2018, compared to 18.2% at December 31, 2017. Working capital increased by $4,169 from December 31, 2017, to December 31, 2018, primarily due to increases in accounts receivable and inventory, which were partially offset by the decrease in cash. Cash Flows from Operating Activities Net cash provided by operating activities was $58,152 during the year ended December 31, 2018. Components of net cash provided by operating activities included net earnings of $46,532, depreciation and amortization expense of $22,514, stock-based compensation of $5,256, and other net non-cash items totaling $340, which were offset by net changes in assets and liabilities of $15,482 and deferred income taxes of 1,008. Cash Flows from Investing Activities Net cash used in investing activities for the year ended December 31, 2018, was $28,485, driven by the net capital expenditures of $28,488. Cash Flows from Financing Activities Net cash used in financing activities for the year ended December 31, 2018, was $42,493. This cash outflow was the result of net debt payments of $26,300, the purchase of treasury stock of $9,440, dividend payments of $5,285, and taxes paid on behalf of equity award participants of $1,468. CTS CORPORATION 23 Capital Resources Long-term debt was comprised of the following: On August 10, 2015, we entered into an unsecured five-year revolving credit agreement (“Revolving Credit Facility”) with a group of banks in order to support our financing needs. The Revolving Credit Facility originally provided for a credit line of $200,000. On May 23, 2016, we requested and received a $100,000 increase in the aggregate revolving credit commitments under our existing credit agreement, which increased the credit line from $200,000 to $300,000. The Revolving Credit Facility requires, among other things, that we comply with a maximum total leverage ratio and a minimum fixed charge coverage ratio. Failure to comply with these covenants could reduce the borrowing availability under the Revolving Credit Facility. We were in compliance with all debt covenants at December 31, 2018. On February 12, 2019, CTS entered into a new amended and restated five-year credit agreement with a group of banks that expires on February 12, 2024. This credit agreement provides for a revolving credit facility of $300 million, which may be increased by $150 million at the request of the Company, subject to the administrative agent’s approval. This new unsecured credit facility replaces the prior $300 million unsecured credit facility, which would have expired August 10, 2020. Borrowings of $50 million under the prior credit agreement were refinanced and the prior agreement was terminated as of February 12, 2019. We use interest rate swaps to convert the Revolving Credit Facility’s variable rate of interest into a fixed rate on a portion of our debt balance. In the second quarter of 2012, we entered into four separate one-year interest rate swap agreements to fix interest rates on $50,000 of long-term debt for the periods January 2013 to January 2017. In the third quarter of 2012, we entered into four additional one-year interest rate swap agreements to fix interest rates on $25,000 of long-term debt for the periods January 2013 to January 2017. In the third quarter of 2016, we entered into three additional one-year interest rate swap agreements to fix interest rates on $50,000 of long-term debt for the periods August 2017 to August 2020. The difference to be paid or received under the terms of the swap agreements will be recognized as an adjustment to interest expense when settled. We have historically funded our capital and operating needs primarily through cash flows from operating activities, supported by available credit under our Revolving Credit Facility. We believe that cash flows from operating activities and available borrowings under our Revolving Credit Facility will be adequate to fund our working capital needs, capital expenditures, and debt service requirements for at least the next twelve months. However, we may choose to pursue additional equity and debt financing to provide additional liquidity or to fund acquisitions. Critical Accounting Policies and Estimates Management prepared the consolidated financial statements under accounting principles generally accepted in the United States of America. These principles require the use of estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions we used are reasonable, based upon the information available. Our estimates and assumptions affect the reported amounts in our financial statements. The following accounting policies comprise those that we believe are the most critical in understanding and evaluating our reported financial results. Revenue Recognition Beginning in January 2018, CTS adopted the provisions of Accounting Standards Update ("ASU") No. 2014-09, "Revenue from Contracts with Customers (Topic 606)". Product revenue is recognized when the transfer of promised goods to a customer occurs in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods. We follow the five step model to determine when this transfer has occurred: 1) identify the contract(s) with the customer; 2) identify the performance obligations in the contract; 3) determine the transaction price; 4) allocate the transaction price to the performance obligations in the contract; 5) recognize revenue when (or as) the entity satisfies a performance obligation. 24 CTS CORPORATION Prior to January 1, 2018, product revenue was recognized once four criteria were met: 1) we have persuasive evidence that an arrangement exists; 2) delivery has occurred and title has passed to the customer, which generally happens at the point of shipment provided that no significant obligations remain; 3) the price is fixed and determinable; and 4) collectability is reasonably assured. Product Warranties Provisions for estimated warranty expenses primarily related to our automotive products are made at the time products are sold. These estimates are established using a quoted industry rate. We adjust our warranty reserve for any known or anticipated warranty claims as new information becomes available. We evaluate our warranty obligations at least quarterly and adjust our accruals if it is probable that future costs will be different than our current reserve. Over the last three years, product warranty reserves have ranged from 0.5% to 2.4% of total sales. We believe our reserve level is appropriate considering all facts and circumstances surrounding any outstanding quality claims and our historical experience selling our products to our customers. Accounts Receivable We have standardized credit granting and review policies and procedures for all customer accounts, including: • Credit reviews of all new significant customer accounts, • Ongoing credit evaluations of current customers, • Credit limits and payment terms based on available credit information, • Adjustments to credit limits based upon payment history and the customer's current creditworthiness, • An active collection effort by regional credit functions, reporting directly to the corporate financial officers, and • Limited credit insurance on the majority of our international receivables. We reserve for estimated credit losses based upon historical experience and specific customer collection issues. Over the last three years, accounts receivable reserves have ranged from 0.3% to 0.7% of total accounts receivable. We believe our reserve level is appropriate considering the quality of the portfolio. While credit losses have historically been within expectations of the reserves established, we cannot guarantee that our credit loss experience will continue to be consistent with historical experience. Inventories We value our inventories at the lower of the actual cost to purchase or manufacture using the first-in, first-out ("FIFO") method, or net realizable value. We review inventory quantities on hand and record a provision for excess and obsolete inventory based on forecasts of product demand and production requirements. Over the last three years, our reserves for excess and obsolete inventories have ranged from 11.2% to 19.5% of gross inventory. We believe our reserve level is appropriate considering the quantities and quality of the inventories. Retirement Plans Actuarial assumptions are used in determining pension income and expense and our defined benefit obligations. We utilize actuaries from consulting companies in each applicable country to develop our discount rates, matching high-quality bonds currently available and expected to be available during the period to maturity of the pension benefit in order to provide the necessary future cash flows to pay the accumulated benefits when due. After considering the recommendations of our actuaries, we have assumed a discount rate, expected rate of return on plan assets, and a rate of compensation increase in determining our annual pension income and expense and the projected benefit obligation. During the fourth quarter of each year, we review our actuarial assumptions in light of current economic factors to determine if the assumptions need to be adjusted. Changes in the actuarial assumptions could have a material effect on our results of operations. Impairment of Goodwill Goodwill of a reporting unit is tested for impairment annually, or more frequently if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant adverse change in legal factors or in the business climate, CTS CORPORATION 25 • Adverse action or assessment by a regulator, • Unanticipated competition, • More-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, • Testing for recoverability of a significant asset group within a reporting unit, and • Allocation of a portion of goodwill to a business to be disposed. If we believe that one or more of the above indicators of impairment have occurred, we perform an impairment test. We have the option to perform a qualitative assessment (commonly referred to as "step zero" test) to determine whether further quantitative analysis for impairment of goodwill and indefinite-lived intangible assets is necessary. The qualitative assessment includes a review of macroeconomic conditions, industry and market considerations, internal cost factors, and our own overall financial and share price performance, among other factors. If, after assessing the totality of events or circumstances we determine that it is not more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, we do not need to perform a quantitative analysis. If a quantitative assessment is required, we estimate the fair value of each reporting unit using a combination of discounted cash flow analysis and market-based valuation methodologies. Determining fair value using a quantitative approach requires significant judgment, including judgments about projected revenues, operating expenses, working capital investment, capital expenditures, and cash flows over a multi-year period. The discount rate applied to our forecasts of future cash flows is based on our estimated weighted average cost of capital. In assessing the reasonableness of our determined fair values, we evaluate our results against our market capitalization. Changes in these estimates and assumptions could materially affect the determination of fair value and impact the goodwill impairment assessment. Our latest assessment was performed using a qualitative approach as of October 1, 2018, and we determined that it was likely that the fair values of our reporting units were more than their carrying amounts, and therefore no impairment charges were recorded. We will monitor future results and will perform a test if indicators trigger an impairment review. Impairment of Other Intangible and Long-Lived Assets We evaluate the impairment of identifiable intangibles and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered that may trigger an impairment review consist of, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant underperformance relative to expected historical or projected future operating results, • Significant changes in the manner of use of the acquired assets or the strategy for the overall business, • Significant negative industry or economic trends. If we believe that one or more indicators of impairment have occurred, we perform a recoverability test by comparing the carrying amount of an asset or asset group to the sum of the undiscounted cash flows expected to result from the use and the eventual disposition of the asset or asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value. No indicators of impairment were identified during the year ended December 31, 2018. Environmental and Legal Contingencies U.S. GAAP requires a liability to be recorded for contingencies when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Significant judgment is required to determine the existence and amounts of our environmental, legal and other contingent liabilities. We regularly consult with attorneys and consultants to determine the relevant facts and circumstances before we record a liability. Changes in laws, regulatory orders, cost estimates, participation of other parties, timing of payments, input of attorneys and consultants, or other circumstances may have a material impact on the recorded liability. 26 CTS CORPORATION Income Taxes Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgments and estimates are required in the determination of consolidated income tax expense. Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets in the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. The assumptions about future taxable income require the use of significant judgment and are consistent with the plans and estimates we are using to manage our underlying businesses. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across our global operations. Accounting Standards Codification (ASC) No. 740 states that a tax benefit from an uncertain tax position may be recognized when it is more-likely-than-not that the position will be sustained upon examination, including resolution of any related appeals or litigation processes, on the basis of its technical merits. We record unrecognized tax benefits as liabilities in accordance with ASC 740 and adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available. Our practice is to recognize interest and penalties related to income tax matters as part of income tax expense. Generally, outside of Canada and the United Kingdom, it has been our historical practice to permanently reinvest the earnings of our non-U.S. subsidiaries in those operations. As previously noted, the Tax Act made significant changes to the taxation of undistributed foreign earnings, requiring that all previously untaxed earnings and profits of our controlled foreign corporation be subjected to a one-time mandatory deemed repatriation tax. The transition tax substantially eliminated the basis difference that existed prior to the Tax Act. However, there are limited other taxes that could continue to apply such as foreign withholding and certain state taxes. We completed the evaluation of our indefinite reinvestment assertion as a result of the Tax Act during the fourth quarter of 2018 and decided not to reinvest the current year earnings of our primary operations, except for in the Czech Republic, Denmark, India, Mexico and Taiwan. We intend to continue to indefinitely reinvest the earnings in these non-U.S. subsidiaries. Contractual Obligations Our contractual obligations as of December 31, 2018, were: We have no off-balance sheet arrangements, except for operating leases, that have a material current effect or are reasonably likely to have a material future effect on our financial condition or changes in our financial condition. Management believes that existing capital resources and funds generated from operations are sufficient to finance anticipated capital requirements. CTS CORPORATION 27

<s>[INST] CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, actuators, and electronic components in North America, Europe, and Asia. CTS provides engineered products to OEMs in the aerospace and defense, industrial, information technology, medical, telecommunications, and transportation markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Fourth Quarter 2018 versus Fourth Quarter 2017 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings (Loss) for the quarters ended December 31, 2018, and December 31, 2017: Sales of $120,073 in the fourth quarter of 2018 increased $9,163 or 8.3% from the fourth quarter of 2017. Sales to transportation markets increased $5,163 or 7.2%. Sales to other end markets increased $4,000 or 10.2%. Changes in foreign exchange rates decreased sales by $880 yearoveryear due to the U.S. Dollar appreciating compared to the Chinese Renminbi and Euro. In the fourth quarter of 2017, we recorded a $13,415 onetime, noncash pension settlement charge. During 2017, CTS offered its pension participants the opportunity to receive a lump sum payment to settle their future pension benefits. A number of participants elected the lump sum option, and the total lump sum payments distributed to these participants when the offer window closed in the fourth quarter was large enough to trigger a pension settlement charge under U.S. GAAP. This charge was recorded in the amount of $4,796 to cost of goods sold, $6,557 to selling, general and administrative expenses and $2,062 to research and development expenses. Gross margin as a percent of sales was 35.5% in the fourth quarter of 2018 compared to 29.6% in the fourth quarter of 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted gross margin unfavorably by $4,796 or 4.3%. The 18 CTS CORPORATION increase in gross margin was primarily driven by savings related to product line transfers associated with the June 2016 Restructuring Plan described in Note 8. Selling, general and administrative expenses were $18,128 or 15.1% of sales in the fourth quarter of 2018 versus $24,973 or 22.5% of sales in the comparable quarter of 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted selling, general and administrative expenses unfavorably by $6,557 or 5.9%. Research and development expenses were $5,804 or 4.8% of sales in the fourth quarter of 2018 compared to $6,714, or 6.1% of sales, in the comparable quarter of 2017. The pension settlement charge recorded in the fourth quarter of 2017 [/INST] Positive. </s>

CTS CORP

2020-02-20

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, actuators, and electronic components in North America, Europe, and Asia. CTS provides engineered products to OEMs and tier one suppliers in the aerospace and defense, industrial, information technology, medical, telecommunications, and transportation markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Year Ended December 31, 2019, versus Year Ended December 31, 2018 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2019, and December 31, 2018: Sales were $468,999 for the year ended December 31, 2019, a decrease of $1,484, or 0.3% from 2018. Sales to transportation markets decreased $1,119 or 0.4%. Sales to other markets decreased $364 or 0.2%. The QTI acquisition, which was completed in July 2019, added $9,252 in sales for the year (see Note 19). Changes in foreign exchange rates decreased sales by $5,135 year-over-year due to the U.S. Dollar appreciating compared to the Chinese Renminbi and Euro. Gross margin as a percent of sales was 33.6% in 2019 versus 35.1% in 2018. The decrease in gross margin was driven primarily by lower volume, foundry inefficiency in our ceramics manufacturing operations, labor and commodity cost increases, a one-time purchase accounting step-up in the value of finished goods inventory acquired with our QTI acquisition, and an unfavorable impact from currency movements. These were partially offset by cost improvement projects as well as savings from our manufacturing transition project. Selling, general and administrative ("SG&A") expenses were $70,408, or 15.0% of sales for the year ended December 31, 2019, versus $73,569 or 15.6% of sales in the comparable period of 2018. The 2019 SG&A costs include amortization of intangibles and other operating costs associated with the QTI acquisition as well as higher environmental expenses, which were offset by CTS CORPORATION 18 lower short-term incentive compensation, the impact of cost reduction actions taken in the fourth quarter, and other cost controls during the year. Research and development expenses were $25,967 or 5.5% of sales in 2019 compared to $25,304 or 5.4% of sales in 2018. Restructuring charges were $7,448 for year ended December 31, 2019. The charges were mainly for building and equipment relocation, severance, and asset impairment charges related to the restructuring of certain operations, as well as a lease termination fee related to a property lease we acquired in the QTI acquisition. Restructuring charges were $5,062 in 2018. Operating earnings were $53,815, or 11.5% of sales in 2019, compared to $61,038, or 13.0% of sales in 2018 as a result of the items discussed above. Other income and expense items are summarized in the following table: Interest expense increased mainly as a result of an increase in debt related to the QTI acquisition. Other expense in 2019 was principally driven by foreign currency translation losses, mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and Euro, as well as an increase in pension expense. The effective income tax rate in 2019 was 28.1% compared to 19.9% in the prior year. The tax rate in 2019 was higher than the U.S. statutory federal tax rate primarily due to foreign earnings that are taxed at higher rates, the impact of taxes on unremitted earnings and unfavorable increases to reserves. The tax rate in 2018 was favorably impacted by a one-time rate change benefit related to the Tax Cuts and Jobs Act of 2017 resulting from the election of tax accounting method changes to accelerate deductions on the 2017 tax return, partially offset by a one-time withholding tax on repatriation of earnings from one of our foreign subsidiaries that was completed during the year to enable the use of tax credits due to expire in 2018. Net earnings were $36,146 or $1.09 per diluted share for the year ended December 31, 2019, compared to earnings of $46,532 or $1.39 per diluted share in the comparable period of 2018. CTS CORPORATION 19 Results of Operations: Years Ended December 31, 2018, versus Year Ended December 31, 2017 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2018, and December 31, 2017: Sales were $470,483 for the year ended December 31, 2018, an increase of $47,490, or 11.2% from 2017. Sales to transportation markets increased $24,873 or 9.0%. Sales to other end markets increased $22,617 or 15.3%. The Noliac acquisition added $9,463 in sales in 2018 and $7,084 in sales in 2017. Changes in foreign exchange rates increased sales by $3,238 year-over-year due to the U.S. Dollar depreciating compared to the Chinese Renminbi and Euro. Gross margin as a percent of sales was 35.1% in 2018 versus 33.2% in 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted gross margin unfavorably by $4,796, or 1.1% of sales. The increase in gross margin was primarily driven by savings related to product line transfers and a favorable impact of foreign exchange rate movements which were partially offset by material cost increases. Selling, general and administrative expenses were $73,569, or 15.6% of sales for the year ended December 31, 2018, versus $71,943 or 17.0% of sales in the comparable period of 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted selling, general and administrative expenses unfavorably by $6,557 or 1.6% of sales. The increase includes higher stock-based compensation and ERP implementation costs as well as incremental costs resulting from the Noliac acquisition in 2017, including amortization of intangibles. Research and development expenses were $25,304 or 5.4% of sales in 2018 compared to $25,146 or 5.9% of sales in 2017. The pension settlement charge recorded in the fourth quarter of 2017 impacted research and development expenses unfavorably by $2,062, or 0.5% of sales. Research and development expenses are focused on expanded applications of existing products, new product development, and enhancements for current products and processes. Restructuring charges were $5,062 for year ended December 31, 2018. The charges were mainly for building and equipment relocation, severance, and travel costs related to the restructuring of certain operations as part of the 2016 Restructuring Plan. Restructuring charges were $4,139 in 2017. The loss on sale of assets in 2017 was driven by a loss on the sale of vacant land at our Hopkinton, Massachusetts facility in September 2017. Operating earnings were $61,038, or 13.0% of sales in 2018, compared to $38,495, or 9.1% of sales in 2017 as a result of the items discussed above. CTS CORPORATION 20 Other income and expense items are summarized in the following table: Interest expense decreased in the year ended December 31, 2018, versus the same period in 2017 primarily due to lower debt balances, a reduction in interest related to interest rate swaps, and a one-time charge related to a liability that was settled in 2017. Interest income increased due to higher interest rates. Other expense in the year ended December 31, 2018, was driven by foreign currency translation losses mainly due to the appreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. Other income in the year ended December 31, 2017 was driven mainly by foreign currency translation gains due to the depreciation of the U.S. Dollar compared to the Chinese Renminbi and the Euro. The effective income tax rate in 2018 was 19.9% compared to 64.1% in the prior year. The tax rate in 2018 was favorably impacted by a discrete one-time rate change benefit related to the Tax Act resulting from the election of tax accounting method changes, partially offset by a one-time withholding tax on repatriation of earnings from one of our foreign subsidiaries that was completed during the year to enable the use of tax credits due to expire in 2018. The tax rate in 2017 was unfavorably impacted by the application of the Tax Act, driven by the remeasurement of the net deferred tax assets from 35% to 21% and the one-time mandatory transition tax on the historical earnings of foreign affiliates, which resulted in a net non-cash charge of $18,001. Net earnings were $46,532 or $1.39 per diluted share for the year ended December 31, 2018, compared to earnings of $14,448 or $0.43 per diluted share in the comparable period of 2017. Liquidity and Capital Resources Cash and cash equivalents were $100,241 at December 31, 2019, and $100,933 at December 31, 2018, of which $98,309 and $96,762, respectively, were held outside the United States. The decrease in cash and cash equivalents of $692 was primarily driven by cash generated from operating activities of $64,405 and net proceeds from an increase in borrowings of long-term debt of $49,700, which were offset by the payment for the QTI acquisition of $73,906, capital expenditures of $21,733, treasury stock purchases of $11,746, dividends paid of $5,238, and taxes paid on behalf of equity award participants of $2,657. Total debt as of December 31, 2019, and December 31, 2018, was $99,700 and $50,000, respectively. Total debt as a percentage of total capitalization, defined as long-term debt as a percentage of total debt and shareholders’ equity, was 19.7% at December 31, 2019, compared to 11.7% at December 31, 2018. Working capital increased by $5,164 from December 31, 2018, to December 31, 2019, driven mainly by the decrease in accrued payroll and benefits due to lower short-term incentive compensation and the decrease in accounts payable, which were partially offset by an increase in operating lease obligations. Cash Flows from Operating Activities Net cash provided by operating activities was $64,405 during the year ended December 31, 2019. Components of net cash provided by operating activities included net earnings of $36,146, depreciation and amortization expense of $24,619, stock-based compensation of $5,015, other net non-cash items totaling $5,160, and a net cash outflow from changes in assets and liabilities of $6,535. CTS CORPORATION 21 Cash Flows from Investing Activities Net cash used in investing activities for the year ended December 31, 2019, was $95,502, driven by the payment for the QTI acquisition of $73,906 and capital expenditures of $21,733. Cash Flows from Financing Activities Net cash provided by financing activities for the year ended December 31, 2019, was $30,059. The net cash inflow was the result of net proceeds from an increase in borrowings of long-term debt of $49,700, which was partially offset by treasury stock purchases of $11,746, dividend payments of $5,238, and taxes paid on behalf of equity award participants of $2,657. Capital Resources Long-term debt was comprised of the following: On February 12, 2019, we entered into an amended and restated five-year Credit Agreement with a group of banks (the "Credit Agreement") to extend the term of the facility. The Credit Agreement provides for a revolving credit facility of $300,000, which may be increased by $150,000 at the request of the Company, subject to the administrative agent's approval. This new unsecured credit facility replaces the prior $300,000 unsecured credit facility, which would have expired August 10, 2020. Borrowings of $50,000 under the prior credit agreement were refinanced into the Credit Agreement. The prior agreement was terminated as of February 12, 2019. The Revolving Credit Facility includes a swing line sublimit of $15,000 and a letter of credit sublimit of $10,000. Borrowings under the Revolving Credit Facility bear interest at the base rate defined in the Credit Agreement. We also pay a quarterly commitment fee on the unused portion of the Revolving Credit Facility. The commitment fee ranges from 0.20% to 0.30% based on the our total leverage ratio. We have entered into interest rate swap agreements to fix interest rates on $50,000 of long-term debt through February 2024. The difference to be paid or received under the terms of the swap agreements is recognized as an adjustment to interest expense when settled. We have historically funded our capital and operating needs primarily through cash flows from operating activities, supported by available credit under our Revolving Credit Facility. We believe that cash flows from operating activities and available borrowings under our Revolving Credit Facility will be adequate to fund our working capital needs, capital expenditures, and debt service requirements for at least the next twelve months. However, we may choose to pursue additional equity and debt financing to provide additional liquidity or to fund acquisitions. Critical Accounting Policies and Estimates Management prepared the consolidated financial statements under accounting principles generally accepted in the United States of America. These principles require the use of estimates, judgments, and assumptions. We believe that the estimates, judgments, and assumptions we used are reasonable, based upon the information available. Our estimates and assumptions affect the reported amounts in our financial statements. The following accounting policies comprise those that we believe are the most critical in understanding and evaluating our reported financial results. CTS CORPORATION 22 Revenue Recognition Product revenue is recognized when the transfer of promised goods to a customer occurs in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods. We follow the five step model to determine when this transfer has occurred: 1) identify the contract(s) with the customer; 2) identify the performance obligations in the contract; 3) determine the transaction price; 4) allocate the transaction price to the performance obligations in the contract; 5) recognize revenue when (or as) the entity satisfies a performance obligation. Product Warranties Provisions for estimated warranty expenses primarily related to our automotive products are made at the time products are sold. These estimates are established using a quoted industry rate. We adjust our warranty reserve for any known or anticipated warranty claims as new information becomes available. We evaluate our warranty obligations at least quarterly and adjust our accruals if it is probable that future costs will be different than our current reserve. Over the last three years, product warranty reserves have ranged from 0.5% to 2.4% of total sales. We believe our reserve level is appropriate considering all facts and circumstances surrounding any outstanding quality claims and our historical experience selling our products to our customers. Accounts Receivable We have standardized credit granting and review policies and procedures for all customer accounts, including: • Credit reviews of all new significant customer accounts, • Ongoing credit evaluations of current customers, • Credit limits and payment terms based on available credit information, • Adjustments to credit limits based upon payment history and the customer's current creditworthiness, • An active collection effort by regional credit functions, reporting directly to the corporate financial officers, and • Limited credit insurance on the majority of our international receivables. We reserve for estimated credit losses based upon historical experience and specific customer collection issues. Over the last three years, accounts receivable reserves have ranged from 0.1% to 0.7% of total accounts receivable. We believe our reserve level is appropriate considering the quality of the portfolio. While credit losses have historically been within expectations of the reserves established, we cannot guarantee that our credit loss experience will continue to be consistent with historical experience. Inventories We value our inventories at the lower of the actual cost to purchase or manufacture using the first-in, first-out ("FIFO") method, or net realizable value. We review inventory quantities on hand and record a provision for excess and obsolete inventory based on forecasts of product demand and production requirements. Over the last three years, our reserves for excess and obsolete inventories have ranged from 10.2% to 18.4% of gross inventory. We believe our reserve level is appropriate considering the quantities and quality of the inventories. Retirement Plans Actuarial assumptions are used in determining pension income and expense and our defined benefit obligations. We utilize actuaries from consulting companies in each applicable country to develop our discount rates, matching high-quality bonds currently available and expected to be available during the period to maturity of the pension benefit in order to provide the necessary future cash flows to pay the accumulated benefits when due. After considering the recommendations of our actuaries, we have assumed a discount rate, expected rate of return on plan assets, and a rate of compensation increase in determining our annual pension income and expense and the projected benefit obligation. During the fourth quarter of each year, we review our actuarial assumptions in light of current economic factors to determine if the assumptions need to be adjusted. Changes in the actuarial assumptions could have a material effect on our results of operations. Impairment of Goodwill Goodwill of a reporting unit is tested for impairment annually, or more frequently if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of a reporting unit below its carrying amount. Examples of such events or circumstances include, but are not limited to, the following: CTS CORPORATION 23 • Significant decline in market capitalization relative to net book value, • Significant adverse change in regulatory factors or in the business climate, • Unanticipated competition, • More-likely-than-not expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of, • Testing for recoverability of a significant asset group within a reporting unit, and • Allocation of a portion of goodwill to a business to be disposed. If we believe that one or more of the above indicators of impairment have occurred, we perform an impairment test. We have the option to perform a qualitative assessment (commonly referred to as "step zero" test) to determine whether further quantitative analysis for impairment of goodwill and indefinite-lived intangible assets is necessary. The qualitative assessment includes a review of macroeconomic conditions, industry and market considerations, internal cost factors, and our own overall financial and share price performance, among other factors. If, after assessing the totality of events or circumstances we determine that it is not more-likely-than-not that the fair value of a reporting unit is less than its carrying amount, we do not need to perform a quantitative analysis. If a quantitative assessment is required, we estimate the fair value of each reporting unit using a combination of discounted cash flow analysis and market-based valuation methodologies. Determining fair value using a quantitative approach requires significant judgment, including judgments about projected revenues, operating expenses, working capital investment, capital expenditures, and cash flows over a multi-year period. The discount rate applied to our forecasts of future cash flows is based on our estimated weighted average cost of capital. In assessing the reasonableness of our determined fair values, we evaluate our results against our market capitalization. Changes in these estimates and assumptions could materially affect the determination of fair value and impact the goodwill impairment assessment. Our latest assessment was performed using a qualitative approach as of October 1, 2019, and we determined that it was likely that the fair values of our reporting units were more than their carrying amounts, and therefore no impairment charges were recorded. We will monitor future results and will perform a test if indicators trigger an impairment review. Impairment of Other Intangible and Long-Lived Assets We evaluate the impairment of identifiable intangibles and other long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered that may trigger an impairment review consist of, but are not limited to, the following: • Significant decline in market capitalization relative to net book value, • Significant underperformance relative to expected historical or projected future operating results, • Significant changes in the manner of use of the acquired assets or the strategy for the overall business, • Significant negative industry or economic trends. If we believe that one or more indicators of impairment have occurred, we perform a recoverability test by comparing the carrying amount of an asset or asset group to the sum of the undiscounted cash flows expected to result from the use and the eventual disposition of the asset or asset group. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value. No indicators of impairment were identified during the year ended December 31, 2019. Environmental and Legal Contingencies U.S. GAAP requires a liability to be recorded for contingencies when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. Significant judgment is required to determine the existence and amounts of our environmental, legal and other contingent liabilities. We regularly consult with attorneys and consultants to determine the relevant facts and circumstances before we record a liability. Changes in laws, regulatory orders, cost estimates, participation of other parties, timing of payments, input of attorneys and consultants, or other circumstances may have a material impact on the recorded liability. CTS CORPORATION 24 Income Taxes Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgments and estimates are required in the determination of consolidated income tax expense. Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets in the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. The assumptions about future taxable income require the use of significant judgment and are consistent with the plans and estimates we are using to manage our underlying businesses. The calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in a multitude of jurisdictions across our global operations. Accounting Standards Codification (ASC) No. 740 states that a tax benefit from an uncertain tax position may be recognized when it is more-likely-than-not that the position will be sustained upon examination, including resolution of any related appeals or litigation processes, on the basis of its technical merits. We record unrecognized tax benefits as liabilities in accordance with ASC 740 and adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available. Our practice is to recognize interest and penalties related to income tax matters as part of income tax expense. Generally, outside of Canada and the United Kingdom, it has been our historical practice to permanently reinvest the earnings of our non-U.S. subsidiaries in those operations. As previously noted, the Tax Act made significant changes to the taxation of undistributed foreign earnings, requiring that all previously untaxed earnings and profits of our controlled foreign corporation be subjected to a one-time mandatory deemed repatriation tax. The transition tax substantially eliminated the basis difference that existed prior to the Tax Act. However, there are limited other taxes that could continue to apply such as foreign withholding and certain state taxes. We completed the evaluation of our indefinite reinvestment assertion as a result of the Tax Act during the fourth quarter of 2018 and decided not to reinvest the current year earnings of our primary operations, except for in the Czech Republic, Denmark, India, Mexico and Taiwan. We intend to continue to indefinitely reinvest the earnings in these non-U.S. subsidiaries. Contractual Obligations Our contractual obligations as of December 31, 2019, were: We have no off-balance sheet arrangements that have a material current effect or are reasonably likely to have a material future effect on our financial condition or changes in our financial condition. Management believes that existing capital resources and funds generated from operations are sufficient to finance anticipated capital requirements. CTS CORPORATION 25

<s>[INST] CTS Corporation ("CTS", "we", "our" or "us") is a leading designer and manufacturer of products that Sense, Connect and Move. Our vision is to be a leading provider of sensing and motion devices as well as connectivity components, enabling an intelligent and seamless world. These devices are categorized by their ability to Sense, Connect or Move. Sense products provide vital inputs to electronic systems. Connect products allow systems to function in synchronization with other systems. Move products ensure required movements are effectively and accurately executed. We are committed to achieving our vision by continuing to invest in the development of products and technologies within these categories. We manufacture sensors, actuators, and electronic components in North America, Europe, and Asia. CTS provides engineered products to OEMs and tier one suppliers in the aerospace and defense, industrial, information technology, medical, telecommunications, and transportation markets. There is an increasing proliferation of sensing and motion applications within various markets we serve. In addition, the increasing connectivity of various devices to the internet results in greater demand for communication bandwidth and data storage, increasing the need for our connectivity products. Our success is dependent on the ability to execute our strategy to support these trends. We are subject to challenges including periodic market softness, competition from other suppliers, changes in technology, and the ability to add new customers, launch new products or penetrate new markets. Results of Operations: Year Ended December 31, 2019, versus Year Ended December 31, 2018 (Amounts in thousands, except percentages and per share amounts): The following table highlights changes in significant components of the Consolidated Statements of Earnings for the years ended December 31, 2019, and December 31, 2018: Sales were $468,999 for the year ended December 31, 2019, a decrease of $1,484, or 0.3% from 2018. Sales to transportation markets decreased $1,119 or 0.4%. Sales to other markets decreased $364 or 0.2%. The QTI acquisition, which was completed in July 2019, added $9,252 in sales for the year (see Note 19). Changes in foreign exchange rates decreased sales by $5,135 yearoveryear due to the U.S. Dollar appreciating compared to the Chinese Renminbi and Euro. Gross margin as a percent of sales was 33.6% in 2019 versus 35.1% in 2018. The decrease in gross margin was driven primarily by lower volume, foundry inefficiency in our ceramics manufacturing operations, labor and commodity cost increases, a onetime purchase accounting stepup in the value of finished goods inventory acquired with our QTI acquisition, and an unfavorable impact from currency movements. These were partially offset by cost improvement projects as well as savings from our manufacturing transition project. Selling, general and administrative ("SG&A") expenses were $70,408, or 15.0% of sales for the year ended December 31, 2019, versus $73,569 or 15.6% of sales in the comparable period of 2018. The 2019 SG&A costs include amortization of intangibles and other operating costs associated with the QTI acquisition as well as higher environmental expenses, which were offset by CTS CORPORATION 18 lower shortterm incentive compensation, the impact of cost reduction actions taken in the fourth quarter, and other cost controls during the year. Research and development expenses were $25,967 or 5.5% of sales in 2019 compared to $25,304 or 5.4% of sales in 2018. Restructuring charges were $7,448 for year ended December 31, 2019. The charges were mainly for building and equipment relocation, severance, and asset impairment charges related to the restructuring of certain operations, as well as a lease termination fee related to a property lease we acquired in the QTI acquisition. Restructuring charges were $5,062 in 2 [/INST] Positive. </s>

TIMKEN CO

2015-03-02

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share data) OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, chain and related products and offers a spectrum of power system rebuild and repair services around the world. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken, Fafnir, Philadelphia Gear, Drives and Interlube. Timken today applies its deep knowledge of metallurgy, tribology and power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both original equipment manufacturers (OEMs) and aftermarket channels. With approximately 16,000 people operating in 28 countries, Timken makes the world more productive and keeps industry in motion. Beginning in the fourth quarter of 2014, the Company began operating under two segments: (1) Mobile Industries and (2) Process Industries. Refer to Note 15 - Segment Information for additional information on the resegmentation of the Company's business segments. The following further describes these business segments: • Mobile Industries offers an extensive portfolio of bearings, seals, lubrication devices and systems, as well as power transmission components, engineered chain, augers and related products and maintenance services, to OEMs of: off-highway equipment for the agricultural, construction and mining markets; on-highway vehicles including passenger cars, light trucks, and medium- and heavy-duty trucks; and rail cars, locomotives, rotor craft and fixed-wing aircraft. Beyond service parts sold to OEMs, aftermarket sales to individual end users, equipment owners, operators and maintenance shops are handled through the Company's extensive network of authorized automotive and heavy-truck distributors, and include hub units, specialty kits and more. Mobile Industries also provides power transmission systems and flight-critical components for civil and military aircraft, which include bearings, helicopter transmission systems, rotor-head assemblies, turbine engine components, gears and housings. • Process Industries supplies industrial bearings and assemblies, power transmission components such as gears and gearboxes, couplings, seals, lubricants, chains and related products and services to OEMs and end users in industries that place heavy demands on operating equipment they make or use. This includes; metals, mining, cement and aggregate production; coal and wind power generation; oil and gas; pulp and paper in applications including printing presses; and cranes, hoists, drawbridges, wind energy turbines, gear drives, drilling equipment, coal conveyors, health and critical motion control equipment, marine equipment and food processing equipment. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors. In addition, the Company’s industrial services group offers end users a broad portfolio of maintenance support and capabilities that include repair and service for bearings and gearboxes as well as electric motor rewind, repair and services. For nearly 100 years, the Company also made and marketed steel within its steel business. However, on June 30, 2014, the Company announced that it had completed the Spinoff into a separate independent publicly traded company, TimkenSteel. The Company's Board of Directors declared a distribution of all outstanding common shares of TimkenSteel through a dividend. At the close of business on June 30, 2014, the Company's shareholders received one common share of TimkenSteel for every two common shares of the Company they held as of the close of business on June 23, 2014. The steel business has been reclassified to discontinued operations for all periods presented. Currently, the Company focuses its strategy on creating value that leads to growth and sustained levels of profitability. The Company works to create value by: • Expanding in new and existing markets by applying the Timken team’s knowledge of metallurgy, friction management and mechanical power transmission to create value for our customers. Using a highly collaborative technical selling model, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by the Company's products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. • Performing with excellence, driving for exceptional results with a passion for superior execution, the Company embraces a continuous improvement culture that is charged with lowering costs, eliminating waste, increasing efficiency, encouraging organizational agility and building greater brand equity. As part of this effort, the Company may also reposition underperforming product lines and segments and divest non-strategic assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2014: • On November 30, 2014, the Company completed the acquisition of the assets of Revolvo Ltd. (Revolvo), a specialty bearing company based in Dudley, United Kingdom (U.K.). Revolvo makes and markets ball and roller bearings for industrial applications in process and heavy industries. Revolvo's split roller bearing housed units are widely used by mining, power generation, food and beverage, pulp and paper, metals, cements, marine and waste-water end users. Revolvo had full-year 2014 sales of approximately $9 million. • On September 8, 2014, the Company announced plans to eliminate its Aerospace segment leadership positions and integrate substantially all aerospace business activities into Mobile Industries under the direction of its Group President. The Company also announced plans to close its aerospace engine overhaul business, located in Mesa, Arizona. The Company subsequently sold the aerospace engine overhaul assets in November 2014. In addition, the Company announced plans to evaluate strategic alternatives for its aerospace MRO parts business, also located in Mesa, and close its aerospace bearing facility located in Wolverhampton, U.K., which is expected to close in early 2016. The Company began reporting the aerospace business results primarily within the Mobile Industries segment starting with the fourth quarter of 2014. • In June 2014, the Company announced that it was committing $60 million to the DeltaX initiative, a multi-year investment to improve the Company's concept-to-commercialization efforts. DeltaX will integrate technology and tools designated to enable the Company to be more agile and competitive. The Company will replace its traditional functional infrastructure with a more product-focused infrastructure, supported by new customer-facing systems. DeltaX is intended to help the Company to execute on its strategy to grow, delivering to the market place much faster and more efficently those products that customers value. As part of the $60 million DeltaX initiative, the XSell project will leverage the SAP infrastructure deployed throughout our global operations. It will provide the global sales team with new customer relationship management capabilities, as well as more consistent, mobility-enabled sales processes and business tools. • On June 13, 2014, the Company's Board of Directors authorized the Company to purchase an additional 10 million of its common shares. The total number of shares that remained authorized for repurchase was 8.9 million shares at December 31, 2014. • On April 28, 2014, the Company completed the acquisition of assets from Schulz Group (Schulz). Based in New Haven, Connecticut, Schulz provides electric motor and generator repairs, motor rewinds, custom controls and panels, systems integration, pump services, machine rebuilds, hydro services and diagnostics for a broad range of commercial and industrial applications. Schulz had full-year 2013 sales of approximately $18 million and employed 125 associates. RESULTS OF OPERATIONS 2014 compared to 2013 Overview: On January 29, 2015, the Company furnished a Current Report on Form 8-K to the Securities and Exchange Commission that included an earnings release issued that same day reporting results for the fourth quarter and full year of 2014, which was furnished as Exhibit 99.1 thereto (the Earning Release). For the twelve months ended December 31, 2014, the Earnings Release reported: (a) income from continuing operations of $147.0 million, or $1.58 per diluted share; (b) income from discontinued operations of $21.7 million, or $0.24 per diluted share; (c) net income of $168.7 million; and (d) net income attributable to The Timken Company of $166.2 million. Between the issuance of the Earnings Release and the filing of this Annual Report on Form 10-K, the Company adjusted an entry in its provision for income taxes for the three and twelve months ended December 31, 2014, reducing the provision for income taxes and increasing net income by $4.6 million, or $0.05 per diluted share. The Company reported net sales for 2014 of approximately $3.1 billion, compared to approximately $3.0 billion in 2013, a 1.3% increase. The increase in sales was primarily due to higher volume in the Process Industries segment, partially offset by decreased volume in the Mobile Industries segment. The lower volume in the Mobile Industries segment was primarily driven by planned program exits that concluded in 2013. In 2014, diluted earnings per share from continuing operations was $1.61, compared to $1.82 in 2013. The Company's net income from continuing operations in 2014, compared to 2013, was lower due to higher impairment and restructuring charges, the impact of planned program exits that concluded at the end of 2013, and pension settlement charges, partially offset by the impact of higher volume, lower manufacturing cost and the gain on the sale of real estate in Sao Paulo, Brazil (Sao Paulo). Income from continuing operations also benefited from a lower effective tax rate. Impairment and restructuring charges primarily related to goodwill impairment for two of the Company's aerospace reporting units within the Mobile Industries segment. Discontinued operations related to Company's former steel business that was spun off on June 30, 2014. Income from discontinued operations was lower in 2014 compared to 2013 as a result of separation costs incurred as a result of the Spinoff. Outlook: The Company expects sales to increase approximately 1% in 2015 compared to 2014, primarily driven by higher demand in the light vehicle, wind energy, marine and industrial aftermarket sectors, offset in large part by the impact of currency-rate changes. The Company's earnings are expected to be lower in 2015 compared to 2014, primarily due to non-cash charges related to the settlement of certain U.S. pension obligations, partially offset by lower impairment and restructuring charges and the impact of higher demand. On January 22, 2015, the Company entered into an agreement pursuant to which the Timken-Latrobe-MPB-Torrington Retirement Plan (the Plan) purchased a group annuity contract from Prudential Insurance Company of America (Prudential) to pay future pension benefits for approximately 5,000 U.S. Timken retirees. The Company has transferred approximately $600 million of the Company's pension obligations and approximately $635 million of the pension assets to Prudential. The Company expects to incur pension settlement charges of approximately $220 million during the first quarter of 2015 in connection with this group annuity purchase. The Company expects to generate cash from continuing operations of approximately $345 million in 2015, an increase of approximately $65 million, or 23%, compared to 2014, as the Company anticipates higher income from continuing operations, excluding non-cash impairment and pension settlement charges. Pension contributions are expected to be approximately $15 million in 2015, compared to $21.1 million in 2014. The Company expects capital expenditures of approximately 4% of sales in 2015, compared to 4.2% of sales in 2014. THE STATEMENTS OF INCOME Sales by Segment: Net sales for 2014 increased $40.8 million, or 1.3%, compared to 2013, primarily due to higher volume of approximately $150 million, driven by increases in the Process Industries' wind energy and industrial aftermarket sectors and the Mobile Industries' rail market sector, as well as the benefit of acquisitions of $25 million. These factors were partially offset by planned program exits in the Mobile Industries segment that concluded in 2013 of approximately $110 million and the impact of foreign currency of approximately $30 million. Gross Profit: Gross profit increased in 2014 compared to 2013, primarily due to lower manufacturing costs of approximately $30 million and the impact of higher sales volume and mix, including the impact of planned program exits, of approximately $10 million. These factors were partially offset by inventory valuation adjustments of approximately $20 million. Selling, General and Administrative Expenses: The decrease in selling, general and administrative expenses of $4.1 million in 2014 compared to 2013 was primarily due to the benefit of cost reduction initiatives of approximately $25 million, partially offset by higher expense related to incentive compensation plans of approximately $15 million and the impact of acquisitions of approximately $5 million. Impairment and Restructuring Charges: Impairment and restructuring charges of $113.4 million in 2014 were primarily due to goodwill and other intangible impairment charges of $96.2 million for two of the Company's aerospace reporting units within the Mobile Industries segment that were recorded in 2014. Impairment and restructuring charges for 2013 were primarily due to severance and related benefit costs of approximately $6 million due to cost-reduction initiatives relating to reductions in headcount in the bearings and power transmission business and the recognition of severance and related benefits of approximately $3 million related to the closure of the manufacturing facility in St. Thomas, Ontario, Canada (St. Thomas). Refer to Note 11 - Impairment and Restructuring Charges in the Notes to the Consolidated Financial Statements for additional discussion. Pension Settlement Charges: Pension settlement charges recorded in 2014 were primarily the result of the settlement of approximately $110 million of the Company's pension obligations related to its defined benefit pension plan in the United States as a result of the lump sum distributions to new retirees and certain deferred vested plan participants in 2014. Pension settlement charges in 2013 primarily related to the settlement of pension obligations for the Company's Canadian defined pension plans as a result of the closure of the Company's manufacturing facility in St. Thomas. Interest Income (Expense): Interest expense for 2014 increased compared to 2013 primarily due to higher average debt and lower capitalized interest. Interest income increased for 2014 compared to 2013 primarily due to interest income recognized on the deferred payments related to the sale of the Company's former manufacturing site in Sao Paulo. Other Income (Expense): During 2014, the Company recognized a gain of $22.6 million, compared to $5.4 million in 2013, related to the sale of its former manufacturing site in Sao Paulo. Refer to Note 7 - Property, Plant and Equipment for additional information on the gain. The Company reported other expense, net in 2014 compared to other income, net in 2013 primarily due to higher charitable donations in 2014. The Company also incurred higher foreign currency exchange losses in 2014 compared to 2013. Income Tax Expense: The effective tax rate on pretax income for 2014 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, the U.S. manufacturing deduction, the U.S. research tax credit and certain discrete tax benefits. These factors were partially offset by U.S. taxation of foreign income, losses at certain foreign subsidiaries where no tax benefit could be recorded, non-deductible intangible asset impairment charges recorded in the Mobile Industries segment and U.S. state and local taxes. The effective tax rate on pretax income for 2013 was unfavorable relative to the U.S. federal statutory rate primarily due to U.S. taxation of foreign income including cash repatriation, losses at certain foreign subsidiaries where no tax benefit could be recorded and U.S. state and local taxes. These factors were partially offset by earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, U.S. foreign tax credits, the U.S. manufacturing deduction and certain discrete U.S. tax benefits. The change in the effective tax rate in 2014 compared to 2013 was primarily due to lower U.S. taxation of foreign income, lower losses at certain foreign subsidiaries where no tax benefit could be recorded and lower U.S. state and local taxes, partially offset by lower U.S. foreign tax credits, lower U.S. manufacturing deduction, non-deductible intangible asset impairment charges recorded in the Mobile Industries segment and the net effect of other discrete items. Discontinued Operations: On June 30, 2014, the Company completed the Spinoff. The operating results, net of tax, included one-time transaction costs in connection with the separation of the two companies of $57.1 million and $13.0 million during 2014 and 2013, respectively. These costs included consulting and professional fees associated with preparing for and executing the Spinoff, as well as lease cancellation fees. For further discussion, please refer to Note 2 - Spinoff Transaction in the Notes to the Consolidated Financial Statements. BUSINESS SEGMENTS The primary measurement used by management to measure the financial performance of each segment is earnings before interest and taxes (EBIT). Refer to Note 15 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. Effective October 1, 2014, the Company began operating under new reportable segments. The Company's two reportable segments are: Mobile Industries and Process Industries. Results of the Company's former Aerospace segment are now primarily included in the Mobile Industries segment. In addition, the Company made adjustments to the allocation of certain selling, general and administrative expenses and certain foreign currency exchange gains or losses for all prior periods presented to better reflect the Company’s operating model and new cost structure following the Spinoff and the elimination of the former Aerospace segment. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions made in 2014 and 2013 and changes in foreign currency exchange rates. The effects of acquisitions and currency exchange rates on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. During the first quarter of 2013, the Company completed the acquisition of Interlube Systems Ltd. (Interlube). Results for Interlube are reported in the Mobile Industries segment. During the second quarter of 2013, the Company completed the acquisition of Hamilton Gear Ltd., d/b/a Standard Machine (Standard Machine), as well as substantially all of the assets of Smith Services, Inc. (Smith Services). During the second quarter of 2014, the Company acquired the assets of Schulz. During the fourth quarter of 2014, the Company acquired the assets of Revolvo. Results for Standard Machine, Smith Services, Schulz and Revolvo are reported in the Process Industries segment. Mobile Industries Segment: The Mobile Industries segment’s net sales, excluding the impact of acquisitions and currency-rate changes, decreased 4.3% in 2014 compared to 2013, primarily due to lower volume of approximately $80 million. The lower volume was primarily driven by a reduction in sales to the light vehicle sector due to planned program exits that concluded in 2013 of approximately $110 million. In addition, heavy truck volume declined approximately $15 million, aerospace aftermarket volume declined approximately $5 million and aerospace original equipment volume declined approximately $5 million. These factors were partially offset by higher volume in the rail market sector of approximately $65 million. EBIT decreased in 2014 compared to 2013, primarily due to the impact of the aerospace business impairment and restructuring charges of approximately $125 million and the impact of lower sales volume and mix, including planned program exits of approximately $35 million. These factors were partially offset by the sale of real estate in Sao Paulo of approximately $25 million. Sales for the Mobile Industries segment are expected to be flat to down approximately 2% in 2015 compared to 2014, reflecting organic growth primarily from the light vehicle market sector, offset by the impact of currency rate changes and a decline in the agriculture market sector. EBIT for the Mobile Industries segment is expected to increase in 2015 compared to 2014 as a result of lower impairment and restructuring charges and lower material costs, offset by the sale of real estate in Sao Paulo. Process Industries Segment: The Process Industries segment’s net sales, excluding the impact of acquisitions and currency-rate changes, increased 10.2% for 2014 compared to 2013, primarily due to an increase in volume of approximately $120 million and favorable pricing of approximately $5 million. The higher volume was primarily due to higher demand in the wind energy market sector of approximately $75 million and higher demand from the industrial aftermarket of approximately $35 million. EBIT in 2014 increased compared to 2013 primarily due to the impact of higher volume of approximately $60 million and lower material and manufacturing costs of approximately $35 million, partially offset by unfavorable sales mix of approximately $15 million and higher selling, general and administrative expenses of approximately $10 million. Sales for the Process Industries segment are expected to increase approximately 2% to 4% in 2015 compared to 2014, driven by organic growth in the industrial aftermarket, targeted original equipment sectors, including wind energy and military marine, and the benefit of acquisitions, partially offset by the impact of currency rate changes. EBIT for the Process Industries segment is expected to increase in 2015 compared to 2014 due to increased volume. Corporate: Corporate expenses increased in 2014 compared to 2013 primarily due to higher expense related to incentive compensation plans and foreign currency exchange losses, which were partially offset by cost reduction initiatives. RESULTS OF OPERATIONS: 2013 compared to 2012 Overview: The Company reported net sales for 2013 of approximately $3.0 billion, compared to approximately $3.4 billion in 2012, a 9.6% decrease. The sales decrease reflected lower volume across most market sectors, and the effect of currency rate changes, partially offset by favorable pricing and the impact of acquisitions. The Company's net income from continuing operations for 2013, compared to 2012, was lower due to the impact of lower volume, unfavorable sales mix and higher manufacturing costs, partially offset by lower selling, general and administrative expenses, favorable pricing and lower restructuring charges. In addition, net income from continuing operations for 2013 was lower due to the U.S. Continued Dumping and Subsidy Offset Act (CDSOA) receipts, net of expense, of $108.0 million ($68.0 million after tax, or approximately $0.69 per diluted share), received in 2012. THE STATEMENTS OF INCOME Sales by Segment: Net sales for 2013 decreased $324.1 million, or 9.6%, compared to 2012, primarily due to lower volume of approximately $315 million across most market sectors. In addition, the decrease in sales reflected planned program exits that concluded at the end of 2013 of approximately $90 million and the effect of currency rate changes of approximately $10 million, partially offset by the impact of prior-year acquisitions of $70 million and favorable pricing of $30 million. Gross Profit: Gross profit decreased in 2013 compared to 2012, primarily due to the impact of lower sales volume of approximately $130 million, higher manufacturing costs of approximately $40 million and the impact of planned program exits that concluded at the end of 2013 of approximately $35 million, partially offset by favorable pricing of approximately $30 million and the impact from prior-year acquisitions of approximately $15 million. Selling, General and Administrative Expenses: The decrease in selling, general and administrative expenses of $7.9 million in 2013 compared to 2012 was primarily due to lower expenses related to incentive compensation plans of approximately $30 million, partially offset by the full year impact of acquisitions of approximately $15 million. Impairment and Restructuring Charges: Impairment and restructuring charges of $8.7 million in 2013 were primarily due to severance and related benefit costs of approximately $6 million due to cost-reduction initiatives relating to reductions in headcount in the bearings and power transmission business. In addition, impairment and restructuring charges for 2013 included to the recognition of severance and related benefits of approximately $3 million related to the closure of the manufacturing facility in St. Thomas. Impairment and restructuring charges of $29.5 million in 2012 were primarily due to the recognition of severance and related benefits, including approximately $10.7 million of pension curtailment charges, as well as impairment charges related to the closure of the manufacturing facility in St. Thomas and the recognition of environmental remediation costs at the former manufacturing facility in Sao Paulo. Refer to Note 11 - Impairment and Restructuring Charges in the Notes to the Consolidated Financial Statements for additional discussion. Interest Income and (Expense): Interest expense for 2013 decreased compared to 2012 primarily due to lower average debt and higher capitalized interest. Interest income decreased for 2013 compared to 2012 primarily due to lower invested cash balances. Other Income (Expense): In 2013, the Company reported expenses in connection with CDSOA of $2.8 million. The Company reported CDSOA receipts, net of expense, of $108.0 million in 2012. Refer to Note 20 - Continued Dumping and Subsidy Offset Act (CDSOA) in the Notes to the Consolidated Financial Statements for additional information In November 2013, the Company finalized the sale of its former manufacturing facility in Sao Paulo, resulting in a $5.4 million gain. The Company is recognizing the gain on the sale of this facility on the installment method. The Company recognized an additional gain of approximately $25 million in 2014 related to this transaction. Income Tax Expense: The effective tax rate on pretax income for 2013 was unfavorable relative to the U.S. federal statutory rate primarily due to U.S. taxation of foreign income including cash repatriation, losses at certain foreign subsidiaries where no tax benefit could be recorded, U.S. non-deductible items and U.S. state and local taxes. These factors were partially offset by discrete U.S. tax benefits, including certain settlements related to tax audits, U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, the U.S. manufacturing deduction and the U.S research tax credit. The effective tax rate for 2012 was slightly favorable relative to the U.S. federal statutory rate primarily due to earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, U.S. Foreign tax credits, the U.S. manufacturing deduction and certain discrete U.S. tax benefits. These factors were partially offset by losses at certain foreign subsidiaries where no tax benefits could be recorded, U.S. state and local taxes and U.S. taxation of foreign income. The change in the effective tax rate in 2013 compared to 2012 was primarily due to U.S. taxation of foreign income, including U.S. taxation on cash repatriation, losses at certain foreign subsidiaries where no tax benefit could be recorded and higher U.S. state and local taxes, partially offset by U.S. foreign tax credits, higher U.S. manufacturing deduction and the net effect of other discrete items. BUSINESS SEGMENTS The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 15 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions and currency exchange rates. The effects of acquisitions and currency exchange rates on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. During the fourth quarter of 2012, the Company completed the acquisition of substantially all of the assets of Wazee Companies, LLC (Wazee). The acquisition of the assets of Wazee, which was completed on December 31, 2012, had no impact on the 2012 operating results. During the first quarter of 2013, the Company completed the acquisition of Interlube. Results for Interlube are reported in the Mobile Industries segment. During the second quarter of 2013, the Company completed the acquisition of Standard Machine, as well as substantially all of the assets of Smith Services. Results for Standard Machine, Smith Services and Wazee are reported in the Process Industries segment. Mobile Industries Segment: The Mobile Industries segment’s net sales, excluding the impact of acquisitions and currency-rate changes, decreased 11.5% in 2013 compared to 2012, primarily due to lower volume of approximately $220 million, partially offset by favorable pricing of $10 million. The lower volume was led by a decrease in off-highway volume of approximately $105 million, and a decrease in heavy truck volume of approximately $30 million, driven by exited business. EBIT decreased in 2013 compared to 2012, primarily due to the impact of lower volume of approximately $80 million and higher manufacturing costs of approximately $35 million, partially offset by lower restructuring charges of approximately $15 million, lower raw material costs of approximately $15 million, lower selling, general and administrative expenses of approximately $10 million, favorable sale mix of approximately $10 million, favorable pricing of $10 million and a gain on the sale of the Company's former manufacturing facility in Sao Paulo of approximately $5 million. Restructuring charges related to the closure of the manufacturing facility in St. Thomas were lower in 2013 compared to 2012. Process Industries Segment: The Process Industries segment’s net sales, excluding the effect of acquisitions and currency-rate changes, decreased 12.5% for 2013 compared to 2012, primarily due to lower volume of approximately $190 million, primarily offset by favorable pricing of $20 million. The lower volume was seen across all market sectors. EBIT decreased in 2013 compared to 2012 due to the impact of lower volume of approximately $80 million, the impact of higher manufacturing costs of approximately $20 million and unfavorable sales mix of approximately $15 million, partially offset by favorable pricing of approximately $20 million, lower selling, general and administrative expenses of approximately $10 million and lower material costs of approximately $10 million. Corporate: Corporate expenses decreased in 2013 compared to 2012, primarily due to lower expense related to incentive compensation plans. THE BALANCE SHEETS The following discussion is a comparison of the Consolidated Balance Sheets at December 31, 2014 and 2013. Current Assets: Cash and cash equivalents decreased primarily due to the Company's purchase of approximately 5.2 million of its common shares for an aggregate of $270.9 million during 2014. Accounts receivable, net increased as a result of higher sales in December 2014 compared to December 2013, partially offset by higher allowance for doubtful accounts of $3.6 million. Other current assets decreased primarily due to the liquidation of a portion of the Company's short-term investments of approximately $10 million. Current assets, discontinued operations at December 31, 2013 related to the Spinoff on June 30, 2014 and primarily included accounts receivable and inventory. Property, Plant and Equipment, Net: The decrease in property, plant and equipment, net in 2014 was primarily due to the reclassification of approximately $45 million of capitalized software from property, plant and equipment to intangible assets in 2014, and the impact of currency-rate changes of approximately $20 million. See "Other Disclosures - Capital Expenditures" for more information. Other Assets: The decrease in goodwill was primarily due to the impairment of two of the Company's aerospace reporting units in 2014. The decrease in non-current pension assets was primarily due to a decrease in the discount rate used to measure the Company's U.S. defined benefit pension plans, as well as the adoption of the new RP-2014 mortality tables. The increase in other intangible assets was primarily due to the reclassification of approximately $45 million of capitalized software from property, plant and equipment to other intangible assets, partially offset by current year amortization expense. Non-current assets, discontinued operations at December 31, 2013 related to the Spinoff and primarily included property, plant and equipment. Current Liabilities: The decrease in short-term debt during 2014 was primarily due to lower borrowings under foreign lines of credit. Salaries, wages and benefits increased primarily due to the increase in accruals for incentive based compensation plans. The decrease in income taxes payable was primarily due to lower current year income tax expense compared to 2013, as well as higher taxes paid. The decrease in other current liabilities was primarily due to the recognition of deferred revenue related to the sale of the Company's former manufacturing site in Sao Paulo, as well as a reduction in accrued restructuring charges. The decrease in the current portion of long-term debt was primarily due to the Company’s $250 million aggregate principal amount of fixed-rate 6.0% senior unsecured notes (2014 Notes) being repaid at maturity in September 2014. Current liabilities, discontinued operations at December 31, 2013 related to the Spinoff and primarily included accounts payable and other accruals. Non-Current Liabilities: The increase in long-term debt during 2014 was primarily due to the issuance of $350 million aggregate principal amount of fixed-rate 3.875% senior unsecured notes that mature on September 1, 2024 (2024 Notes). The increase in accrued pension cost was primarily due to a decrease in the discount rate used to measure the projected benefit obligation, as well as the adoption of the new RP-2014 mortality tables. The increase in accrued postretirement benefits cost was primarily due to a decrease in the discount rate used to measure the accumulated benefit obligation. The decrease in deferred income taxes related primarily to the reduction of pre-paid pension assets, impairment of intangible assets and depreciation of fixed assets. Non-current liabilities, discontinued operations at December 31, 2013 related to the Spinoff and primarily included long-term debt, accrued pension cost and accrued postretirement benefits cost. Shareholders’ Equity: Earnings invested in the business decreased in 2014 primarily due to the Spinoff. The decrease in accumulated other comprehensive loss was primarily due to a $228.4 million after-tax adjustment related to the Spinoff, partially offset by a pension and postretirement liability adjustment of $43.1 million and a foreign currency translation adjustment of $41.3 million. The pension and postretirement liability adjustment was primarily due to a decrease in the discount rate used to measure the pension and postretirement plan obligations, as well as the adoption of the new RP-2014 mortality tables, partially offset by higher than expected returns on plan assets, amortization of net actuarial losses and pension settlement charges. The foreign currency translation adjustment was due to the strengthening of the U.S. dollar against most other currencies. The increase in treasury shares was primarily due to the Company's purchase during 2014 of 5.2 million of its common shares for an aggregate of $270.9 million, partially offset by shares issued pursuant to stock compensation plans. CASH FLOWS Operating activities provided net cash of $307.0 million in 2014, compared to $430.0 million in 2013. The decrease in cash from operating activities was primarily due to lower cash provided by discontinued operations and higher cash used for income taxes and working capital items, partially offset by lower pension contributions and other postretirement benefit payments and an increase in income from continuing operations adjusted for impairment charges. Net cash provided by discontinued operations decreased to $25.5 million in 2014 from $137.2 million in 2013 primarily as a result of separation costs incurred to effect the Spinoff. Income taxes represented a use of cash of $15.3 million in 2014, after representing a source of cash of $67.5 million in 2013, as the Company incurred lower tax expense and paid higher taxes in 2014 compared to 2013. Net income from continuing operations decreased $30.7 million in 2014 compared to 2013, largely due to the impact from $98.9 million of impairment charges that were incurred in 2014. Pension and other postretirement benefit contributions and payments were $49.9 million in 2014, compared to $93.4 million in 2013. The following chart displays the impact of working capital items on cash during 2014 and 2013: Investing activities used cash of $194.7 million in 2014 compared to $376.0 million in 2013. The decrease was primarily due to a $114.9 million decrease in investing activities from discontinued operations, a $42.5 million decrease in cash used for acquisitions, a $6.8 million decrease in cash used for capital expenditures, as well as a $18.9 million increase in cash from the disposal of property, plant and equipment primarily due to the sale of real estate in Sao Paulo and South Africa. Net cash used by financing activities was $202.2 million and $249.3 million in 2014 and 2013, respectively. The decreased cash used by financing activities was primarily due to net cash provided by discontinued operations and a decrease in net borrowings, partially offset by increased purchases of common shares in 2014 and cash transferred to TimkenSteel. The Company purchased 5.2 million of its common shares for an aggregate of $270.9 million in 2014 after purchasing 3.4 million of its common shares for an aggregate of $189.2 million in 2013. In addition, the Company transferred cash of $46.5 million to TimkenSteel in connection with the Spinoff. Net cash from discontinued operations provided $100 million in the first six months of 2014 as TimkenSteel borrowed $100 million under its line of credit prior to the Spinoff. Net borrowings provided cash of $85.7 million in 2014 after using cash of $3.2 million in 2013. LIQUIDITY AND CAPITAL RESOURCES Total debt was $530.1 million and $445.7 million at December 31, 2014 and 2013, respectively. Debt exceeded cash and cash equivalents by $236.0 million and $46.0 million at December 31, 2014 and 2013, respectively. The ratio of net debt to capital was 12.9% and 1.7% at December 31, 2014 and 2013, respectively. Reconciliation of total debt to net debt and the ratio of net debt to capital: Net Debt: Ratio of Net Debt to Capital: The Company presents net debt because it believes net debt is more representative of the Company’s financial position than total debt due to the amount of cash and cash equivalents. At December 31, 2014, approximately $130.9 million, or 46.9%, of the Company's cash and cash equivalents resided in jurisdictions outside the United States. Repatriation of these funds to the United States could be subject to domestic and foreign taxes and some portion may be subject to governmental restrictions. Part of the Company's strategy is to grow in attractive market sectors, many of which are outside the United States. This strategy may include making investments in facilities and equipment and potential new acquisitions. The Company plans to fund these investments, as well as meet working capital requirements, with cash and cash equivalents and unused lines of credit within the geographic location of these investments when possible. On April 30, 2014, the Company amended its three-year Asset Securitization Agreement, reducing its aggregate borrowing availability from $200 million to $100 million. The Asset Securitization Agreement matures on November 30, 2015, is subject to certain borrowing base limitations and is secured by certain domestic trade receivables of the Company. At December 31, 2014, the Company had no outstanding borrowings under the Asset Securitization Agreement; however, certain borrowing base limitations reduced the availability under the Asset Securitization Agreement to $72.7 million. The Company has a $500 million Senior Credit Facility that matures on May 11, 2016. At December 31, 2014, the Company had no outstanding borrowings under the Senior Credit Facility but had letters of credit outstanding totaling $8.6 million, which reduced the availability under the Senior Credit Facility to $491.4 million. Under the Senior Credit Facility, the Company has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. At December 31, 2014, the Company was in full compliance with the covenants under the Senior Credit Facility. The maximum consolidated leverage ratio permitted under the Senior Credit Facility is 3.25 to 1.0. As of December 31, 2014, the Company’s consolidated leverage ratio was 1.03 to 1.0. The minimum consolidated interest coverage ratio permitted under the Senior Credit Facility is 4.0 to 1.0. As of December 31, 2014, the Company’s consolidated interest coverage ratio was 16.32 to 1.0. The interest rate under the Senior Credit Facility is based on the Company’s consolidated leverage ratio. In addition, the Company pays a facility fee based on the consolidated leverage ratio multiplied by the aggregate commitments of all of the lenders under the Senior Credit Facility. Other sources of liquidity include short-term and long-term lines of credit for certain of the Company’s foreign subsidiaries, which provide for borrowings up to $234.0 million in the aggregate. The majority of these lines are uncommitted. At December 31, 2014, the Company had borrowings outstanding of $7.4 million and guarantees of $5.8 million, which reduced the availability under these facilities to $220.8 million. The Company expects that any cash requirements in excess of cash on hand will be met by the committed funds available under its Asset Securitization Agreement and the Senior Credit Facility. Management believes it has sufficient liquidity to meet its obligations through at least the term of the Senior Credit Facility. The Company expects to remain in compliance with its debt covenants. However, the Company may need to limit its borrowings under the Senior Credit Facility or other facilities in order to remain in compliance. As of December 31, 2014, the Company could have borrowed the full amounts available under the Senior Credit Facility and Asset Securitization Agreement, and would have still been in compliance with its debt covenants. In August 2014, the Company issued $350 million of fixed-rate unsecured notes that mature in September 2024. The Company used a portion of the net proceeds from this issuance to repay the $250 million of fixed-rated unsecured notes that matured on September 15, 2014. The Company expects to generate cash from continuing operations of approximately $345 million in 2015, an increase of approximately $65 million, or 23%, compared to 2014, as the Company anticipates higher income from continuing operations, excluding non-cash impairment and pension settlement charges. Pension contributions are expected to be approximately $15 million in 2015, compared to $21.1 million in 2014. The Company expects capital expenditures of approximately 4% of sales in 2015, compared to 4.2% of sales in 2014. CONTRACTUAL OBLIGATIONS The Company’s contractual debt obligations and contractual commitments outstanding as of December 31, 2014 were as follows: Payments due by Period: The interest payments beyond five years primarily relate to medium-term notes that mature over the next 16 years. Purchase commitments are defined as an agreement to purchase goods or services that are enforceable and legally binding on the Company. Included in purchase commitments above are certain obligations related to take or pay contracts, capital commitments, service agreements and utilities. Many of these commitments relate to take or pay contracts, in which the Company guarantees payment to ensure availability of products or services. These purchase commitments do not represent the entire anticipated purchases in the future, but represent only those items for which the Company is contractually obligated. The majority of the products and services purchased by the Company are purchased as needed, with no commitment. Retirement benefits represent pension and health care payments, including lump sum distributions, expected to be paid to retirees or their beneficiaries over the next ten years. These payments are largely covered by pension and postretirement benefit plan assets. The table above does not reflect the group annuity contract purchased on January 22, 2015, which transferred approximately $600 million of pension obligations to Prudential. Refer to Note 21 - Subsequent Events in the Notes to the Consolidated Financial Statements for additional information. During 2014, the Company made cash contributions of approximately $21.1 million to its global defined benefit pension plans. The Company currently expects to make contributions to its global defined benefit pension plans totaling approximately $15 million in 2015. Returns for the Company’s global defined benefit pension plan assets in 2014 were 11.15%, above the expected rate of return of 7.25% due to broad increases in global equity markets. The higher returns positively impacted the funded status of the plans at the end of 2014 and are expected to result in lower pension expense in future years. Refer to Note 13 - Retirement Benefit Plans and Note 14 - Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. The Company's 2012 common share purchase plan authorized the Company to buy, in the open market or in privately negotiated transactions, up to 10 million common shares, which are to be held as treasury shares and used for specified purposes. On June 13, 2014, the Company's Board of Directors authorized an additional 10 million common shares for repurchase under this plan. The authorization expires on December 31, 2015. During 2014, the Company purchased 5.2 million of its common shares for approximately $270.9 million in the aggregate under this plan. As of December 31, 2014, 8.9 million common shares remain authorized for purchase under this plan. As disclosed in Note 10 - Contingencies and Note 16 - Income Taxes in the Notes to the Consolidated Financial Statements, the Company has exposure for certain legal and tax matters. As of December 31, 2014, the Company had approximately $57.5 million of total gross unrecognized tax benefits. The Company anticipates a decrease in its unrecognized tax positions of $40 million to $45 million during the next 12 months. The anticipated decrease is primarily due to settlements with tax authorities. Future tax positions are not known at this time and therefore not included in the above summary of the Company’s fixed contractual obligations. Refer to Note 16 - Income Taxes in the Notes to the Consolidated Financial Statements for additional information. The Company does not have any off-balance sheet arrangements with unconsolidated entities or other persons. RECENTLY ADOPTED ACCOUNTING PRONOUNCMENTS Information required for this Item is incorporated by reference to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The following paragraphs include a discussion of some critical areas that require a higher degree of judgment, estimates and complexity. Revenue recognition: The Company recognizes revenue when title passes to the customer. This occurs at the shipping point except for goods sold by certain foreign entities and certain exported goods, where title passes when the goods reach their destination. Selling prices are fixed based on purchase orders or contractual arrangements. Shipping and handling costs billed to customers are included in net sales and the related costs are included in cost of products sold in the Consolidated Statements of Income. The Company recognizes a portion of its revenues on the percentage of completion method. In 2014 and 2013, the Company recognized approximately $50 million and $55 million, respectively, in net sales under the percentage-of-completion method. Inventory: Inventories are valued at the lower of cost or market, with approximately 48% valued by the last-in, first-out (LIFO) method and the remaining 52% valued by the first-in, first-out (FIFO) method. The majority of the Company’s domestic inventories are valued by the LIFO method, and all of the Company’s international inventories are valued by the FIFO method. An actual valuation of the inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and costs. Because these are subject to many factors beyond management’s control, annual results may differ from interim results as they are subject to the final year-end LIFO inventory valuation. The Company recognized an increase in its LIFO reserve of $0.4 million during 2014 compared to a decrease in its LIFO reserve of $3.8 million during 2013. Goodwill: The Company tests goodwill and indefinite-lived intangible assets for impairment at least annually. The Company performs its annual impairment test as of October first, after the annual forecasting process is completed. Furthermore, goodwill is reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Each interim period, management of the Company assesses whether or not an indicator of impairment is present that would necessitate that a goodwill impairment analysis be performed in an interim period other than during the fourth quarter. The goodwill impairment analysis is a two-step process. Step one compares the carrying amount of the reporting unit to its estimated fair value. To the extent that the carrying value of the reporting unit exceeds its estimated fair value, step two is performed, where the reporting unit’s carrying value of goodwill is compared to the implied fair value of goodwill. To the extent that the carrying value of goodwill exceeds the implied fair value of goodwill, impairment exists and must be recognized. The Company reviews goodwill for impairment at the reporting unit level. The Mobile Industries segment has four reporting units and the Process Industries segment has two reporting units. The reporting units within the Mobile Industries segment are Mobile Industries, Aerospace Bearing, Aerospace Transmissions and Aerospace Aftermarket. The reporting units within the Process Industries segment are Process Industries and Industrial Services. The Company prepares its goodwill impairment analysis by comparing the estimated fair value of each reporting unit, using an income approach (a discounted cash flow model), as well as a market approach, with its carrying value. The income approach and market approach are weighted in arriving at fair value based on the relative merits of the methods used and the quantity and quality of collected data to arrive at the indicated fair value. During the third quarter of 2014, the Company determined there was an indicator for impairment for two of its three Aerospace reporting units, specifically Aerospace Transmissions and Aerospace Aftermarket, within its former Aerospace segment (now included in the Mobile Industries segment) as a result of declining sales forecasts and financial performance within the reporting units. The Company utilized currently updated forecasts for the income approach as part of the goodwill impairment analysis. As a result of the lower earnings and cash flow forecasts, the Company determined that the goodwill associated with the Aerospace Transmissions and the Aerospace Aftermarket reporting units could not support the carrying value of their goodwill. As a result, the Company recorded a pretax impairment charge of $86.3 million during the third quarter of 2014, which was reported in impairment and restructuring charges in the Consolidated Statement of Income. Refer to Note 8 - Goodwill and Other Intangible Assets in the Notes to the Consolidated Financial Statements for additional information. During the fourth quarter of 2014, the Company completed its annual goodwill impairment testing with no further impairment identified. The income approach requires several assumptions including future sales growth, EBIT (earnings before interest and taxes) margins and capital expenditures. The Company’s reporting units each provide their forecast of results for the next three years. These forecasts are the basis for the information used in the discounted cash flow model. The discounted cash flow model also requires the use of a discount rate and a terminal revenue growth rate (the revenue growth rate for the period beyond the three years forecasted by the reporting units), as well as projections of future operating margins (for the period beyond the forecasted three years). During the fourth quarter of 2014, the Company used a discount rate for its reporting units of 10.5% to 13.0% and a terminal revenue growth rate of 3%. The market approach requires several assumptions including sales and EBITDA (earnings before interest, taxes, depreciation and amortization) multiples for comparable companies that operate in the same markets as the Company’s reporting units. During the fourth quarter of 2014, the Company used sales multiples of 0.75 to 1.80 for its reporting units. During the fourth quarter of 2014, the Company used EBITDA multiples of 6.0 to 9.0 for its reporting units. As of December 31, 2014, the Company had $259.5 million of goodwill on its Consolidated Balance Sheet, of which $89.6 million was attributable to the Mobile Industries segment and $169.9 million was attributable to the Process Industries segment. See Note 8 - Goodwill and Other Intangible Assets in the Notes to Consolidated Financial Statements for the carrying amount of goodwill by segment. The fair value of the Aerospace Bearing and Industrial Services reporting units was $225.3 million and $356.7 million, respectively, compared to their carrying value of $205.9 million and $294.8 million, respectively. The fair value of the Mobile Industries and Process Industries reporting units exceeded its carrying value by a significant amount. As a result, the Company did not recognize any goodwill impairment charges during the fourth quarter of 2014. A 30 basis point increase in the discount rate would have resulted in the Aerospace Bearing reporting units failing step one of the goodwill impairment analysis, which would have required the completion of step two of the goodwill impairment analysis to arrive at a potential goodwill impairment loss. A 300 basis point increase in the discount rate would have resulted in the Industrial Services reporting unit failing step one of the goodwill impairment analysis. The projected cash flows could have declined by 4.2% for the Aerospace Bearing reporting unit and the fair value would have still exceeded its carrying value. The projected cash flows could have declined by as much as 29.3% for the Industrial Services reporting unit and the fair value would have still exceeded its carrying value. In 2014, the income approach for the Aerospace Bearing and Industrial Services reporting units was weighted by 70% and the market approach was weighted by 30% in arriving at fair value. The 70/30 weighting was selected to give consideration for the fact that the metrics for the last twelve months for the Aerospace Bearing and Industrial Services reporting units were not reflective of expected performance and the discounted-cash flow model provided a more normalized view of future operating conditions for the Aerospace Bearing and Industrial Services reporting units. Had the Company used a 50/50 weighting, the Company would still have passed step one of the goodwill impairment test for the Aerospace Bearing and Industrial Services reporting units for the year ended December 31, 2014. Restructuring costs: The Company’s policy is to recognize restructuring costs in accordance with Accounting Standards Codification (ASC) Topic 420, “Exit or Disposal Cost Obligations,” and ASC Topic 712, “Compensation and Non-retirement Post-Employment Benefits.” Detailed contemporaneous documentation is maintained and updated to ensure that accruals are properly supported. If management determines that there is a change in estimate, the accruals are adjusted to reflect this change. Income taxes: The Company, which is subject to income taxes in the United States and numerous non-U.S. jurisdictions, accounts for income taxes in accordance with ASC Topic 740, “Income Taxes.” Deferred tax assets and liabilities are recorded for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as net operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. The Company records valuation allowances against deferred tax assets by tax jurisdiction when it is more likely than not that such assets will not be realized. In determining the need for a valuation allowance, the historical and projected financial performance of the entity recording the net deferred tax asset is considered along with any other pertinent information. Deferred tax assets relate primarily to pension and postretirement benefit obligations in the United States, which the Company believes are more likely than not to result in future tax benefits. In the ordinary course of the Company’s business, there are many transactions and calculations where the ultimate income tax determination is uncertain. The Company is regularly under audit by tax authorities. Accruals for uncertain tax positions are provided for in accordance with the requirements of ASC Topic 740. The Company records interest and penalties related to uncertain tax positions as a component of income tax expense. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, valuation allowances against deferred tax assets, and accruals for uncertain tax positions. Benefit Plans: The Company sponsors a number of defined benefit pension plans that cover eligible associates. The Company also sponsors several funded and unfunded postretirement plans that provide health care and life insurance benefits for eligible retirees and their dependents. These plans are accounted for in accordance with ASC Topic 715-30, "Defined Benefit Plans - Pension," and ASC Topic 715-60, "Defined Benefit Plans - Other Postretirement." The measurement of liabilities related to these plans is based on management's assumptions related to future events, including discount rates, rates of return on pension plan assets, rates of compensation increases and health care cost trend rates. Management regularly evaluates these assumptions and adjusts them as required and appropriate. Other plan assumptions are also reviewed on a regular basis to reflect recent experience and the Company's future expectations. Actual experience that differs from these assumptions may affect future liquidity, expense and the overall financial position of the Company. While the Company believes that current assumptions are appropriate, significant differences in actual experience or significant changes in these assumptions may materially affect the Company's pension and other postretirement employee benefit obligations and its future expense and cash flow. The discount rate is used to calculate the present value of expected future pension and postretirement cash flows as of the measurement date. The Company establishes the discount rate by constructing a notional portfolio of high-quality corporate bonds and matching the coupon payments and bond maturities to projected benefit payments under the Company's pension and postretirement welfare plans. The bonds included in the portfolio are generally non-callable. A lower discount rate will result in a higher benefit obligation; conversely, a higher discount rate will result in a lower benefit obligation. The discount rate is also used to calculate the annual interest cost, which is a component of net periodic benefit cost. The expected rate of return on plan assets is determined by analyzing the historical long-term performance of the Company's pension plan assets, as well as the mix of plan assets between equities, fixed income securities and other investments, the expected long-term rate of return expected for those asset classes and long-term inflation rates. Short-term asset performance can differ significantly from the expected rate of return, especially in volatile markets. A lower-than-expected rate of return on pension plan assets will increase pension expense and future contributions. Defined Benefit Pension Plans: The Company recognized net periodic benefit cost of $54.6 million in 2014 for defined benefit pension plans, excluding the steel business spunoff on June 30, 2014, compared to $45.9 million in 2013. The increase in net periodic cost was primarily due to higher pension settlement charges and lower expected rate of return, partially offset by lower amortization of net actuarial losses. The higher pension settlement charges of $33.5 million for 2014, compared to $7.2 million for 2013, was the result of lump sum distributions in 2014 for retirees and a special lump sum offering to certain deferred vested participants. Pension settlement charges in 2013 related to the closure of the Company's manufacturing facility in St. Thomas. The lower expected return from plan assets for 2014, compared to 2013, was due to the impact of a 75 basis point reduction in the expected rate of return on pension plan assets. The lower amortization of net actuarial losses was primarily due to a 100 basis point reduction in the discount rate used to measure the defined benefit pension obligation from 4.0% at December 31, 2012 to 5.02% at December 31, 2013. The discount rate used to remeasure the defined benefit pension obligation as a result of the spinoff of TimkenSteel at April 30, 2014 was 4.68% also resulted in lower amortization compared to 2013. Net actuarial losses are amortized over the average remaining service period of participants in the defined benefit pension plans. In 2015, the Company expects net periodic benefit cost to increase to approximately $273 million for defined benefit pension plans. The expected increase is primarily due to higher pension settlement charges and a lower expected rate of return on plan assets, partially offset by lower amortization of net actuarial losses and lower interest cost. Pension settlement charges are expected to increase approximately $210 million. The Company entered into an agreement on January 22, 2015 pursuant to which the Plan purchased a group annuity contract from Prudential to transfer approximately $600 million of its pension obligations related to one of its U.S. defined benefit pension plans. This is expected to result in a pension settlement charge of approximately $220 million. The lower expected return from plan assets for 2015 is primarily due to a 125 basis point reduction in the expected return on pension assets for 2014. The decrease in the expected rate of return is due to the Company's move to a higher level of debt securities, offset by a lower level of equity securities to maintain its overfunded status on U.S. pension plans. Interest cost is expected to decrease in 2015, compared to 2014, primarily due to a decrease in the Company's discount rate used for expense purposes from 5.02% for the first four months of 2014 and 4.68% for the last eight months of 2014 compared to 4.20% for 2015. Amortization of net actuarial losses is expected to decrease as a result of the impact of pension settlement charges that were recorded in 2014 and will be recorded in 2015, as well as favorable asset returns over the last several years, partially offset by a reduction in the discount rate to measure the pension obligation from 4.68% at April 30, 2014 (the measurement date for the spinoff of the defined benefit pension plans related to TimkenSteel) to 4.20% at December 31, 2014 and the adoption of the new RP-2014 mortality tables. The weighted-average amortization period for the Company's global defined pension plans is approximately 11 years. The Company expects to contribute approximately $15 million to its defined benefit pension plans in 2015 compared to $21.1 million in 2014. The following table below presents a reconciliation of the cumulative net actuarial losses at December 31, 2009 and the cumulative net actuarial losses at December 31, 2014: During the period between December 31, 2009 and December 31, 2014, the Company recognized net actuarial losses totaling $401.5 million for defined benefit pension plans. These actuarial losses primarily occurred in 2011, 2012 and 2014, offset by gains in 2010 and 2013. In 2011, the net actuarial loss of $404.6 million was primarily due to a 75 basis point reduction in the Company's discount rate used to measure its defined benefit pension obligation. The change in the discount rate accounted for $234.1 million of the net actuarial loss. The remaining portion of the net actuarial loss for 2011 was due to lower than expected asset returns of $100.4 million and other changes in actuarial assumptions of $70.1 million. In 2012, the net actuarial loss of $263.1 million was primarily due to a 100 basis point reduction in the Company's discount rate used to measure its defined benefit pension obligation. The change in the discount rate accounted for approximately $370 million of the net actuarial loss. Net actuarial losses as a result of the discount rate were partially offset by higher than expected asset returns of approximately $140 million (a net asset gain of $361.7 million on actual assets in 2012, or positive 13.8% on pension plan assets of $3.1 billion, compared to an expected return of $221.1 million, or 8.25%, in 2012). The remaining portion of the net actuarial loss for 2012 was due to other changes in actuarial assumptions. In 2014, the net actuarial loss of $161.2 million was primarily due to a 82 basis point reduction in the Company's discount rate used to measure its defined benefit pension obligation, as well as the impact of adopting the new RP-2014 mortality tables for pension obligations. The change in the discount rate accounted for approximately $226 million of the net actuarial loss, and the change due to the adoption of the new RP-2014 mortality tables accounted for approximately $59 million. Net actuarial losses as a result of the discount rate and the adoption of the new mortality tables were partially offset by higher than expected asset returns of approximately $117 million (a net asset gain of $292.7 million on actual assets in 2014, or positive 11.2% on pension plan assets of $2.1 billion, compared to an expected return of $175.7 million, or 7.25%, in 2014). The remaining portion of the net actuarial loss for 2014 was due to other changes in actuarial assumptions. In 2013, the net actuarial gain of $376.3 million was primarily due to a 102 basis point increase in the Company's discount rate used to measure its defined benefit pension obligation. The change in the discount rate accounted for approximately $320 million of the net actuarial gain. In addition to the change in the discount rate, higher than expected asset returns of approximately $100 million (a net asset gain of $334.0 million on actual assets in 2013, or positive 10.8% on pension plan assets of $3.3 billion, compared to an expected return of $232.0 million, or 8.0%, in 2013). The remaining portion of the net actuarial gain for 2013 was due to other changes in actuarial assumptions. The impact of these net actuarial losses for defined benefit pension plans, as well as net actuarial losses related to postretirement benefit plans and net prior service costs for defined benefit pension and postretirement plans, has increased total equity by $102.4 million after tax for the period between December 31, 2009 and December 31, 2014. During this same time period, the Company contributed a total of $988.7 million to its global defined benefit pension plans, of which approximately $910.7 million was discretionary. As discussed above, the Company expects to contribute approximately $15 million to its global defined benefit pension plans in 2014. Despite the net actuarial losses recorded for the period between December 31, 2009 and December 31, 2014, only approximately $21 million of contributions was required in 2014. The contributions over the last five years, as well as favorable returns on pension assets, has contributed to the Company's U.S. defined benefit pension plans being overfunded and a lower requirement for the Company to contribute to its defined benefit pension plans. However, the effect of actuarial losses on future earnings and operating cash flow, as well as the impact from the lower interest rate to measure the Company's pension obligations is expected to be favorable in 2015, compared to 2014. For expense purposes in 2014, the Company applied a discount rate of 5.02% for the first four months of 2014, and a discount rate of 4.68% for the last eight months of 2014 to its U.S. defined benefit pension plans as a result of a remeasurement of the U.S. defined benefit pension plans due to the spinoff of the plans related to TimkenSteel. For expense purposes for 2015, the Company has applied a discount rate of 4.20% for the defined benefit pension plans. For expense purposes in 2014, the Company applied an expected rate of return of 7.25% for the Company’s U.S. pension plan assets. For expense purposes in 2015, the Company will apply an expected rate of return on plan assets of 6.00%. The reduction in expected rate of return on plan assets is due to the Company's move to a higher level of debt securities offset by a lower level of equity securities to maintain its overfunded status on U.S. pension plans. The following table presents the sensitivity of the Company's U.S. projected pension benefit obligation (PBO), total equity and 2015 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the PBO by $48.4 million and decrease total equity by $48.4 million. The change in equity in the table above is reflected on a pre-tax basis. Defined benefit pension plans in the United States represent 80% of the Company's benefit obligation and 84% of the fair value of the Company's plan assets at December 31, 2014. The Company uses a combined U.S. federal and state statutory rate of approximately 37% to calculate the after tax impact on equity for U.S. plans. The Company uses the local statutory tax rate in effect to calculate the after tax impact on equity for all remaining non-U.S. plans. For some non-U.S. plans, a valuation allowance has been recorded against the tax benefits recorded in equity and, therefore, no tax benefits are recognized on an after tax basis. Postretirement Benefit Plans: The Company recognized net periodic benefit cost of $7.4 million in 2014 for postretirement benefit plans, excluding the steel business spun off on June 30, 2014, compared to $9.2 million in 2013. The decrease was primarily due to lower amortization of actuarial losses. The lower amortization of net actuarial losses was primarily due to a 79 basis point increase in the discount rate used to measure the defined benefit pension obligation from 3.80% at December 31, 2012 to 4.59% at December 31, 2013. The discount rate used to remeasure the defined benefit pension obligation as a result of the Spinoff at April 30, 2014 was 4.33% also resulted in lower amortization compared to 2013. In 2015, the Company expects net periodic benefit cost to decrease to approximately $5 million for postretirement benefit plans. The expected decrease is primarily due to lower interest cost of approximately $1 million and a higher expected rate of return of approximately $1 million. The lower expected interest cost for 2014 is primarily due to a 64 basis point decrease in the Company's discount rate for expense purposes from 4.59% for 2014 to 3.95% for 2015. The higher expected return from plan assets for 2015 is primarily due to a 125 basis point increase in the expected return on pension assets for 2015. For expense purposes in 2014, the Company applied a discount rate of 4.59% for the first four months of 2014, and a discount rate of 4.33% for the last eight months of 2014 to its postretirement benefit plans. For expense purposes in 2015, the Company will apply a discount rate of 3.95% to its postretirement benefit plans. For expense purposes in 2014, the Company applied an expected rate of return of 5.00% to the Voluntary Employee Beneficiary Association (VEBA) trust assets. For expense purposes in 2015, the Company will apply an expected rate of return of 6.25% to the VEBA trust assets. The following table presents the sensitivity of the Company's accumulated other postretirement benefit obligation (ABO), total equity and 2015 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the ABO by $5.8 million and decrease equity by $5.8 million. The change in total equity in the table above is reflected on a pre-tax basis. For measurement purposes for postretirement benefits, the Company assumed a weighted-average annual rate of increase in per capita cost (health care cost trend rate) for medical and prescription drug benefits of 7.0% for 2015, declining steadily for the next eight years to 5.0%; and 9.0% for HMO benefits for 2015, declining gradually for the next 16 years to 5.0%. The assumed health care cost trend rate may have a significant effect on the amounts reported. A one percentage point increase in the assumed health care cost trend rate would have increased the 2014 total service and interest cost components by $0.4 million and would have increased the postretirement obligation by $7.6 million. A one percentage point decrease would provide corresponding reductions of $0.3 million and $6.7 million, respectively. Other loss reserves: The Company has a number of loss exposures that are incurred in the ordinary course of business such as environmental claims, product liability, product warranty, litigation and accounts receivable reserves. Establishing loss reserves for these matters requires management’s estimate and judgment with regards to risk exposure and ultimate liability or realization. These loss reserves are reviewed periodically and adjustments are made to reflect the most recent facts and circumstances. OTHER DISCLOSURES: Capital Expenditures: The Company made capital expenditures of $126.8 million and $133.6 million in the years ended December 31, 2014 and December 31, 2013, respectively. These capital expenditures support on-going business needs, including facility maintenance, organic growth, continuous improvement and other business initiatives. The Company invested in the construction of a new building connected to its technology center in North Canton, Ohio, to serve as the Company’s world headquarters subsequent to the Spinoff. The new building was completed in 2014, and the total cost was approximately $67 million. Foreign Currency: Assets and liabilities of subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the reporting period. Related translation adjustments are reflected as a separate component of accumulated other comprehensive loss. Foreign currency gains and losses resulting from transactions are included in the Consolidated Statements of Income. The Company recognized a foreign currency exchange loss of $9.9 million, $9.1 million and $6.5 million for the years ended December 31, 2014, 2013 and 2012, respectively. For the year ended December 31, 2014, the Company recorded a negative non-cash foreign currency translation adjustment of $41.3 million that decreased shareholders’ equity, compared to a negative non-cash foreign currency translation adjustment of $11.5 million that decreased shareholders’ equity for the year ended December 31, 2013. The foreign currency translation adjustments for the year ended December 31, 2014 were negatively impacted by the strengthening of the U.S. dollar relative to most other currencies. Trade Law Enforcement: The U.S. government has an antidumping duty order in effect covering tapered roller bearings from China. The Company is a producer of these bearings, as well as ball bearings and other bearing types, in the United States. In 2012, the U.S. government extended this order for an additional five years. Antidumping duty orders covering ball bearings from Japan and the United Kingdom were sunset, as expected, by the U.S. Department of Commerce in March 2014, retroactive to September 2011. Quarterly Dividend: On February 14, 2015, the Company’s Board of Directors declared a quarterly cash dividend of $0.25 per common share. The quarterly dividend will be paid on March 6, 2015 to shareholders of record as of February 23, 2015. This will be the 371st consecutive dividend paid on the common shares of the Company. Forward-Looking Statements Certain statements set forth in this Annual Report on Form 10-K and in the Company’s 2014 Annual Report to Shareholders (including the Company’s forecasts, beliefs and expectations) that are not historical in nature are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. In particular, Management’s Discussion and Analysis on pages 20 through 47 contains numerous forward-looking statements. Forward-looking statements generally will be accompanied by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “outlook,” “intend,” “may,” “possible,” “potential,” “predict,” “project” or other similar words, phrases or expressions. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. The Company cautions readers that actual results may differ materially from those expressed or implied in forward-looking statements made by or on behalf of the Company due to a variety of factors, such as: (a) deterioration in world economic conditions, or in economic conditions in any of the geographic regions in which the Company conducts business, including additional adverse effects from the global economic slowdown, terrorism or hostilities. This includes: political risks associated with the potential instability of governments and legal systems in countries in which the Company or its customers conduct business, and changes in currency valuations; (b) the effects of fluctuations in customer demand on sales, product mix and prices in the industries in which the Company operates. This includes: the ability of the Company to respond to rapid changes in customer demand, the effects of customer bankruptcies or liquidations, the impact of changes in industrial business cycles, and whether conditions of fair trade continue in the U.S. markets; (c) competitive factors, including changes in market penetration, increasing price competition by existing or new foreign and domestic competitors, the introduction of new products by existing and new competitors, and new technology that may impact the way the Company’s products are sold or distributed; (d) changes in operating costs. This includes: the effect of changes in the Company’s manufacturing processes; changes in costs associated with varying levels of operations and manufacturing capacity; availability and cost of raw materials and energy; changes in the expected costs associated with product warranty claims; changes resulting from inventory management and cost reduction initiatives and different levels of customer demands; the effects of unplanned plant shutdowns; and changes in the cost of labor and benefits; (e) the success of the Company’s operating plans, announced programs, initiatives and capital investments; the ability to integrate acquired companies; the ability of acquired companies to achieve satisfactory operating results, including results being accretive to earnings; and the Company’s ability to maintain appropriate relations with unions that represent Company associates in certain locations in order to avoid disruptions of business; (f) unanticipated litigation, claims or assessments. This includes: claims or problems related to intellectual property, product liability or warranty, environmental issues, and taxes; (g) changes in worldwide financial markets, including availability of financing and interest rates, which affect: the Company’s cost of funds and/or ability to raise capital; and customer demand and the ability of customers to obtain financing to purchase the Company’s products or equipment that contain the Company’s products; (h) the impact on the Company's pension obligations due to changes in interest rates, investment performance and other tactics designed to reduce risk; (i) retention of CDSOA distributions; (j) the Company's ability to realize the benefits of the Spinoff and avoid possible indemnification liabilities entered into with TimkenSteel in connection with the Spinoff; (k) the taxable nature of the Spinoff; and (l) those items identified under Item 1A. Risk Factors on pages 7 through 14. Additional risks relating to the Company’s business, the industries in which the Company operates or the Company’s common shares may be described from time to time in the Company’s filings with the Securities and Exchange Commission. All of these risk factors are difficult to predict, are subject to material uncertainties that may affect actual results and may be beyond the Company’s control. Readers are cautioned that it is not possible to predict or identify all of the risks, uncertainties and other factors that may affect future results and that the above list should not be considered to be a complete list. Except as required by the federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

<s>[INST] OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, chain and related products and offers a spectrum of power system rebuild and repair services around the world. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken, Fafnir, Philadelphia Gear, Drives and Interlube. Timken today applies its deep knowledge of metallurgy, tribology and power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both original equipment manufacturers (OEMs) and aftermarket channels. With approximately 16,000 people operating in 28 countries, Timken makes the world more productive and keeps industry in motion. Beginning in the fourth quarter of 2014, the Company began operating under two segments: (1) Mobile Industries and (2) Process Industries. Refer to Note 15 Segment Information for additional information on the resegmentation of the Company's business segments. The following further describes these business segments: Mobile Industries offers an extensive portfolio of bearings, seals, lubrication devices and systems, as well as power transmission components, engineered chain, augers and related products and maintenance services, to OEMs of: offhighway equipment for the agricultural, construction and mining markets; onhighway vehicles including passenger cars, light trucks, and medium and heavyduty trucks; and rail cars, locomotives, rotor craft and fixedwing aircraft. Beyond service parts sold to OEMs, aftermarket sales to individual end users, equipment owners, operators and maintenance shops are handled through the Company's extensive network of authorized automotive and heavytruck distributors, and include hub units, specialty kits and more. Mobile Industries also provides power transmission systems and flightcritical components for civil and military aircraft, which include bearings, helicopter transmission systems, rotorhead assemblies, turbine engine components, gears and housings. Process Industries supplies industrial bearings and assemblies, power transmission components such as gears and gearboxes, couplings, seals, lubricants, chains and related products and services to OEMs and end users in industries that place heavy demands on operating equipment they make or use. This includes; metals, mining, cement and aggregate production; coal and wind power generation; oil and gas; pulp and paper in applications including printing presses; and cranes, hoists, drawbridges, wind energy turbines, gear drives, drilling equipment, coal conveyors, health and critical motion control equipment, marine equipment and food processing equipment. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors. In addition, the Company’s industrial services group offers end users a broad portfolio of maintenance support and capabilities that include repair and service for bearings and gearboxes as well as electric motor rewind, repair and services. For nearly 100 years, the Company also made and marketed steel within its steel business. However, on June 30, 2014, the Company announced that it had completed the Spinoff into a separate independent publicly traded company, TimkenSteel. The Company's Board of Directors declared a distribution of all outstanding common shares of TimkenSteel through a dividend. At the close of business on June 30, 2014, the Company's shareholders received one common share of TimkenSteel for every two common shares of the Company they held as of the close of business on June 23, 2014. The steel business has been reclassified to discontinued operations for all periods presented. Currently, the Company focuses its strategy on creating value that leads to growth and sustained levels of profitability. The Company works to create value by: Expanding in new and existing markets by applying the Timken team’s knowledge of metallurgy, friction management and mechanical power transmission to create value for our customers. Using a highly collaborative technical selling model, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and [/INST] Positive. </s>

TIMKEN CO

2016-02-24

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share data) OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, belts, chain and related products and offers a spectrum of power system rebuild and repair services. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken, Fafnir, Philadelphia Gear, Carlisle, Drives and Interlube. Timken today applies its deep knowledge of metallurgy, friction management and mechanical power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both original equipment manufacturers (OEMs) and aftermarket channels. With more than 14,000 people operating in 28 countries, Timken makes the world more productive and keeps industry in motion. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: • Mobile Industries serves OEM customers that manufacture off-highway equipment for the agricultural, mining and construction markets; on-highway vehicles including passenger cars, light trucks, and medium- and heavy-duty trucks; rail cars and locomotives; and rotorcraft and fixed-wing aircraft. Beyond service parts sold to OEMs, aftermarket sales to individual end users, equipment owners, operators and maintenance shops are handled through the Company's extensive network of authorized automotive and heavy-truck distributors. • Process Industries serves OEM and end-user customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal and wind power generation; oil and gas extraction and refining; pulp and paper and food processing; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors. Timken creates value by understanding customer needs and applying its know-how in attractive market sectors. Timken’s business strengths include its channel mix and end-market diversity, serving a broad range of customers and industries across the globe. The Company collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for our products and services. The Timken Business Model is the specific framework for how the Company evaluates opportunities and differentiates itself in the market. The Company’s Strategy is to apply the Timken Business Model and leverage the Company’s competitive differentiators and strengths to create customer value and drive increased growth and profitability by: Capturing Opportunities and Expanding Reach. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Performing With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Driving Effective Capital Deployment. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes (1) investing in the core business through capital expenditures, research and development and organic growth initiatives like DeltaX; (2) pursuing strategic acquisitions to broaden our portfolio and capabilities, with an focus on bearings, adjacent power transmission products and related services; and (3) returning capital to shareholders through share repurchases and dividends. As part of this framework, the Company may also restructure, reposition or divest underperforming product lines or assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2015: Product and Global Manufacturing Footprint Expansion • On December 4, 2015, the Company launched the 6000 series line of metric deep groove ball bearings and introduced a new line of Drives® Leaf Chain in North America, completing the global rollout of the series as an element of the Company's DeltaX growth initiative. DeltaX is a multi-year initiative designed to accelerate product development and line expansion. • On November 19, 2015, the Company announced plans to build a 161,000-square-foot manufacturing plant in Romania. The new plant will produce ISO and inch-sized Timken® tapered roller bearings up to 12 inches outside diameter for global power transmission, off-highway and distribution customers. The Company broke ground on the new plant in early February 2016, with projected start-up in 2017. • On April 28, 2015, the Company expanded its product offering of high performance spherical roller bearings. The new product line includes medium bore high performance spherical roller bearings featuring either steel or brass cages in a variety of sizes. The new offering of spherical roller bearings includes several new features that are expected to contribute to longer bearing life and to run cooler than other comparable products. • On April 10, 2015, the Company launched the Timken® UC-series ball bearing housed unit product line, an extension of the Company’s housed unit bearing portfolio. • On March 19, 2015, the Company unveiled its new 27,000-square-foot, state-of-the-art gear drive manufacturing facility in Houston, Texas. This facility serves customers in the power generation, oil and gas exploration, refining and pipeline/pumping industries that require reliable, high-speed enclosed gearboxes to keep pumps, compressors and generators operating in harsh conditions. Financing Agreements and Pension Plan Transactions • On November 30, 2015, the Company amended its $100 million Asset Securitization Agreement (Accounts Receivable Facility) to, among other things, extend the maturity to November 30, 2018. • On November 30, 2015, the Company entered into an agreement pursuant to which one of its U.S. defined benefit pension plans purchased a group annuity contract from Prudential Insurance Company of America (Prudential) that requires Prudential to pay and administer future pension benefits for approximately 3,400 U.S. Timken retirees. The purchase was funded by existing pension plan assets and required no cash contribution from the Company to Prudential in this transaction. As a result of the purchase of the group annuity contract, the Company incurred non-cash pension settlement charges of $241.8 million in the fourth quarter of 2015. Coupled with the group annuity contract purchased in January discussed below, the Company transferred a total of approximately $1.1 billion of pension obligations to Prudential in 2015, which reduced the Company's total projected benefit obligation by approximately 50%. • On June 19, 2015, the Company amended and restated its five-year $500 million Senior Credit Facility to, among other things, extend the maturity to June 19, 2020. • On January 23, 2015, the Company entered into an agreement pursuant to which another of its U.S. defined benefit pension plans purchased a group annuity contract from Prudential that requires Prudential to pay and administer future pension benefits for approximately 5,000 U.S. Timken salaried retirees. The purchase was funded by existing pension plan assets and required no cash contribution from the Company to Prudential in this transaction. As a result of the purchase of the group annuity contract as well as lump-sum distributions to new retirees, the Company incurred pension settlement charges of $215.2 million in the first quarter of 2015. Acquisitions and Divestitures • On October 21, 2015, the Company completed the sale of all of the outstanding stock of Timken Alcor Aerospace Technologies, Inc. (Alcor), located in Mesa, Arizona. Alcor was engaged in the design, engineering, sourcing, manufacture and sale of parts and components used in gas turbine engines and helicopter drivetrain applications and filing applications for and obtaining certificates reflecting a Parts Manufacturer Approval (PMA) issued by the United States Federal Aviation Administration (FAA) for such parts and components. For the twelve months ending September 30, 2015, Alcor had sales of $20.6 million. The results of the operations of Alcor prior to the sale were reported in the Mobile Industries segment. The Company recognized a gain on the sale of Alcor of approximately $29 million. • On September 1, 2015, the Company acquired all the membership interests of Carlstar Belt LLC (the Belts business). The Belts business is a leading North American manufacturer of belts used in industrial, commercial and consumer applications. Based in Springfield, Missouri, the Belts business had sales of approximately $140 million for the twelve months ending June 30, 2015. The results of the operations of the Belts business are reported in the Mobile Industries and Process Industries segments based on the customers served. RESULTS OF OPERATIONS 2015 vs. 2014 Overview: The decrease in sales was primarily due to the impact of foreign currency exchange rate changes and lower end market demand, partially offset by the benefit of acquisitions. The Company's net income from continuing operations in 2015 was lower compared to 2014 due to non-cash pension settlement charges recorded in 2015, the impact of lower volume across most end market sectors, unfavorable price/mix and foreign currency exchange rate changes. These factors were partially offset by lower selling, general and administrative expenses, lower material and operating costs and a lower provision for income taxes. The decrease in income from discontinued operations in 2015 compared with 2014 was due to the spinoff of TimkenSteel that was completed on June 30, 2014. Outlook: The Company expects 2016 full-year sales to decline 4% to 5% compared with 2015, driven by lower demand across most market sectors and the estimated impact of foreign currency exchange rate changes, partially offset by the impact of acquisitions. The Company's earnings from continuing operations are expected to be higher in 2016 than 2015, primarily due to the absence of material pension settlement charges in 2016, lower raw material costs, and lower selling, general and administrative expenses, partially offset by the impact of lower volume and price/mix, higher impairment and restructuring charges and the impact of foreign currency exchange rate changes. The Company expects to generate operating cash from continuing operations of approximately $300 million in 2016, a decrease from 2015 of approximately $75 million or 20.0%, as the Company anticipates lower income, excluding non-cash impairment and pension settlement charges. Pension contributions are expected to be approximately $15 million in 2016, compared with $10.8 million in 2015. The Company expects capital expenditures to be approximately 4.5% of sales in 2016, compared with 3.7% of sales in 2015. THE STATEMENTS OF INCOME Sales: Net sales decreased in 2015 compared with 2014 primarily due to the effect of foreign currency exchange rates of $152 million and lower organic sales of $90 million, partially offset by the benefit of acquisitions of $39 million. The decrease in organic sales volume was driven by lower demand across most of the Company's end market sectors, partially offset by growth in the wind, military marine, rail and automotive sectors. Gross Profit: Gross profit decreased in 2015 compared with 2014, primarily due to the impact of lower volume of $40 million, unfavorable price/mix of $37 million and the impact of foreign currency exchange rate changes of $63 million. These factors were partially offset by the impact of inventory valuation adjustments that occurred during 2014 of $20 million, lower raw material and operating costs net of manufacturing underutilization and the impact of acquisitions. Selling, General and Administrative Expenses: The decrease in selling, general and administrative expenses in 2015 compared with 2014 was primarily due to lower incentive compensation expense of $28 million and the impact of foreign currency exchange rate changes of $20 million. The benefits of cost reduction initiatives were largely offset by the impact of acquisitions, higher pension and bad debt expense and costs associated with ongoing growth initiatives. Impairment and Restructuring Charges: Impairment and restructuring charges of $14.7 million in 2015 were primarily due to severance and related benefit costs associated with initiatives to reduce headcount, impairment charges of $3.0 million related to the Company's service center in Niles, Ohio and exit costs of approximately $3.0 million related to the Company's termination of its relationship with one of its third-party sales representatives in Colombia. Impairment and restructuring charges of $113.4 million in 2014 were primarily due to goodwill and other intangible impairment charges of $96.2 million that were recorded in the third quarter of 2014. Pension Settlement Charges: Pension settlement charges in 2015 were primarily due to the purchase of group annuity contracts from Prudential by two of the Company's U.S. defined benefit pension plans. The two group annuity contracts require Prudential to pay and administer future pension benefits for approximately 8,400 U.S. Timken retirees in the aggregate. The Company transferred a total of approximately $1.1 billion of its pension obligations and a total of approximately $1.2 billion of pension assets to Prudential in these transactions. In addition to the purchase of the group annuity contracts, the Company made lump-sum distributions of $37 million to new retirees. The Company also incurred pension settlement and curtailment charges related to one of its Canadian defined benefit pension plans. As a result of the group annuity contracts, lump-sum distributions as well as pension settlement and curtailment charges related to the Canadian pension plan, the Company incurred total pension settlement and curtailment charges of $465.0 million, including professional fees of $2.6 million, in 2015. Pension settlement charges recorded in 2014 were primarily the result of the settlement of approximately $110 million of the Company's pension obligations related to its defined benefit pension plan in the United States as a result of lump sum distributions to new retirees and certain deferred vested plan participants in 2014. Gain on Divestiture: Gain on divestiture in 2015 was primarily related to the gain on the sale of Alcor of $29.0 million in the fourth quarter of 2015, partially offset by a loss on the sale of the Company's repair business in Niles, Ohio of $0.3 million in the second quarter of 2015. Interest Income (Expense): Interest expense for 2015 increased compared with 2014 primarily due to lower capitalized interest and higher average debt, partially offset by lower average interest rates. Interest income decreased for 2015 compared with 2014 primarily due to lower interest income recognized on the deferred payments related to the sale of real estate in Sao Paulo, Brazil (Sao Paulo). The last of the deferred payments was received during the fourth quarter of 2015. Other (Expense) Income: During 2014, the Company recognized a gain of $22.6 million related to the sale of real estate in Sao Paulo. During the fourth quarter of 2015, the Company wrote-off $9.7 million that remained in construction in process (CIP) after the related assets were placed into service. The majority of these assets were placed into service between 2008 and 2012. This item was identified during an examination of aged balances in the CIP account. Management of the Company concluded that the correction of this error in the fourth quarter of 2015 and the presence of this error in prior periods was immaterial to all periods presented. Income Tax Expense: The effective tax rate for 2015 was 64.1%, which reflects a tax benefit on pretax loss. The tax benefit rate of 64.1% was greater than the U.S. statutory rate of 35% primarily due to the tax benefits of reversals of certain valuation allowances in foreign jurisdictions, U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, reversals of reserves for uncertain tax positions, state and local taxes, the U.S. manufacturing deduction, the U.S. research tax credit and other U.S. tax benefits. These factors were offset by U.S. taxation of foreign earnings, recording of deferred tax liabilities related to foreign branch operations, and losses at certain foreign subsidiaries where no tax benefit could be recorded. The effective tax rate on pretax income for 2014 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, adjustments to tax accruals for undistributed foreign earnings, the U.S. manufacturing deduction, the U.S. research tax credit and other U.S. tax benefits. These factors were partially offset by U.S. taxation of foreign income, losses at certain foreign subsidiaries where no tax benefit could be recorded, non-deductible intangible asset impairment charges recorded in the Mobile Industries segment and accruals for uncertain tax positions. The following is the reconciliation between the provision/(benefit) for income taxes and the amount computed by applying income tax rate of 35% to income before taxes: Discontinued Operations: On June 30, 2014, the Company completed the spinoff of TimkenSteel. The operating results, net of tax, included one-time transaction costs of $57.1 million during 2014. These costs included consulting and professional fees associated with preparing for and executing the spinoff of TimkenSteel. BUSINESS SEGMENTS The Company's reportable segments are business units that target different industry sectors. While the segments often operate using a shared infrastructure, each reportable segment is managed to address specific customer needs in these diverse market segments. The primary measurement used by management to measure the financial performance of each segment is earnings before interest and taxes (EBIT). Refer to Note 16 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions and divestitures completed in 2015 and 2014 and foreign currency exchange rate changes. The effects of acquisitions, divestitures and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions and divestitures completed in 2015 and 2014: • During the fourth quarter of 2015, the Company sold all of the outstanding stock of Alcor. Results for Alcor were reported in the Mobile Industries segment. • During the third quarter of 2015, the Company acquired the Belts business. Results for the Belts business are reported in the Mobile Industries and Process Industries segments based on the customers served. • During the fourth quarter of 2014, the Company acquired substantially all of the assets of Revolvo Ltd. (Revolvo). Results for Revolvo are reported in the Process Industries segment. • During the fourth quarter of 2014, the Company sold its aerospace engine overhaul business. Results for the aerospace engine overhaul business were reported in the Mobile Industries segment. • During the second quarter of 2014, the Company acquired substantially all of the assets of Schulz Group (Schulz). Results for Schulz are reported in the Process Industries segment. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions, divestitures and foreign currency exchange rate changes, decreased $47.6 million or 2.8% in 2015 compared with 2014. The decrease in net sales was primarily due to lower volume in the off-highway (primarily agriculture) and aerospace end market sectors, partially offset by organic growth in the rail and automotive sectors. EBIT increased in 2015 compared with 2014 primarily due to the impact of goodwill impairment and inventory valuation adjustments of $118 million recorded in 2014, a gain on the sale of Alcor of $29 million recorded in 2015, the benefit of lower raw material and operating costs net of manufacturing underutilization, lower selling, general and administrative expenses and the impact of acquisitions. These factors were partially offset by a gain on the sale of real estate in Brazil of $23 million recorded in 2014, lower volume of $20 million and unfavorable price/mix of $14 million and the negative impact of foreign currency exchange rate changes of $18 million. Full-year sales for the Mobile Industries segment are expected to be down approximately 5% in 2016 compared with 2015. This reflects lower expected volume in the rail, off-highway and aerospace end market sectors and the estimated impact of foreign currency exchange rate changes, partially offset by organic growth in the automotive end market sector and the benefit of acquisitions. EBIT for the Mobile Industries segment is expected to decrease in 2016 compared with 2015 as a result of the gain from the sale of Alcor in 2015, the impact of lower volume and the impact of foreign currency exchange rate changes, partially offset by lower raw material and operating costs, selling, general and administrative expenses and the benefit of acquisitions. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, decreased $43.5 million or 3.1% in 2015 compared with 2014 primarily due to lower volume in the industrial distribution, services and heavy industries end market sectors, partially offset by organic growth in the wind energy and military marine sectors. EBIT was lower in 2015 compared with 2014 primarily due to the impact of lower volume of $21 million, unfavorable price/mix of $24 million, the impact of unfavorable foreign currency exchange rate changes of $25 million and higher impairment and restructuring charges. These factors were partially offset by lower selling, general and administrative expenses, the impact of lower material and operating costs net of manufacturing underutilization and the impact of acquisitions. EBIT also included a charge of $8.2 million in the fourth quarter of 2015 related to the write-off of certain CIP balances. Refer to Note 8 - Property, Plant and Equipment for additional information. Full-year sales for the Process Industries segment are expected to be down approximately 4% in 2016 compared with 2015. This reflects lower expected volume in the industrial distribution, services and heavy industries end market sectors and the negative impact of foreign currency exchange rate changes, partially offset by the benefit of acquisitions. EBIT for the Process Industries segment is expected to increase in 2016 compared with 2015 primarily due to lower selling, general and administrative expenses, raw material and operating costs, partially offset by foreign currency exchange rate changes and the impact of lower volume and price/mix. Unallocated Corporate: Corporate expenses decreased in 2015 compared with 2014 primarily due to lower incentive compensation expenses and the impact of cost reduction initiatives. RESULTS OF OPERATIONS: 2014 vs. 2013 Overview: The increase in sales in 2014 compared with 2013 was primarily due to higher volume across most end market sectors, partially offset by planned program exits that concluded in 2013. The Company's net income from continuing operations in 2014, compared with 2013, was lower due to higher impairment and restructuring charges, the impact of planned program exits that concluded at the end of 2013 and pension settlement charges, partially offset by the impact of higher volume, lower manufacturing cost and the gain on the sale of real estate in Sao Paulo. Income from continuing operations also benefited from a lower effective tax rate. Impairment and restructuring charges primarily related to goodwill impairment. Income from discontinued operations was lower in 2014 compared with 2013 due to the spinoff of TimkenSteel on June 30, 2014. THE STATEMENTS OF INCOME Sales: Net sales increased in 2014 compared with 2013, primarily due to higher volume of $150 million, as well as the benefit of acquisitions of $25 million. These factors were partially offset by planned program exits which concluded in 2013, of approximately $110 million and the impact of foreign currency rate changes of $30 million. Gross Profit: Gross profit increased in 2014 compared with 2013, primarily due to the impact of higher volume of $64 million and lower manufacturing and material costs of $33 million. These factors were partially offset by planned program exits which concluded in 2013 of $35 million, the impact of inventory valuation adjustments of $19 million and the impact of lower price/mix of $15 million. Selling, General and Administrative Expenses: The decrease in selling, general and administrative expenses in 2014 compared with 2013 was primarily due to the benefit of cost-reduction initiatives of $24 million, partially offset by higher expense related to incentive compensation plans of $13 million and the impact of acquisitions of $6 million. Impairment and Restructuring Charges: Impairment and restructuring charges of $113.4 million in 2014 were primarily due to goodwill and other intangible impairment charges of $96.2 million for two of the Company's aerospace reporting units within the Mobile Industries segment that were recorded in 2014. Impairment and restructuring charges for 2013 were primarily due to severance and related benefit costs of $6 million due to cost-reduction initiatives relating to reductions in headcount in the bearings and power transmission business and the recognition of severance and related benefits of $3 million related to the closure of the manufacturing facility in St. Thomas, Ontario, Canada (St. Thomas). Pension Settlement Charges: Pension settlement charges recorded in 2014 were primarily due to the settlement of approximately $110 million of the Company's pension obligations related to its defined benefit pension plan in the United States as a result of the lump sum distributions to new retirees and certain deferred vested plan participants in 2014. Pension settlement charges in 2013 primarily related to the settlement of pension obligations for the Company's Canadian defined pension plans as a result of the closure of the Company's manufacturing facility in St. Thomas. Interest Income and (Expense): Interest expense for 2014 increased compared with 2013 primarily due to higher average debt and lower capitalized interest. Interest income increased for 2014 compared with 2013 primarily due to interest income recognized on the deferred payments related to the sale of the Company's former manufacturing site in Sao Paulo. Other Income (Expense): During 2014, the Company recognized a gain of $22.6 million, compared with $5.4 million in 2013, related to the sale of its former manufacturing site in Sao Paulo. The Company reported other expense, net in 2014 compared with other income, net in 2013 primarily due to higher charitable donations in 2014. The Company also incurred higher foreign currency exchange rate changes in 2014 compared with 2013. Income Tax Expense: The effective tax rate on pretax income for 2014 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, the U.S. manufacturing deduction, the U.S. research tax credit and certain discrete tax benefits. These factors were partially offset by U.S. taxation of foreign income, losses at certain foreign subsidiaries where no tax benefit could be recorded, non-deductible intangible asset impairment charges recorded in the Mobile Industries segment and U.S. state and local taxes. The effective tax rate on pretax income for 2013 was unfavorable relative to the U.S. federal statutory rate primarily due to U.S. taxation of foreign income including cash repatriation, losses at certain foreign subsidiaries where no tax benefit could be recorded and U.S. state and local taxes. These factors were partially offset by earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, U.S. foreign tax credits, the U.S. manufacturing deduction and certain discrete U.S. tax benefits. The change in the effective tax rate in 2014 compared with 2013 was primarily due to lower U.S. taxation of foreign income, lower losses at certain foreign subsidiaries where no tax benefit could be recorded and lower U.S. state and local taxes, partially offset by lower U.S. foreign tax credits, lower U.S. manufacturing deduction, non-deductible intangible asset impairment charges recorded in the Mobile Industries segment and the net effect of other discrete items. Discontinued Operations: On June 30, 2014, the Company completed the Spinoff. The operating results, net of tax, included one-time transaction costs in connection with the separation of the two companies of $57.1 million and $13.0 million during 2014 and 2013, respectively. These costs included consulting and professional fees associated with preparing for and executing the Spinoff, as well as lease cancellation fees. BUSINESS SEGMENTS The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 16 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions made in 2014 and 2013 and changes in foreign currency exchange rate changes. The effects of acquisitions and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions and divestitures completed in 2014 and 2013: • During the fourth quarter of 2014, the Company acquired substantially all of the assets of Revolvo. Results for Revolvo are reported in the Process Industries segment. • During the second quarter of 2014, the Company acquired substantially all of the assets of Schulz. Results for Schulz are reported in the Process Industries segment. • During the second quarter of 2013, the Company completed the acquisition of Hamilton Gear Ltd., d/b/a Standard Machine (Standard Machine), as well as substantially all of the assets of Smith Services, Inc. (Smith Services). Results for Standard Machine and Smith Services are reported in the Process Industries segment. • During the first quarter of 2013, the Company completed the acquisition of Interlube Systems Ltd. (Interlube). Results for Interlube are reported in the Mobile Industries segment. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, decreased in 2014 compared with 2013, primarily due to lower volume of $80 million. The lower volume was primarily driven by a reduction in sales to the light vehicle sector due to planned program exits that concluded in 2013 of approximately $110 million and lower heavy truck and aerospace demand, partially offset by organic growth in the rail end market sector. EBIT decreased in 2014 compared with 2013, primarily due to the impact of the aerospace business impairment and restructuring charges of $125 million and the impact of lower sales volume and price/mix, including planned program exits of $37 million. These factors were partially offset by the sale of real estate in Sao Paulo of $23 million. Process Industries Segment: The Process Industries segment’s net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased for 2014 compared with 2013, primarily due to an increase in volume of $121 million and favorable pricing of $5 million. The higher volume was primarily due to higher demand in the wind energy and industrial distribution end market sectors. EBIT in 2014 increased compared with 2013 primarily due to the impact of higher volume of $59 million and lower material and manufacturing costs of $39 million, partially offset by unfavorable price/mix of $10 million and higher selling, general and administrative expenses of $8 million. Unallocated Corporate: Corporate expenses increased in 2014 compared with 2013 primarily due to higher expense related to incentive compensation plans and foreign currency exchange rate changes, which were partially offset by cost-reduction initiatives. THE BALANCE SHEETS The following discussion is a comparison of the Consolidated Balance Sheets at December 31, 2015 and 2014. On February 3, 2016, the Company furnished a Current Report on Form 8-K to the Securities and Exchange Commission that included an earnings release issued that same day reporting results for the fourth quarter and full year of 2015, which was furnished as Exhibit 99.1 thereto (the Earning Release). The Earnings Release reported: (a) accounts receivable of $447.0 million; (b) other assets of $128.9 million; (c) accrued expenses of $247.8 million; and (d) total shareholders' equity of $1,337.2 million as of December 31, 2015. The consolidated balance sheet in this Annual Report on Form 10-K reports (a) accounts receivable of $454.6 million; (b) other assets of $116.2 million; (c) accrued expenses of $255.4 million; and (d) total shareholders' equity of $1,324.5 million as of December 31, 2015. The changes reflect adjustments to (1) present offsetting items separately in the accounts receivable and accrued expenses accounts and (2) correct an entry between deferred tax assets and other comprehensive income, a component of shareholders' equity. Current Assets: The reduction in cash and cash equivalents was primarily due to share repurchases and the acquisition of the Belts business. Refer to the Consolidated Statements of Cash Flows for further discussion of the change in cash and cash equivalents. Restricted cash decreased due to the closure of a pledged account for workers compensation. Accounts receivable, net, decreased as a result of foreign currency exchange rate changes and lower sales in December 2015 compared with December 2014, partially offset by the impact of current year acquisitions. Inventories, net, decreased as a result of foreign currency exchange rate changes and lower production volume, partially offset by the impact of current-year acquisitions. The change in deferred income taxes was the result of the reclassification to non-current deferred tax assets as a result of the adoption of Accounting Standards Update 2015-17, Balance Sheet Classification of Deferred Taxes (ASU 2015-17), as of the year ended December 31, 2015. Property, Plant and Equipment, Net: The change in property, plant and equipment, net, in 2015 was primarily due to current-year acquisitions, partially offset by the impact of foreign currency exchange rate changes. Property, plant and equipment, net included a write-off of $9.7 million in 2015 due to the correction of an error. Refer to Note 8 - Property, Plant and Equipment for additional information. Other Assets: The increase in goodwill was primarily due to the acquisition of the Belts business in the third quarter of 2015. The decrease in non-current pension assets was primarily due to the remeasurement of the Company's U.S. defined benefit pension plans as a result of the purchase of two group annuity contracts from Prudential, including the related premium, that requires Prudential to pay and administer future pension benefits for approximately 8,400 U.S. Timken retirees in the aggregate, partially offset by an increase in the discount rate to measure the underlying pension obligation. The increase in other intangible assets was primarily due to the acquisition of the Belts business in the third quarter of 2015, partially offset by current-year amortization expense. The increase in deferred income taxes was primarily due to the adoption of ASU 2015-17, as well as the impact of current year book-tax temporary differences including pension expense, partially offset by bonus depreciation and other items. Current Liabilities: The increase in short-term debt was primarily due to net borrowings of $49 million under the Accounts Receivable Facility and additional borrowings under foreign lines of credit of $6 million. The increase in current portion of long-term debt was primarily due to the reclassification of $15 million of the fixed rate medium-term notes maturing in the third quarter of 2016. The increase in accounts payable was due primarily to higher days outstanding driven by the Company's initiative to extend payment terms with its suppliers. The decrease in accrued salaries, wages and benefits was the result of the impact of fewer associates on the payroll at the end of 2015 as a result of cost reduction initiatives, partially offset by lower accruals for 2015 performance-based compensation compared with 2014. The decrease in income taxes payable was primarily due to the reclassification of uncertain tax positions to a non-current income taxes payable and income tax payments, partially offset by the current tax provision for 2015. Non-Current Liabilities: The increase in long-term debt was due to borrowings of $265.7 million under the Senior Credit Facility, partially offset by payments of $190.6 million and the effect of the reclassification of $15 million of the fixed rate medium-term notes maturing in the third quarter of 2016 to current liabilities. The decrease in accrued pension cost during 2015 was primarily due to pension contributions of $10.6 million and a decrease of $8.0 million as a result of an increase in the discount rate used to measure the pension obligation. The increase in other non-current liabilities during 2015 was primarily due to a reclassification of $31.0 million from current income taxes payable to non-current income taxes payable, partially offset by a $5.3 million decrease in long-term incentive compensation accruals. Shareholders’ Equity: Earnings invested in the business in 2015 decreased by the net loss attributable to the Company of $70.8 million and dividends declared of $87.0 million. The decrease in accumulated other comprehensive loss was primarily due to a pension and post-retirement liability adjustment of $265.9 million after tax, partially offset by a $71.5 million decrease in foreign currency translation. The pension and post-retirement liability adjustment was primarily due to pension settlement charges (including the premiums paid), net of the increase in the discount rate to measure the underlying pension obligation. The foreign currency translation adjustments were due to the strengthening of the U.S. dollar relative to most foreign currencies, including Brazilian Real, Canadian Dollar, Chinese Renminbi, Romanian Leu and British Pound. See "Other Matters - Foreign Currency" for further discussion regarding the impact of foreign currency translation. The increase in treasury shares was primarily due to the Company's purchase of 8.6 million of its common shares for $309.7 million in 2015, partially offset by net shares issued for stock compensation plans during 2015. CASH FLOWS Operating activities from continuing operations provided net cash of $374.8 million in 2015, after providing net cash of $281.5 million in 2014. The increase was primarily due to the net favorable change in working capital items of $89.7 million from 2014 to 2015. The following chart displays the impact of working capital items on cash during 2015 and 2014, respectively: Net cash from continuing operations used by investing activities of $265.2 million in 2015 increased from the same period in 2014 primarily due to a $191.6 million increase in cash used for acquisitions, partially offset by a $38.8 million increase in cash provided from divestitures. Net cash from continuing operations used by financing activities was $241.6 million in 2015, compared with $302.2 million in 2014. The decrease in cash used by financing activities was primarily due to an increase in net borrowings, a decrease in restricted cash, partially offset by higher total cost of purchases of the Company's common shares during 2015 compared with 2014 and lower net proceeds from the exercise of options. In addition, there was a transfer of cash to TimkenSteel as part of the Spinoff in 2014. The following chart displays the factors impacting cash from financing activities during 2015 and 2014, respectively: LIQUIDITY AND CAPITAL RESOURCES Total debt was $657.7 million and $530.1 million at December 31, 2015 and 2014, respectively. Debt exceeded cash and cash equivalents by $527.9 million and $236.0 million at December 31, 2015 and 2014, respectively. The ratio of net debt to capital was 28.2% and 12.9% at December 31, 2015 and 2014, respectively. Reconciliation of total debt to net debt and the ratio of net debt to capital: Net Debt: Ratio of Net Debt to Capital: The Company presents net debt because it believes net debt is more representative of the Company's financial position than total debt due to the amount of cash and cash equivalents held by the Company. At December 31, 2015, approximately $123 million, or over 90%, of the Company's cash and cash equivalents resided in jurisdictions outside the United States. It is the Company's practice to use available cash in the United States to pay down short term debt drawn on its Senior Credit Facility or Accounts Receivable Facility, in order to minimize total interest expense. As a result, the majority of the Company's cash on hand was outside the United States. Repatriation of these funds to the United States could be subject to domestic and foreign taxes and some portion may be subject to governmental restrictions. Part of the Company's strategy is to grow in attractive market sectors, many of which are outside the United States. This strategy may include making investments in facilities and equipment and potential new acquisitions. The Company plans to fund these investments, as well as meet working capital requirements, with cash and cash equivalents and unused lines of credit within the geographic location of these investments when possible. The Company has a $100 million Accounts Receivable Facility that matures on November 30, 2018. The Accounts Receivable Facility is subject to certain borrowing base limitations and is secured by certain domestic accounts receivable of the Company. As of December 31, 2015, the Company had $49.0 million in outstanding borrowings, at an interest rate of 1.05%. There was $5.6 million of additional borrowing capacity available under the Accounts Receivable Facility at December 31, 2015. The Company has a $500.0 million Senior Credit Facility that matures on June 19, 2020. At December 31, 2015, the Company had $75.2 million of outstanding borrowings under the Senior Credit Facility and had zero letters of credit outstanding, which reduced the availability under the Senior Credit Facility to $424.8 million. Under the Senior Credit Facility, the Company has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. At December 31, 2015, the Company was in full compliance with the covenants under the Senior Credit Facility. The maximum consolidated leverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0 (3.75 to 1.0 for a limited period up to four quarters following an acquisition with a purchase price of $200 million or greater). As of December 31, 2015, the Company’s consolidated leverage ratio was 1.44 to 1.0. The minimum consolidated interest coverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0. As of December 31, 2015, the Company’s consolidated interest coverage ratio was 14.86 to 1.0. The interest rate under the Senior Credit Facility is based on the Company’s debt rating. In addition, the Company pays a facility fee based on the consolidated leverage ratio multiplied by the aggregate commitments of all of the lenders under the Senior Credit Facility. The Senior Credit Facility has an interest rate of 1.45% as of December 31, 2015. Other sources of liquidity include short-term and long-term lines of credit for certain of the Company’s foreign subsidiaries, which provide for borrowings up to $217.9 million in the aggregate. The majority of these lines are uncommitted. At December 31, 2015, the Company had borrowings outstanding of $13.0 million and guarantees of $4.4 million, which reduced the availability under these facilities to $200.5 million. The Company expects that any cash requirements in excess of cash on hand will be met by the committed funds available under its Accounts Receivable Facility and the Senior Credit Facility. Management believes it has sufficient liquidity to meet its obligations through at least the term of the Senior Credit Facility. The Company expects to remain in compliance with its debt covenants. However, the Company may need to limit its borrowings under the Senior Credit Facility or other facilities in order to remain in compliance. As of December 31, 2015, the Company could have borrowed the full amounts available under the Senior Credit Facility and Accounts Receivable Facility, and would have still been in compliance with its debt covenants. In August 2014, the Company issued $350 million of fixed-rate unsecured notes that mature in September 2024 (the 2024 Notes). The Company used a portion of the net proceeds from this issuance to repay the $250 million of fixed-rated unsecured notes that matured on September 15, 2014. The Company expects to generate cash from continuing operations of approximately $300 million in 2016, a decrease of approximately $75 million, or 20%, compared with 2015, as the Company anticipates lower income, excluding non-cash impairment and pension settlement charges. Pension contributions are expected to be approximately $15.0 million in 2016, compared with $10.8 million in 2015. The Company expects capital expenditures of approximately 4.5% of sales in 2016, compared with 3.7% of sales in 2015. CONTRACTUAL OBLIGATIONS The Company’s contractual debt obligations and contractual commitments outstanding as of December 31, 2015 were as follows: Payments due by period: The interest payments beyond five years primarily relate to medium-term notes. Refer to Note 10 - Financing Arrangements for additional information. Purchase commitments are defined as an agreement to purchase goods or services that are enforceable and legally binding on the Company. Included in purchase commitments above are certain obligations related to take or pay contracts, capital commitments, service agreements and utilities. Many of these commitments relate to take or pay contracts, in which the Company guarantees payment to ensure availability of products or services. These purchase commitments do not represent the entire anticipated purchases in the future, but represent only those items that the Company is contractually obligated to purchase. The majority of the products and services purchased by the Company are purchased as needed, with no commitment. In order to maintain minimum funding requirements, the Company is required to make contributions to the trusts established for its defined benefit pension plans and other postretirement benefit plans. The table above shows the expected future minimum cash contributions to the trusts for the funded plans as well as estimated future benefit payments to participants for the unfunded plans. Those minimum funding requirements and estimated benefit payments can vary significantly. The amounts in the table above are based on actuarial estimates using current assumptions for, among other things, discount rates, expected return on assets and health care cost trend rates. See Note 14 - Retirement Benefit Plans and Note 15 - Postretirement Benefit Plans to our consolidated financial statements for additional information on retirement benefit plans and other postretirement benefit plans. During 2015, the Company made cash contributions of approximately $10.8 million to its global defined benefit pension plans. The Company currently expects to make contributions to its global defined benefit pension plans totaling approximately $15 million in 2016. Returns for the Company’s global defined benefit pension plan assets in 2015 were 0.61%, below the expected rate of return of 6.0% predominantly due to decreases in the long duration fixed-income markets. The lower returns negatively impacted the funded status of the plans at the end of 2015. However, due to the Company's pension de-risking activities, as well as a 49 basis points increase in discount rates used to measure the Company's defined benefit pension obligations, the lower returns were largely offset and the Company expects lower pension expense, excluding pension settlement charges in future years. Refer to Note 14 - Retirement Benefit Plans and Note 15 - Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. As disclosed in Note 11 - Contingencies and Note 17 - Income Taxes in the Notes to the Consolidated Financial Statements, the Company has exposure for certain legal and tax matters. As of December 31, 2015, the Company had approximately $51.3 million of total gross unrecognized tax benefits. The Company anticipates a decrease in its unrecognized tax positions of $35 million to $40 million during the next 12 months. The anticipated decrease is primarily due to settlements with tax authorities. Future tax positions are not known at this time and therefore not included in the above summary of the Company’s fixed contractual obligations. Refer to Note 17 - Income Taxes in the Notes to the Consolidated Financial Statements for additional information. The Company does not have any off-balance sheet arrangements with unconsolidated entities or other persons. RECENTLY ADOPTED ACCOUNTING PRONOUNCMENTS Information required for this Item is incorporated by reference to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The following paragraphs include a discussion of some critical areas that require a higher degree of judgment, estimates and complexity. Revenue recognition: The Company generally recognizes revenue when title passes to the customer. This occurs at the shipping point except for goods sold by certain foreign entities and certain exported goods, where title passes when the goods reach their destination. Selling prices are fixed based on purchase orders or contractual arrangements. Shipping and handling costs billed to customers are included in net sales and the related costs are included in cost of products sold in the Consolidated Statements of Income. The Company recognizes a portion of its revenues on the percentage of completion method measured on the cost-to-cost basis. In 2015, 2014 and 2013, the Company recognized approximately $66 million, $50 million and $55 million, respectively, in net sales under the percentage-of-completion method. Inventory: Inventories are valued at the lower of cost or market, with approximately 53% valued by the first-in, first-out (FIFO) method and the remaining 47% valued by the last-in, first-out (LIFO) method. The majority of the Company’s domestic inventories are valued by the LIFO method, and all of the Company’s international inventories are valued by the FIFO method. An actual valuation of the inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and costs. Because these are subject to many factors beyond management’s control, annual results may differ from interim results as they are subject to the final year-end LIFO inventory valuation. The Company recognized a decrease in its LIFO reserve of $11.6 million during 2015 compared with an increase in its LIFO reserve of $0.4 million during 2014. Goodwill: The Company tests goodwill and indefinite-lived intangible assets for impairment at least annually. The Company performs its annual impairment test as of October first, after the annual forecasting process is completed. Furthermore, goodwill is reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Each interim period, management of the Company assesses whether or not an indicator of impairment is present that would necessitate that a goodwill impairment analysis be performed in an interim period other than during the fourth quarter. The goodwill impairment analysis is a two-step process. Step one compares the carrying amount of the reporting unit to its estimated fair value. To the extent that the carrying value of the reporting unit exceeds its estimated fair value, step two is performed, where the reporting unit’s carrying value of goodwill is compared with the implied fair value of goodwill. To the extent that the carrying value of goodwill exceeds the implied fair value of goodwill, impairment exists and must be recognized. The Company reviews goodwill for impairment at the reporting unit level. The Mobile Industries segment has three reporting units and the Process Industries segment has two reporting units. The reporting units within the Mobile Industries segment are Mobile Industries, Aerospace Transmissions and Aerospace Aftermarket. The reporting units within the Process Industries segment are Process Industries and Industrial Services. The Company prepares its goodwill impairment analysis by comparing the estimated fair value of each reporting unit, using an income approach (a discounted cash flow model), as well as a market approach, with its carrying value. The income approach and market approach are weighted in arriving at fair value based on the relative merits of the methods used and the quantity and quality of collected data to arrive at the indicated fair value. The income approach requires several assumptions including future sales growth, EBIT (earnings before interest and taxes) margins and capital expenditures. The Company’s reporting units each provide their forecast of results for the next three years. These forecasts are the basis for the information used in the discounted cash flow model. The discounted cash flow model also requires the use of a discount rate and a terminal revenue growth rate (the revenue growth rate for the period beyond the three years forecasted by the reporting units), as well as projections of future operating margins (for the period beyond the forecasted three years). During the fourth quarter of 2015, the Company used a discount rate for its reporting units of 9.0% to 12.5% and a terminal revenue growth rate of 1% to 3%. The market approach requires several assumptions including sales and EBITDA (earnings before interest, taxes, depreciation and amortization) multiples for comparable companies that operate in the same markets as the Company’s reporting units. During the fourth quarter of 2015, the Company used sales multiples of 0.60 to 2.55 for its reporting units. During the fourth quarter of 2015, the Company used EBITDA multiples of 6.0 to 9.5 for its reporting units. As of December 31, 2015, the Company had $327.3 million of goodwill on its Consolidated Balance Sheet, of which $97.0 million was attributable to the Mobile Industries segment and $230.3 million was attributable to the Process Industries segment. See Note 9 - Goodwill and Other Intangible Assets in the Notes to Consolidated Financial Statements for the carrying amount of goodwill by segment. The fair value of the Aerospace Transmission reporting unit was $96.0 million, compared with their carrying value of $88.3 million. The fair value of the other reporting units exceeded its carrying value by a significant amount. As a result, the Company did not recognize any goodwill impairment charges during the fourth quarter of 2015. A 30 basis point increase in the discount rate would have resulted in the Aerospace Transmission reporting unit failing step one of the goodwill impairment analysis, which would have required the completion of step two of the goodwill impairment analysis to arrive at a potential goodwill impairment loss. A 3.9% decline in projected cash flows would have caused the Aerospace Transmission reporting unit to fail and the fair value would have still exceeded its carrying value. Restructuring costs: The Company’s policy is to recognize restructuring costs in accordance with Accounting Standards Codification (ASC) Topic 420, “Exit or Disposal Cost Obligations,” and ASC Topic 712, “Compensation and Non-retirement Post-Employment Benefits.” Detailed contemporaneous documentation is maintained and updated to ensure that accruals are properly supported. If management determines that there is a change in estimate, the accruals are adjusted to reflect this change. Income taxes: The Company, which is subject to income taxes in the United States and numerous non-U.S. jurisdictions, accounts for income taxes in accordance with ASC Topic 740, “Income Taxes.” Deferred tax assets and liabilities are recorded for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as net operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. The Company records valuation allowances against deferred tax assets by tax jurisdiction when it is more likely than not that such assets will not be realized. In determining the need for a valuation allowance, the historical and projected financial performance of the entity recording the net deferred tax asset is considered along with any other pertinent information. Deferred tax assets relate primarily to pension and post-retirement benefit obligations in the United States, which the Company believes are more likely than not to result in future tax benefits. In 2015, the company recorded $34.7M of tax benefit related to the reversal of valuation allowances. See Note 17 - Income Taxes in the Notes to Consolidated Financial Statements for further discussion on the valuation allowance reversals. In the ordinary course of the Company’s business, there are many transactions and calculations where the ultimate income tax determination is uncertain. The Company is regularly under audit by tax authorities. Accruals for uncertain tax positions are provided for in accordance with the requirements of ASC Topic 740. The Company records interest and penalties related to uncertain tax positions as a component of income tax expense. In 2015, the company recorded $5.9M of net tax benefits related to uncertain tax positions. The company recorded tax benefits of $18.6M related to settlements with tax authorities and reduction in prior year reserves and $12.7M of tax expense related to current and prior year tax positions and interest expense. See Note 17 - Income Taxes in the Notes to Consolidated Financial Statements for further discussion on the uncertain tax positions reserve reversals. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, valuation allowances against deferred tax assets, and accruals for uncertain tax positions. Benefit Plans: The Company sponsors a number of defined benefit pension plans that cover eligible associates. The Company also sponsors several funded and unfunded post-retirement plans that provide health care and life insurance benefits for eligible retirees and their dependents. These plans are accounted for in accordance with ASC Topic 715-30, "Defined Benefit Plans - Pension," and ASC Topic 715-60, "Defined Benefit Plans - Other Postretirement." The measurement of liabilities related to these plans is based on management's assumptions related to future events, including discount rates, rates of return on pension plan assets, rates of compensation increases and health care cost trend rates. Management regularly evaluates these assumptions and adjusts them as required and appropriate. Other plan assumptions are also reviewed on a regular basis to reflect recent experience and the Company's future expectations. Actual experience that differs from these assumptions may affect future liquidity, expense and the overall financial position of the Company. While the Company believes that current assumptions are appropriate, significant differences in actual experience or significant changes in these assumptions may materially affect the Company's pension and other post-retirement employee benefit obligations and its future expense and cash flow. The discount rate is used to calculate the present value of expected future pension and post-retirement cash flows as of the measurement date. The Company establishes the discount rate by constructing a notional portfolio of high-quality corporate bonds and matching the coupon payments and bond maturities to projected benefit payments under the Company's pension and post-retirement welfare plans. The bonds included in the portfolio are generally non-callable. A lower discount rate will result in a higher benefit obligation; conversely, a higher discount rate will result in a lower benefit obligation. The discount rate is also used to calculate the annual interest cost, which is a component of net periodic benefit cost. The expected rate of return on plan assets is determined by analyzing the historical long-term performance of the Company's pension plan assets, as well as the mix of plan assets between equities, fixed income securities and other investments, the expected long-term rate of return expected for those asset classes and long-term inflation rates. Short-term asset performance can differ significantly from the expected rate of return, especially in volatile markets. A lower-than-expected rate of return on pension plan assets will increase pension expense and future contributions. Defined Benefit Pension Plans: The Company recognized net periodic benefit cost of $497.8 million in 2015 for defined benefit pension plans compared with $54.6 million in 2014. The increase in net periodic cost was primarily due to higher pension settlement charges and lower expected return on plan assets, partially offset by lower interest costs and lower amortization of net actuarial losses. The increase in pension settlement charges was primarily due to the Company entering into two agreements pursuant to which two of the Company's U.S. defined benefit pension plans purchased group annuity contracts from Prudential. The two group annuity contracts require Prudential to pay and administer future pension benefits for approximately 8,400 U.S. Timken retirees in the aggregate. The Company transferred a total of approximately $1.1 billion of its pension obligations and a total of approximately $1.2 billion of pension assets to Prudential in these transactions. In addition to the purchase of the group annuity contracts, the Company made lump-sum distributions of $37.3 million to new retirees in the United States. The Company also entered into an agreement pursuant to which one of the Company's Canadian defined benefit pension plans purchased a group annuity contract from Canada Life Assurance Company of Canada (Canada Life). The group annuity contract requires Canada Life to pay and administer future pension benefits for approximately 40 Canadian retirees. As a result of the group annuity contracts and lump-sum distributions, as well as pension settlement and curtailment charges related to the Company's Canadian pension plans, the Company incurred total pension settlement and curtailment charges of $465.0 million, including professional fees of $2.6 million, in 2015. In 2014, the Company incurred pension settlement charges of $33.5 million as a result of lump sum distributions in 2014 for retirees and a special lump sum offering to certain deferred vested participants. The lower expected return from plan assets for 2015, compared with 2014, was primarily due to the impact of a 125 basis point reduction in the expected rate of return on pension plan assets, as well as the impact of lower pension plan assets as a result of the purchase of the group annuity contracts. The decrease in the expected rate of return was due to the Company's move to a higher level of fixed income debt securities and a lower level of equity securities to maintain its overfunded status on U.S. pension plans. The lower interest costs were primarily due to lower defined benefit pension obligations as a result of the purchase of the group annuity contracts in 2015, and the lower amortization of net actuarial losses was due primarily to the recognition of pension settlement charges, which reduced the amount of net actuarial losses to be amortized. Net actuarial losses are generally amortized over the average remaining service period of participants in the defined benefit pension plans. Refer to Note 1 - Significant Accounting Policies for additional information on the amortization of actuarial gains and losses. In 2016, the Company expects net periodic benefit cost to decrease to approximately $52 million for defined benefit pension plans. The expected decrease is primarily due to lower pension settlement charges, lower interest costs and lower amortization of net actuarial losses, partially offset by lower expected return on plan assets. Pension settlement charges are expected to decrease approximately $440 million as the Company expects to incur pension settlement charges of approximately $25 million in 2016, compared with $465.0 million in 2015. Interest costs are expected to decrease in 2016, compared with 2015, primarily due to a decrease in the Company's defined benefit pension obligations as a result of the purchase of the group annuity contracts in 2015. Amortization of actuarial losses is expected to decrease as a result of the impact of the pension settlement charges that were recorded in 2015. The expected return on plan assets is expected to decrease as a result of lower pension assets due to the purchase of the group annuity contracts in 2015 and a lower expected rate of return. The Company expects to contribute approximately $15 million to its defined benefit pension plans in 2016 compared with $10.8 million in 2015. The following table below presents a reconciliation of the cumulative net actuarial losses at December 31, 2012 and the cumulative net actuarial losses at December 31, 2015: Net actuarial losses at December 31, 2012 $ 1,489.4 Plus/minus actuarial (gains) and losses recognized: Net actuarial gains recognized in 2013 $ (376.3 ) Net actuarial losses recognized in 2014 161.2 Net actuarial losses recognized in 2015 89.5 (125.6 ) Minus amortization of net actuarial losses: Amortization of net actuarial losses in 2013 $ (116.8 ) Amortization of net actuarial losses in 2014 (60.9 ) Amortization of net actuarial losses in 2015 (36.3 ) (214.0 ) Settlement charges recognized in 2013 (7.2 ) Settlement charges recognized in 2014 (33.5 ) Settlement charges recognized in 2015 (461.2 ) Curtailment loss recognized in 2015 (0.6 ) Spinoff of TimkenSteel (347.4 ) Foreign currency impact (19.2 ) Net actuarial losses at December 31, 2015 $ 280.7 During the period between December 31, 2012 and December 31, 2015, net actuarial losses decreased by $1.2 billion. This decrease included $501.9 million of pension settlement charges, representing an acceleration of previously recognized net actuarial gains and losses, the spinoff of TimkenSteel of $347.4 million, the amortization of actuarial losses of $214.0 million and net actuarial gains totaling $125.6 million recognized for defined benefit pension plans. The net actuarial gains primarily occurred in 2013, offset by losses in 2014 and 2015. In 2013, the net actuarial gain of $376.3 million was primarily due to a 102 basis point increase in the Company's discount rate used to measure its defined benefit pension obligations. The change in the discount rate accounted for approximately $320 million of the net actuarial gain. In addition to the change in the discount rate, higher than expected asset returns of approximately $100 million (a net asset gain of $334.0 million on actual assets in 2013, or positive 10.8% on pension plan assets of $3.3 billion, compared with an expected return of $232.0 million, or 8.0%, in 2013). The remaining portion of the net actuarial gain for 2013 was due to other changes in actuarial assumptions. In 2014, the net actuarial loss of $161.2 million was primarily due to an 82 basis point reduction in the Company's discount rate used to measure its defined benefit pension obligations, as well as the impact of adopting the new RP-2014 mortality tables for pension obligations. The change in the discount rate accounted for approximately $226 million of the net actuarial loss, and the change due to the adoption of the new RP-2014 mortality tables accounted for approximately $59 million. Net actuarial losses as a result of the discount rate and the adoption of the new mortality tables were partially offset by higher than expected asset returns of approximately $117 million (a net asset gain of $292.7 million on actual assets in 2014, or positive 11.2% on pension plan assets of $2.1 billion, compared with an expected return of $175.7 million, or 7.25%, in 2014). The remaining portion of the net actuarial loss for 2014 was due to other changes in actuarial assumptions. In 2015, the net actuarial loss of $89.5 million was primarily due to the amount of the premium of $116.1 million paid to Prudential (the difference between the pension assets transferred to Prudential and the pension obligations transferred to Prudential) in connection with the purchase of the group annuity contracts in 2015, as well as lower than expected asset returns of $51.8 million (a net asset gain of $27.5 million on actual assets in 2015, or a positive 1.3% on pension assets of $858.3 million, compared with an expected return of $79.3 million, or 6.0%, in 2015). These items were partially offset by a 50 basis point increase in the Company's discount rate used to measure its defined benefit pension obligations. The change in the discount rate accounted for $56.1 million. The remaining portion of the net actuarial loss for 2015 was due to other changes in actuarial assumptions. During the period between December 31, 2012 and December 31, 2015, the Company contributed a total of $152.6 million to its global defined benefit pension plans, of which approximately $105.0 million was discretionary. As discussed above, the Company expects to contribute approximately $15 million to its global defined benefit pension plans in 2016. Despite the net actuarial losses recorded for the period between December 31, 2012 and December 31, 2015, only approximately $11 million of contributions were required in 2015. The contributions over the last three years, as well as favorable returns on pension assets, have contributed to the Company's U.S. defined benefit pension plans being overfunded and a lower requirement for the Company to contribute to its defined benefit pension plans. The effect of actuarial losses on future earnings and operating cash flow, as well as a higher discount rate to measure the Company's pension obligations, is expected to be favorable in 2016, compared with 2015. For expense purposes in 2015, the Company applied a discount rate of 4.20% for one month and a discount rate of 3.98% for eleven months for one of its U.S. defined benefit pension plans due to the remeasurement of the defined benefit pension plan as a result of the purchase of a group annuity contract in January 2015. For expense purposes in 2015, the Company applied a discount rate of 4.20% for eleven months and a discount rate of 4.64% for one month for another of its U.S. defined benefit pension plans as a result of a remeasurement of the defined benefit pension plan as a result of the purchase of a group annuity contract in November 2015. For expense purposes in 2016, the Company will apply a discount rate of 4.69% to its U.S. defined benefit pension plans. For expense purposes in 2015, the Company applied an expected rate of return of 6.00% for the Company’s U.S. pension plan assets. For expense purposes in 2016, the Company will apply an expected rate of return on plan assets of 5.75%. The reduction in expected rate of return on plan assets is due to the Company's move to a greater investment in fixed-income debt securities and a reduction in equity securities in an effort to de-risk the pension assets and maintain its overfunded status on U.S. pension plans. The following table presents the sensitivity of the Company's U.S. projected pension benefit obligation (PBO), total equity and 2016 expense to the indicated increase/decrease in key assumptions: + / - Change at December 31, 2015 Change PBO Equity 2016 Expense Assumption: Discount rate +/- 0.25% $ 21.1 $ 21.1 $ 1.9 Actual return on plan assets +/- 0.25% N/A 1.3 - Expected return on assets +/- 0.25% N/A N/A 1.2 In the table above, a 25 basis point decrease in the discount rate will increase the PBO by $21.1 million and decrease total equity by $21.1 million. The change in equity in the table above is reflected on a pre-tax basis. Defined benefit pension plans in the United States represent 64% of the Company's benefit obligation and 65% of the fair value of the Company's plan assets at December 31, 2015. The Company uses a combined U.S. federal and state statutory rate of approximately 37% to calculate the after tax impact on equity for U.S. plans. The Company uses the local statutory tax rate in effect to calculate the after tax impact on equity for all remaining non-U.S. plans. For some non-U.S. plans, a valuation allowance has been recorded against the tax benefits recorded in equity and, therefore, no tax benefits are recognized on an after tax basis. Postretirement Benefit Plans: The Company recognized net periodic benefit cost of $5.1 million in 2015 for postretirement benefit plans, compared with $7.4 million in 2014. The decrease was primarily due to lower interest costs, partially offset by a higher expected return on plan assets. The lower interest costs were primarily due to a 64 basis point decrease in the Company's discount rate for expense purposes from 4.59% for 2014 to 3.95% for 2015. The higher expected return on plan assets for 2015 was primarily due to a 125 basis point increase in the expected return on VEBA assets. In 2016, the Company expects net periodic benefit cost to increase slightly to $5.3 million for post-retirement benefit plans. The expected increase is primarily due to a lower expected return on plan assets of $0.5 million, partially offset by lower interest costs of $0.4 million. The lower expected return on plan assets was primarily due to a 25 basis point decrease in the expected rate of return for 2016. The expected decrease in interest costs was primarily due to lower accumulated benefit obligation. For expense purposes in 2015, the Company applied a discount rate of 3.95% for 2015 to its post-retirement benefit plans. For expense purposes in 2016, the Company will apply a discount rate of 4.39% to its post-retirement benefit plans. For expense purposes in 2015, the Company applied an expected rate of return of 6.25% to the Voluntary Employee Beneficiary Association (VEBA) trust assets. For expense purposes in 2016, the Company will apply an expected rate of return of 6.00% to the VEBA trust assets. The following table presents the sensitivity of the Company's accumulated other post-retirement benefit obligation (ABO), total equity and 2016 expense to the indicated increase/decrease in key assumptions: + / - Change at December 31, 2015 Change ABO Equity 2016 Expense Assumption: Discount rate +/- 0.25% $ 4.6 $ 4.6 $ 0.4 Actual return on plan assets +/- 0.25% N/A 0.3 - Expected return on assets +/- 0.25% N/A N/A 0.3 In the table above, a 25 basis point decrease in the discount rate will increase the ABO by $4.6 million and decrease equity by $4.6 million. The change in total equity in the table above is reflected on a pre-tax basis. For measurement purposes for post-retirement benefits, the Company assumed a weighted-average annual rate of increase in per capita cost (health care cost trend rate) for medical and prescription drug benefits of 6.75% for 2016, declining steadily for the next seven years to 5.0%; and 8.75% for HMO benefits for 2016, declining gradually for the next 15 years to 5.0%. The assumed health care cost trend rate may have a significant effect on the amounts reported. A one percentage point increase in the assumed health care cost trend rate would have increased the 2015 total service and interest cost components by $0.3 million and would have increased the post-retirement obligation by $6.4 million. A one percentage point decrease would provide corresponding reductions of $0.3 million and $5.7 million, respectively. Other loss reserves: The Company has a number of loss exposures that are incurred in the ordinary course of business such as environmental claims, product liability, product warranty, litigation and accounts receivable reserves. Establishing loss reserves for these matters requires management’s judgment with regards to estimating risk exposure and ultimate liability or realization. These loss reserves are reviewed periodically and adjustments are made to reflect the most recent facts and circumstances. OTHER DISCLOSURES: Foreign Currency: Assets and liabilities of subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the reporting period. Related translation adjustments are reflected as a separate component of accumulated other comprehensive loss. Foreign currency gains and losses resulting from transactions are included in the Consolidated Statements of Income. The Company recognized a foreign currency exchange loss resulting from transactions of $0.3 million, $9.9 million and $9.1 million for the years ended December 31, 2015, 2014 and 2013, respectively. For the year ended December 31, 2015, the Company recorded a negative non-cash foreign currency translation adjustment of $71.5 million that decreased shareholders’ equity, compared with a negative non-cash foreign currency translation adjustment of $41.3 million that decreased shareholders’ equity for the year ended December 31, 2014. The foreign currency translation adjustments for the year ended December 31, 2015 were negatively impacted by the strengthening of the U.S. dollar relative to most other currencies. Trade Law Enforcement: The U.S. government has an antidumping duty order in effect covering tapered roller bearings from China. The Company is a producer of these bearings, as well as ball bearings and other bearing types, in the United States. In 2012, the U.S. government extended this order for an additional five years. Antidumping duty orders covering ball bearings from Japan and the United Kingdom were sunset, as expected, by the U.S. Department of Commerce in March 2014, retroactive to September 2011. U.S. Continued Dumping and Subsidy Offset Act (CDSOA): CDSOA provides for distribution of monies collected by U.S. Customs and Border Protection (U.S. Customs) from antidumping cases to qualifying domestic producers where the domestic producers have continued to invest in their technology, equipment and people. In September 2002, the World Trade Organization (WTO) ruled that CDSOA payments are not consistent with international trade rules. In February 2006, U.S. legislation was enacted that ended CDSOA distributions for dumped imports covered by antidumping duty orders entering the United States after September 30, 2007. Instead, any such antidumping duties collected would remain with the U.S. Treasury. Several countries have objected that this U.S. legislation is not consistent with WTO rulings, and were granted retaliation rights by the WTO, typically in the form of increased tariffs on some imported goods from the United States. The European Union and Japan have been retaliating in this fashion against the operation of U.S. law. In 2006, the U.S. Court of International Trade (CIT) ruled, in two separate decisions, that the procedure for determining recipients eligible to receive CDSOA distributions was unconstitutional. In addition, several other court cases challenging various provisions of CDSOA were ongoing. As a result, from 2006 through 2010, U.S. Customs withheld a portion of the amounts that would otherwise have been distributed under CDSOA. In February 2009, the U.S. Court of Appeals for the Federal Circuit reversed both of the 2006 decisions of the CIT. Later in December 2009, a plaintiff petitioned the U.S. Supreme Court to hear a further appeal, but the Supreme Court declined the petition, allowing the appellate court reversals to stand. At that time, several court cases challenging various provisions of the CDSOA were still unresolved, so U.S. Customs accepted the CIT’s recommendation to continue to withhold CDSOA receipts related to 2006 through 2010 until January 2012. U.S. Customs began distributing the withheld funds to affected domestic producers in early April 2012. In April 2012, the Company received CDSOA distributions for amounts originally withheld from 2006 through 2010. While some of the challenges to CDSOA have been resolved, others are still in litigation. Since there continue to be legal challenges to CDSOA, U.S. Customs has advised all affected domestic producers that it is possible that CDSOA distributions could be subject to clawback. Management of the Company believes that the likelihood of clawback is remote. Quarterly Dividend: On February 12, 2016, the Company’s Board of Directors declared a quarterly cash dividend of $0.26 per common share. The quarterly dividend will be paid on March 3, 2016 to shareholders of record as of February 23, 2016. This will be the 375th consecutive dividend paid on the common shares of the Company. Forward-Looking Statements Certain statements set forth in this Annual Report on Form 10-K and in the Company’s 2015 Annual Report to Shareholders (including the Company’s forecasts, beliefs and expectations) that are not historical in nature are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. In particular, Management’s Discussion and Analysis on pages 18 through 47 contains numerous forward-looking statements. Forward-looking statements generally will be accompanied by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “outlook,” “intend,” “may,” “possible,” “potential,” “predict,” “project” or other similar words, phrases or expressions. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. The Company cautions readers that actual results may differ materially from those expressed or implied in forward-looking statements made by or on behalf of the Company due to a variety of factors, such as: (a) deterioration in world economic conditions, or in economic conditions in any of the geographic regions in which the Company or its customers or suppliers conducts business, including additional adverse effects from the global economic slowdown, terrorism or hostilities. This includes: political risks associated with the potential instability of governments and legal systems in countries in which the Company, its customers or suppliers conduct business, and changes in currency valuations; (b) the effects of fluctuations in customer demand on sales, product mix and prices in the industries in which the Company operates. This includes: the ability of the Company to respond to rapid changes in customer demand, the effects of customer bankruptcies or liquidations, the impact of changes in industrial business cycles, and whether conditions of fair trade continue in the U.S. markets; (c) competitive factors, including changes in market penetration, increasing price competition by existing or new foreign and domestic competitors, the introduction of new products by existing and new competitors, and new technology that may impact the way the Company’s products are produced, sold or distributed; (d) changes in operating costs. This includes: the effect of changes in the Company’s manufacturing processes; changes in costs associated with varying levels of operations and manufacturing capacity; availability and cost of raw materials; changes in the expected costs associated with product warranty claims; changes resulting from inventory management and cost reduction initiatives; the effects of unplanned plant shutdowns; and changes in the cost of labor and benefits; (e) the success of the Company’s operating plans, announced programs, initiatives and capital investments; the ability to integrate acquired companies; the ability of acquired companies to achieve satisfactory operating results, including results being accretive to earnings; and the Company’s ability to maintain appropriate relations with unions that represent Company associates in certain locations in order to avoid disruptions of business; (f) unanticipated litigation, claims or assessments. This includes: claims or problems related to intellectual property, product liability or warranty, environmental issues, and taxes; (g) changes in worldwide capital markets, including availability of financing and interest rates on satisfactory terms, which affect: the Company’s cost of funds and/or ability to raise capital; and the ability of customers to obtain financing to purchase the Company’s products or equipment that contain the Company’s products; (h) the impact on the Company's pension obligations due to changes in interest rates, investment performance, changes in law or regulation, and other tactics designed to reduce risk; (i) retention of CDSOA distributions; (j) the Company's ability to avoid any indemnification liabilities entered into with TimkenSteel in connection with the Spinoff, and the ability of TimkenSteel to satisfy any indemnification liabilities it entered into in connection with the Spinoff; (k) the taxable nature of the Spinoff; and (l) those items identified under Item 1A. Risk Factors on pages 6 through 12. Additional risks relating to the Company’s business, the industries in which the Company operates or the Company’s common shares may be described from time to time in the Company’s filings with the Securities and Exchange Commission. All of these risk factors are difficult to predict, are subject to material uncertainties that may affect actual results and may be beyond the Company’s control. Readers are cautioned that it is not possible to predict or identify all of the risks, uncertainties and other factors that may affect future results and that the above list should not be considered to be a complete list. Except as required by the federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

<s>[INST] OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, belts, chain and related products and offers a spectrum of power system rebuild and repair services. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken, Fafnir, Philadelphia Gear, Carlisle, Drives and Interlube. Timken today applies its deep knowledge of metallurgy, friction management and mechanical power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both original equipment manufacturers (OEMs) and aftermarket channels. With more than 14,000 people operating in 28 countries, Timken makes the world more productive and keeps industry in motion. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: Mobile Industries serves OEM customers that manufacture offhighway equipment for the agricultural, mining and construction markets; onhighway vehicles including passenger cars, light trucks, and medium and heavyduty trucks; rail cars and locomotives; and rotorcraft and fixedwing aircraft. Beyond service parts sold to OEMs, aftermarket sales to individual end users, equipment owners, operators and maintenance shops are handled through the Company's extensive network of authorized automotive and heavytruck distributors. Process Industries serves OEM and enduser customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal and wind power generation; oil and gas extraction and refining; pulp and paper and food processing; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors. Timken creates value by understanding customer needs and applying its knowhow in attractive market sectors. Timken’s business strengths include its channel mix and endmarket diversity, serving a broad range of customers and industries across the globe. The Company collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for our products and services. The Timken Business Model is the specific framework for how the Company evaluates opportunities and differentiates itself in the market. The Company’s Strategy is to apply the Timken Business Model and leverage the Company’s competitive differentiators and strengths to create customer value and drive increased growth and profitability by: Capturing Opportunities and Expanding Reach. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Performing With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Driving Effective Capital Deployment. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes (1) investing in the core business through capital expenditures, research and development and organic growth initiatives like DeltaX; (2) pursuing strategic acquisitions to broaden our portfolio and [/INST] Negative. </s>

TIMKEN CO

2017-02-21

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share data) OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, belts, chain, couplings, and related products and offers a variety of power system rebuild and repair services. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken®, Fafnir®, Philadelphia Gear®, Carlisle®, Drives®, Lovejoy® and InterlubeTM. Timken applies its deep knowledge of metallurgy, friction management and mechanical power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both OEM and aftermarket channels. With more than 14,000 people operating in 28 countries, Timken makes the world more productive and keeps industry in motion. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: • Mobile Industries serves OEM customers that manufacture off-highway equipment for the agricultural, mining and construction markets; on-highway vehicles including passenger cars, light trucks, and medium- and heavy-duty trucks; rail cars and locomotives; outdoor power equipment; and rotorcraft and fixed-wing aircraft. Beyond service parts sold to OEMs, aftermarket sales to individual end users, equipment owners, operators and maintenance shops are handled through the Company's extensive network of authorized automotive and heavy-truck distributors. • Process Industries serves OEM and end-user customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal and wind power generation; oil and gas extraction and refining; pulp and paper and food processing; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors. Timken creates value by understanding customer needs and applying its know-how in attractive market sectors. The Company’s business strengths include its channel mix and end-market diversity, serving a broad range of customers and industries across the globe. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Timken Business Model is the specific framework for how the Company evaluates opportunities and differentiates itself in the market. The Company’s Strategy is to apply the Timken Business Model and leverage the Company’s competitive differentiators and strengths to create customer value and drive increased growth and profitability by: Capturing Opportunities and Expanding Reach. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Performing With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Driving Effective Capital Deployment. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes (1) investing in the core business through capital expenditures, research and development and organic growth initiatives like DeltaX; (2) pursuing strategic acquisitions to broaden our portfolio and capabilities, with a focus on bearings, adjacent power transmission products and related services; and (3) returning capital to shareholders through share repurchases and dividends. As part of this framework, the Company may also restructure, reposition or divest underperforming product lines or assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2016: Business Highlights • The Company continued to advance its manufacturing footprint initiatives with: ◦ The announced closures of its bearing plants in Pulaski, Tennessee ("Pulaski") and Altavista, Virginia ("Altavista") and its manufacturing facility in Benoni, South Africa ("Benoni"), which are expected to be completed in 2017. Production from Altavista will be transferring to the Company's bearing plant near Lincolnton, North Carolina; and ◦ The closure of its bearing facility in the United Kingdom ("U.K."). • Received a multi-year contract from the U.S. Department of Defense ("DoD") to provide engineering and supply Philadelphia Gear main reduction gears for the Navy's next generation of Arleigh Burke DDG 51 class ships. The fixed price contract includes options that, if exercised, could bring the cumulative value of the contract to more than $1 billion over its estimated 10-year life; and • Completed the installation of aerospace transmission overhaul and repair equipment at its plant in Manchester, Connecticut. This equipment adds new capabilities and will support a contract secured in 2015 to overhaul and repair up to roughly 220 Apache AH64D main transmissions for the DoD over a three-year period. Share Repurchases • On February 6, 2017, the Company's Board of Directors approved a new share repurchase plan pursuant to which the Company may purchase up to ten million of its common shares, in the aggregate. This new share purchase plan expires on February 28, 2021. Acquisitions • On October 31, 2016, the Company acquired EDT Corp. ("EDT"), a manufacturer of polymer housed units and stainless steel ball bearings used widely by the food and beverage industry, for $10 million in cash. Headquartered in Vancouver, Washington, EDT had sales of less than $10 million for the twelve months ended September 30, 2016. • On July 8, 2016, the Company acquired Lovejoy Inc. ("Lovejoy"), a manufacturer of premium industrial couplings and universal joints, for $63.5 million in cash and assumed debt of $2.2 million. Headquartered in Downers Grove, Illinois, with additional locations in the U.S., Canada and Germany, Lovejoy had sales of approximately $55 million for the twelve months ended June 30, 2016. RESULTS OF OPERATIONS 2016 vs. 2015 Overview: The decrease in net sales was primarily due to lower end-market demand and the impact of foreign currency exchange rate changes, partially offset by the net benefit of acquisitions and divestitures. The increase in net income in 2016 compared with 2015 was primarily due to pretax pension settlement charges that were $436.9 million lower than 2015 and pretax U.S. Continued Dumping and Subsidy Offset Act ("CDSOA") income of $59.6 million recorded in 2016. In addition, the Company's net income in 2016 was impacted by lower volume across most market sectors, unfavorable price/mix, higher restructuring charges and the impact of foreign currency exchange rate changes, partially offset by lower material and manufacturing costs, and lower selling, general and administrative ("SG&A") expenses compared with 2015. The prior year also included a gain from the divestiture of Timken Alcor Aerospace Technologies, Inc. ("Alcor") and higher discrete income tax benefits. Outlook: The Company expects 2017 full-year sales to be flat compared with 2016, as the benefit of acquisitions is offset by the estimated negative impact of foreign currency exchange rate changes. The Company's earnings are expected to be lower in 2017 than 2016, primarily due to no expected CDSOA income in 2017, partially offset by lower pension settlement charges. Timken plans to adopt mark-to-market accounting for its defined benefit pension and other postretirement benefit plans in the first quarter of 2017, which will impact earnings before interest and taxes ("EBIT")for 2017 and prior years on a retrospective basis. Refer to Change in Accounting Principle in the Other Disclosures section for additional information. The Company expects to generate operating cash of approximately $310 million in 2017, a decrease from 2016 of approximately $92 million or 23%, as the Company anticipates lower net income (including no expected CDSOA receipts), lower benefit from working capital and higher income tax payments. The Company expects capital expenditures to be approximately 4% of sales in 2017, compared with 5% of sales in 2016. THE STATEMENTS OF INCOME Sales: Net sales decreased in 2016 compared with 2015 primarily due to lower organic sales of $239 million, the effect of foreign currency exchange rate changes of $47 million and divestitures of $15 million, partially offset by the benefit of acquisitions of $99 million. The decrease in organic sales was driven by lower demand across most market sectors, partially offset by growth in the automotive market sector. Gross Profit: Gross profit decreased in 2016 compared with 2015, primarily due to the impact of lower volume of $91 million, unfavorable price/mix of $65 million, higher restructuring charges and the impact of foreign currency exchange rate changes. These factors were partially offset by lower material and manufacturing costs net of manufacturing underutilization of $61 million and the benefit of acquisitions. Selling, General and Administrative Expenses: The decrease in SG&A expenses in 2016 compared with 2015 was primarily due to the benefit of cost reduction initiatives of $41 million, the impact of foreign currency exchange rate changes, lower depreciation expense and lower non-income tax expense, partially offset by additional expenses from Carlstar Belts LLC ("Timken Belts"), Lovejoy and EDT acquired in September 2015, July 2016, and October 2016, respectively. Impairment and Restructuring Charges: Impairment and restructuring charges of $21.7 million in 2016 were primarily comprised of severance and related benefit costs associated with initiatives to reduce headcount and right-size the Company's manufacturing footprint, including the planned closures of the Altavista, Pulaski and Benoni bearing plants. In addition, the Company recognized impairment charges of $3.9 million during 2016 associated with the planned closures of the Altavista and Benoni bearing plants. Impairment and restructuring charges of $14.7 million in 2015 were primarily due to severance and related benefit costs associated with initiatives to reduce headcount, impairment charges of $3.0 million related to the Company's service center in Niles, Ohio and exit costs of approximately $3.0 million related to the Company's termination of its relationship with one of its third-party sales representatives in Colombia. Pension Settlement Charges: Pension settlement charges in 2016 were primarily related to $19 million of lump-sum distributions to new retirees and deferred vested participants that triggered remeasurements, as well as $7 million related to the purchase of a group annuity contract from The Canada Life Assurance Company ("Canada Life") for one of the Company's Canadian defined benefit pension plans, which was executed in September 2016. These actions resulted in a decrease in the Company's pension obligations of approximately $70 million. Pension settlement charges in 2015 were primarily due to the purchase of group annuity contracts from Prudential Insurance Company of America ("Prudential") by two of the Company's U.S. defined benefit pension plans. The two group annuity contracts require Prudential to pay and administer future pension benefits for approximately 8,400 U.S. Timken retirees in the aggregate. The Company transferred a total of approximately $1.1 billion of its pension obligations and a total of approximately $1.2 billion of pension assets to Prudential in these transactions. In addition to the purchase of the group annuity contracts, the Company made lump-sum distributions of $37.2 million to new retirees. The Company also incurred pension settlement and curtailment charges related to one of its Canadian defined benefit pension plans. As a result of the group annuity contracts, lump-sum distributions as well as pension settlement and curtailment charges related to the Canadian pension plan, the Company incurred total pension settlement and curtailment charges of $465.0 million, including professional fees of $2.6 million, in 2015. Gain on Divestiture: Gain on divestiture in 2015 was primarily related to the gain on the sale of Alcor of $29.0 million in the fourth quarter of 2015. Interest Income (Expense): Other (Expense) Income: CDSOA income, net in 2016 represents income recorded in connection with funds awarded to the Company from monies collected by U.S. Customs and Border Protection ("U.S. Customs") from antidumping cases, net of related professional fees. Refer to Note 21 - Continued Dumping and Subsidy Offset Act for further discussion. During the fourth quarter of 2015, the Company wrote-off $9.7 million that remained in construction in process ("CIP") after the related assets were placed into service. The majority of these assets were placed into service between 2008 and 2012. This item was identified during an examination of aged balances in the CIP account. Management of the Company concluded that the correction of this error in the fourth quarter of 2015 and the presence of this error in prior periods was immaterial to all periods presented. Income Tax Expense: The effective tax rate for 2016 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, the U.S. manufacturing deduction, and certain discrete tax benefits (net). These favorable impacts were partially offset by U.S. taxation of foreign income and losses at certain foreign subsidiaries where no tax benefit could be recorded. The effective tax rate for 2015 was 64.1%, which reflects a tax benefit on pretax loss. The tax benefit rate of 64.1% was greater than the U.S. statutory rate of 35% primarily due to the tax benefits of reversals of certain valuation allowances in foreign jurisdictions, U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, reversals of reserves for uncertain tax positions, state and local taxes, the U.S. manufacturing deduction, the U.S. research tax credit and other U.S. tax benefits. These factors were offset by U.S. taxation of foreign earnings, recording of deferred tax liabilities related to foreign branch operations, and losses at certain foreign subsidiaries where no tax benefit could be recorded. The change in the effective tax rate for 2016 compared with 2015 was primarily due to reduced valuation allowance releases in 2016, partially offset by increased US foreign tax credits, the US manufacturing deduction, and discrete tax items occurring in 2016. Refer to the table below for additional detail of the impact of each item on income tax expense. (1) U.S. taxation includes the impact of foreign tax credits, U.S. Manufacturing deductions, U.S. Research and Experimentation credit, U.S. state and local taxation, U.S. taxation of foreign earnings and other U.S. items. Refer to Note 17 - Income Taxes for more information on the computation of the income tax expense in interim periods. BUSINESS SEGMENTS The Company's reportable segments are business units that serve different industry sectors. While the segments often operate using shared infrastructure, each reportable segment is managed to address specific customer needs in these diverse market sectors. The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 16 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions and divestitures completed in 2016 and 2015 and foreign currency exchange rate changes. The effects of acquisitions, divestitures and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions and divestitures completed in 2016 and 2015: • The Company acquired EDT during the fourth quarter of 2016. Results for EDT are reported in the Process Industries segment. • The Company acquired Lovejoy during the third quarter of 2016. Substantially all of the results for Lovejoy are reported in the Process Industries segment based on the customers and underlying markets served. • The Company sold Alcor during the fourth quarter of 2015. Results for Alcor prior to the sale were reported in the Mobile Industries segment. • The Company acquired Timken Belts during the third quarter of 2015. Results for Timken Belts are reported in the Mobile Industries and Process Industries segments based on the customers and underlying markets served. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions, divestitures and foreign currency exchange rate changes, decreased $120.2 million or 7.7% in 2016 compared with 2015. The decline in net sales was primarily driven by a decrease in the rail, off-highway, aerospace and heavy truck market sectors, partially offset by organic growth in the automotive market sector. EBIT decreased by $64.5 million or 37.2% in 2016 compared with 2015 primarily due to unfavorable price/mix of $52 million, the impact of lower volume of $35 million, higher restructuring charges, the impact of foreign currency exchange rate changes and the net unfavorable impact of acquisitions and divestitures, partially offset by lower material and manufacturing costs net of manufacturing underutilization of $53 million and lower SG&A expenses. EBIT for 2015 also included a gain on the sale of Alcor of $29 million. Full-year sales for the Mobile Industries segment are expected to be down approximately 4% to 5% in 2017 compared with 2016. This reflects lower expected volume in the rail, agriculture and heavy truck market sectors and the unfavorable impact of foreign currency exchange rate changes of approximately 1.5%, partially offset by the benefit of acquisitions. EBIT for the Mobile Industries segment is expected to decrease in 2017 compared with 2016 due to lower volume, unfavorable price/mix and the impact of foreign currency exchange rate changes. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, decreased $119.2 million or 9.1% in 2016 compared with 2015. The decline was primarily due to lower demand across the heavy industries (mainly oil and gas), industrial aftermarket, military marine and wind energy market sectors. EBIT decreased $27.0 million or 14.2% in 2016 compared with 2015 primarily due to the impact of lower volume of $56 million and unfavorable price/mix, partially offset by lower SG&A expenses of $24 million and lower material and manufacturing costs net of manufacturing underutilization. EBIT in 2015 also included a charge of $8.2 million related to the write-off of certain CIP balances. Refer to Note 8 - Property, Plant and Equipment for additional information. Full-year sales for the Process Industries segment are expected to be up approximately 4% to 5% in 2017 compared with 2016. This reflects higher expected demand in the industrial aftermarket and wind energy sectors and the benefit of acquisitions, partially offset by the unfavorable impact of foreign currency exchange rate changes of approximately 1.5%. EBIT for the Process Industries segment is expected to increase in 2017 compared with 2016 primarily due to the impact of higher volume and the impact of improved manufacturing underutilization and the benefit of acquisitions, partially offset by foreign currency exchange rate changes. Corporate: Corporate expenses decreased in 2016 compared with 2015 primarily due to cost reduction initiatives. RESULTS OF OPERATIONS: 2015 vs. 2014 Overview: The decrease in net sales was primarily due to the impact of foreign currency exchange rate changes and lower end market demand, partially offset by the benefit of acquisitions. The Company's net income from continuing operations in 2015 was lower compared to 2014 due to non-cash pension settlement charges of $465.0 million recorded in 2015, the impact of lower volume across most end market sectors, unfavorable price/mix and foreign currency exchange rate changes. These factors were partially offset by lower SG&A expenses, lower material and manufacturing costs and a lower provision for income taxes. The decrease in income from discontinued operations in 2015 compared with 2014 was due to the Spinoff that was completed on June 30, 2014. THE STATEMENTS OF INCOME Sales: Net sales decreased in 2015 compared with 2014, primarily due to the impact of foreign currency exchange rate changes of $152 million and lower organic sales of $90 million, partially offset by the benefit of acquisitions of $39 million. The decrease in organic sales was driven by lower demand across most of the Company's end market sectors, partially offset by growth in the wind, military marine, rail and automotive sectors. Gross Profit: Gross profit decreased in 2015 compared with 2014, primarily due to the impact of lower volume of $40 million, unfavorable price/mix of $37 million and the impact of foreign currency exchange rate changes of $63 million. These factors were partially offset by the impact of inventory valuation adjustments that occurred during 2014 of $20 million, lower raw material and operating costs net of manufacturing underutilization and the impact of acquisitions. Selling, General and Administrative Expenses: The decrease in SG&A expenses in 2015 compared with 2014 was primarily due to lower incentive compensation expense of $28 million and the impact of foreign currency exchange rate changes of $20 million. The benefits of cost reduction initiatives were largely offset by the impact of acquisitions, higher pension and bad debt expense and costs associated with ongoing growth initiatives. Impairment and Restructuring Charges: Impairment and restructuring charges of $14.7 million in 2015 were primarily due to severance and related benefit costs associated with initiatives to reduce headcount, impairment charges of $3.0 million related to the Company's service center in Niles, Ohio and exit costs of approximately $3.0 million related to the Company's termination of its relationship with one of its third-party sales representatives in Colombia. Impairment and restructuring charges of $113.4 million in 2014 were primarily due to goodwill and other intangible impairment charges of $96.2 million that were recorded in the third quarter of 2014. Pension Settlement Charges: Pension settlement charges in 2015 were primarily due to the purchase of group annuity contracts from Prudential by two of the Company's U.S. defined benefit pension plans. The two group annuity contracts require Prudential to pay and administer future pension benefits for approximately 8,400 U.S. Timken retirees in the aggregate. The Company transferred a total of approximately $1.1 billion of its pension obligations and a total of approximately $1.2 billion of pension assets to Prudential in these transactions. In addition to the purchase of the group annuity contracts, the Company made lump-sum distributions of $37 million to new retirees. The Company also incurred pension settlement and curtailment charges related to one of its Canadian defined benefit pension plans. As a result of the group annuity contracts, lump-sum distributions as well as pension settlement and curtailment charges related to the Canadian pension plan, the Company incurred total pension settlement and curtailment charges of $465.0 million, including professional fees of $2.6 million, in 2015. Pension settlement charges recorded in 2014 were primarily the result of the settlement of approximately $110 million of the Company's pension obligations related to its defined benefit pension plan in the United States as a result of lump sum distributions to new retirees and certain deferred vested plan participants in 2014. Gain on Divestiture: Gain on divestiture in 2015 was primarily related to the gain on the sale of Alcor of $29.0 million in the fourth quarter of 2015, partially offset by a loss on the sale of the Company's repair business in Niles, Ohio of $0.3 million in the second quarter of 2015. Interest Income (Expense): Interest expense for 2015 increased compared with 2014 primarily due to lower capitalized interest and higher average debt, partially offset by lower average interest rates. Interest income decreased for 2015 compared with 2014 primarily due to lower interest income recognized on the deferred payments related to the sale of real estate in Sao Paulo, Brazil ("Sao Paulo"). The last of the deferred payments was received during the fourth quarter of 2015. Other (Expense) Income: During 2014, the Company recognized a gain of $22.6 million related to the sale of real estate in Sao Paulo. During the fourth quarter of 2015, the Company wrote-off $9.7 million that remained in CIP after the related assets were placed into service. The majority of these assets were placed into service between 2008 and 2012. This item was identified during an examination of aged balances in the CIP account. Management of the Company concluded that the correction of this error in the fourth quarter of 2015 and the presence of this error in prior periods was immaterial to all periods presented. Income Tax Expense: The effective tax rate for 2015 was 64.1%, which reflects a tax benefit on pretax loss. The tax benefit rate of 64.1% was greater than the U.S. statutory rate of 35% primarily due to the tax benefits of reversals of certain valuation allowances in foreign jurisdictions, U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, reversals of reserves for uncertain tax positions, state and local taxes, the U.S. manufacturing deduction, the U.S. research tax credit and other U.S. tax benefits. These factors were offset by U.S. taxation of foreign earnings, recording of deferred tax liabilities related to foreign branch operations, and losses at certain foreign subsidiaries where no tax benefit could be recorded. The effective tax rate on pretax income for 2014 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, adjustments to tax accruals for undistributed foreign earnings, the U.S. manufacturing deduction, the U.S. research tax credit and other U.S. tax benefits. These factors were partially offset by U.S. taxation of foreign income, losses at certain foreign subsidiaries where no tax benefit could be recorded, non-deductible intangible asset impairment charges recorded in the Mobile Industries segment and accruals for uncertain tax positions. Refer to the table below for additional detail of the impact of each item on income tax expense: (1) U.S. taxation includes the impact of foreign tax credits, U.S. Manufacturing deductions, U.S. Research and Experimentation credit, U.S. state and local taxation, U.S. taxation of foreign earnings and other U.S. items. Discontinued Operations: On June 30, 2014, the Company completed the Spinoff. The operating results, net of tax, included one-time transaction costs of $57.1 million during 2014. These costs included consulting and professional fees associated with preparing for and executing the Spinoff. BUSINESS SEGMENTS The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 16 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions and divestitures completed in 2015 and 2014 and foreign currency exchange rate changes. The effects of acquisitions, divestitures and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions and divestitures completed in 2015 and 2014: • The Company sold Alcor during the fourth quarter of 2015. Results for Alcor were reported in the Mobile Industries segment. • The Company acquired the Belts business during the third quarter of 2015. Results for Timken Belts are reported in the Mobile Industries and Process Industries segments based on the customers served. • The Company acquired Revolvo Ltd. ("Revolvo") during the fourth quarter of 2014. Results for Revolvo are reported in the Process Industries segment. • The Company sold its aerospace engine overhaul business during the fourth quarter of 2014. Results for the aerospace engine overhaul business were reported in the Mobile Industries segment. • The Company acquired Schulz Group ("Schulz") during the second quarter of 2014. Results for Schulz are reported in the Process Industries segment. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions, divestitures and foreign currency exchange rate changes, decreased $47.6 million or 2.8% in 2015 compared with 2014. The decrease in net sales was primarily due to lower volume in the off-highway (primarily agriculture) and aerospace end market sectors, partially offset by organic growth in the rail and automotive sectors. EBIT was lower in 2015 compared with 2014 primarily due to the impact of goodwill impairment and inventory valuation adjustments of $118 million recorded in 2014, a gain on the sale of Alcor of $29 million recorded in 2015, the benefit of lower raw material and operating costs net of manufacturing underutilization, lower SG&A expenses and the impact of acquisitions. These factors were partially offset by a gain on the sale of real estate in Brazil of $23 million recorded in 2014, lower volume of $20 million and unfavorable price/mix of $14 million and the negative impact of foreign currency exchange rate changes of $18 million. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, decreased $43.5 million or 3.1% in 2015 compared with 2014 primarily due to lower volume in the industrial distribution, services and heavy industries end market sectors, partially offset by organic growth in the wind energy and military marine sectors. EBIT was lower in 2015 compared with 2014 primarily due to the impact of lower volume of $21 million, unfavorable price/mix of $24 million, the impact of unfavorable foreign currency exchange rate changes of $25 million and higher impairment and restructuring charges. These factors were partially offset by lower SG&A expenses, the impact of lower material and operating costs net of manufacturing underutilization and the impact of acquisitions. EBIT also included a charge of $8.2 million in the fourth quarter of 2015 related to the write-off of certain CIP balances. Refer to Note 8 - Property, Plant and Equipment for additional information. Corporate: Corporate expenses decreased in 2015 compared with 2014 primarily due to lower incentive compensation expenses and the impact of cost reduction initiatives. THE BALANCE SHEETS The following discussion is a comparison of the Consolidated Balance Sheets at December 31, 2016 and 2015. Current Assets: Refer to the Consolidated Statements of Cash Flows for discussion of the change in cash and cash equivalents. Accounts receivable, net, decreased as a result of lower sales in December 2016 compared with December 2015 and the impact of foreign currency exchange rate changes, partially offset by the impact of current year acquisitions. Property, Plant and Equipment, Net: The increase in property, plant and equipment, net, in 2016 was primarily due to capital expenditures of $128.0 million and additions from current-year acquisitions of $16.6 million, partially offset by current-year depreciation of $95.5 million, the impact of foreign currency exchange rate changes of $15.4 million and impairment charges of $3.6 million. Other Assets: The increase in goodwill was primarily due to the acquisition of Lovejoy in the third quarter of 2016. The decrease in non-current pension assets was primarily due a decrease in the discount rate used to measure the obligation for the Company's U.S. and U.K. defined benefit pension plans, which negatively impacted the funded status of these plans. See Note 14 - Retirement Benefit Plans for additional information. The decrease in deferred income taxes was primarily due to purchase accounting adjustments, changes in tax rates and other deferred tax adjustments, partially offset by the impact of current year book-tax temporary differences including pension expense and depreciation. The decrease in other non-current assets was primarily due to the reclassification of $18.6 million of tax payments in India to income taxes payable in order to apply these payments to the underlying liabilities to which they related during the third quarter of 2016. Current Liabilities: The decrease in short-term debt was primarily due to the change in classification of the outstanding borrowings under the Accounts Receivable Facility in accordance with the terms of the agreement and the Company's expectations relative to the minimum borrowing base. Current portion of long-term debt decreased due to the payment of medium term notes that matured during the third quarter of 2016, partially offset by the Company's 7.01% Fixed-rate Medium-Term Notes, Series A (2017 Notes) that will be repaid at maturity in November 2017. The increase in accounts payable was primarily due to higher days outstanding driven by the Company's initiative to extend payment terms with its suppliers. The decrease in accrued salaries, wages and benefits was primarily due to lower expected retiree medical payments for the next twelve months, the elimination of one of the Company’s Canadian pension plans and the impact of lower headcount versus the prior year. The increase in income taxes payable reflects the current tax provision, less income tax payments, the reclassification of tax payments in India of $18.6 million and the reclassification of certain accruals for uncertain tax positions to non-current liabilities. Non-Current Liabilities: The increase in long-term debt was primarily due to the classification of $49 million of outstanding borrowings under the Accounts Receivable Facility in accordance with the terms of the agreement and the Company's expectations relative to the minimum borrowing base as long-term at December 31, 2016 compared with zero as of December 31, 2015, along with an $8.6 million increase in borrowing under the Senior Credit Facility. The increase in accrued pension cost was primarily due to a decrease in the discount rate used to measure the obligation for the Company's unfunded defined benefit pension plans. The increase in other non-current liabilities during 2016 was primarily due to acquisition related expense of $4.1 million. Shareholders’ Equity: Earnings invested in the business in 2016 increased by net income attributable to the Company of $152.6 million, partially offset by dividends declared of $81.6 million. The increase in accumulated other comprehensive loss was primarily due to foreign currency translation adjustments of $34.5 million and pension and postretirement liability adjustments of $0.6 million after tax. The foreign currency translation adjustments were due to the strengthening of the U.S. dollar relative to other foreign currencies, including the British Pound Sterling and the Chinese Renminbi Yuan, partially offset by increases related to the Brazilian Real. See "Other Disclosures - Foreign Currency" for further discussion regarding the impact of foreign currency translation. The increase in pension and postretirement liability adjustments was primarily due to a decrease in the discount rate used to measure the underlying pension obligation, mostly offset by pension settlement charges, amortization of actuarial gains and losses, an amendment to the Company's postretirement obligation and the impact of income taxes. The increase in treasury shares was primarily due to the Company's purchase of 3.1 million of its common shares for $101.0 million, partially offset by $13.9 million worth of net shares issued for stock compensation plans during 2016. CASH FLOWS Operating Activities: Operating activities provided net cash of $402.0 million in 2016, after providing net cash of $374.8 million in 2015. The increase was due to the favorable impact of income taxes of $227.8 million and a net favorable change in working capital items of $13.3 million, partially offset by lower net income of $212.4 million, excluding pension settlement charges. Refer to the tables below for additional detail of the impact of each line on net cash provided by operating activities. The following chart displays the impact of working capital items on cash during 2016 and 2015, respectively: The following table displays the impact of income taxes on cash during 2016 and 2015, respectively: The following table displays the effect on cash for major components of net income during 2016 and 2015, respectively: Investing Activities: Net cash used in investing activities of $211.0 million in 2016 decreased from the same period in 2015 primarily due to a $140.7 million decrease in cash used for acquisitions, partially offset by a $46.2 million reduction in proceeds from divestitures, a $31.9 million increase in cash used in capital expenditures, and an $8.3 million reduction in proceeds from the sale of property, plant and equipment. Financing Activities: The following chart displays the factors impacting cash from financing activities during 2016 and 2015, respectively: LIQUIDITY AND CAPITAL RESOURCES Reconciliation of total debt to net debt and the ratio of net debt to capital: Net Debt: Ratio of Net Debt to Capital: The Company presents net debt because it believes net debt is more representative of the Company's financial position than total debt due to the amount of cash and cash equivalents held by the Company. At December 31, 2016, approximately $134 million, or over 90%, of the Company's $149 million cash and cash equivalents resided in jurisdictions outside the United States. It is the Company's practice to use available cash in the United States to pay down its Senior Credit Facility or Accounts Receivable Facility, in order to minimize total interest expense. As a result, the majority of the Company's cash on hand was outside the United States. Repatriation of these funds to the United States could be subject to domestic and foreign taxes and some portion may be subject to governmental restrictions. Part of the Company's strategy is to grow in attractive market sectors, many of which are outside the United States. This strategy includes making investments in facilities and equipment and potential new acquisitions. The Company plans to fund these investments, as well as meet working capital requirements, with cash and cash equivalents and unused lines of credit within the geographic location of these investments where possible. The Company has a $100 million Accounts Receivable Facility that matures on November 30, 2018. The Accounts Receivable Facility is subject to certain borrowing base limitations and is secured by certain domestic accounts receivable of the Company. Certain borrowing base limitations reduced the availability of the Accounts Receivable Facility to $67.2 million at December 31, 2016. As of December 31, 2016, there were outstanding borrowings of $48.9 million under the Accounts Receivable Facility, which reduced the availability under this facility to $18.3 million. The interest rate on the Accounts Receivable Facility is variable and was 1.65% as of December 31, 2016, which reflects the prevailing commercial paper rate plus facility fees. The Company has a $500.0 million Senior Credit Facility that matures on June 19, 2020. At December 31, 2016, the Company had outstanding borrowings of $83.8 million, which reduced the availability to $416.2 million. The Senior Credit Facility has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. At December 31, 2016, the Company was in full compliance with the covenants under the Senior Credit Facility and its other debt agreements. The maximum consolidated leverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0 (3.75 to 1.0 for a limited period up to four quarters following an acquisition with a purchase price of $200 million or greater). As of December 31, 2016, the Company’s consolidated leverage ratio was 1.77 to 1.0. The minimum consolidated interest coverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0. As of December 31, 2016, the Company’s consolidated interest coverage ratio was 11.37 to 1.0. The interest rate under the Senior Credit Facility is variable with a spread based on the Company’s debt rating. The weighted-average borrowing rate was 1.50% as of December 31, 2016. In addition, the Company pays a facility fee based on the consolidated leverage ratio multiplied by the aggregate commitments of all of the lenders under the Senior Credit Facility. Other sources of liquidity include short-term lines of credit for certain of the Company’s foreign subsidiaries, which provide for borrowings up to approximately $202.7 million. Most of these credit lines are uncommitted. At December 31, 2016, the Company had borrowings outstanding of $19.2 million and guarantees of $1.9 million, which reduced the availability under these facilities to $181.6 million. The Company expects that any cash requirements in excess of cash on hand and cash generated from operating activities will be met by the committed funds available under its Accounts Receivable Facility and the Senior Credit Facility. Management believes it has sufficient liquidity to meet its obligations through at least the term of the Senior Credit Facility. The Company expects to remain in compliance with its debt covenants. However, the Company may need to limit its borrowings under the Senior Credit Facility or other facilities in order to remain in compliance. As of December 31, 2016, the Company could have borrowed the full amounts available under the Senior Credit Facility and Accounts Receivable Facility, and would have still been in compliance with its debt covenants. In August 2014, the Company issued $350 million aggregate principal amount of fixed-rate unsecured notes that mature in September 2024 (the "2024 Notes"). The Company used a portion of the net proceeds from this issuance to repay the $250 million aggregate principal amount of fixed-rated unsecured notes that matured on September 15, 2014. The Company expects cash from operations of approximately $310 million in 2017, a decrease from 2016 of approximately $92 million or 23%, driven by lower net income (including no expected CDSOA receipts), lower benefit from working capital and higher income tax payments. The Company expects capital expenditures of approximately 4% of sales in 2017, compared with 5% of sales in 2016. CONTRACTUAL OBLIGATIONS The Company’s contractual debt obligations and contractual commitments outstanding as of December 31, 2016 were as follows: Payments due by period: The interest payments beyond five years primarily relate to long-term fixed-rate notes. Refer to Note 10 - Financing Arrangements for additional information. Purchase commitments are defined as an agreement to purchase goods or services that are enforceable and legally binding on the Company. Included in purchase commitments above are certain obligations related to take or pay contracts, capital commitments, service agreements and utilities. Many of these commitments relate to take or pay contracts, in which the Company guarantees payment to ensure availability of products or services. These purchase commitments do not represent the entire anticipated purchases in the future, but represent only those items that the Company is contractually obligated to purchase. The majority of the products and services purchased by the Company are purchased as needed, with no commitment. In order to maintain minimum funding requirements, the Company is required to make contributions to the trusts established for its defined benefit pension plans and other postretirement benefit plans. The table above shows the expected future minimum cash contributions to the trusts for the funded plans as well as estimated future benefit payments to participants for the unfunded plans. Those minimum funding requirements and estimated benefit payments can vary significantly. The amounts in the table above are based on actuarial estimates using current assumptions for, among other things, discount rates, expected return on assets and health care cost trend rates. Refer to Note 14 - Retirement Benefit Plans and Note 15 - Postretirement Benefit Plans for additional information. During 2016, the Company made cash contributions of approximately $15 million to its global defined benefit pension plans. The Company currently expects to make contributions to its global defined benefit pension plans totaling approximately $10 million in 2017. Returns for the Company’s global defined benefit pension plan assets in 2016 were 8.50%, above the expected rate of return of 6.0% predominantly due to increases in the long duration fixed-income markets. The higher returns positively impacted the funded status of the plans at the end of 2016. However, due to a 35 basis point reduction in the discount rate used to measure the Company's U.S. defined benefit pension obligations and a 125 basis point reduction in the discount rate used to measure its U.K defined benefit pension obligations, the higher returns were largely offset. Despite the negative impact of the lower discount rates, the Company expects slightly lower pension expense, excluding pension settlement charges, in future years. Refer to Note 14 - Retirement Benefit Plans and Note 15 - Postretirement Benefit Plans for additional information. Refer to Note 11 - Contingencies and Note 17 - Income Taxes for additional information regarding the Company's exposure for certain legal and tax matters. As of December 31, 2016, the Company had approximately $39.2 million of total gross unrecognized tax benefits. The Company believes it is reasonably possible that the amount of unrecognized tax positions could decrease by approximately $25 million during the next 12 months. The potential decrease would be primarily driven by settlements with tax authorities and the expiration of various statutes of limitation. Future tax positions are not known at this time and therefore not included in the above summary of the Company’s fixed contractual obligations. Refer to Note 17 - Income Taxes for additional information. The Company does not have any off-balance sheet arrangements with unconsolidated entities or other persons. RECENTLY ADOPTED ACCOUNTING PRONOUNCMENTS Information required for this Item is incorporated by reference to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The following paragraphs include a discussion of some critical areas that require a higher degree of judgment, estimates and complexity. Revenue recognition: The Company generally recognizes revenue when title passes to the customer. This occurs at the shipping point except for goods sold by certain foreign entities and certain exported goods, where title passes when the goods reach their destination. Selling prices are fixed based on purchase orders or contractual arrangements. Shipping and handling costs billed to customers are included in net sales and the related costs are included in cost of products sold in the Consolidated Statements of Income. The Company recognizes a portion of its revenues on the percentage-of-completion method measured on the cost-to-cost basis. In 2016, 2015 and 2014, the Company recognized approximately $68 million, $66 million and $50 million, respectively, in net sales under the percentage-of-completion method. As of December 31, 2016 and 2015, $63.5 million and $62.5 million of accounts receivable, net, respectively, related to these net sales. Inventory: Inventories are valued at the lower of cost or market, with approximately 53% valued by the first-in, first-out ("FIFO") method and the remaining 47% valued by the last-in, first-out ("LIFO") method. The majority of the Company’s domestic inventories are valued by the LIFO method, and all of the Company’s international inventories are valued by the FIFO method. An actual valuation of the inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and costs. Because these are subject to many factors beyond management’s control, annual results may differ from interim results as they are subject to the final year-end LIFO inventory valuation. The Company recognized a decrease in its LIFO reserve of $4.2 million during 2016 compared with a decrease in its LIFO reserve of $11.6 million during 2015. Goodwill: The Company tests goodwill and indefinite-lived intangible assets for impairment at least annually. The Company performs its annual impairment test as of October first, after the annual forecasting process is completed. Furthermore, goodwill is reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Each interim period, management of the Company assesses whether or not an indicator of impairment is present that would necessitate that a goodwill impairment analysis be performed in an interim period other than during the fourth quarter. The goodwill impairment analysis is a two-step process. Step one compares the carrying amount of the reporting unit to its estimated fair value. To the extent that the carrying value of the reporting unit exceeds its estimated fair value, step two is performed, where the reporting unit’s carrying value of goodwill is compared with the implied fair value of goodwill. To the extent that the carrying value of goodwill exceeds the implied fair value of goodwill, impairment exists and must be recognized. The Company reviews goodwill for impairment at the reporting unit level. The Mobile Industries segment has three reporting units and the Process Industries segment has two reporting units. The reporting units within the Mobile Industries segment are Mobile Industries, Aerospace Transmissions and Aerospace Aftermarket. The reporting units within the Process Industries segment are Process Industries and Industrial Services. The Company prepares its goodwill impairment analysis by comparing the estimated fair value of each reporting unit, using an income approach (a discounted cash flow model), as well as a market approach, with its carrying value. The income approach and market approach are weighted in arriving at fair value based on the relative merits of the methods used and the quantity and quality of collected data to arrive at the indicated fair value. The income approach requires several assumptions including future sales growth, EBIT (earnings before interest and taxes) margins and capital expenditures. The Company’s reporting units each provide their forecast of results for the next three years. These forecasts are the basis for the information used in the discounted cash flow model. The discounted cash flow model also requires the use of a discount rate and a terminal revenue growth rate (the revenue growth rate for the period beyond the three years forecasted by the reporting units), as well as projections of future operating margins (for the period beyond the forecasted three years). During the fourth quarter of 2016, the Company used a discount rate for its reporting units of 8.0% to 11.0% and a terminal revenue growth rate of 1.0% to 3.5%. The market approach requires several assumptions including sales and EBITDA (earnings before interest, taxes, depreciation and amortization) multiples for comparable companies that operate in the same markets as the Company’s reporting units. During the fourth quarter of 2016, the Company used sales multiples of 0.75 to 3.30 for its reporting units. During the fourth quarter of 2016, the Company used EBITDA multiples of 6.5 to 10.0 for its reporting units. As of December 31, 2016, the Company had $357.5 million of goodwill on its Consolidated Balance Sheet, of which $97.2 million was attributable to the Mobile Industries segment and $260.3 million was attributable to the Process Industries segment. See Note 9 - Goodwill and Other Intangible Assets in the Notes to Consolidated Financial Statements for the carrying amount of goodwill by segment. The fair value of the Aerospace Transmission reporting unit was $81.5 million, compared with its carrying value of $71.5 million. This reporting unit only had $1.8 million of goodwill at December 31, 2016. The fair value of the other reporting units exceeded their carrying values by a significant amount. As a result, the Company did not recognize any goodwill impairment charges during the fourth quarter of 2016. A 60 basis point increase in the discount rate would have resulted in the Aerospace Transmission reporting unit failing step one of the goodwill impairment analysis, which would have required the completion of step two of the goodwill impairment analysis to arrive at a potential goodwill impairment loss. The projected cash flows could have declined by as much as 6.6% for the Aerospace Transmission reporting unit and the fair value would have still exceeded its carrying value. Restructuring costs: The Company’s policy is to recognize restructuring costs in accordance with Accounting Standards Codification (ASC) Topic 420, “Exit or Disposal Cost Obligations,” and ASC Topic 712, “Compensation and Non-retirement Post-Employment Benefits.” Detailed contemporaneous documentation is maintained and updated to ensure that accruals are properly supported. If management determines that there is a change in estimate, the accruals are adjusted to reflect this change. Income taxes: Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, valuation allowances against deferred tax assets, and accruals for uncertain tax positions. The Company, which is subject to income taxes in the United States and numerous non-U.S. jurisdictions, accounts for income taxes in accordance with ASC Topic 740, “Income Taxes.” Deferred tax assets and liabilities are recorded for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as net operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. The Company records valuation allowances against deferred tax assets by tax jurisdiction when it is more likely than not that such assets will not be realized. In determining the need for a valuation allowance, the historical and projected financial performance of the entity recording the net deferred tax asset is considered along with any other pertinent information. Deferred tax assets relate primarily to pension and postretirement benefit obligations in the United States, which the Company believes are more likely than not to result in future tax benefits. The net activity from additions and reversals of valuation allowances was immaterial in 2016 and 2014. In 2015, the company recorded $34.7 million of tax benefit related to the reversal of valuation allowances. Refer to Note 17 - Income Taxes for further discussion on the valuation allowance reversals. In the ordinary course of the Company’s business, there are many transactions and calculations where the ultimate income tax determination is uncertain. The Company is regularly under audit by tax authorities. Accruals for uncertain tax positions are provided for in accordance with the requirements of ASC Topic 740. The Company records interest and penalties related to uncertain tax positions as a component of income tax expense. In 2016, the company recorded $8.1 million of net tax benefits related to uncertain tax positions. The company recorded tax benefits of $16.9 million related to settlements with tax authorities and reduction in prior year reserves and $8.8 million of tax expense related to current and prior year tax positions and interest expense. Refer to Note 17 - Income Taxes for further discussion on the uncertain tax positions reserve reversals. Benefit Plans: The Company sponsors a number of defined benefit pension plans that cover eligible associates. The Company also sponsors several funded and unfunded postretirement plans that provide health care and life insurance benefits for eligible retirees and their dependents. These plans are accounted for in accordance with ASC Topic 715-30, "Defined Benefit Plans - Pension," and ASC Topic 715-60, "Defined Benefit Plans - Other Postretirement." The measurement of liabilities related to these plans is based on management's assumptions related to future events, including discount rates, rates of return on pension plan assets, rates of compensation increases and health care cost trend rates. Management regularly evaluates these assumptions and adjusts them as required and appropriate. Other plan assumptions are also reviewed on a regular basis to reflect recent experience and the Company's future expectations. Actual experience that differs from these assumptions may affect future liquidity, expense and the overall financial position of the Company. While the Company believes that current assumptions are appropriate, significant differences in actual experience or significant changes in these assumptions may materially affect the Company's pension and other postretirement employee benefit obligations and its future expense and cash flow. The discount rate is used to calculate the present value of expected future pension and postretirement cash flows as of the measurement date. The Company establishes the discount rate by constructing a notional portfolio of high-quality corporate bonds and matching the coupon payments and bond maturities to projected benefit payments under the Company's pension and postretirement welfare plans. The bonds included in the portfolio are generally non-callable. A lower discount rate will result in a higher benefit obligation; conversely, a higher discount rate will result in a lower benefit obligation. The discount rate is also used to calculate the annual interest cost, which is a component of net periodic benefit cost. The expected rate of return on plan assets is determined by analyzing the historical long-term performance of the Company's pension plan assets, as well as the mix of plan assets between equities, fixed income securities and other investments, the expected long-term rate of return expected for those asset classes and long-term inflation rates. Short-term asset performance can differ significantly from the expected rate of return, especially in volatile markets. A lower-than-expected rate of return on pension plan assets will increase pension expense and future contributions. Defined Benefit Pension Plans: The Company recognized net periodic benefit cost of $57.7 million in 2016 for defined benefit pension plans compared with $497.8 million in 2015. The decrease in net periodic benefit cost was primarily due to lower pension settlement charges, lower interest costs and lower amortization of net actuarial losses, partially offset by lower expected return on plan assets. Pension settlement charges decreased from $465.0 million in 2015 to $28.1 million in 2016. The decrease in pension settlement charges was primarily due to the Company entering into two agreements in 2015 pursuant to which two of the Company's U.S. defined benefit pension plans purchased group annuity contracts from Prudential. The two group annuity contracts required Prudential to pay and administer future pension benefits for approximately 8,400 U.S. Timken retirees in the aggregate. The Company transferred a total of approximately $1.1 billion of its pension obligations and a total of approximately $1.2 billion of pension assets to Prudential in these transactions. In addition to the purchase of the group annuity contracts, the Company made lump-sum distributions of $37.2 million to new retirees in the United States in 2015. In 2015, the Company also entered into an agreement pursuant to which one of the Company's Canadian defined benefit pension plans purchased a group annuity contract from Canada Life. The group annuity contract required Canada Life to pay and administer future pension benefits for approximately 40 Canadian retirees. As a result of the group annuity contracts and lump-sum distributions, as well as pension settlement and curtailment charges related to the Company's Canadian pension plans, the Company incurred total pension settlement and curtailment charges of $465.0 million, including professional fees of $2.6 million, in 2015. In 2016, one of the Company's Canadian defined benefit pension plans purchased a group annuity contract from Canada Life to pay and administer future pension benefits for 135 Canadian retirees, as well as lump-sum distributions to deferred vested participants of $6.8 million were paid in the same plan. The Company also made lump-sum distributions of $32.4 million to new retirees in 2016 in one of the Company's U.S. defined benefit pension plans. In addition, the Company made lump-sum distributions to deferred vested participants in 2016 in another of the Company's U.S. defined benefit pension plans. As a result of the group annuity contract purchase and lump-sum distributions that triggered remeasurment, the Company recognized pension settlement charges of $28.1 million, including professional fees of $1.5 million, in 2016. The lower interest costs in 2016 were primarily due to lower defined benefit pension obligations as a result of the purchase of the group annuity contracts in 2015, and the lower amortization of net actuarial losses was due primarily to the recognition of pension settlement charges in 2015, which reduced the amount of net actuarial losses to be amortized in 2016. Net actuarial losses are generally amortized over the average remaining service period of participants in the defined benefit pension plans. Refer to Note 1 - Significant Accounting Policies for additional information on the amortization of actuarial gains and losses. The lower expected return from plan assets for 2016, compared to 2015, was primarily due to a lower pension asset base in 2016 primarily due to the purchase of the group annuity contracts in 2015 and a lower expected rate of return. In 2017, the Company expects net periodic benefit cost to decrease to approximately $42 million for defined benefit pension plans. The expected decrease is primarily due to lower pension settlement charges and lower interest costs, partially offset by higher amortization of net actuarial losses. Pension settlement charges are expected to decrease approximately $15 million as the Company expects to incur pension settlement charges of approximately $13 million in 2017, compared with $28.1 million in 2016. Interest costs are expected to decrease in 2017, compared with 2016, primarily due to a decrease in the weighted-average discount rate used for expense purposes from 4.69% for 2016 to 4.34% for 2017 for U.S. defined benefit pension plans and from 3.75% for 2016 to 2.50% for 2017 for the Company's U.K. defined benefit pension plan. Amortization of actuarial losses is expected to increase as a result of a decrease in the discount rate to measure the Company's pension obligations for its U.S. and U.K defined benefit pension plans. The Company expects to contribute approximately $10 million to its defined benefit pension plans in 2017 compared with $15.0 million in 2016. The following table below presents a reconciliation of the cumulative net actuarial losses at December 31, 2013 and the cumulative net actuarial losses at December 31, 2016: During the period between December 31, 2013 and December 31, 2016, net actuarial losses decreased by $702.9 million. This decrease included $521.3 million of pension settlement charges, representing an acceleration of previously recognized net actuarial gains and losses, the Spinoff of $347.4 million and the amortization of actuarial losses of $115.1 million, partially offset by net actuarial losses totaling $312.3 million recognized for defined benefit pension plans. The net actuarial losses occurred the years between 2014 and 2016. In 2014, the net actuarial loss of $161.2 million was primarily due to an 82 basis point reduction in the Company's discount rate used to measure its defined benefit pension obligations, as well as the impact of adopting the new RP-2014 mortality tables for pension obligations. The change in the discount rate accounted for approximately $226 million of the net actuarial loss, and the change due to the adoption of the new RP-2014 mortality tables accounted for approximately $59 million. Net actuarial losses as a result of the discount rate and the adoption of the new mortality tables were partially offset by higher than expected asset returns of approximately $117 million (a net asset gain of $292.7 million on actual assets in 2014, or positive 11.2% on pension plan assets of $2.1 billion, compared with an expected return of $175.7 million, or 7.25%, in 2014). The remaining portion of the net actuarial loss for 2014 was due to other changes in actuarial assumptions. In 2015, the net actuarial loss of $89.5 million was primarily due to the amount of the premium of $116.1 million paid to Prudential (the difference between the pension assets transferred to Prudential and the pension obligations transferred to Prudential) in connection with the purchase of the group annuity contracts in 2015, as well as lower than expected asset returns of $51.8 million (a net asset gain of $27.5 million on actual assets in 2015, or a positive 1.3% on pension assets of $858.3 million, compared with an expected return of $79.3 million, or 6.0%, in 2015). These items were partially offset by a 50 basis point increase in the Company's discount rate used to measure its defined benefit pension obligations. The change in the discount rate accounted for $56.1 million. The remaining portion of the net actuarial loss for 2015 was due to other changes in actuarial assumptions. In 2016, the net actuarial loss of $61.6 million was primarily due to a 35 basis point reduction in the discount rate used to measure the Company's U.S. defined benefit pension obligations and a 125 basis point reduction in the discount rate used to measure its U.K defined benefit pension obligations. The change in the discount rate accounted for approximately $87 million of the net actuarial loss. Net actuarial losses as a result of the discount rate were partially offset by higher than expected asset returns of approximately $37 million (a net asset gain of $77.0 million on actual assets in 2016, or positive 8.5% on pension plan assets of $798.3 million, compared with an expected return of $40.1 million, or 6%, in 2016). The remaining portion of the net actuarial loss for 2016 was due to other changes in actuarial assumptions. During the period between December 31, 2013 and December 31, 2016, the Company contributed a total of $46.9 million to its global defined benefit pension plans. As discussed above, the Company expects to contribute approximately $10 million to its global defined benefit pension plans in 2017. Despite the net actuarial losses recorded for the period between December 31, 2013 and December 31, 2016, only approximately $8 million of contributions were required in 2016. The contributions over the last three years, as well as favorable returns on pension assets, have contributed to the Company's U.S. defined benefit pension plans being overfunded and a lower requirement for the Company to contribute to its defined benefit pension plans. The effect of actuarial losses on future earnings and operating cash flow, as well as a lower discount rate to measure the Company's pension obligations, is expected to be favorable in 2017, compared with 2016. For expense purposes in 2016, the Company applied a weighted-average discount rate of 4.69% to its US defined benefit pension plans. For expense purposes in 2017, the Company will apply a weighted-average discount rate of 4.34% to its U.S. defined benefit pension plans. For expense purposes in 2016, the Company applied an expected weighted-average rate of return of 5.78% for the Company’s U.S. pension plan assets. For expense purposes in 2017, the Company will apply an expected weighted-average rate of return on plan assets of 5.78%. The following table presents the sensitivity of the Company's U.S. projected pension benefit obligation ("PBO"), total equity and 2016 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the PBO by $21.4 million and decrease total equity by $21.4 million. The change in equity in the table above is reflected on a pre-tax basis. Defined benefit pension plans in the United States represent 66% of the Company's benefit obligation and 66% of the fair value of the Company's plan assets at December 31, 2016. The Company uses a combined U.S. federal and state statutory rate of approximately 37% to calculate the after tax impact on equity for U.S. plans. The Company uses the local statutory tax rate in effect to calculate the after tax impact on equity for all remaining non-U.S. plans. For some non-U.S. plans, a valuation allowance has been recorded against the tax benefits recorded in equity and, therefore, no tax benefits are recognized on an after tax basis. Postretirement Benefit Plans: The Company recognized net periodic benefit cost of $5.8 million in 2016 for postretirement benefit plans, compared with $5.1 million in 2015. The increase was primarily due to a lower expected return on plan assets. The lower expected return on plan assets for 2016 was primarily due to a 25 basis point decrease in the expected return on assets in the Company's Voluntary Employee Beneficiary Association (VEBA) trust. In 2017, the Company expects net periodic benefit cost to decrease to $2.3 million for postretirement benefit plans. The expected decrease is primarily due to lower amortization of prior service cost of $2.1 million and lower interest costs of $1.9 million, partially offset by a lower expected return on plan assets of $0.8 million. The lower amortization of prior service costs is primarily due to an amendment to the Company's postretirement benefit plan in 2016. The Company will no longer offer company subsidized postretirement medical benefits to non-bargaining employees who retire after December 31, 2016. This amendment reduced the accumulated benefit obligation by $11.4 million in 2016. This amount will be amortized over the remaining service period of the employees affected by this amendment. The expected decrease in interest costs was primarily due to a 42 basis point reduction in the discount rated used for expense purposes. The lower expected return on plan assets is primarily due to a reduction in VEBA trust assets in 2016 that will affect the expected return on plan assets in 2017. For expense purposes in 2016, the Company applied a discount rate of 4.39% to its postretirement benefit plans. For expense purposes in 2017, the Company will apply a discount rate of 3.97% to its postretirement benefit plans. For expense purposes in 2016, the Company applied an expected rate of return of 6.00% to the VEBA trust assets. For expense purposes in 2017, the Company will apply an expected rate of return of 6.00% to the VEBA trust assets. The following table presents the sensitivity of the Company's accumulated other postretirement benefit obligation (ABO), total equity and 2017 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the ABO by $4.2 million and decrease equity by $4.2 million. The change in total equity in the table above is reflected on a pre-tax basis. For measurement purposes for postretirement benefits, the Company assumed a weighted-average annual rate of increase in per capita cost (health care cost trend rate) for medical and prescription drug benefits of 6.50% for 2017, declining steadily for the next six years to 5.0%; and 8.50% for HMO benefits for 2017, declining gradually for the next 14 years to 5.0%. The assumed health care cost trend rate may have a significant effect on the amounts reported. A one percentage point increase in the assumed health care cost trend rate would have increased the 2016 total service and interest cost components by $0.2 million and would have increased the postretirement obligation by $6.0 million. A one percentage point decrease would provide corresponding reductions of $0.2 million and $5.3 million, respectively. Other loss reserves: The Company has a number of loss exposures that are incurred in the ordinary course of business such as environmental claims, product liability, product warranty, litigation and accounts receivable reserves. Establishing loss reserves for these matters requires management’s judgment with regards to estimating risk exposure and ultimate liability or realization. These loss reserves are reviewed periodically and adjustments are made to reflect the most recent facts and circumstances. OTHER DISCLOSURES: Foreign Currency: Assets and liabilities of subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the reporting period. Related translation adjustments are reflected as a separate component of accumulated other comprehensive loss. Foreign currency gains and losses resulting from transactions are included in the Consolidated Statements of Income. The Company recognized a foreign currency exchange loss resulting from transactions of $5.6 million, $0.3 million and $9.9 million for the years ended December 31, 2016, 2015 and 2014, respectively. For the year ended December 31, 2016, the Company recorded a negative non-cash foreign currency translation adjustment of $34.5 million that decreased shareholders’ equity, compared with a negative non-cash foreign currency translation adjustment of $71.5 million that decreased shareholders’ equity for the year ended December 31, 2015. The foreign currency translation adjustments for the year ended December 31, 2016 were negatively impacted by the strengthening of the U.S. dollar relative to most other currencies. Change in Accounting Principle: Timken plans to adopt mark-to-market accounting for its defined benefit pension and other postretirement benefit plans in the first quarter of 2017, subject to the completion of its preferability analysis. Under the new accounting method, the Company will immediately recognize actuarial gains and losses through earnings in the year in which they occur (in the fourth quarter or earlier as triggering events warrant). Under the current accounting method, actuarial gains and losses are recognized as a component of other comprehensive income (loss) and amortized to earnings over many years. Also in the first quarter of 2017, the Company plans to change its policy for recognizing returns on plan assets from a market-related value method (based on a smoothing of asset returns) to a fair value method. Once adopted, these policy changes will be applied retrospectively to prior years. The Company is currently determining the impact on prior years and will provide that information later in 2017. Actual results for 2016 and related disclosures, as well as the Company's 2017 outlook, included in this Form 10-K do not reflect the impact of these voluntary method changes. Trade Law Enforcement: The U.S. government has an antidumping duty order in effect covering tapered roller bearings from China. The Company is a producer of these bearings, as well as ball bearings and other bearing types, in the United States. In 2012, the U.S. government extended this order for an additional five years. Antidumping duty orders covering ball bearings from Japan and the United Kingdom were sunset, as expected, by the U.S. Department of Commerce in March 2014, retroactive to September 2011. Quarterly Dividend: On February 10, 2017, the Company’s Board of Directors declared a quarterly cash dividend of $0.26 per common share. The quarterly dividend will be paid on March 3, 2017 to shareholders of record as of February 22, 2017. This will be the 379th consecutive quarterly dividend paid on the common shares of the Company. Forward-Looking Statements Certain statements set forth in this Annual Report on Form 10-K and in the Company’s 2016 Annual Report to Shareholders (including the Company’s forecasts, beliefs and expectations) that are not historical in nature are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. In particular, Management’s Discussion and Analysis on pages 17 through 47 contains numerous forward-looking statements. Forward-looking statements generally will be accompanied by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “outlook,” “intend,” “may,” “possible,” “potential,” “predict,” “project” or other similar words, phrases or expressions. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. Actual results may differ materially from those expressed or implied in forward-looking statements made by or on behalf of the Company due to a variety of factors, such as: (a) deterioration in world economic conditions, or in economic conditions in any of the geographic regions in which the Company or its customers or suppliers conducts business, including additional adverse effects from the global economic slowdown, terrorism or hostilities. This includes: political risks associated with the potential instability of governments and legal systems in countries in which the Company, its customers or suppliers conduct business, and changes in foreign currency valuations; (b) the effects of fluctuations in customer demand on sales, product mix and prices in the industries in which the Company operates. This includes: the ability of the Company to respond to rapid changes in customer demand, the effects of customer or supplier bankruptcies or liquidations, the impact of changes in industrial business cycles, and whether conditions of fair trade continue in our markets; (c) competitive factors, including changes in market penetration, increasing price competition by existing or new foreign and domestic competitors, the introduction of new products by existing and new competitors, and new technology that may impact the way the Company’s products are produced, sold or distributed; (d) changes in operating costs. This includes: the effect of changes in the Company’s manufacturing processes; changes in costs associated with varying levels of operations and manufacturing capacity; availability and cost of raw materials; changes in the expected costs associated with product warranty claims; changes resulting from inventory management and cost reduction initiatives; the effects of unplanned plant shutdowns; and changes in the cost of labor and benefits; (e) the success of the Company’s operating plans, announced programs, initiatives and capital investments; the ability to integrate acquired companies; the ability of acquired companies to achieve satisfactory operating results, including results being accretive to earnings; and the Company’s ability to maintain appropriate relations with unions that represent Company associates in certain locations in order to avoid disruptions of business; (f) unanticipated litigation, claims or assessments. This includes: claims or problems related to intellectual property, product liability or warranty, environmental issues, and taxes; (g) changes in worldwide capital markets, including availability of financing and interest rates on satisfactory terms, which affect: the Company’s cost of funds and/or ability to raise capital; and the ability of customers to obtain financing to purchase the Company’s products or equipment that contain the Company’s products; (h) the impact on the Company's pension obligations due to changes in interest rates, investment performance, changes in law or regulation, and other tactics designed to reduce risk; (i) the impact of changes to the Company's accounting methods, including the actual impact of the adoption of mark-to-market accounting; (j) retention of CDSOA distributions; (k) the taxable nature of the Spinoff; and (l) those items identified under Item 1A. Risk Factors on pages 6 through 11. Additional risks relating to the Company’s business, the industries in which the Company operates or the Company’s common shares may be described from time to time in the Company’s filings with the Securities and Exchange Commission. All of these risk factors are difficult to predict, are subject to material uncertainties that may affect actual results and may be beyond the Company’s control. Readers are cautioned that it is not possible to predict or identify all of the risks, uncertainties and other factors that may affect future results and that the above list should not be considered to be a complete list. Except as required by the federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

<s>[INST] OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, belts, chain, couplings, and related products and offers a variety of power system rebuild and repair services. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken®, Fafnir®, Philadelphia Gear®, Carlisle®, Drives®, Lovejoy® and InterlubeTM. Timken applies its deep knowledge of metallurgy, friction management and mechanical power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both OEM and aftermarket channels. With more than 14,000 people operating in 28 countries, Timken makes the world more productive and keeps industry in motion. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: Mobile Industries serves OEM customers that manufacture offhighway equipment for the agricultural, mining and construction markets; onhighway vehicles including passenger cars, light trucks, and medium and heavyduty trucks; rail cars and locomotives; outdoor power equipment; and rotorcraft and fixedwing aircraft. Beyond service parts sold to OEMs, aftermarket sales to individual end users, equipment owners, operators and maintenance shops are handled through the Company's extensive network of authorized automotive and heavytruck distributors. Process Industries serves OEM and enduser customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal and wind power generation; oil and gas extraction and refining; pulp and paper and food processing; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors. Timken creates value by understanding customer needs and applying its knowhow in attractive market sectors. The Company’s business strengths include its channel mix and endmarket diversity, serving a broad range of customers and industries across the globe. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Timken Business Model is the specific framework for how the Company evaluates opportunities and differentiates itself in the market. The Company’s Strategy is to apply the Timken Business Model and leverage the Company’s competitive differentiators and strengths to create customer value and drive increased growth and profitability by: Capturing Opportunities and Expanding Reach. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Performing With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Driving Effective Capital Deployment. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes (1) investing in the core business through capital expenditures, research and development and organic growth initiatives like DeltaX; (2) pursuing [/INST] Negative. </s>

TIMKEN CO

2018-02-15

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share data) OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, belts, chain, lubrication systems, couplings, industrial clutches and brakes and related products and offers a variety of power system rebuild and repair services. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken®, Fafnir®, Philadelphia Gear®, Drives®, Lovejoy® and Groeneveld®. Timken applies its deep knowledge of metallurgy, friction management and mechanical power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both original equipment manufacturers ("OEMs") and aftermarket channels. With more than 15,000 people operating in 33 countries, Timken makes the world more productive and keeps industry in motion. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: • Mobile Industries serves OEM customers that manufacture off-highway equipment for the agricultural, mining and construction markets; on-highway vehicles including passenger cars, light trucks, and medium- and heavy-duty trucks; rail cars and locomotives; outdoor power equipment; rotorcraft and fixed-wing aircraft; and other mobile equipment. Beyond service parts sold to OEMs, aftermarket sales and services to individual end users, equipment owners, operators and maintenance shops are handled directly or through the Company's extensive network of authorized automotive and heavy-truck distributors. • Process Industries serves OEM and end-user customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal and wind power generation; oil and gas extraction and refining; pulp and paper and food processing; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors and through the provision of services directly to end users. Timken creates value by understanding customer needs and applying its know-how in attractive market sectors, serving a broad range of customers and industries across the globe. The Company’s business strengths include its product technology, end-market diversity, geographic reach and aftermarket mix. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling largely through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Timken Business Model is the specific framework for how the Company evaluates opportunities and differentiates itself in the market. Outgrowing Our Markets. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Operating With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Deploying Capital to Drive Shareholder Value. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes: (1) investing in the core business through capital expenditures, research and development and organic growth initiatives; (2) pursuing strategic acquisitions to broaden our portfolio and capabilities, with a focus on bearings, adjacent power transmission products and related services; and (3) returning capital to shareholders through dividends and share repurchases. As part of this framework, the Company also may restructure, reposition or divest underperforming product lines or assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2017: Acquisitions • On April 3, 2017, the Company completed the acquisition of the shares of Torsion Control Products, Inc. ("Torsion Control Products"), a manufacturer of engineered torsional couplings used in the construction, agriculture and mining industries. Torsion Control Products, located in Rochester Hills, Michigan, had sales of approximately $20 million for the 12 months ended December 31, 2016. Based on markets and customers served, substantially all of the results for Torsion Control Products are reported in the Mobile Industries segment. • On May 5, 2017, the Company completed the acquisition of the assets of PT Tech, Inc. ("PT Tech"), a manufacturer of engineered clutches, brakes, hydraulic power take-off units and other torque management devices used in mining, aggregate, wood recycling and metals industries. PT Tech, located in Sharon Center, Ohio, had sales of approximately $22 million for the 12 months ended April 30, 2017. Based on markets and customers served, substantially all of the results for PT Tech are reported in the Mobile Industries segment. • On July 3, 2017, the Company completed the acquisition of the shares of Wenjo B.V. ("Groeneveld"), a leading provider of automated lubrication solutions used in on- and off-highway applications. Groeneveld, located in Gorinchem, Netherlands with manufacturing facilities in Italy, had sales of approximately $105 million for the 12 months ended May 31, 2017. Based on markets and customers served, substantially all of the results for Groeneveld are reported in the Mobile Industries segment. • On July 5, 2017, the Company announced that the Company's majority-owned subsidiary, Timken India Ltd. ("Timken India"), entered into a definitive agreement to acquire ABC Bearings Limited ("ABC Bearings"), a manufacturer of tapered, cylindrical and spherical roller bearings and slewing rings in India. The transaction is structured as a merger of ABC Bearings into Timken India, whereby shareholders of ABC Bearings will receive shares of Timken India as consideration. The transaction is subject to receipt of various approvals in India, which are expected to be completed in the first half of 2018. ABC Bearings, located in Mumbai, India, operates primarily out of manufacturing facilities in Bharuch, Gujarat and Dehradun, Uttarakhand and had sales of approximately $29 million for the 12 months ended May 31, 2017. Operational Highlights • On June 13, 2017, the Company held the grand opening for its new state-of-the-art bearing plant in Prahova, Romania, where Timken® metric tapered roller bearings are manufactured. The new plant strengthens the Company's global footprint and product offering. RESULTS OF OPERATIONS 2017 vs. 2016 Overview: The increase in net sales was primarily due to higher end-market demand and the benefit of acquisitions. The increase in net income in 2017 compared with 2016 was primarily due to improved performance across the business, as well as lower net actuarial losses due to the remeasurement of pension and other postretirement assets and obligations ("Mark-to-Market Charges"), restructuring charges, and income tax expense, partially offset by lower pre-tax U.S. Continued Dumping and Subsidy Offset Act ("CDSOA") income of $59.6 million. The improvement in business performance reflects higher volume, favorable manufacturing performance, the benefit of acquisitions and the favorable impact of foreign currency exchange rate changes, partially offset by unfavorable price/mix and higher material, logistics and selling, general and administrative ("SG&A") expenses. Outlook: The Company expects 2018 full-year sales to increase 9% to 10% compared with 2017 primarily due to increased demand across most end-market sectors, higher pricing, the benefit of acquisitions and the favorable impact of foreign currency exchange rate changes. The Company's earnings are expected to be higher in 2018 than 2017, primarily due to the impact of higher volume, favorable price/mix, the benefit of acquisitions and the favorable impact of foreign currency exchange rate changes, partially offset by higher operating costs, a higher income tax rate and higher interest expense. The Company expects to generate operating cash of approximately $350 million in 2018, an increase from 2017 of approximately $113 million or 48%, as the Company anticipates higher net income and lower working capital requirements. The Company expects capital expenditures to be 3.5% to 4.0% of sales in 2018, compared with 3.5% of sales in 2017. THE STATEMENTS OF INCOME Sales: Net sales increased in 2017 compared with 2016 primarily due to higher organic revenue of $186 million, the benefit of acquisitions of $131 million and the favorable impact of foreign currency exchange rate changes of $17 million. The increase in organic revenue was driven by higher demand across most of the Company's market sectors led by the off-highway, industrial distribution and heavy truck sectors, partially offset by lower demand in the rail sector. Gross Profit: Gross profit increased in 2017 compared with 2016 primarily due to the impact of higher volume of $74 million, the benefit of acquisitions of $52 million, favorable manufacturing performance of $49 million and lower Mark-to-Market Charges of $31 million. These factors were partially offset by higher material and logistics costs of $34 million and unfavorable price/mix of $34 million. Selling, General and Administrative Expenses: The increase in SG&A expenses in 2017 compared with 2016 was primarily due to the impact of acquisitions and higher incentive compensation expense, partially offset by lower Mark-to-Market Charges. Impairment and Restructuring Charges: Impairment and restructuring charges of $4.3 million in 2017 were primarily comprised of severance and related benefit costs associated with initiatives to reduce headcount and right-size the Company's manufacturing footprint, including the planned closure of its bearing plant in Pulaski, Tennessee ("Pulaski"). Impairment and restructuring charges of $21.7 million in 2016 were primarily comprised of severance and related benefit costs associated with initiatives to reduce headcount and right-size the Company's manufacturing footprint, including the planned closures of its bearing plants in Altavista, Virginia ("Altavista"), Pulaski and Benoni, South Africa ("Benoni"). In addition, the Company recognized impairment charges of $3.9 million during 2016 that were primarily associated with the planned closures of the Altavista and Benoni bearing plants. Interest Expense and Income: Interest expense increased in 2017 compared to 2016 primarily due to an increase in outstanding debt mostly associated with the Groeneveld acquisition. Refer to Note 10 - Financing Arrangements in the Notes to the Consolidated Financial Statements for further discussion. Other Income (Expense): CDSOA income, net in 2016 represents income recorded in connection with funds distributed to the Company from monies collected by U.S. Customs and Border Protection ("U.S. Customs") from antidumping cases, net of related professional fees. Refer to Note 21 - Continued Dumping and Subsidy Offset Act in the Notes to the Consolidated Financial Statements for further discussion. The increase in other income (expense), net for 2017, compared to 2016 was primarily due to lower foreign currency exchange losses and gains recorded from the sale of the Company's former manufacturing facilities in Benoni and Altavista during 2017. Income Tax Expense: The effective tax rate for 2017 was 22.2%, which was favorable to the U.S. federal statutory rate of 35% due to earnings in certain foreign jurisdictions where the effective rate is less than 35%, U.S. foreign tax credits realized on earnings distributed to the United States, and favorable U.S. permanent deductions and tax credits. The effective tax rate was further impacted favorably by the net reversal of accruals for prior year uncertain tax positions, a valuation allowance release, and other discrete items. These favorable impacts were partially offset by provisional amounts for the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate enacted under the Tax Cuts and Jobs Act of 2017 ("U.S. Tax Reform"). U.S. Tax Reform includes a number of changes to existing U.S. tax laws that impact the Company, most notably a reduction of the U.S. corporate income tax rate from 35% to 21% for tax years beginning after December 31, 2017. U.S. Tax Reform also requires companies to pay a one-time net charge related to the taxation of unremitted foreign earnings, creates new taxes on certain foreign sourced earnings and allows for immediate expensing of certain depreciable assets after September 27, 2017. The effective tax rate for 2016 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, the U.S. manufacturing deduction, and certain discrete tax benefits (net). These favorable impacts were partially offset by U.S. taxation of foreign income and losses at certain foreign subsidiaries where no tax benefit could be recorded. The change in the effective rate for 2017 compared with 2016 was primarily due to favorable discrete tax items. Refer to the table below for additional detail of the impact of each item on income tax expense. (1) U.S. taxation includes the impact of foreign tax credits, U.S. Manufacturing deductions, U.S. Research and Experimentation credit, U.S. state and local taxation, U.S. taxation of foreign earnings and other U.S. items. (2) Net reversal of accruals for uncertain tax positions were primarily driven by expiration of applicable statutes of limitations. Refer to Note 17 - Income Taxes in the Notes to the Consolidated Financial Statements for more information on the computation of the income tax expense in interim periods. BUSINESS SEGMENTS The Company's reportable segments are business units that serve different industry sectors. While the segments often operate using shared infrastructure, each reportable segment is managed to address specific customer needs in these diverse market sectors. The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 16 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions and divestitures completed in 2017 and 2016 and foreign currency exchange rate changes. The effects of acquisitions and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions completed in 2017 and 2016 by segment based on the customers and underlying markets served: • The Company acquired Groeneveld during the third quarter of 2017. Substantially all of the results for Groeneveld are reported in the Mobile Industries segment. • The Company acquired Torsion Control Products and PT Tech during the second quarter of 2017. Substantially all of the results for both businesses are reported in the Mobile Industries segment. • The Company acquired the shares of EDT Corp. ("EDT") during the fourth quarter of 2016. Substantially all of the results for EDT are reported in the Process Industries segment. • The Company acquired the shares of Lovejoy, Inc. ("Lovejoy") during the third quarter of 2016. Substantially all of the results for Lovejoy are reported in the Process Industries segment. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased by $87.0 million or 6.0% in 2017 compared with 2016, reflecting organic growth in the off-highway and heavy truck market sectors, partially offset by decreased demand in the rail sector. EBIT increased by $45.0 million or 51.7% in 2017 compared with 2016 primarily due to higher volume of $32 million, lower Mark-to-Market Charges of $23 million, favorable manufacturing performance of $21 million, the benefit of acquisitions of $16 million, lower restructuring charges of $9 million and the impact of foreign currency exchange rate changes of $6 million. These factors were offset partially by higher material and logistics costs of $26 million, increased SG&A expense of $19 million and unfavorable price/mix of $16 million. The higher SG&A expense was primarily due to higher incentive compensation expense. Full-year sales for the Mobile Industries segment are expected to be up approximately 9% to 11% in 2018 compared with 2017. This reflects improved demand in the off-highway and heavy truck sectors, higher pricing, the benefit of acquisitions and the favorable impact of foreign currency exchange rate changes. EBIT for the Mobile Industries segment is expected to increase in 2018 compared with 2017 primarily due to the impact of higher volume and the impact of acquisitions and favorable price/mix, partially offset by higher operating costs. The results for 2017 include the impacts of pension and other postretirement benefit Mark-to-Market Charges, which are not accounted for in the 2018 outlook because the amount will not be known until the fourth quarter of 2018. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased by $99.1 million or 8.1% in 2017 compared with 2016. The increase was primarily driven by organic growth in the industrial distribution, general industrial OE and military marine sectors. EBIT increased by $71.0 million or 47.5% in 2017 compared with 2016 primarily due to the impact of higher volume of $49 million, favorable manufacturing performance of $29 million, lower Mark-to-Market Charges of $18 million, lower restructuring charges of $7 million and the benefit of acquisitions. These factors were partially offset by unfavorable price/mix of $26 million, higher material and logistics costs of $8 million and higher SG&A expense of $7 million. The higher SG&A expense was due to higher incentive compensation expense. Full-year sales for the Process Industries segment are expected to be up approximately 8% to 10% in 2018 compared with 2017. This reflects expected growth across most end-market sectors, led by industrial distribution, general industrial OE and industrial services, higher pricing and the favorable impact of foreign currency exchange rate changes. EBIT for the Process Industries segment is expected to increase in 2018 compared with 2017 primarily due to the impact of higher volume, favorable price/mix and the favorable impact of foreign currency exchange rate changes, partially offset by higher operating costs. The results for 2017 include the impacts of pension and other postretirement benefit Mark-to-Market Charges, which are not accounted for in the 2018 outlook because the amount will not be known until the fourth quarter of 2018. Corporate: RESULTS OF OPERATIONS: 2016 vs. 2015 Overview: The decrease in net sales was primarily due to lower end-market demand and the impact of foreign currency exchange rate changes, partially offset by the net benefit of acquisitions and divestitures. The decrease in net income in 2016 compared with 2015 was primarily due to the impact of lower volume across most market sectors, unfavorable price/mix, higher Mark-to-Market Charges, higher restructuring charges and the impact of foreign currency exchange rate changes. These factors were offset partially by pretax CDSOA income of $59.6 million recorded in 2016, lower material and manufacturing costs and lower SG&A expenses. The prior year also included a gain from the divestiture of Timken Alcor Aerospace Technologies, Inc. ("Alcor") and higher discrete income tax benefits. THE STATEMENTS OF INCOME Sales: Net sales decreased in 2016 compared with 2015 primarily due to lower organic sales of $239 million, the effect of foreign currency exchange rate changes of $47 million and divestitures of $15 million, partially offset by the benefit of acquisitions of $99 million. The decrease in organic sales was driven by lower demand across most market sectors, partially offset by growth in the automotive market sector. Gross Profit: Gross profit decreased in 2016 compared with 2015 primarily due to the impact of lower volume of $91 million, unfavorable price/mix of $65 million, higher Mark-to-Market Charges of $43 million, higher restructuring charges and the impact of foreign currency exchange rate changes. These factors were offset partially by lower material and manufacturing costs net of manufacturing underutilization of $52 million and the benefit of acquisitions. Selling, General and Administrative Expenses: The increased in SG&A expenses in 2016 compared with 2015 was primarily due to higher Mark-to-Market Charges of $42 million, additional expenses from Carlstar Belt LLC ("Timken Belts"), Lovejoy and EDT acquired in September 2015, July 2016, and October 2016, respectively, partially offset by the benefit of cost reduction initiatives of $26 million, the impact of foreign currency exchange rate changes, lower depreciation expense and lower non-income tax expense. Impairment and Restructuring Charges: Impairment and restructuring charges of $21.7 million in 2016 were comprised primarily of severance and related benefit costs associated with initiatives to reduce headcount and right-size the Company's manufacturing footprint, including the planned closures of the Altavista, Pulaski and Benoni bearing plants. In addition, the Company recognized impairment charges of $3.9 million during 2016 that were primarily associated with the planned closures of the Altavista and Benoni bearing plants. Impairment and restructuring charges of $14.7 million in 2015 were primarily due to severance and related benefit costs associated with initiatives to reduce headcount, impairment charges of $3.0 million related to the Company's service center in Niles, Ohio and exit costs of approximately $3.0 million related to the Company's termination of its relationship with one of its third-party sales representatives in Colombia. Pension Settlement Charges: Pension settlement charges in 2015 were primarily due to the purchase of group annuity contracts from Prudential Insurance Company of America ("Prudential") by two of the Company's U.S. defined benefit pension plans. The two group annuity contracts require Prudential to pay and administer future pension benefits for approximately 8,400 U.S. Timken retirees in the aggregate. The Company transferred a total of approximately $1.1 billion of its pension obligations and a total of approximately $1.2 billion of pension assets to Prudential in these transactions. The Company also incurred pension settlement and curtailment charges related to one of its Canadian defined benefit pension plans. As a result of the group annuity contracts, as well as pension settlement and curtailment charges related to the Canadian pension plan, the Company incurred total pension settlement and curtailment charges of $119.9 million, including professional fees of $2.6 million, in 2015. Gain on Divestiture: Gain on divestiture in 2015 was related primarily to the gain on the sale of Alcor of $29.0 million in the fourth quarter of 2015. Interest Expense and Income: Other Income (Expense): CDSOA income, net in 2016 represents income recorded in connection with funds awarded to the Company from monies collected by U.S. Customs from antidumping cases, net of related professional fees. During the fourth quarter of 2015, the Company wrote-off $9.7 million that remained in construction in process ("CIP") after the related assets were placed into service. The majority of these assets were placed into service between 2008 and 2012. This item was identified during an examination of aged balances in the CIP account. Management of the Company concluded that the correction of this error in the fourth quarter of 2015 and the presence of this error in prior periods was immaterial to all periods presented. Income Tax Expense: The effective tax rate for 2016 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, the U.S. manufacturing deduction, and certain discrete tax benefits (net). These favorable impacts were partially offset by U.S. taxation of foreign income and losses at certain foreign subsidiaries where no tax benefit could be recorded. The effective tax rate for 2015 was 12.1%. The tax rate of 12.1% was less than the U.S. statutory rate of 35% primarily due to the tax benefits from the reversals of certain valuation allowances in foreign jurisdictions, U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, reversals of reserves for uncertain tax positions, state and local taxes, the U.S. manufacturing deduction, the U.S. research tax credit and other U.S. tax benefits. These factors were offset by U.S. taxation of foreign earnings, recording of deferred tax liabilities related to foreign branch operations, and losses at certain foreign subsidiaries where no tax benefit could be recorded. The change in the effective tax rate for 2016 compared with 2015 was primarily due to unfavorable discrete items. Refer to the table below for additional detail of the impact of each item on income tax expense. (1) U.S. taxation includes the impact of foreign tax credits, U.S. Manufacturing deductions, U.S. Research and Experimentation credit, U.S. state and local taxation, U.S. taxation of foreign earnings and other U.S. items. BUSINESS SEGMENTS The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 16 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions and divestitures completed in 2016 and 2015 and foreign currency exchange rate changes. The effects of acquisitions, divestitures and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions and divestitures completed in 2016 and 2015: • The Company acquired EDT during the fourth quarter of 2016. Results for EDT are reported in the Process Industries segment. • The Company acquired Lovejoy during the third quarter of 2016. Substantially all of the results for Lovejoy are reported in the Process Industries segment based on the customers and underlying markets served. • The Company sold Alcor during the fourth quarter of 2015. Results for Alcor prior to the sale were reported in the Mobile Industries segment. • The Company acquired Timken Belts during the third quarter of 2015. Results for Timken Belts are reported in the Mobile Industries and Process Industries segments based on the customers and underlying markets served. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions, divestitures and foreign currency exchange rate changes, decreased $120.2 million or 7.7% in 2016 compared with 2015. The decline in net sales was primarily driven by a decrease in the rail, off-highway, aerospace and heavy truck market sectors, partially offset by organic growth in the automotive market sector. EBIT was lower in 2016 compared with 2015 primarily due to unfavorable price/mix of $52 million, higher Mark-to-Market Charges of $43 million, the impact of lower volume of $35 million, higher restructuring charges, the impact of foreign currency exchange rate changes and the net unfavorable impact of acquisitions and divestitures, partially offset by lower material and manufacturing costs net of manufacturing underutilization of $46 million and lower SG&A expenses. EBIT for 2015 also included a $29 million gain on the sale of Alcor. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, decreased $119.2 million or 9.1% in 2016 compared with 2015. The decline was primarily due to lower demand across the heavy industries (mainly oil and gas), industrial aftermarket, military marine and wind energy market sectors. EBIT was lower in 2016 compared with 2015 primarily due to the impact of lower volume of $56 million, higher Mark-to-Market Charges of $25 million and unfavorable price/mix, partially offset by lower SG&A expenses of $20 million and lower material and manufacturing costs net of manufacturing underutilization. EBIT in 2015 also included a charge of $8.2 million related to the write-off of certain CIP balances. Corporate: Corporate expenses increased in 2016 compared with 2015 primarily due to higher Mark-to-Market Charges of $17 million, partially offset by cost reduction initiatives. THE BALANCE SHEETS The following discussion is a comparison of the Consolidated Balance Sheets at December 31, 2017 and 2016. Current Assets: Refer to the "Cash Flows" section for discussion on the change in cash and cash equivalents. Accounts receivable, net increased primarily due to higher sales in December 2017 compared to December 2016, current-year acquisitions of $28 million and the impact of foreign currency exchange rate changes of $17 million. Inventories, net increased due to higher demand, current-year acquisitions of $29 million and the impact of foreign currency exchange rate changes of $27 million. Other current assets increased primarily due to an increase in receivables for value-added taxes for several foreign legal entities and an income tax receivable related to the overpayment of current year income taxes in the United States. Property, Plant and Equipment, Net: The increase in property, plant and equipment, net in 2017 was primarily due to the impact of foreign currency exchange rate changes of $34 million and acquisitions in 2017 of $32 million. Other Assets: The increase in goodwill was primarily due to $150 million of goodwill acquired from acquisitions in 2017 and the impact of foreign currency exchange rate changes. The decrease in non-current pension assets was primarily due to the implementation of new mortality assumptions and experience losses for the Company’s U.S. defined benefit pension plans, which negatively impacted funded status. See Note 14 - Retirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. The increase in other intangible assets was primarily due to $174 million of intangible assets acquired from the current-year acquisitions and current-year expenditures for software of $8 million, partially offset by amortization in 2017 of $40 million. The decrease in other non-current assets is primarily due to the decrease in the fair value of derivative assets. Current Liabilities: The increase in short-term debt was primarily due to the change in classification of the outstanding borrowings of $63 million under the Amended and Restated Asset Securitization Agreement ("Accounts Receivable Facility"), as the agreement is expected to expire in November 2018, and higher borrowings of $23 million under foreign lines of credit. The increase in accounts payable was primarily due to increased purchasing activity, as well as higher days outstanding driven by the Company's ongoing initiative to extend payment terms with its suppliers. The increase in accrued salaries, wages and benefits was primarily due to higher accruals for incentive compensation expense, as well as current-year acquisitions. The increase in other current liabilities was primarily due to higher accrued customer rebates, partially offset by lower restructuring accruals. Non-Current Liabilities: The increase in long-term debt was primarily due to the issuance of €150 million ($179.3 million at December 31, 2017) of fixed-rate 2.02% senior unsecured notes on September 7, 2017 ("2027 Notes") and new borrowings of €100 million ($119.7 million at December 31, 2017) under a variable-rate term loan ("2020 Term Loan") that were both used to refinance the Groeneveld acquisition, partially offset by the change in classification of the outstanding borrowings under the Accounts Receivable Facility in accordance with the terms of the agreement and the reduction in borrowings of $32 million under the Company's Senior Credit Facility. The increase in accrued pension cost was primarily due to a decrease in the discount rate used to measure the obligation for the Company's unfunded defined benefit pension plans. The increase in deferred income taxes was primarily due to deferred taxes recognized as a result of the acquisition of Groeneveld. Shareholders’ Equity: Earnings invested in the business in 2017 increased by net income attributable to the Company of $203.4 million, partially offset by dividends declared of $83.3 million. The decrease in accumulated other comprehensive loss was primarily due to foreign currency translation adjustments of $44.7 million. The foreign currency translation adjustments were due to the weakening of the U.S. dollar relative to other foreign currencies, including the Chinese Yuan, Romanian Leu, Indian Rupee and Polish Zloty. See "Other Matters - Foreign Currency" for further discussion regarding the impact of foreign currency translation. CASH FLOWS Operating Activities: Operating activities provided net cash of $236.8 million in 2017, compared with net cash of $403.9 million provided in 2016. The decrease was primarily due to an increase in cash used for working capital items of $107.2 million, the unfavorable impact of income taxes on cash of $45.1 million, the non-cash impact of lower pension and other postretirement expense of $55.1 million and the impact of foreign currency exchange rate changes of $15.6 million, partially offset by higher net income of $61.2 million and the non-cash impact of higher stock-based compensation expense of $10.6 million. Refer to the tables below for additional detail of the impact of the factors on net cash provided by operating activities. The following chart displays the impact of working capital items on cash during 2017 and 2016, respectively: The following table displays the impact of income taxes on cash during 2017 and 2016, respectively: Investing Activities: Net cash used in investing activities of $448.7 million in 2017 increased from the same period in 2016 primarily due to a $274.2 million increase in cash used for acquisitions, partially offset by a $32.8 million reduction in cash used for capital expenditures. Financing Activities: Net cash provided by financing activities was $167.0 million in 2017 compared with net cash of $171.3 million used in financing activities in 2016. The increase was primarily due to an increase in net borrowings of $274.9 million, primarily used to fund the Groeneveld acquisition that closed on July 3, 2017, and lower cash used in share repurchases of $57.6 million during 2017 compared with 2016. LIQUIDITY AND CAPITAL RESOURCES Reconciliation of total debt to net debt and the ratio of net debt to capital: Net Debt: Ratio of Net Debt to Capital: The Company presents net debt because it believes net debt is more representative of the Company's financial position than total debt due to the amount of cash and cash equivalents held by the Company. At December 31, 2017, $118.9 million of the Company's $121.6 million of cash and cash equivalents resided in jurisdictions outside the United States. It is the Company's practice to use available cash in the United States to pay down its Senior Credit Facility or Accounts Receivable Facility in order to minimize total interest expense. Repatriation of non-U.S. cash could be subject to taxes and some portion may be subject to governmental restrictions. Part of the Company's strategy is to grow in attractive market sectors, many of which are outside the United States. This strategy includes making investments in facilities, equipment and potential new acquisitions. The Company plans to fund these investments, as well as meet working capital requirements, with cash and cash equivalents and unused lines of credit within the geographic location of these investments where feasible. The Company expects that any cash requirements in excess of cash on hand and cash generated from operating activities will be met by the committed funds available under its Accounts Receivable Facility and the Senior Credit Facility. Management believes it has sufficient liquidity to meet its obligations through at least the term of the Senior Credit Facility. The Company has a $100.0 million Accounts Receivable Facility that matures on November 30, 2018. The Company is exploring opportunities to refinance the facility prior to its maturity. The Accounts Receivable Facility is subject to certain borrowing base limitations and is secured by certain domestic accounts receivable of the Company. Certain borrowing base limitations reduced the availability of the Accounts Receivable Facility to $82.3 million at December 31, 2017. As of December 31, 2017, the Company had $62.9 million in outstanding borrowings, which reduced the availability under the facility to $19.4 million. The interest rate on the Accounts Receivable Facility is variable and was 2.15% as of December 31, 2017, which reflects the prevailing commercial paper rate plus facility fees. The Company has a $500.0 million Senior Credit Facility that matures on June 19, 2020. At December 31, 2017, the Senior Credit Facility had outstanding borrowings of $52.0 million, which reduced the availability to $448.0 million. The Senior Credit Facility has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. The maximum consolidated leverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0. As of December 31, 2017, the Company’s consolidated leverage ratio was 2.0 to 1.0. The minimum consolidated interest coverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0. As of December 31, 2017, the Company’s consolidated interest coverage ratio was 13.8 to 1.0. The interest rate under the Senior Credit Facility is variable and represents a blended U.S. Dollar and Euro rate with a spread based on the Company’s debt rating. This rate was 1.83% as of December 31, 2017. In addition, the Company pays a facility fee based on the consolidated leverage ratio multiplied by the aggregate commitments of all of the lenders under the Senior Credit Facility. Other sources of liquidity include short-term lines of credit for certain of the Company’s foreign subsidiaries, which provide for borrowings up to approximately $288.9 million. Most of these credit lines are uncommitted. At December 31, 2017, the Company had borrowings outstanding of $42.5 million and bank guarantees of $0.2 million, which reduced the availability under these facilities to $246.2 million. On September 7, 2017, the Company issued the 2027 Notes in the aggregate principal amount of €150 million. On September 18, 2017, the Company entered into the €100 million 2020 Term Loan. Proceeds from the 2027 Notes and 2020 Term Loan were used to repay amounts drawn from the Senior Credit Facility to fund the Groeneveld acquisition. Refer to Note 10 - Financing Arrangements in the Notes to the Consolidated Financial Statements for additional information. At December 31, 2017, the Company was in full compliance with the covenants under the Senior Credit Facility and its other debt agreements. The Company expects to remain in compliance with its debt covenants. However, the Company may need to limit its borrowings under the Senior Credit Facility or other facilities in order to remain in compliance. As of December 31, 2017, the Company could have borrowed the full amounts available under the Senior Credit Facility and Accounts Receivable Facility and still would have been in compliance with all of its debt covenants. The Company expects to generate operating cash of approximately $350 million in 2018, an increase from 2017 of approximately $113 million or 48%, as the Company anticipates higher net income and lower working capital requirements. The Company expects capital expenditures to be 3.5% to 4.0% of sales in 2018, compared with 3.5% of sales in 2017. CONTRACTUAL OBLIGATIONS The Company’s contractual debt obligations and contractual commitments outstanding as of December 31, 2017 were as follows: Payments due by period: The interest payments beyond five years primarily relate to long-term fixed-rate notes. Refer to Note 10 - Financing Arrangements in the Notes to the Consolidated Financial Statements for additional information. Purchase commitments are defined as an agreement to purchase goods or services that are enforceable and legally binding on the Company. Included in purchase commitments above are certain obligations related to take-or-pay contracts, capital commitments, service agreements and utilities. Many of these commitments relate to take-or-pay contracts in which the Company guarantees payment to ensure availability of products or services. These purchase commitments do not represent the entire anticipated purchases in the future, but represent only those items that the Company contractually is obligated to purchase. The majority of the products and services purchased by the Company are purchased as needed, with no commitment. In order to maintain minimum funding requirements, the Company is required to make contributions to the trusts established for its defined benefit pension plans and other postretirement benefit plans. The table above shows the expected future minimum cash contributions to the trusts for the funded plans as well as estimated future benefit payments to participants for the unfunded plans. Those minimum funding requirements and estimated benefit payments can vary significantly. The amounts in the table above are based on actuarial estimates using current assumptions for, among other things, discount rates, expected return on assets and health care cost trend rates. Refer to Note 14 - Retirement Benefit Plans and Note 15 - Other Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. During 2017, the Company made cash contributions of approximately $11.5 million to its global defined benefit pension plans and $12.4 million to its other postretirement benefit plans. The Company currently expects to make contributions to its global defined benefit pension plans totaling approximately $10 million in 2018. The Company also expects to make payments of approximately $5 million to its other postretirement benefit plans in 2018. Excluding Mark-to-Market Charges, the Company expects slightly lower pension expense. Mark-to-Market Charges are not accounted for in the 2018 outlook because the amount will not be known until the fourth quarter of 2018. Refer to Note 14 - Retirement Benefit Plans and Note 15 - Other Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. Refer to Note 11 - Contingencies and Note 17 - Income Taxes in the Notes to the Consolidated Financial Statements for additional information regarding the Company's exposure for certain legal and tax matters. The Company does not have any off-balance sheet arrangements with unconsolidated entities or other persons. RECENTLY ADOPTED ACCOUNTING PRONOUNCMENTS Information required for this Item is incorporated by reference to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The following paragraphs include a discussion of some critical areas that require a higher degree of judgment, estimates and complexity. Revenue recognition: The Company generally recognizes revenue when title passes to the customer. This occurs at the shipping point except for goods sold by certain foreign entities and certain exported goods, where title passes when the goods reach their destination. Selling prices are fixed based on purchase orders or contractual arrangements. Shipping and handling costs billed to customers are included in net sales and the related costs are included in cost of products sold in the Consolidated Statements of Income. The Company recognizes a portion of its revenues on the percentage-of-completion method measured on the cost-to-cost basis. In 2017, 2016 and 2015, the Company recognized approximately $83 million, $68 million and $66 million, respectively, in net sales under the percentage-of-completion method. As of December 31, 2017 and 2016, $67.3 million and $63.5 million of accounts receivable, net, respectively, related to these net sales. Inventory: Inventories are valued at the lower of cost or market, with approximately 55% valued by the first-in, first-out ("FIFO") method and the remaining 45% valued by the last-in, first-out ("LIFO") method. The majority of the Company’s domestic inventories are valued by the LIFO method, while all of the Company’s international inventories are valued by the FIFO method. An actual valuation of the inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and costs. Because these are subject to many factors beyond management’s control, annual results may differ from interim results as they are subject to the final year-end LIFO inventory valuation. The Company recognized a decrease in its LIFO reserve of $11.9 million during 2017 compared to an increase in its LIFO reserve of $4.7 million during 2016. Goodwill and Indefinite-lived Intangible Assets: The Company tests goodwill and indefinite-lived intangible assets for impairment at least annually, performing its annual impairment test as of October 1st. Furthermore, goodwill and indefinite-lived intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Each interim period, the Company assesses whether or not an indicator of impairment is present that would necessitate a goodwill and indefinite-lived intangible assets impairment analysis be performed in an interim period other than during the fourth quarter. The Company reviews goodwill for impairment at the reporting unit level. The Mobile Industries segment has four reporting units and the Process Industries segment has two reporting units. The reporting units within the Mobile Industries segment are Mobile Industries, Lubrication Systems, Aerospace Drive Systems (formerly Aerospace Transmissions) and Aerospace Bearing Inspection (formerly Aerospace Aftermarket). The reporting units within the Process Industries segment are Process Industries and Industrial Services. The Lubrication Systems reporting unit was established as a result of the Groeneveld acquisition. Accounting guidance permits an entity to first assess qualitative factors to determine whether additional goodwill impairment testing is required. The Company chose to utilize this qualitative assessment in the annual goodwill impairment testing of the Process Industries, Industrial Services and Lubrication Systems reporting units in the fourth quarter of 2017. Based on this qualitative assessment, the Company concluded that it was not more likely than not that the fair values of these reporting units were less than their respective carrying values. The Company chose to perform a quantitative goodwill impairment analysis in the annual goodwill impairment testing of the Mobile Industries, Aerospace Drive Systems and Aerospace Bearing Inspection reporting units in the fourth quarter of 2017. The quantitative goodwill impairment analysis is a two-step process. Step one compares the carrying amount of the reporting unit to its estimated fair value. To the extent that the carrying value of the reporting unit exceeds its estimated fair value, step two is performed, where the reporting unit’s carrying value of goodwill is compared with the implied fair value of goodwill. To the extent that the carrying value of goodwill exceeds the implied fair value of goodwill, impairment exists and must be recognized. The Company prepares its quantitative goodwill impairment analysis by comparing the estimated fair value of each reporting unit, using an income approach (a discounted cash flow model), as well as a market approach, with its carrying value. The income approach and market approach are weighted in arriving at fair value based on the relative merits of the methods used and the quantity and quality of collected data to arrive at the indicated fair value. The income approach requires several assumptions including future sales growth, EBIT margins and capital expenditures. The Company’s reporting units each provide their forecast of results for the next four years. These forecasts are the basis for the information used in the discounted cash flow model. The discounted cash flow model also requires the use of a discount rate and a terminal revenue growth rate (the revenue growth rate for the period beyond the three years forecast by the reporting units), as well as projections of future operating margins (for the period beyond the forecast three years). During the fourth quarter of 2017, the Company used discount rates for its reporting units of 8.5% to 12.5% and a terminal revenue growth rate of 1.0% to 3.0%. The market approach requires several assumptions including sales and EBITDA (earnings before interest, taxes, depreciation and amortization) multiples for comparable companies that operate in the same markets as the Company’s reporting units. During the fourth quarter of 2017, the Company used sales multiples of 0.85 to 2.75 for its reporting units. During the fourth quarter of 2017, the Company used EBITDA multiples of 6.8 to 9.0 for its reporting units. As of December 31, 2017, the Company had $511.8 million of goodwill on its Consolidated Balance Sheet, of which $254.3 million was attributable to the Mobile Industries segment and $257.5 million was attributable to the Process Industries segment. See Note 9 - Goodwill and Other Intangible Assets in the Notes to the Consolidated Financial Statements for the carrying amount of goodwill by segment. Material goodwill does not exist at reporting units that are at risk of failing step one of the quantitative goodwill impairment analysis. Restructuring costs: The Company’s policy is to recognize restructuring costs in accordance with Accounting Standards Codification ("ASC") Topic 420, “Exit or Disposal Cost Obligations,” and ASC Topic 712, “Compensation and Non-retirement Post-Employment Benefits.” Detailed contemporaneous documentation is maintained and updated to ensure that accruals are properly supported. If management determines that there is a change in estimate, the accruals are adjusted to reflect this change. Income taxes: Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, valuation allowances against deferred tax assets, and accruals for uncertain tax positions. The Company, which is subject to income taxes in the United States and numerous non-U.S. jurisdictions, accounts for income taxes in accordance with ASC Topic 740, “Income Taxes.” Deferred tax assets and liabilities are recorded for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as net operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. Deferred tax assets relate primarily to pension and postretirement benefit obligations in the United States, which the Company believes are more likely than not to result in future tax benefits. The Company records valuation allowances against deferred tax assets by tax jurisdiction when it is more likely than not that such assets will not be realized. In determining the need for a valuation allowance, the historical and projected financial performance of the entity recording the net deferred tax asset is considered along with any other pertinent information. The Company recorded $12.6 million of tax benefit related to the reversal of valuation allowances in 2017 and $34.7 million of tax benefit related to the reversal of valuation allowances in 2015. There were no valuation allowance reversals in 2016. Refer to Note 17 - Income Taxes in the Notes to the Consolidated Financial Statements for further discussion on the valuation allowance reversals. In the ordinary course of the Company’s business, there are many transactions and calculations where the ultimate income tax determination is uncertain. The Company is regularly under audit by tax authorities. Accruals for uncertain tax positions are provided for in accordance with the requirements of ASC Topic 740. The Company records interest and penalties related to uncertain tax positions as a component of income tax expense. In 2017, the Company recorded $30.6 million of net tax benefits related to uncertain tax positions, which consist of recorded tax items of $40.2 million related to expiration of applicable statues of limitations in multiple jurisdictions, a reduction in prior year reserves and a reduction in accrued interest that is partially offset by $9.6 million related to current and prior year tax positions. Refer to Note 17 - Income Taxes in the Notes to the Consolidated Financial Statements for further discussion on the uncertain tax positions reserve reversals. Benefit Plans: The Company sponsors a number of defined benefit pension plans that cover eligible associates. The Company also sponsors several funded and unfunded postretirement plans that provide health care and life insurance benefits for eligible retirees and their dependents. These plans are accounted for in accordance with ASC Topic 715-30, "Defined Benefit Plans - Pension," and ASC Topic 715-60, "Defined Benefit Plans - Other Postretirement." The measurement of liabilities related to these plans is based on management's assumptions related to future events, including discount rates, rates of return on pension plan assets, rates of compensation increases and health care cost trend rates. Management regularly evaluates these assumptions and adjusts them as required and appropriate. Other plan assumptions also are reviewed on a regular basis to reflect recent experience and the Company's future expectations. Actual experience that differs from these assumptions may affect future liquidity, expense and the overall financial position of the Company. While the Company believes that current assumptions are appropriate, significant differences in actual experience or significant changes in these assumptions may affect materially the Company's pension and other postretirement employee benefit obligations and its future expense and cash flow. The discount rate is used to calculate the present value of expected future pension and postretirement cash flows as of the measurement date. The Company establishes the discount rate by constructing a notional portfolio of high-quality corporate bonds and matching the coupon payments and bond maturities to projected benefit payments under the Company's pension and postretirement welfare plans. The bonds included in the portfolio generally are non-callable. A lower discount rate will result in a higher benefit obligation; conversely, a higher discount rate will result in a lower benefit obligation. The discount rate also is used to calculate the annual interest cost, which is a component of net periodic benefit cost. The expected rate of return on plan assets is determined by analyzing the historical long-term performance of the Company's pension plan assets, as well as the mix of plan assets between equities, fixed-income securities and other investments, the expected long-term rate of return expected for those asset classes and long-term inflation rates. Short-term asset performance can differ significantly from the expected rate of return, especially in volatile markets. A lower-than-expected rate of return on pension plan assets will increase pension expense and future contributions. Effective January 1, 2017, the Company voluntarily changed its accounting principles for recognizing actuarial gains and losses and expected returns on plan assets for its defined benefit pension and other postretirement benefit plans, with retrospective application to prior periods. Prior to 2017, the Company amortized, as a component of pension and other postretirement expense, unrecognized actuarial gains and losses (included within Accumulated other comprehensive income (loss)) over the average remaining service period of active plan participants expected to receive benefits under the plan, or average remaining life expectancy of inactive plan participants when all or almost all of individual plan participants were inactive. The Company also historically calculated the market-related value of plan assets based on a five-year market adjustment. Under the new principles, actuarial gains and losses will be immediately recognized through net periodic benefit cost in the Statement of Income, upon the annual remeasurement in the fourth quarter, or on an interim basis if specific events trigger a remeasurement. In addition, the Company has changed its accounting policy for measuring the market-related value of plan assets from a calculated amount (based on a five-year smoothing of asset returns) to fair value. The Company believes these changes are preferable as they result in an accelerated recognition of actuarial gains and losses and changes in fair value of plan assets in its Consolidated Statement of Income, which provides greater transparency and better aligns with fair value principles by fully reflecting the impact of interest rate and economic changes on the Company's pension and other postretirement benefit liabilities and assets in the Company's operating results in the year in which the gains and losses are incurred. Defined Benefit Pension Plans: The Company recognized net periodic benefit cost of $30.3 million in 2017 for defined benefit pension plans, compared with net periodic benefit cost of $73.4 million in 2016. The decrease was primarily due to actuarial losses of $23.2 million recognized in 2017, compared with actuarial losses of $60.9 million in 2017. In addition, the Company recognized lower interest expense of $5.0 million, partially offset by lower expected return on plan assets of $1.7 million. In 2017, the Company recognized actuarial losses of $23.2 million primarily due to the impact of a net reduction in the discount rate used to measure its defined benefit pension obligations of $52.9 million and the impact of experience losses and other changes in valuation assumptions of $8.7 million, partially offset by higher than expected returns on plan assets of $38.4 million. The impact of the net reduction in the discount rate used to measure the Company's defined benefit pension obligations was primarily driven by a 54 basis point reduction in the discount rate used to measure its U.S. defined benefit plan obligations. The higher than expected asset returns of $38.4 million resulted from a net asset gain of $77.5 million on actual assets in 2017, or positive 10.6% weighted average return on pension plan assets of $824.3 million, compared with an expected return of $39.1 million, or 4.44%, in 2017. In 2016, the Company recognized actuarial losses of $60.9 million primarily due to the impact of a net reduction in the discount rate used to measure its defined benefit pension obligations of $86.9 million and the impact of experience losses and other changes in valuation assumptions of $10.2 million, partially offset by higher than expected returns on plan assets of $36.2 million. The impact of the net reduction in the discount rate used to measure the Company's defined benefit pension obligations was primarily driven by a 125 basis point reduction in the discount rate used to measure its defined benefit plan obligations in the United Kingdom and a 36 basis point reduction in the discount rate used to measure its defined benefit plan obligations in the United States. The higher than expected asset returns of $36.2 million resulted from a net asset gain of $77.0 million on actual assets in 2016, or positive 8.5% weighted average return on pension plan assets of $798.3 million, compared with an expected return of $40.8 million, or 5.09%, in 2016. In 2018, the Company expects net periodic benefit cost of approximately $6 million for defined benefit pension plans, compared with net periodic benefit cost of $30.3 million in 2017. Net periodic benefit cost for 2018 does not include Mark-to-Market Charges that will be recognized immediately through earnings in the fourth quarter of 2018, or on an interim basis if specific events trigger a remeasurement. Excluding the actuarial losses of $23.2 million recognized in 2017, the expected net periodic benefit cost of $5.8 million in 2018 compares to net periodic benefit cost of $7.1 million in 2017 as the Company expects higher expected return on plan assets of $2.1 million and lower interest costs of $1.4 million, partially offset by lower curtailment of $1.1 million and higher service costs of $0.8 million. The Company expects to contribute approximately $10 million to its defined benefit pension plans in 2018 compared with $11.5 million in 2017. For expense purposes in 2017, the Company applied a weighted-average discount rate of 4.34% to its U.S. defined benefit pension plans. For expense purposes in 2018, the Company will apply a weighted-average discount rate of 3.80% to its U.S. defined benefit pension plans. For expense purposes in 2017, the Company applied an expected weighted-average rate of return of 5.92% for the Company’s U.S. pension plan assets. For expense purposes in 2018, the Company will apply an expected weighted-average rate of return on plan assets of 5.78%. The following table presents the sensitivity of the Company's U.S. projected pension benefit obligation ("PBO") and 2017 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the PBO by $22.7 million and decrease income before income taxes by $22.7 million. Defined benefit pension plans in the United States represent 66% of the Company's benefit obligation and 65% of the fair value of the Company's plan assets at December 31, 2017. Other Postretirement Benefit Plans: The Company recognized net periodic benefit credit of $1.4 million in 2017 for other postretirement benefit plans, compared with net periodic benefit cost of $10.6 million in 2016. The decrease was primarily due to actuarial gains of $4.0 million recognized in 2017, compared with actuarial losses of $4.5 million in 2016. In addition, the Company recognized lower amortization of prior service cost of $2.0 million and lower interest expense of $1.9 million. In 2017, the Company offered a financial incentive for eligible participants of the Company's retiree health and life insurance plans to opt-out of coverage from the plans. The Company recognized actuarial gains in 2017 as a result of the opt-out program impact of $14.4 million and higher than expected returns on plan assets of $3.7 million, partially offset by the net impact of assumption changes of $14.1 million, including the impact of a 40 basis point reduction in the Company's discount rate used to measure its defined benefit postretirement obligations of $6.9 million and the impact of other assumption changes of $7.2 million. The Company recognized actuarial losses in 2016 as a result of the net impact of assumption changes of $4.3 million, including the impact of a 42 basis point reduction in the Company's discount rate used to measure its defined benefit postretirement obligations of $8.2 million, offset by the impact of other assumption changes of $3.9 million, and lower than expected asset returns on plan assets of $0.2 million. The lower amortization of prior service costs in 2017 was due to an amendment to the Company's postretirement benefit plan in 2016. As a result of this amendment, the Company has ceased offering company-subsidized postretirement medical benefits to certain U.S. employees who retire after December 31, 2016. This amendment reduced the accumulated benefit obligation by $11.4 million in 2016. This amount is being amortized over the remaining service period of the employees affected by this amendment. The lower interest expense in 2017 was primarily due to a 42 basis point reduction in the discount rate used for expense purposes. In 2018, the Company expects net periodic benefit cost of $2.2 million for other postretirement benefit plans, compared to net periodic benefit credit of $1.4 million in 2017. Net periodic benefit cost for 2018 does not include Mark-to-Market Charges that will be recognized immediately through earnings in the fourth quarter of 2018, or on an interim basis if specific events trigger a remeasurement. Excluding the actuarial gain of $4.0 million recognized in 2017, the expected net periodic benefit cost of $2.2 million in 2018 compares to net periodic benefit cost of $2.6 million in 2017 as the Company expects lower interest costs of $1.6 million and lower amortization of prior service cost of $0.6 million, partially offset by a lower expected return on plan assets of $1.9 million. The expected decrease in interest costs is primarily due to a 40 basis point reduction in the discount rated used for expense purposes for 2018. The lower expected return on plan assets is primarily due to a reduction in return on assets in the Company's Voluntary Employee Beneficiary Association ("VEBA") trust in 2017 that will affect the expected return on plan assets in 2018. For expense purposes in 2017, the Company applied a discount rate of 3.97% to its other postretirement benefit plans. For expense purposes in 2018, the Company will apply a discount rate of 3.57% to its other postretirement benefit plans. For expense purposes in 2017, the Company applied an expected rate of return of 6.00% to the VEBA trust assets. For expense purposes in 2018, the Company will apply an expected rate of return of 4.50% to the VEBA trust assets. The following table presents the sensitivity of the Company's accumulated other postretirement benefit obligation ("ABO") and 2017 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the ABO by $4.4 million and decrease income before income taxes by $4.4 million. For measurement purposes for postretirement benefits, the Company assumed a weighted-average annual rate of increase in per capita cost (health care cost trend rate) for medical and prescription drug benefits of 6.25% for 2018, declining steadily for the next six years to 5.00%; and 8.25% for HMO benefits for 2018, declining gradually for the next 13 years to 5.0%. The assumed health care cost trend rate may have a significant effect on the amounts reported. A one percentage point increase in the assumed health care cost trend rate would have increased the 2017 total service and interest cost components by $0.2 million and would have increased the postretirement obligation by $4.4 million. A one percentage point decrease would provide corresponding reductions of $0.2 million and $3.9 million, respectively. Other loss reserves: The Company has a number of loss exposures that are incurred in the ordinary course of business such as environmental clean-up, product liability, product warranty, litigation and accounts receivable reserves. Establishing loss reserves for these matters requires management’s judgment with regards to estimating risk exposure and ultimate liability or realization. These loss reserves are reviewed periodically and adjustments are made to reflect the most recent facts and circumstances. OTHER DISCLOSURES: Foreign Currency: Assets and liabilities of subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the reporting period. Related translation adjustments are reflected as a separate component of accumulated other comprehensive loss. Foreign currency gains and losses resulting from transactions are included in the Consolidated Statements of Income. The Company recognized a foreign currency exchange loss resulting from transactions of $3.7 million, $5.6 million and $0.3 million for the years ended December 31, 2017, 2016 and 2015, respectively. For the year ended December 31, 2017, the Company recorded a positive non-cash foreign currency translation adjustment of $44.7 million that increased shareholders’ equity, compared with a negative non-cash foreign currency translation adjustment of $24.5 million that decreased shareholders’ equity for the year ended December 31, 2016. The foreign currency translation adjustments for the year ended December 31, 2017 were impacted positively by the weakening of the U.S. dollar relative to other currencies. Trade Law Enforcement: The U.S. government has an antidumping duty order in effect covering tapered roller bearings from China. The Company is a producer of these bearings, as well as ball bearings and other bearing types, in the United States. The U.S. government currently is conducting a review of whether or not this antidumping duty order should continue in place for an additional five years. Furthermore, in 2017 the U.S. government initiated, after receipt of a petition from the Company, an antidumping duty investigation of certain tapered roller bearings from the Republic of Korea ("Korea"). The Korea antidumping duty investigation is ongoing. Quarterly Dividend: On February 9, 2018, the Company’s Board of Directors declared a quarterly cash dividend of $0.27 per common share. The quarterly dividend will be paid on March 2, 2018 to shareholders of record as of February 20, 2018. This will be the 383rd consecutive quarterly dividend paid on the common shares of the Company. Forward-Looking Statements Certain statements set forth in this Annual Report on Form 10-K and in the Company’s 2017 Annual Report to Shareholders (including the Company’s forecasts, beliefs and expectations) that are not historical in nature are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. In particular, Management’s Discussion and Analysis on pages 17 through 45 contains numerous forward-looking statements. Forward-looking statements generally will be accompanied by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “outlook,” “intend,” “may,” “possible,” “potential,” “predict,” “project” or other similar words, phrases or expressions. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. Actual results may differ materially from those expressed or implied in forward-looking statements made by or on behalf of the Company due to a variety of factors, such as: (a) deterioration in world economic conditions, or in economic conditions in any of the geographic regions in which the Company or its customers or suppliers conducts business, including additional adverse effects from the global economic slowdown, terrorism or hostilities. This includes: political risks associated with the potential instability of governments and legal systems in countries in which the Company, its customers or suppliers conduct business, and changes in foreign currency valuations; (b) the effects of fluctuations in customer demand on sales, product mix and prices in the industries in which the Company operates. This includes: the ability of the Company to respond to rapid changes in customer demand, the effects of customer or supplier bankruptcies or liquidations, the impact of changes in industrial business cycles, and whether conditions of fair trade continue in our markets; (c) competitive factors, including changes in market penetration, increasing price competition by existing or new foreign and domestic competitors, the introduction of new products by existing and new competitors, and new technology that may impact the way the Company’s products are produced, sold or distributed; (d) changes in operating costs. This includes: the effect of changes in the Company’s manufacturing processes; changes in costs associated with varying levels of operations and manufacturing capacity; availability and cost of raw materials; changes in the expected costs associated with product warranty claims; changes resulting from inventory management and cost reduction initiatives; the effects of unplanned plant shutdowns; and changes in the cost of labor and benefits; (e) the success of the Company’s operating plans, announced programs, initiatives and capital investments; the ability to integrate acquired companies; the ability of acquired companies to achieve satisfactory operating results, including results being accretive to earnings; and the Company’s ability to maintain appropriate relations with unions that represent Company associates in certain locations in order to avoid disruptions of business; (f) unanticipated litigation, claims or assessments. This includes: claims or problems related to intellectual property, product liability or warranty, environmental issues, and taxes; (g) changes in worldwide capital markets, including availability of financing and interest rates on satisfactory terms, which affect: the Company’s cost of funds and/or ability to raise capital; and the ability of customers to obtain financing to purchase the Company’s products or equipment that contain the Company’s products; (h) the impact on the Company's pension obligations due to changes in interest rates, investment performance, changes in law or regulation, and other tactics designed to reduce risk; (i) the impact of changes to the Company's accounting methods, including the actual impact of the adoption of mark-to-market accounting; (j) retention of CDSOA distributions; and (k) those items identified under Item 1A. Risk Factors on pages 6 through 11. Additional risks relating to the Company’s business, the industries in which the Company operates or the Company’s common shares may be described from time to time in the Company’s filings with the Securities and Exchange Commission. All of these risk factors are difficult to predict, are subject to material uncertainties that may affect actual results and may be beyond the Company’s control. Readers are cautioned that it is not possible to predict or identify all of the risks, uncertainties and other factors that may affect future results and that the above list should not be considered to be a complete list. Except as required by the federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

<s>[INST] OVERVIEW Introduction: The Timken Company engineers, manufactures and markets bearings, transmissions, gearboxes, belts, chain, lubrication systems, couplings, industrial clutches and brakes and related products and offers a variety of power system rebuild and repair services. The Company’s growing product and services portfolio features many strong industrial brands, such as Timken®, Fafnir®, Philadelphia Gear®, Drives®, Lovejoy® and Groeneveld®. Timken applies its deep knowledge of metallurgy, friction management and mechanical power transmission across the broad spectrum of bearings and related systems to improve the reliability and efficiency of machinery and equipment all around the world. Known for its quality products and collaborative technical sales model, Timken focuses on providing value to diverse markets worldwide through both original equipment manufacturers ("OEMs") and aftermarket channels. With more than 15,000 people operating in 33 countries, Timken makes the world more productive and keeps industry in motion. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: Mobile Industries serves OEM customers that manufacture offhighway equipment for the agricultural, mining and construction markets; onhighway vehicles including passenger cars, light trucks, and medium and heavyduty trucks; rail cars and locomotives; outdoor power equipment; rotorcraft and fixedwing aircraft; and other mobile equipment. Beyond service parts sold to OEMs, aftermarket sales and services to individual end users, equipment owners, operators and maintenance shops are handled directly or through the Company's extensive network of authorized automotive and heavytruck distributors. Process Industries serves OEM and enduser customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal and wind power generation; oil and gas extraction and refining; pulp and paper and food processing; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors and through the provision of services directly to end users. Timken creates value by understanding customer needs and applying its knowhow in attractive market sectors, serving a broad range of customers and industries across the globe. The Company’s business strengths include its product technology, endmarket diversity, geographic reach and aftermarket mix. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling largely through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Timken Business Model is the specific framework for how the Company evaluates opportunities and differentiates itself in the market. Outgrowing Our Markets. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Operating With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Deploying Capital to Drive Shareholder Value. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes: (1) investing in the core business through capital expenditures, research and development and organic growth initiatives; (2) pursuing strategic acquisitions to bro [/INST] Negative. </s>

TIMKEN CO

2019-02-15

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share data) OVERVIEW Introduction: The Timken Company designs and manages a growing portfolio of engineered bearings and power transmission products. With more than a century of innovation and increasing knowledge, we continuously improve the reliability and efficiency of global machinery and equipment to move the world forward. Timken posted $3.6 billion in sales in 2018 and employs more than 17,000 people globally, operating in 35 countries. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: • Mobile Industries serves OEM customers that manufacture off-highway equipment for the agricultural, mining and construction markets; on-highway vehicles including passenger cars, light trucks, and medium- and heavy-duty trucks; rail cars and locomotives; outdoor power equipment; rotorcraft and fixed-wing aircraft; and other mobile equipment. Beyond service parts sold to OEMs, aftermarket sales and services to individual end users, equipment owners, operators and maintenance shops are handled directly or through the Company's extensive network of authorized automotive and heavy-truck distributors. • Process Industries serves OEM and end-user customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal power generation and renewable energy sources; oil and gas extraction and refining; pulp and paper and food processing; automation and robotics; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors and through the provision of services directly to end users. Timken creates value by understanding customer needs and applying its know-how to serve a broad range of customers in attractive markets and industries across the globe. The Company’s business strengths include its product technology, end-market diversity, geographic reach and aftermarket mix. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling largely through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Company's strategy has three primary elements: Outgrowing Our Markets. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Operating With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Deploying Capital to Drive Shareholder Value. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes: (1) investing in the core business through capital expenditures, research and development and other organic growth initiatives; (2) pursuing strategic acquisitions to broaden its portfolio and capabilities across diverse markets, with a focus on bearings, adjacent power transmission products and related services; (3) returning capital to shareholders through dividends and share repurchases; and (4) maintaining a strong balance sheet and sufficient liquidity. As part of this framework, the Company may also restructure, reposition or divest underperforming product lines or assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2018: • On August 30, 2018, the Company's majority-owned subsidiary, Timken India Limited ("Timken India"), completed the acquisition of ABC Bearings Limited ("ABC Bearings"), a manufacturer of tapered, cylindrical and spherical roller bearings and slewing rings in India with expected annual sales at the time of acquisition of approximately $30 million. The acquisition was funded primarily with Timken India stock. • On September 1, 2018, the Company completed the acquisition of Apiary Investments Holdings Limited ("Cone Drive"), a leader in precision drives used in diverse markets including solar, automation, aerial platforms and food and beverage. Cone Drive, located in Traverse City, Michigan operates in the U.S. and China and had expected annual sales at the time of acquisition of approximately $100 million. The acquisition was funded primarily with new debt. • On September 18, 2018, the Company completed the acquisition of Rollon S.p.A. ("Rollon"), a leader in engineered linear motion products, specializing in the design and manufacture of linear guides, telescopic rails and linear actuators used in a wide range of attractive applications such as passenger rail, aerospace, packaging and logistics, medical and automation. Rollon, located near Milan, Italy has manufacturing operations in Italy, Germany and the U.S and had expected annual sales at the time of acquisition of approximately $140 million. The acquisition was primarily funded with new debt. • On September 19, 2018, the Company divested Groeneveld Information Technology Holding B.V. (the "ICT Business"), located in Gorinchem, Netherlands. The Company acquired the ICT business in July 2017 as part of the Groeneveld Group ("Groeneveld") acquisition. The ICT Business, a non-core telematics business, is separate from the Groeneveld lubrications solutions business and employed approximately 70 people. The ICT Business had sales of approximately $15 million for the twelve months ended September 30, 2018. RESULTS OF OPERATIONS 2018 vs. 2017 Overview: The increase in net sales was primarily due to organic revenue growth driven by higher end-market demand, the benefit of acquisitions and the impact of higher pricing. The increase in net income in 2018 compared with 2017 was primarily due to improved performance across the business, driven by the impact of higher volume, favorable price/mix, the net benefit of acquisitions and improved manufacturing performance, as well as lower net actuarial losses ("Mark-to-Market Charges") due to the remeasurement of pension and other postretirement assets and obligations, restructuring charges and interest expense. These factors were partially offset by the impact of higher selling, general and administrative ("SG&A") expenses, higher income tax expenses and higher material and logistics costs (including tariffs). Outlook: The Company expects 2019 full-year sales to increase approximately 8% to 10% compared with 2018 primarily due to increased demand across most end-market sectors and the benefit of acquisitions, including the recently completed ABC Bearings, Cone Drive and Rollon acquisitions, offset partially by unfavorable currency. The Company's earnings are expected to be higher in 2019 than 2018, primarily due to the impact of higher volume, favorable price/mix and the benefit of acquisitions, partially offset by higher material, logistics (including tariffs) and SG&A expenses, as well as higher income tax and interest expenses. Additionally, depreciation and amortization expense is expected to increase in 2019, primarily due to incremental depreciation and amortization from acquisitions completed in 2018. The Company expects to generate operating cash of approximately $450 million in 2019, an increase from 2018 of approximately $118 million, or 35%, as the Company anticipates higher net income and lower working capital requirements. The Company expects capital expenditures to be approximately $150 million in 2019, compared with $113 million in 2018. THE STATEMENTS OF INCOME Sales: Net sales increased in 2018 compared with 2017, primarily due to higher organic revenue of $396 million and the benefit of acquisitions of $177 million. The increase in organic revenue was driven by higher demand across all of the Company's end-market sectors, as well as the impact of higher pricing. Gross Profit: Gross profit increased in 2018 compared with 2017, primarily due to the impact of higher volume of $133 million, favorable price/mix of $66 million, the benefit of acquisitions of $54 million, improved manufacturing performance of $12 million and lower restructuring costs of $6 million. These factors were partially offset by higher material and logistics costs of $44 million (including tariffs). Selling, General and Administrative Expenses: The increase in SG&A expenses in 2018 compared with 2017 was primarily due to the impact of acquisitions of $39 million, higher compensation expense and other spending increases to support the higher sales levels. Interest Expense and Income: Interest expense increased in 2018 compared to 2017 primarily due to an increase in outstanding debt to fund the acquisitions of Groeneveld, Rollon and Cone Drive. Refer to Note 9 - Financing Arrangements in the Notes to the Consolidated Financial Statements for further discussion. Other Income (Expense): The decrease in non-service pension and other postretirement costs for 2018 compared with 2017 was primarily due to lower Mark-to-Market Charges of $8.8 million. The Mark-to-Market Charges resulted from the remeasurement of pension and postretirement plan obligations and assets due to changes in actuarial assumptions, partially offset by the benefit of curtailments for two of the U.S. pension plans. Refer to Note 12 - Retirement Benefit Plans in the Notes to the Consolidated Financial Statements for more information. Income Tax Expense: The effective tax rate for 2018 was 25.1%, which was unfavorable to the U.S. federal statutory rate of 21% primarily due to earnings in certain foreign jurisdictions where the effective rate was higher than 21%, unfavorable U.S. permanent differences and U.S. state and local income tax expenses. These impacts were partially offset by reductions to the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate enacted under the Tax Cuts and Jobs Act of 2017 (“U.S. Tax Reform”). The effective tax rate for 2017 was 22.2%, which was favorable to the U.S. federal statutory rate of 35% primarily due to earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, U.S. foreign tax credits realized on earnings distributed to the United States, and favorable U.S. permanent deductions and tax credits. The effective tax rate was also favorably impacted by the net reversal of accruals for prior year uncertain tax positions, a valuation allowance release and other discrete items. These favorable impacts were partially offset by provisional amounts for the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate enacted under U.S. Tax Reform. U.S. Tax Reform included a number of changes to existing U.S. tax laws that impacted the Company, most notably a reduction of the U.S. corporate income tax rate from 35% to 21% for tax years beginning after December 31, 2017. U.S. Tax Reform also required companies to pay a one-time net charge related to the taxation of unremitted foreign earnings, created new taxes on certain foreign sourced earnings and allowed for immediate expensing of certain depreciable assets after September 27, 2017. The change in the effective rate for 2018 compared with 2017 was an increase of 2.9%. The increase was primarily due to the net reversal of accruals for prior year uncertain tax positions in 2017. The effective tax rate also increased due to earnings in certain foreign jurisdictions where the effective rate was higher than 21%, unfavorable U.S. permanent differences and the release of valuations allowances in 2017. These impacts were partially offset by reductions to the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate. Refer to Note 16 - Income Taxes in the Notes to the Consolidated Financial Statements for more information on the computation of the income tax expense in interim periods. BUSINESS SEGMENTS The Company's reportable segments are business units that serve different industry sectors. While the segments often operate using shared infrastructure, each reportable segment is managed to address specific customer needs in these diverse market sectors. The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 15 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions completed in 2018 and 2017 and foreign currency exchange rate changes. The effects of acquisitions and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions completed in 2018 and 2017 by segment based on the customers and underlying markets served: • The Company acquired ABC Bearings, Cone Drive and Rollon during the third quarter of 2018. Substantially all of the results for ABC Bearings are reported in the Mobile Industries segment. Results for Cone Drive and Rollon are reported in the Mobile Industries and Process Industries segments based on customers and underlying market sectors served. • The Company acquired Groeneveld during the third quarter of 2017. Substantially all of the results for Groeneveld are reported in the Mobile Industries segment. • The Company acquired Torsion Control Products, Inc. ("Torsion Control Products") and PT Tech, Inc. ("PT Tech") during the second quarter of 2017. Substantially all of the results for Torsion Control Products are reported in the Mobile Industries segment. Results for PT Tech are reported in the Mobile Industries and Process Industries segments based on customers and underlying market sectors served. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased in 2018 compared with 2017, reflecting organic growth across all market sectors, as well as higher pricing. EBIT increased in 2018 compared with 2017, primarily due to higher volume of $53 million, the benefit of acquisitions of $15 million, favorable price/mix of $11 million, lower restructuring charges of $9 million and improved manufacturing performance of $5 million. These factors were partially offset by higher material and logistics costs of $24 million (including tariffs) and higher SG&A expenses of $8 million. Full-year sales for the Mobile Industries segment are expected to be up approximately 4% to 6% in 2019 compared with 2018. This reflects expected growth across most end-market sectors, led by rail, off-highway and aerospace, as well as the benefit of acquisitions, partially offset by the impact of foreign currency translation adjustments. EBIT for the Mobile Industries segment is expected to increase in 2019 compared with 2018 primarily due to the impact of higher volume, favorable price/mix, improved manufacturing performance, and the impact of acquisitions, partially offset by impact of foreign currency exchange rate changes, higher material, logistics (including tariffs) and SG&A expenses. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased in 2018 compared with 2017 reflecting increased demand across all market sectors, as well as higher pricing. EBIT increased in 2018 compared with 2017 primarily due to the impact of higher volume of $84 million, favorable price/mix of $51 million, improved manufacturing performance of $6 million and the benefit of acquisitions of $12 million (excluding inventory step-up expense of $8 million). These factors were partially offset by higher material and logistics costs of $20 million (including tariffs) and higher SG&A expenses of $16 million. Full-year sales for the Process Industries segment are expected to be up approximately 13% to 15% in 2019 compared with 2018. This reflects expected growth across most market sectors, as well as the benefit of acquisitions, partially offset by the impact of foreign currency translation adjustments. EBIT for the Process Industries segment is expected to increase in 2019 compared with 2018 primarily due to the impact of higher volume, favorable price/mix, and the impact of acquisitions, partially offset by higher operating costs. Corporate: Corporate expense increased in 2018 compared with 2017 primarily due to the impact of acquisition-related costs of $10 million. RESULTS OF OPERATIONS: 2017 vs. 2016 Overview: The increase in net sales was primarily due to higher end-market demand and the benefit of acquisitions. The increase in net income in 2017 compared with 2016 was primarily due to improved performance across the business, as well as lower Mark-to-Market Charges, restructuring charges, and income tax expense, partially offset by lower pre-tax U.S. Continued Dumping and Subsidy Offset Act ("CDSOA") income of $59.6 million. The improvement in business performance reflects higher volume, favorable manufacturing performance, the benefit of acquisitions and the favorable impact of foreign currency exchange rate changes, partially offset by unfavorable price/mix and higher material, logistics and SG&A expenses. THE STATEMENTS OF INCOME Sales: Net sales increased in 2017 compared with 2016 primarily due to higher organic revenue of $186 million, the benefit of acquisitions of $131 million and the favorable impact of foreign currency exchange rate changes of $17 million. The increase in organic revenue was driven by higher demand across most of the Company's market sectors led by the off-highway, industrial distribution and heavy truck sectors, partially offset by lower demand in the rail sector. Gross Profit: Gross profit increased in 2017 compared with 2016 primarily due to the impact of higher volume of $74 million, the benefit of acquisitions of $52 million and favorable manufacturing performance of $49 million. These factors were partially offset by higher material and logistics costs of $34 million and unfavorable price/mix of $34 million. Selling, General and Administrative Expenses: The increased in SG&A expenses in 2017 compared with 2016 was primarily due to the impact of acquisitions and higher incentive compensation expense. Impairment and Restructuring Charges: Impairment and restructuring charges of $4.3 million in 2017 were primarily comprised of severance and related benefit costs associated with initiatives to reduce headcount and right-size the Company's manufacturing footprint, including the planned closure of its bearing plant in Pulaski, Tennessee ("Pulaski"). Impairment and restructuring charges of $21.7 million in 2016 were primarily comprised of severance and related benefit costs associated with initiatives to reduce headcount and right-size the Company's manufacturing footprint, including the planned closures of its bearing plants in Altavista, Virginia ("Altavista"), Pulaski and Benoni, South Africa ("Benoni"). In addition, the Company recognized impairment charges of $3.9 million during 2016 that were primarily associated with the planned closures of the Altavista and Benoni bearing plants. Interest Expense and Income: Interest expense increased in 2017 compared to 2016 primarily due to an increase in outstanding debt mostly associated with the Groeneveld acquisition. Refer to Note 9 - Financing Arrangements in the Notes to the Consolidated Financial Statements for further discussion. Other Income (Expense): CDSOA income, net in 2016 represents income recorded in connection with funds distributed to the Company from monies collected by U.S. Customs and Border Protection ("U.S. Customs") from antidumping cases, net of related professional fees. Refer to Note 20 - Continued Dumping and Subsidy Offset Act in the Notes to the Consolidated Financial Statements for further discussion. The decrease in non-service pension and other postretirement costs for 2017 compared to 2016 was primarily due to lower Mark-to-Market Charges of $47 million. The increase in other income (expense), net for 2017, compared to 2016 was primarily due to lower foreign currency exchange losses and gains recorded from the sale of the Company's former manufacturing facilities in Benoni and Altavista during 2017. Income Tax Expense: The effective tax rate for 2017 was 22.2%, which was favorable to the U.S. federal statutory rate of 35% due to earnings in certain foreign jurisdictions where the effective rate is less than 35%, U.S. foreign tax credits realized on earnings distributed to the United States, and favorable U.S. permanent deductions and tax credits. The effective tax rate was further impacted favorably by the net reversal of accruals for prior year uncertain tax positions, a valuation allowance release, and other discrete items. These favorable impacts were partially offset by provisional amounts for the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate enacted under the U.S. Tax Reform. U.S. Tax Reform includes a number of changes to existing U.S. tax laws that impact the Company, most notably a reduction of the U.S. corporate income tax rate from 35% to 21% for tax years beginning after December 31, 2017. U.S. Tax Reform also requires companies to pay a one-time net charge related to the taxation of unremitted foreign earnings, creates new taxes on certain foreign sourced earnings and allows for immediate expensing of certain depreciable assets after September 27, 2017. The effective tax rate for 2016 was favorable relative to the U.S. federal statutory rate primarily due to U.S. foreign tax credits, earnings in certain foreign jurisdictions where the effective tax rate is less than 35%, the U.S. manufacturing deduction, and certain discrete tax benefits (net). These favorable impacts were partially offset by U.S. taxation of foreign income and losses at certain foreign subsidiaries where no tax benefit could be recorded. The change in the effective rate for 2017 compared with 2016 was primarily due to favorable discrete tax items. Refer to the table below for additional detail of the impact of each item on income tax expense. (1) U.S. taxation includes the impact of foreign tax credits, U.S. manufacturing deductions, the U.S. research and experimentation credit, U.S. state and local taxation, U.S. taxation of foreign earnings and other U.S. items. (2) Net reversal of accruals for uncertain tax positions were primarily driven by expiration of applicable statutes of limitations. BUSINESS SEGMENTS The primary measurement used by management to measure the financial performance of each segment is EBIT. Refer to Note 15 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBIT by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions completed in 2017 and 2016 and foreign currency exchange rate changes. The effects of acquisitions and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions and divestitures completed in 2017 and 2016: • The Company acquired Groeneveld during the third quarter of 2017. Substantially all of the results for Groeneveld are reported in the Mobile Industries segment. • The Company acquired Torsion Control Products and PT Tech during the second quarter of 2017. Results for PT Tech are reported in the Mobile Industries and Process Industries segments based on customers and underlying market sectors served. • The Company acquired EDT Corp. ("EDT") during the fourth quarter of 2016. Substantially all of the results for EDT are reported in the Process Industries segment. • The Company acquired Lovejoy, Inc. ("Lovejoy") during the third quarter of 2016. Substantially all of the results for Lovejoy are reported in the Process Industries segment. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased in 2017 compared with 2016, reflecting organic growth in the off-highway and heavy truck market sectors, partially offset by decreased demand in the rail sector. EBIT increased in 2017 compared with 2016 primarily due to higher volume of $32 million, favorable manufacturing performance of $18 million, the benefit of acquisitions of $16 million, lower restructuring charges of $9 million and the impact of foreign currency exchange rate changes of $6 million. These factors were offset partially by higher material and logistics costs of $26 million, increased SG&A expense of $19 million and unfavorable price/mix of $16 million. The higher SG&A expense was primarily due to higher incentive compensation expense. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased $99.1 million, or 8.1%, in 2017 compared with 2016. The increase was primarily driven by organic growth in the industrial distribution, general industrial OE and military marine sectors. EBIT increased in 2017 compared with 2016 primarily due to the impact of higher volume of $49 million, favorable manufacturing performance of $29 million, lower restructuring charges of $7 million and the benefit of acquisitions. These factors were partially offset by unfavorable price/mix of $26 million, higher material and logistics costs of $8 million and higher SG&A expense of $7 million. The higher SG&A expense was due to higher incentive compensation expense. Corporate: THE BALANCE SHEETS The following discussion is a comparison of the Consolidated Balance Sheets at December 31, 2018 and 2017. Current Assets: Refer to the "Cash Flows" section for discussion on the change in Cash and cash equivalents. Accounts receivable increased primarily due to higher sales in December 2018 compared to December 2017, an increase in average days outstanding, which includes the impact of acquisitions in 2018, partially offset by the reclassification of revenue recognized in excess of billings to Unbilled receivables under the Accounting Standards Update ("ASU") 2014-09, "Revenue from Contracts with Customers (Topic 606)" ("new revenue standard") and the impact of foreign currency exchange rate changes of $19.3 million. Unbilled receivables is now presented on the Consolidated Balance Sheet due to the adoption of the new revenue standard, including revenue recognized in excess of billings. Prior to the adoption of the new revenue standard, the Company recognized a portion of its revenues on the percentage-of-completion method. As of December 31, 2017, revenue recognized in excess of billings of $67.3 million related to these revenues was included in "Accounts receivable, less allowances" on the Consolidated Balance Sheet. In accordance with the new revenue standard, $72.7 million of revenue recognized in excess of billings related to these revenues are included in "Unbilled receivables" on the Consolidated Balance Sheet at December 31, 2018. In addition, as part of the adoption of the new revenue standard, the Company identified other customer arrangements in which there is continuous transfer of control to the customer, resulting in an additional $43.9 million of unbilled receivables as of December 31, 2018. Refer to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements for additional information. Inventories increased due to the impact of higher production to meet anticipated customer demand and $61.6 million from the businesses acquired during 2018, partially offset by the impact of foreign currency exchange rate changes of $30.4 million. Property, Plant and Equipment, Net: The increase in property, plant and equipment, net in 2018 was primarily due to capital expenditures of $106.7 million and $71.7 million from businesses acquired in 2018, partially offset by depreciation of $99.3 million and the net impact of foreign currency exchange rate changes of $29.5 million in 2018. Other Assets: The increase in goodwill in 2018 was primarily due to acquisitions in 2018. The increase in other intangible assets was primarily due to acquisitions of $372.6 million in 2018, partially offset by amortization of $46.8 million and the impact of foreign currency exchange rate changes of $10.6 million in 2018. The decrease in non-current pension assets was primarily due to a decrease in the Company's United Kingdom defined benefit pension plan discount rates and by a change in funded status of two of the Company's U.S. defined benefit pension plans from overfunded to underfunded. The increase in other non-current assets is primarily due to the acquisitions in 2018. Current Liabilities: The decrease in short-term debt was primarily due to the reclassification of borrowings under the Company's Asset Securitization Agreement (the "Accounts Receivable Facility") from short-term debt to long-term debt due to the renewal of the Accounts Receivable Facility for a period of three years (until November 30, 2021) in the third quarter of 2018 and lower borrowings under foreign lines of credit. The increase in accrued salaries, wages and benefits was primarily due to the reclassification of $22.5 million from non-current pension liabilities to current pension liabilities, most of which relates to the expected 2019 payout of deferred compensation to a former executive officer of the Company, as well as higher accruals for incentive compensation and the impact of acquisitions in 2018. Non-Current Liabilities: The increase in long-term debt was primarily due to the issuance of $400 million aggregate principal amount of senior notes due 2028 ("2028 Notes") and $350 million of borrowings under the variable-rate term loan due in 2023 ("2023 Term Loan") used to finance the Rollon and Cone Drive acquisitions, as well as the reclassification of borrowings under the Company's Accounts Receivable Facility from short-term debt to long-term debt due to the renewal of this facility for a period of three years (until November 30, 2021). The decrease in accrued pension costs was primarily due the reclassification of $22.5 million from non-current pension liabilities to current pension liabilities, most of which relates to the expected 2019 payout of deferred compensation to a former executive officer of the Company, partially offset by a change in funded status of two of the Company's U.S. defined benefit pension plans from overfunded to underfunded. The decrease in accrued postretirement benefit costs was primarily due to an increase in the discount rate used to measure the Company's postretirement benefit plan obligation and the results of an opt out program offered to current retirees, partially offset by lower than expected asset returns and postretirement accrual additions through acquisitions in 2018. The increase in deferred income taxes was primarily due to recording of deferred tax liabilities for non-deductible intangible assets from acquisitions in 2018. Shareholders’ Equity: Earnings invested in the business in 2018 increased primarily by net income attributable to the Company of $302.8 million, partially offset by dividends declared of $85.7 million. The increase in accumulated other comprehensive loss was primarily due to foreign currency adjustments of $60.5 million. See "Other Disclosures - Foreign Currency" for further discussion regarding the impact of foreign currency translation. The increase in treasury shares was primarily due to the Company's purchase of 2.3 million of its common shares for $98.5 million, partially offset by $22.4 million of net shares issued for stock compensation plans for 2018. The increase in noncontrolling interest was primarily due to the shares of Timken India used for the acquisition of ABC Bearings. CASH FLOWS Operating Activities: The increase in net cash provided by operating activities in 2018 compared with 2017 was primarily due to higher net income of $103.2 million and the favorable impact of income taxes on cash of $17.1 million and other balance sheet line items, partially offset by an increase in cash used for working capital items of $95.9 million. Refer to the table below for additional detail of the impact of each line on net cash provided by operating activities. The following chart displays the impact of working capital items on cash during 2018 and 2017, respectively: The following table displays the impact of income taxes on cash during 2018 and 2017, respectively: Investing Activities: The increase in net cash used in investing activities in 2018 compared with 2017 was primarily due to a $418.6 million increase in cash used for acquisitions and $7.9 million increase in cash used in capital expenditures when compared to the prior year, partially offset by $14.0 million in cash proceeds from the divestiture of the ICT Business. Financing Activities: The increase in net cash provided by financing activities in 2018 compared with 2017 was primarily due to an increase in net borrowings of $455.5 million needed to fund the Cone Drive and Rollon acquisitions in 2018, partially offset by an increase in cash used for share repurchases of $55.1 million and a reduction in proceeds from stock option activity of $20.1 million during 2018 compared with 2017. LIQUIDITY AND CAPITAL RESOURCES Reconciliation of total debt to net debt and the ratio of net debt to capital: Net Debt: Ratio of Net Debt to Capital: The Company presents net debt because it believes net debt is more representative of the Company's financial position than total debt due to the amount of cash and cash equivalents held by the Company. At December 31, 2018, $130.0 million of the Company's $132.5 million of cash and cash equivalents resided in jurisdictions outside the U.S. It is the Company's practice to use available cash in the U.S. to pay down its Amended and Restated Credit Agreement ("Senior Credit Facility") or Accounts Receivable Facility in order to minimize total interest expense. Repatriation of non-U.S. cash could be subject to taxes and some portion may be subject to governmental restrictions. Part of the Company's strategy is to grow in attractive market sectors, many of which are outside the U.S. This strategy includes making investments in facilities, equipment and potential new acquisitions. The Company plans to fund these investments, as well as meet working capital requirements, with cash and cash equivalents and unused lines of credit within the geographic location of these investments where feasible. The Company expects that any cash requirements in excess of cash on hand and cash generated from operating activities will be met by the committed funds available under its Accounts Receivable Facility and Senior Credit Facility. Management believes it has sufficient liquidity to meet its obligations through the term of the Senior Credit Facility and expects to renew the Senior Credit Facility prior to its maturity in June 2020. On September 28, 2018, the Company renewed its $100 million Accounts Receivable Facility, which now matures on November 30, 2021. The Accounts Receivable Facility is subject to certain borrowing base limitations and is secured by certain domestic accounts receivable of the Company. Borrowings under the Accounts Receivable Facility were not reduced by any such borrowing base limitations at December 31, 2018. As of December 31, 2018, the Company had $75.0 million in outstanding borrowings, which reduced the availability under the facility to $25.0 million. The interest rate on the Accounts Receivable Facility is variable and was 3.22% as of December 31, 2018, which reflects the prevailing commercial paper rate plus facility fees. The Company has a $500.0 million Senior Credit Facility that matures on June 19, 2020. At December 31, 2018, the Senior Credit Facility had outstanding borrowings of $43.9 million, which reduced the availability to $456.1 million. The Senior Credit Facility has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. The maximum consolidated leverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0 (3.75 to 1.0 for a limited period up to four quarters following an acquisition with a purchase price of $200 million or greater). As of December 31, 2018, the Company’s consolidated leverage ratio was 2.45 to 1.0. The minimum consolidated interest coverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0. As of December 31, 2018, the Company’s consolidated interest coverage ratio was 13.74 to 1.0. The interest rate under the Senior Credit Facility is variable with a spread based on the Company’s debt rating. The average rate on outstanding U.S. Dollar borrowings was 3.40% and the average rate on outstanding Euro borrowings was 1.10% as of December 31, 2018. In addition, the Company pays a facility fee based on the consolidated leverage ratio multiplied by the aggregate commitments of all of the lenders under the Senior Credit Facility. Other sources of liquidity include short-term lines of credit for certain of the Company’s foreign subsidiaries, which provide for borrowings up to approximately $273.4 million. Most of these credit lines are uncommitted. At December 31, 2018, the Company had borrowings outstanding of $33.6 million and bank guarantees of $0.4 million, which reduced the aggregate availability under these facilities to $239.4 million. On September 6, 2018, the Company issued the 2028 Notes in the aggregate principal amount of $400 million. On September 11, 2018, the Company entered into the 2023 Term Loan and borrowed $350 million. Proceeds from the 2028 Notes and the 2023 Term Loan were used to fund the acquisitions of Cone Drive and Rollon, which closed on September 1, 2018 and September 18, 2018, respectively. Refer to Note 9 - Financing Arrangements to the Notes to the Consolidated Financial Statements for additional information. On September 7, 2017, the Company issued senior unsecured notes that mature on September 7, 2027 (the "2027 Notes") in the aggregate principal amount of €150 million. On September 18, 2017, the Company entered into a variable-rate €100 million term loan that matures on September 18, 2020 (the "2020 Term Loan"). On June 14, 2018, the Company repaid approximately €6.5 million under the 2020 Term Loan, reducing the principal balance to €93.5 million as of December 31, 2018. Proceeds from the 2027 Notes and the 2020 Term Loan were used to repay amounts drawn from the Senior Credit Facility to fund the acquisition of Groeneveld, which closed on July 3, 2017. All of these debt instruments, except the 2028 Notes, have two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. These covenants are similar to those in the Senior Credit Facility. At December 31, 2018, the Company was in full compliance with both of these covenants. The 2028 Notes have no specific financial covenants. The Company expects to generate operating cash of approximately $450 million in 2019, an increase from 2018 of approximately $118 million or 35%, as the Company anticipates higher net income and lower working capital requirements. The Company expects capital expenditures to be approximately $150 million in 2019, compared with $113 million in 2018. CONTRACTUAL OBLIGATIONS The Company’s contractual debt obligations and contractual commitments outstanding as of December 31, 2018 were as follows: Payments due by period: The interest payments beyond five years primarily relate to long-term fixed-rate notes. Refer to Note 9 - Financing Arrangements in the Notes to the Consolidated Financial Statements for additional information. Purchase commitments are defined as an agreement to purchase goods or services that are enforceable and legally binding on the Company. Included in purchase commitments above are certain obligations related to take-or-pay contracts, capital commitments, service agreements and utilities. Many of these commitments relate to take-or-pay contracts in which the Company guarantees payment to ensure availability of products or services. These purchase commitments do not represent the entire anticipated purchases in the future, but represent only those items that the Company contractually is obligated to purchase. The majority of the products and services purchased by the Company are purchased as needed, with no commitment. In order to maintain minimum funding requirements, the Company is required to make contributions to the trusts established for its defined benefit pension plans and other postretirement benefit plans. The table above shows the expected future minimum cash contributions to the trusts for the funded plans as well as estimated future benefit payments to participants for the unfunded plans. Those minimum funding requirements and estimated benefit payments can vary significantly. The amounts in the table above are based on actuarial estimates using current assumptions for, among other things, discount rates, expected return on assets and health care cost trend rates. Refer to Note 12 - Retirement Benefit Plans and Note 13 - Other Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. During 2018, the Company made cash contributions of approximately $11.3 million to its global defined benefit pension plans and $7.4 million to its other postretirement benefit plans. The Company currently expects to make contributions to its global defined benefit pension plans totaling approximately $34 million in 2019, most of which relates to the expected 2019 payout of deferred compensation to a former executive officer of the Company. The Company also expects to make payments of approximately $5 million to its other postretirement benefit plans in 2019. Excluding Mark-to-Market Charges, the Company expects slightly lower pension expense in 2019. Mark-to-Market Charges are not accounted for in the 2019 outlook because the amount will not be known until the fourth quarter of 2019, or on an interim basis if specific events trigger a remeasurement. Refer to Note 12 - Retirement Benefit Plans and Note 13 - Other Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. Refer to Note 10 - Contingencies and Note 16 - Income Taxes in the Notes to the Consolidated Financial Statements for additional information regarding the Company's exposure for certain legal and tax matters. The Company does not have any off-balance sheet arrangements with unconsolidated entities or other persons. New Accounting Guidance Issued and Not Yet Adopted Information required for this Item is incorporated by reference to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The following paragraphs include a discussion of some critical areas that require a higher degree of judgment, estimates and complexity. Revenue recognition: A contract exists when it has approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. Revenue is recognized when performance obligations under the terms of a contract with a customer of the Company are satisfied. Refer to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements for further discussion around the Company's revenue policy. Unbilled Receivables: "Unbilled receivables" on the Consolidated Balance Sheet primarily include unbilled amounts typically resulting from sales under long-term contracts when the following conditions exist; (i) cost-to-cost method of revenue recognition is utilized; (ii) the revenue recognized exceeds the amount billed to the customer; and (iii) the right to payment is primarily subject only to the passage of time. The amounts recorded for unbilled amounts do not exceed their net realizable value. Refer to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements for further discussion around the Company's policy relating to "Unbilled receivables". Inventory: Inventories are valued at the lower of cost or market, with approximately 56% valued by the first-in, first-out ("FIFO") method and the remaining 44% valued by the last-in, first-out ("LIFO") method. The majority of the Company’s domestic inventories are valued by the LIFO method, while all of the Company’s international inventories are valued by the FIFO method. An actual valuation of the inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and costs. Because these are subject to many factors beyond management’s control, annual results may differ from interim results as they are subject to the final year-end LIFO inventory valuation. The Company recognized a decrease in its LIFO reserve of $6.2 million during 2018 compared to an increase in its LIFO reserve of $4.7 million during 2017. Goodwill and Indefinite-lived Intangible Assets: The Company tests goodwill and indefinite-lived intangible assets for impairment at least annually, performing its annual impairment test as of October 1st. Furthermore, goodwill and indefinite-lived intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Each interim period, the Company assesses whether or not an indicator of impairment is present that would necessitate a goodwill and indefinite-lived intangible assets impairment analysis be performed in an interim period other than during the fourth quarter. The Company reviews goodwill for impairment at the reporting unit level. The Mobile Industries segment has four reporting units and the Process Industries segment has two reporting units. The reporting units within the Mobile Industries segment are Mobile Industries, Lubrication Systems, Aerospace Drive Systems (formerly Aerospace Transmissions) and Aerospace Bearing Inspection (formerly Aerospace Aftermarket). The reporting units within the Process Industries segment are Process Industries and Industrial Services. The Lubrication Systems reporting unit was established as a result of the Groeneveld acquisition. Accounting guidance permits an entity to first assess qualitative factors to determine whether additional goodwill impairment testing is required. The Company chose to utilize this qualitative assessment in the annual goodwill impairment testing of the Mobile Industries, Aerospace Bearing Inspection, Process Industries, Industrial Services and Lubrication Systems reporting units in the fourth quarter of 2018. Based on this qualitative assessment, the Company concluded that it was more likely than not that the fair values of these reporting units were exceeding their respective carrying values. The Company chose to perform a quantitative goodwill impairment analysis in the annual goodwill impairment testing of the Aerospace Drive Systems reporting unit with a goodwill balance of $1.8 million. The quantitative goodwill impairment analysis compares the carrying amount of the reporting unit to its estimated fair value. To the extent that the carrying value of the reporting unit exceeds its estimated fair value, impairment exists and must be recognized. The Company prepares its quantitative goodwill impairment analysis by comparing the estimated fair value of each reporting unit, using an income approach (a discounted cash flow model), with its carrying value. The income approach requires several assumptions including future sales growth, EBIT margins and capital expenditures. The Company’s Aerospace Drive Systems reporting unit provided their forecast of results for the next four years. These forecasts are the basis for the information used in the discounted cash flow model. The discounted cash flow model also requires the use of a discount rate and a terminal revenue growth rate (the revenue growth rate for the period beyond the four years forecast by the reporting units), as well as projections of future operating margins (for the period beyond the forecast four years). During the fourth quarter of 2018, the Company used a discount rate for the Aerospace Drive Systems reporting unit of 13.0% and a terminal revenue growth rate of 2.0%. The quantitative analysis using these assumptions supported the Company's conclusion that the fair value of this reporting unit exceeded its carrying value. As of December 31, 2018, the Company had $960.5 million of goodwill on its Consolidated Balance Sheet, of which $349.7 million was attributable to the Mobile Industries segment and $610.8 million was attributable to the Process Industries segment. See Note 8 - Goodwill and Other Intangible Assets in the Notes to the Consolidated Financial Statements for the carrying amount of goodwill by segment. Material goodwill does not exist at reporting units that are at risk of failing the quantitative goodwill impairment analysis. Restructuring costs: The Company’s policy is to recognize restructuring costs in accordance with Accounting Standards Codification ("ASC") Topic 420, “Exit or Disposal Cost Obligations,” and ASC Topic 712, “Compensation and Non-retirement Post-Employment Benefits.” Detailed contemporaneous documentation is maintained and updated to ensure that accruals are properly supported. If management determines that there is a change in estimate, the accruals are adjusted to reflect this change. Income taxes: Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, valuation allowances against deferred tax assets, and accruals for uncertain tax positions. The Company, which is subject to income taxes in the United States and numerous non-U.S. jurisdictions, accounts for income taxes in accordance with ASC Topic 740, “Income Taxes.” Deferred tax assets and liabilities are recorded for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as net operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. Deferred tax assets relate primarily to pension and postretirement benefit obligations in the United States, which the Company believes are more likely than not to result in future tax benefits. The Company records valuation allowances against deferred tax assets by tax jurisdiction when it is more likely than not that such assets will not be realized. In determining the need for a valuation allowance, the historical and projected financial performance of the entity recording the net deferred tax asset is considered along with any other pertinent information. There were no valuation allowance reversals in 2018 and 2016. The Company recorded $12.6 million of tax benefit related to the reversal of valuation allowances in 2017. Refer to Note 16 - Income Taxes in the Notes to the Consolidated Financial Statements for further discussion on the valuation allowance reversals. In the ordinary course of the Company’s business, there are many transactions and calculations where the ultimate income tax determination is uncertain. The Company is regularly under audit by tax authorities. Accruals for uncertain tax positions are provided for in accordance with the requirements of ASC Topic 740. The Company records interest and penalties related to uncertain tax positions as a component of income tax expense. In 2018, the Company recorded $3.2 million of net tax benefits for uncertain tax positions which consisted of $6.6 million related to the net reversal of accruals for prior year uncertain tax positions and settlements with tax authorities. This benefit was partially offset by $3.4 million of increases to current and prior year uncertain tax positions. The Company also recorded $14.8 million of uncertain tax positions related to prior years for acquisitions made during 2018. The SEC issued Staff Accounting Bulletin No. 118 (“SAB 118”) in December 2017 to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of U.S. Tax Reform. In accordance with SAB 118, the accounting for the tax effects of U.S. Tax Reform is complete as of December 31, 2018. Refer to Note 16 - Income Taxes in the Notes to the Consolidated Financial Statements for further discussion on the uncertain tax positions reserve reversals. Purchase accounting and business combinations: Assets acquired and liabilities assumed as part of a business combination are recognized at their acquisition date fair values. Refer to Note 1 - Significant Accounting Policies for further discussion regarding the fair value process and Note 2 - Acquisitions and Divestitures for further discussion regarding assumptions and estimates. Benefit Plans: The Company sponsors a number of defined benefit pension plans that cover eligible associates. The Company also sponsors several funded and unfunded postretirement plans that provide health care and life insurance benefits for eligible retirees and their dependents. These plans are accounted for in accordance with ASC Topic 715-30, "Defined Benefit Plans - Pension," and ASC Topic 715-60, "Defined Benefit Plans - Other Postretirement." The measurement of liabilities related to these plans is based on management's assumptions related to future events, including discount rates, rates of return on pension plan assets, rates of compensation increases and health care cost trend rates. Management regularly evaluates these assumptions and adjusts them as required and appropriate. Other plan assumptions also are reviewed on a regular basis to reflect recent experience and the Company's future expectations. Actual experience that differs from these assumptions may affect future liquidity, expense and the overall financial position of the Company. While the Company believes that current assumptions are appropriate, significant differences in actual experience or significant changes in these assumptions may affect materially the Company's pension and other postretirement employee benefit obligations and its future expense and cash flow. The discount rate is used to calculate the present value of expected future pension and postretirement cash flows as of the measurement date. The Company establishes the discount rate by constructing a notional portfolio of high-quality corporate bonds and matching the coupon payments and bond maturities to projected benefit payments under the Company's pension and postretirement welfare plans. The bonds included in the portfolio generally are non-callable. A lower discount rate will result in a higher benefit obligation; conversely, a higher discount rate will result in a lower benefit obligation. The discount rate also is used to calculate the annual interest cost, which is a component of net periodic benefit cost. The expected rate of return on plan assets is determined by analyzing the historical long-term performance of the Company's pension plan assets, as well as the mix of plan assets between equities, fixed-income securities and other investments, the expected long-term rate of return expected for those asset classes and long-term inflation rates. Short-term asset performance can differ significantly from the expected rate of return, especially in volatile markets. A lower-than-expected rate of return on pension plan assets will increase pension expense and future contributions. The Company recognizes actuarial gains and losses immediately through net periodic benefit cost upon the annual remeasurement in the fourth quarter, or on an interim basis if specific events trigger a remeasurement. Defined Benefit Pension Plans: The Company recognized actuarial losses of $38.8 million during 2018 primarily due to lower than expected returns on plan assets of $83.4 million driven by negative returns on fixed income investments offset by the increase in discount rates used to measure the obligation of $62.4 million. The impact of experience losses and other changes in valuation assumptions resulted in losses of approximately $17.8 million. The discount rate used to measure the U.S. obligation increased by 56 basis points compared to 2017. In 2019, the Company expects net periodic benefit cost of $9.2 million for defined benefit pension plans, compared with net periodic benefit cost of $35.0 million in 2018. Net periodic benefit cost for 2019 does not include Mark-to-Market Charges that will be recognized immediately through earnings in the fourth quarter of 2019, or on an interim basis if specific events trigger a remeasurement. Excluding the actuarial losses of $38.8 million recognized in 2018, the expected net periodic benefit cost of $9.2 million in 2019 compares to net periodic benefit cost of $6.4 million in 2018 as the Company expects lower expected return on plan assets of $4.9 million, partially offset by lower service costs of $2.2 million. The Company expects to contribute to its defined benefit pension plans or pay directly to participants of defined benefit plans approximately $34.0 million in 2019 compared with $11.3 million in 2018. The increase in 2019 planned employer contributions/payments is primarily due to the expected payout of deferred compensation to a former executive officer of the Company. For expense purposes in 2018, the Company applied a weighted-average discount rate of 3.80% to its U.S. defined benefit pension plans. For expense purposes in 2019, the Company will apply a weighted-average discount rate of 4.36% to its U.S. defined benefit pension plans. For expense purposes in 2018, the Company applied an expected weighted-average rate of return of 5.78% for the Company’s U.S. pension plan assets. For expense purposes in 2019, the Company will apply an expected weighted-average rate of return on plan assets of 6.12%. The following table presents the sensitivity of the Company's U.S. projected pension benefit obligation ("PBO") and 2018 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the PBO by $16.6 million and decrease income before income taxes by $16.6 million. Defined benefit pension plans in the United States represent 66% of the Company's benefit obligation and 64% of the fair value of the Company's plan assets at December 31, 2018. Other Postretirement Benefit Plans: The Company recognized actuarial gains of $16.7 million during 2018 primarily due to the impact of a 73 basis point increase in the discount rate used to measure the Company's defined benefit postretirement obligation and due to a number of participants opting out of coverage from the plans in response to a financial incentive program offered to eligible participants of the Company's retiree health and life insurance plans. The Company recognized actuarial gains of $10.6 million as a result of the increase in the discount rate and $10.4 million as a result of the impact of the opt-out program. In 2019, the Company expects net periodic benefit cost of $2.4 million for other postretirement benefit plans, compared to net periodic benefit credit of $14.4 million in 2018. Net periodic benefit cost for 2019 does not include Mark-to-Market Charges that will be recognized immediately through earnings in the fourth quarter of 2019, or on an interim basis if specific events trigger a remeasurement. Excluding the actuarial gain of $16.7 million recognized in 2018, the expected net periodic benefit cost of $2.4 million in 2019 compares to net periodic benefit cost of $2.4 million in 2018 as the Company expects lower amortization of prior service cost of $0.5 million, partially offset by a lower expected return on plan assets of $0.5 million. The lower expected return on plan assets is primarily due to a reduction in return on assets in the Company's Voluntary Employee Beneficiary Association ("VEBA") trust in 2018 that will affect the expected return on plan assets in 2019. For expense purposes in 2018, the Company applied a discount rate of 3.57% to its other postretirement benefit plans. For expense purposes in 2019, the Company will apply a discount rate of 4.30% to its other postretirement benefit plans. For expense purposes in 2018, the Company applied an expected rate of return of 4.50% to the VEBA trust assets. For expense purposes in 2019, the Company will apply an expected rate of return of 4.85% to the VEBA trust assets. The following table presents the sensitivity of the Company's accumulated other postretirement benefit obligation ("ABO") and 2018 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the ABO by $3.2 million and decrease income before income taxes by $3.2 million. For measurement purposes for postretirement benefits, the Company assumed a weighted-average annual rate of increase in per capita cost (health care cost trend rate) for medical and prescription drug benefits of 6.00% for 2019, declining steadily for the next six years to 5.00%; and 8.00% for HMO benefits for 2019, declining gradually for the next 13 years to 5.0%. The assumed health care cost trend rate may have a significant effect on the amounts reported. A one percentage point increase in the assumed health care cost trend rate would have increased the 2018 total service and interest cost components by $0.2 million and would have increased the postretirement obligation by $3.3 million. A one percentage point decrease would provide corresponding reductions of $0.1 million and $3.0 million, respectively. Other loss reserves: The Company has a number of loss exposures that are incurred in the ordinary course of business such as environmental clean-up, product liability, product warranty, litigation and accounts receivable reserves. Establishing loss reserves for these matters requires management’s judgment with regards to estimating risk exposure and ultimate liability or realization. These loss reserves are reviewed periodically and adjustments are made to reflect the most recent facts and circumstances. OTHER DISCLOSURES: Foreign Currency: Assets and liabilities of subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the reporting period. Related translation adjustments are reflected as a separate component of accumulated other comprehensive loss. Foreign currency gains and losses resulting from transactions are included in the Consolidated Statements of Income. The Company recognized a foreign currency exchange impact resulting from transactions of $1.3 million of income, $3.7 million and $5.6 million of expense for the years ended December 31, 2018, 2017 and 2016, respectively. For the year ended December 31, 2018, the Company recorded a negative non-cash foreign currency translation adjustment of $60.5 million that decreased shareholders’ equity, compared with a positive non-cash foreign currency translation adjustment of $44.7 million that increased shareholders’ equity for the year ended December 31, 2017. The foreign currency translation adjustments for the year ended December 31, 2018 were impacted negatively by the strengthening of the U.S. dollar relative to other currencies as of December 31, 2018 compared to December 31, 2017. Trade Law Enforcement: The U.S. government has an antidumping duty order in effect covering tapered roller bearings from China. The Company is a producer of these bearings, as well as ball bearings and other bearing types, in the U.S. Quarterly Dividend: On February 6, 2019, the Company’s Board of Directors declared a quarterly cash dividend of $0.28 per common share. The quarterly dividend will be paid on March 4, 2019 to shareholders of record as of February 20, 2019. This will be the 387th consecutive quarterly dividend paid on the common shares of the Company. Forward-Looking Statements Certain statements set forth in this Annual Report on Form 10-K and in the Company’s 2018 Annual Report to Shareholders that are not historical in nature (including the Company’s forecasts, beliefs and expectations) are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. In particular, Management’s Discussion and Analysis contains numerous forward-looking statements. Forward-looking statements generally will be accompanied by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “outlook,” “intend,” “may,” “possible,” “potential,” “predict,” “project” or other similar words, phrases or expressions. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. The Company cautions readers that actual results may differ materially from those expressed or implied in forward-looking statements made by or on behalf of the Company due to a variety of factors, such as: (a) deterioration in world economic conditions, or in economic conditions in any of the geographic regions in which the Company or its customers or suppliers conduct business, including adverse effects from a global economic slowdown, terrorism or hostilities. This includes: political risks associated with the potential instability of governments and legal systems in countries in which the Company or its customers or suppliers conduct business, changes in currency valuations and recent world events that have increased the risks posed by international trade disputes, tariffs and sanctions; (b) the effects of fluctuations in customer demand on sales, product mix and prices in the industries in which the Company operates. This includes: the ability of the Company to respond to rapid changes in customer demand, the effects of customer or supplier bankruptcies or liquidations, the impact of changes in industrial business cycles, and whether conditions of fair trade continue in our markets; (c) competitive factors, including changes in market penetration, increasing price competition by existing or new foreign and domestic competitors, the introduction of new products by existing and new competitors, and new technology that may impact the way the Company’s products are produced, sold or distributed; (d) changes in operating costs. This includes: the effect of changes in the Company’s manufacturing processes; changes in costs associated with varying levels of operations and manufacturing capacity; availability and cost of raw materials and energy; changes in the expected costs associated with product warranty claims; changes resulting from inventory management and cost reduction initiatives; the effects of unplanned plant shutdowns; and changes in the cost of labor and benefits; (e) the success of the Company’s operating plans, announced programs, initiatives and capital investments; the ability to integrate acquired companies; and the ability of acquired companies to achieve satisfactory operating results, including results being accretive to earnings; (f) the Company’s ability to maintain appropriate relations with unions or works councils that represent Company associates in certain locations in order to avoid disruptions of business; (g) unanticipated litigation, claims or assessments. This includes: claims or problems related to intellectual property, product liability or warranty, environmental issues, and taxes; (h) changes in worldwide financial and capital markets, including availability of financing and interest rates on satisfactory terms, which affect: the Company’s cost of funds and/or ability to raise capital; as well as customer demand and the ability of customers to obtain financing to purchase the Company’s products or equipment that contain the Company’s products; (i) the Company's ability to satisfy its obligations under its debt agreements, as well as its ability to renew or refinance borrowings on favorable terms; (j) the impact on the Company's pension obligations and assets due to changes in interest rates, investment performance and other tactics designed to reduce risk; and (k) those items identified under Item 1A. Risk Factors on pages 6 through 11. Additional risks relating to the Company’s business, the industries in which the Company operates or the Company’s common shares may be described from time to time in the Company’s filings with the Securities and Exchange Commission. All of these risk factors are difficult to predict, are subject to material uncertainties that may affect actual results and may be beyond the Company’s control. Readers are cautioned that it is not possible to predict or identify all of the risks, uncertainties and other factors that may affect future results and that the above list should not be considered to be a complete list. Except as required by the federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

<s>[INST] OVERVIEW Introduction: The Timken Company designs and manages a growing portfolio of engineered bearings and power transmission products. With more than a century of innovation and increasing knowledge, we continuously improve the reliability and efficiency of global machinery and equipment to move the world forward. Timken posted $3.6 billion in sales in 2018 and employs more than 17,000 people globally, operating in 35 countries. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: Mobile Industries serves OEM customers that manufacture offhighway equipment for the agricultural, mining and construction markets; onhighway vehicles including passenger cars, light trucks, and medium and heavyduty trucks; rail cars and locomotives; outdoor power equipment; rotorcraft and fixedwing aircraft; and other mobile equipment. Beyond service parts sold to OEMs, aftermarket sales and services to individual end users, equipment owners, operators and maintenance shops are handled directly or through the Company's extensive network of authorized automotive and heavytruck distributors. Process Industries serves OEM and enduser customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; coal power generation and renewable energy sources; oil and gas extraction and refining; pulp and paper and food processing; automation and robotics; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors and through the provision of services directly to end users. Timken creates value by understanding customer needs and applying its knowhow to serve a broad range of customers in attractive markets and industries across the globe. The Company’s business strengths include its product technology, endmarket diversity, geographic reach and aftermarket mix. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling largely through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Company's strategy has three primary elements: Outgrowing Our Markets. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and mechanical power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets those applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Operating With Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel future growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Deploying Capital to Drive Shareholder Value. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes: (1) investing in the core business through capital expenditures, research and development and other organic growth initiatives; (2) pursuing strategic acquisitions to broaden its portfolio and capabilities across diverse markets, with a focus on bearings, adjacent power transmission products and related services; (3) returning capital to shareholders through dividends and share repurchases; and (4) maintaining a strong balance sheet and sufficient liquidity. As part of this framework, the Company may also restructure, reposition or divest underperforming product lines or assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2018: On August 30, 2018, the Company's majorityowned subsidiary, Timken India Limited ("Timken India"), [/INST] Positive. </s>

TIMKEN CO

2020-02-14

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations (Dollars in millions, except per share data) OVERVIEW Introduction: The Timken Company designs and manufactures a growing portfolio of engineered bearings and power transmission products. With more than a century of knowledge and innovation, the Company continuously improves the reliability and efficiency of global machinery and equipment to move the world forward. Timken posted $3.8 billion in sales in 2019 and employs more than 18,000 people globally, operating in 42 countries. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: • Mobile Industries serves OEM customers that manufacture off-highway equipment for the agricultural, mining and construction markets; on-highway vehicles including passenger cars, light trucks, and medium- and heavy-duty trucks; rail cars and locomotives; outdoor power equipment; rotorcraft and fixed-wing aircraft; and other mobile equipment. Beyond service parts sold to OEMs, aftermarket sales and services to individual end users, equipment owners, operators and maintenance shops are handled directly or through the Company's extensive network of authorized distributors. • Process Industries serves OEM and end-user customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; power generation and renewable energy sources; oil and gas extraction and refining; pulp and paper and food processing; automation and robotics; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors and through the provision of services directly to end users. Timken creates value by understanding customer needs and applying its know-how to serve a broad range of customers in attractive markets and industries across the globe. The Company’s business strengths include its product technology, end-market diversity, geographic reach and aftermarket mix. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling largely through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Company's strategy has three primary elements: Profitable Growth. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Operational Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Capital Deployment to Drive Shareholder Value. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes: (1) investing in the core business through capital expenditures, research and development and other organic growth initiatives; (2) pursuing strategic acquisitions to broaden its portfolio and capabilities across diverse markets, with a focus on bearings, adjacent power transmission products and related services; (3) returning capital to shareholders through dividends and share repurchases; and (4) maintaining a strong balance sheet and sufficient liquidity. As part of this framework, the Company may also restructure, reposition or divest underperforming product lines or assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2019: • On November 1, 2019, the Company completed the acquisition of BEKA Lubrication ("BEKA"), a leading global supplier of automatic lubrications systems serving a diverse range of industrial sectors including wind, food and beverage, rail, on- and off-highway and other process industries. BEKA, located in Pegnitz, Germany, employs approximately 900 people, and had annual sales at the time of the acquisition of approximately $135 million. The acquisition was funded with cash on hand and through borrowings under existing credit facilities. • On April 1, 2019, the Company acquired Diamond Chain Company ("Diamond Chain"), a leading supplier of high-performance roller chains for industrial markets. Diamond Chain serves a diverse range of sectors, including industrial distribution, material handling, food and beverage, agriculture, construction and other process industries. At the time of the acquisition, Diamond had annual sales of approximately $60 million. Diamond Chain has manufacturing operations in the U.S. and China and employs approximately 370 people. The acquisition was funded with cash on hand and through borrowings under existing credit facilities. RESULTS OF OPERATIONS 2019 vs. 2018 Overview: The increase in net sales was primarily driven by the benefit of acquisitions, the impact of higher pricing and higher demand in the Process Industries segment, partially offset by the unfavorable impact of foreign currency exchange rate changes and lower shipments in the Mobile Industries segment. The increase in net income in 2019 compared with 2018 was primarily due to the net benefit of acquisitions, favorable price/mix and the impact of a lower tax rate driven by net discrete benefits, partially offset by the impact of lower volume, unfavorable currency and higher interest expense. Results for 2019 also benefited from pension and other postretirement plan remeasurement income compared to expense in 2018. Outlook: The Company expects 2020 full-year revenue to be in the range of down 2% to up 2% compared with 2019 primarily due to the benefit of acquisitions made in 2019, offset by expected organic declines and the impact of currency. The Company's earnings are expected to be down in 2020 compared with 2019, primarily due to the impact of lower volume, higher manufacturing costs and higher income tax expense, partially offset by lower material and logistics costs, favorable price/mix and the impact of acquisitions. The Company expects to generate operating cash of approximately $585 million in 2020, an increase from 2019 of approximately $35 million, or 6%, as the Company anticipates lower pension and medical benefit plan payments, partially offset by less cash generation from working capital and higher capital expenditures. The Company expects capital expenditures to be approximately $160 million in 2020, compared with $141 million in 2019. THE STATEMENTS OF INCOME Sales: Net sales increased in 2019 compared with 2018, primarily due to the benefit of acquisitions of $270 million and higher organic revenue of $11 million, partially offset by the unfavorable impact of foreign currency exchange rate changes of $72 million. The increase in organic revenue was driven primarily by improved demand in the Process Industries segment and the impact of positive pricing, partially offset by lower shipments in the Mobile Industries segment. Gross Profit: Gross profit increased in 2019 compared with 2018, primarily due to the benefit of acquisitions of $86 million, favorable price/mix of $51 million and lower material and logistics costs (including tariffs) of $5 million. These factors were partially offset by the impact of lower volume of $19 million, the unfavorable impact of foreign currency exchange rate changes of $15 million and property losses of $8 million. Selling, General and Administrative Expenses: The increase in selling, general and administrative ("SG&A") expenses in 2019 compared with 2018 was primarily due to SG&A expense from acquisitions of $45 million, partially offset by the favorable impact from changes in foreign currency exchange rates of $10 million. Interest Expense and Income: Interest expense increased in 2019 compared to 2018 primarily due to higher average outstanding debt during the year, which was primarily used to fund acquisitions. Refer to Note 11 - Financing Arrangements in the Notes to the Consolidated Financial Statements for further discussion. Other Income (Expense): The increase in non-service pension and other postretirement income (expense) for 2019 compared with 2018 was primarily due to the recognition of net actuarial gains ("Mark-to-Market Charges") of $4.2 million in 2019 compared to actuarial losses of $22.1 million in 2018. The Mark-to-Market Charges were the result of higher than expected returns on plan assets and the impact of a reduction in contractual rates for Medicare Advantage plans, driven by a law change that repealed the tax on Health Care Insurers after 2020, partially offset by lower discount rates to measure the benefit obligations for pension and other postretirement plans. Actuarial losses in 2018 were partially offset by the benefit of curtailment gains of $10.2 million for two of the U.S. pension plans. Refer to Note 14 - Retirement Benefit Plans and Note 15 - Other Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for more information. Income Tax Expense: The effective tax rate for 2019 was 20.7%, which was slightly favorable compared to the U.S. federal statutory rate of 21%, primarily due to the release of foreign valuation allowance against certain foreign deferred tax assets and the remeasurement of deferred tax balances to reflect the reduced India statutory tax rate. These impacts were partially offset by earnings in foreign jurisdictions where the effective tax rate was higher than 21%, additional discrete accruals for uncertain tax positions, U.S. state and local income taxes and withholding taxes recorded on planned dividend distributions. The effective tax rate for 2018 was 25.1%, which was unfavorable compared to the U.S. federal statutory rate of 21%, primarily due to earnings in certain foreign jurisdictions where the effective tax rate was higher than 21%, unfavorable U.S. permanent differences and U.S. state and local income taxes. These impacts were partially offset by reductions to the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate enacted under the Tax Cuts and Jobs Act of 2017 (“U.S. Tax Reform”). The change in the effective rate for 2019 compared with 2018 was a decrease of 4.4%. The decrease was primarily due to the release of certain valuation allowances and the remeasurement of deferred tax balances to reflect the reduced India statutory tax rate. These impacts were partially offset by additional discrete accruals for uncertain tax positions and withholding taxes recorded on planned dividend distributions. Refer to Note 5 - Income Taxes in the Notes to the Consolidated Financial Statements for more information on the computation of the income tax expense in interim periods. BUSINESS SEGMENTS The Company's reportable segments are business units that serve different industry sectors. While the segments often operate using shared infrastructure, each reportable segment is managed to address specific customer needs in these diverse market sectors. Beginning in the fourth quarter of 2019, the main operating income metric used by management to measure the financial performance of each segment was earnings before interest, taxes, depreciation and amortization ("EBITDA"). The Company made this change because recent acquisitions have resulted in an increased amount of purchase accounting amortization expense that affects comparability of results across periods and versus other companies. The primary measurement used by management to measure the financial performance of each segment prior to the fourth quarter of 2019 was earnings before interest and taxes ("EBIT"). Segment results have been revised for all periods presented to be consistent with new measure of segment performance. Refer to Note 4 - Segment Information in the Notes to the Consolidated Financial Statements for the reconciliation of EBITDA by segment to consolidated income before income taxes. The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions and divestitures completed in 2019 and 2018 and foreign currency exchange rate changes. The effects of acquisitions, divestitures and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions completed in 2019 and 2018 by segment based on the customers and underlying markets served: • The Company acquired BEKA during the fourth quarter of 2019. The majority of the results for BEKA are reported in the Mobile Industries segment. • The Company acquired Diamond Chain during the second quarter of 2019. The majority of the results for Diamond Chain are reported in the Process Industries segment. • The Company acquired ABC Bearings Limited ("ABC Bearings"), Apiary Investments Holding Limited ("Cone Drive"), and Rollon S.p.A. ("Rollon") during the third quarter of 2018. Substantially all of the results for ABC Bearings are reported in the Mobile Industries segment. Results for Cone Drive and Rollon are reported in the Mobile Industries and Process Industries segments based on customers and underlying market sectors served. • The Company divested Groeneveld Information Technology Holding B.V. (the "ICT Business") on September 19, 2018. The Company acquired the ICT Business in July 2017 as part of the Groeneveld Group ("Groeneveld") acquisition. The ICT Business is separate from the Groeneveld lubrication solutions business and was considered non-core to the operations. Results for the ICT Business were reported in the Mobile Industries segment. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions, divestitures and foreign currency exchange rate changes, decreased $47.8 million or 2.5% in 2019 compared with 2018, reflecting lower shipments in the off highway and heavy truck sectors, partially offset by growth in the aerospace and rail sectors, as well as higher pricing. EBITDA increased in 2019 by $12.7 million or 4.7% compared with 2018, primarily due to favorable price/mix, lower material and logistics costs, the net benefit of acquisitions, and lower SG&A expenses. These factors were partially offset by the impact of lower volume and related manufacturing utilization, as well as property losses and related expenses from flood damage at a Company facility in Tennessee and fire damage at a facility in China. Full-year sales for the Mobile Industries segment are expected to be roughly flat to down 4% in 2020 compared with 2019. This reflects a decrease of organic revenue in the off-highway, heavy truck and automotive sectors, partially offset by the impact of acquisitions. EBITDA for the Mobile Industries segment is expected to decrease in 2020 compared with 2019 primarily due to lower shipments and higher manufacturing costs, partially offset by favorable price/mix, lower material and logistics costs and the impact of acquisitions. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased $59.0 million or 3.5% in 2019 compared with 2018. The increase was primarily driven by growth in the renewable energy sector, as well as positive pricing. EBITDA increased $60.9 million or 15.0% in 2019 compared with 2018 primarily due to the net benefit of acquisitions, favorable price/mix and the impact of higher volume, partially offset by higher SG&A expenses. Full-year sales for the Process Industries segment are expected to be flat to up 4% in 2020 compared with 2019. This reflects expected growth in the renewable energy and industrial services sectors, as well as the benefit of acquisitions, partially offset by a decline in revenue in the industrial distribution sector. EBITDA for the Process Industries segment is expected to increase in 2020 compared with 2019 primarily due to favorable price/mix, lower material costs and the impact of acquisitions, partially offset by higher manufacturing costs and SG&A expenses. Corporate: Corporate expenses decreased in 2019 compared with 2018 primarily due to higher transaction costs related to acquisitions in 2018. RESULTS OF OPERATIONS: 2018 vs. 2017 Overview: The increase in net sales was primarily due to organic revenue growth driven by higher end-market demand, the benefit of acquisitions and the impact of higher pricing. The increase in net income in 2018 compared with 2017 was primarily due to improved performance across the business, driven by the impact of higher volume, favorable price/mix, the net benefit of acquisitions and improved manufacturing performance, as well as lower Mark-to-Market Charges due to the remeasurement of pension and other postretirement assets and obligations, restructuring charges, and interest expense. These factors were partially offset by the impact of higher SG&A expenses, higher income tax expenses and higher material and logistics costs (including tariffs). THE STATEMENTS OF INCOME Sales: Net sales increased in 2018 compared with 2017 primarily due to higher organic revenue of $396 million and the benefit of acquisitions of $177 million. The increase in organic revenue was driven by higher demand across all of the Company's end-market sectors, as well as the impact of higher pricing. Gross Profit: Gross profit increased in 2018 compared with 2017 primarily due to the impact of higher volume of $133 million, the favorable price/mix of $66 million, the benefit of acquisitions of $54 million, improved manufacturing performance of $12 million and lower restructuring costs of $6 million. These factors were partially offset by higher material and logistics costs of $44 million (including tariffs). Selling, General and Administrative Expenses: The increased in SG&A expenses in 2018 compared with 2017 was primarily due to the impact of acquisitions of $39 million, higher compensation expense and other spending increases to support the higher sales levels. Interest Expense and Income: Interest expense increased in 2018 compared to 2017 primarily due to an increase in outstanding debt to fund the acquisitions of Groeneveld, Rollon and Cone Drive. Other Income (Expense): The decrease in non-service pension and other postretirement expense for 2018 compared to 2017 was primarily due to lower Mark-to-Market Charges of $8.8 million. The Mark-to-Market Charges resulted from the remeasurement of pension and postretirement plan obligations and assets due to changes in actuarial assumptions, partially offset by the benefit of curtailments for two of the U.S. pension plans. Income Tax Expense: The effective tax rate for 2018 was 25.1%, which was unfavorable compared to the U.S. federal statutory rate of 21% primarily due to earnings in certain foreign jurisdictions where the effective rate was higher than 21%, unfavorable U.S. permanent differences and U.S. state and local income tax expenses. These impacts were partially offset by reductions to the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate enacted under U.S. Tax Reform. The effective tax rate for 2017 was 22%, which was favorable compared to the U.S. federal statutory rate of 35% primarily due to earnings in certain foreign jurisdictions where the effective tax rate was less than 35%, U.S. foreign tax credits realized on earnings distributed to the United States, and favorable U.S. permanent deductions and tax credits. The effective tax rate was also favorably impacted by the net reversal of accruals for prior year uncertain tax positions, a valuation allowance release and other discrete items. These favorable impacts were partially offset by provisional amounts for the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate enacted under U.S. Tax Reform. U.S. Tax Reform included a number of changes to existing U.S. tax laws that impact the Company, most notably a reduction of the U.S. corporate income tax rate from 35% to 21% for tax years beginning after December 31, 2017. U.S. Tax Reform also requires companies to pay a one-time net charge related to the taxation of unremitted foreign earnings, created new taxes on certain foreign sourced earnings and allowed for immediate expensing of certain depreciable assets after September 27, 2017. The change in the effective rate for 2018 compared with 2017 was an increase of 2.9%. The increase was primarily due to the net reversal of accruals for prior year uncertain tax positions in 2017. The effective tax rate also increased due to earnings in certain foreign jurisdictions where the effective rate was higher than 21%, unfavorable U.S. permanent differences and the release of valuations allowances in 2017. These impacts were partially offset by reductions to the one-time net charge related to the taxation of unremitted foreign earnings and the remeasurement of U.S. deferred tax balances to reflect the new U.S. corporate income tax rate. BUSINESS SEGMENTS The presentation of segment results below includes a reconciliation of the changes in net sales for each segment reported in accordance with U.S. GAAP to net sales adjusted to remove the effects of acquisitions completed in 2018 and 2017 and foreign currency exchange rate changes. The effects of acquisitions and foreign currency exchange rate changes on net sales are removed to allow investors and the Company to meaningfully evaluate the percentage change in net sales on a comparable basis from period to period. The following items highlight the Company's acquisitions and divestitures completed in 2018 and 2017: • The Company acquired ABC Bearings, Cone Drive and Rollon during the third quarter of 2018. Substantially all of the results for ABC Bearings are reported in the Mobile Industries segment. Results for Cone Drive and Rollon are reported in the Mobile Industries and Process Industries segments based on customers and underlying market sectors served. • The Company acquired Groeneveld during the third quarter of 2017. Substantially all of the results for Groeneveld are reported in the Mobile Industries segment. • The Company acquired Torsion Control Products, Inc. ("Torsion Control Products") and PT Tech, Inc. ("PT Tech") during the second quarter of 2017. Results for Torsion Control Products and PT Tech are reported in the Mobile Industries and Process Industries segments based on customers and underlying market sectors served. Mobile Industries Segment: The Mobile Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased in 2018 compared with 2017, reflecting organic growth across all market sectors, as well as higher pricing. EBITDA increased in 2018 compared with 2017 primarily due to higher volume of $53 million, the benefit of acquisitions of $15 million, favorable price/mix of $11 million, lower restructuring charges of $9 million and improved manufacturing performance of $5 million. These factors were offset partially by higher material and logistics costs of $24 million (including tariffs) and higher SG&A expenses of $8 million. Process Industries Segment: The Process Industries segment's net sales, excluding the effects of acquisitions and foreign currency exchange rate changes, increased in 2018 compared with 2017 reflecting increased demand across all market sectors, as well as higher pricing. EBITDA increased in 2018 compared with 2017 primarily due to the impact of higher volume of $84 million, favorable price/mix of $51 million, improved manufacturing performance of $6 million and the benefit of acquisitions of $12 million (excluding inventory step-up expense of $8 million). These factors were partially offset by higher material and logistics costs of $20 million (including tariffs) and higher SG&A expenses of $16 million. Corporate: Corporate expense increased in 2018 compared with 2017 primarily due to the impact of acquisition-related costs of $10 million. THE BALANCE SHEETS The following discussion is a comparison of the Consolidated Balance Sheets at December 31, 2019 and 2018. Current Assets: Refer to the "Cash Flows" section for discussion on the change in cash and cash equivalents. Unbilled receivables increased primarily due to higher marine production and related revenue recognized over time in December 2019 of $110 million compared to $101 million in December 2018. The increase in other current assets was primarily due to the increase current income taxes receivable and in the fair value of derivative instruments outstanding. Property, Plant and Equipment, Net: The increase in property, plant and equipment, net in 2019 was primarily due to capital expenditures of $136.8 million and $51.1 million from businesses acquired in 2019, partially offset by depreciation of $103.3 million and the net impact of foreign currency exchange rate changes of $8.2 million in 2019. Operating Lease Assets The increase in operating lease assets in 2019 was primarily due to the adoption of the new lease accounting standard. The increase also includes the reclassification of $15.3 million of lease assets from non-current assets to operating lease assets related to purchase accounting adjustments from the ABC Bearings acquisition. These reclassified assets do not have corresponding lease liabilities. Refer to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements for further discussion. Other Assets: The increase in goodwill in 2019 was primarily due to acquisitions in 2019. The increase in other intangible assets was primarily due to the impact of acquisitions of $87.1 million in 2019, partially offset by amortization of $57.3 million and the impact of foreign currency exchange rate changes of $8.0 million in 2019. During the third quarter of 2019, the Company made changes to the medical plan offerings for certain Company postretirement benefit plans, effective January 1, 2020, which will impact the benefits provided to certain retirees. The plan amendment triggered a remeasurement, which resulted in a reduction in the postretirement benefit obligation with a corresponding amount recorded to accumulated other comprehensive loss. As a result of the plan amendment, one of the Company's postretirement benefit plans became overfunded. See Note 15 - Other Postretirement Benefit Plans for further discussion. The increase in deferred income taxes was primarily due to the reversal of foreign valuation allowances in the fourth quarter of 2019, partially offset by a reduction in deferred income taxes related to the plan amendment of the Company's postretirement benefit plans. See Note 5 - Income Taxes for further discussion. The decrease in other non-current assets was primarily due to the reclassification of $15.3 million of lease assets from non-current assets to operating lease assets related to the ABC Bearings acquisition. Current Liabilities: The decrease in short-term debt was primarily due to the decrease in borrowings under the variable-rate lines of credit for the Company's foreign subsidiaries. The increase in the current portion of long-term debt was primarily due to the 2020 Term Loan (as defined below) being reclassified to the current portion of long-term debt as it matures on September 18, 2020. Refer to Note 11 - Financing Arrangements to the Notes to the Consolidated Financial Statements for additional information. The increase in accounts payable was primarily due to efforts by the Company to extend supplier payment terms in 2019, as well as the impact of acquisitions. The decrease in accrued salaries, wages and benefits was primarily due to timing as the payments for 2018 performance-based compensation exceeded accruals for 2019 performance-based compensation expense. In addition, the current pension liability decreased due to the payout of deferred compensation to a former executive of the Company. Refer to Note 14 - Retirement Benefit Plans to the Notes to the Consolidated Financial Statements for additional information. Non-Current Liabilities: The decrease in accrued postretirement benefits was primarily due to changes to the medical plan offerings for certain of the Company's postretirement benefit plans, effective January 1, 2020, which will impact the benefits provided to certain retirees. The plan amendment triggered a remeasurement, which resulted in a $92.8 million reduction in the postretirement benefit obligation and a corresponding amount of income recorded to accumulated other comprehensive loss. This reduction was partially offset by the reclassification of the overfunded status of one of the Company's postretirement benefit plans as a result of the above-described plan amendment. Refer to Note 15 - Other Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for further discussion. The increase in long-term operating lease liabilities was primarily due to the adoption of the new lease accounting standard. Refer to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements for further discussion. The increase in the deferred income taxes was primarily due to the decrease in accrued postretirement benefits discussed above and additional deferred tax liabilities from recent acquisitions. Refer to Note 5 - Income Taxes in the Notes to the Consolidated Financial Statements for further discussion. Shareholders’ Equity: Earnings invested in the business in 2019 increased primarily by net income attributable to the Company of $362.1 million, partially offset by dividends declared of $84.9 million. The decrease in accumulated other comprehensive loss was primarily due to a reduction in the postretirement benefit obligation due to a plan amendment that resulted in a corresponding after-tax reduction in accumulated other comprehensive loss of $70.5 million ($92.8 million pretax), partially offset by current year foreign currency adjustments of $19.9 million. See "Other Disclosures - Foreign Currency" for further discussion regarding the impact of foreign currency translation. The decrease in treasury shares was primarily due to the Company's purchase of 1.4 million of its common shares for $62.7 million, partially offset by $43.2 million of shares issued, net of shares surrendered, for stock compensation plans for 2019. The increase in noncontrolling interest was primarily due to a lower income tax rate and higher income of $10 million at Timken India Limited ("Timken India"), and the 2019 acquisition of the joint venture partner's interest in Timken-XEMC (Hunan) Bearing Co., Ltd, which had losses of $9 million in 2018 and are now included in total Company retained earnings as of December 31, 2019. CASH FLOWS Operating Activities: The increase in net cash provided by operating activities in 2019 compared with 2018 was primarily due a favorable impact of working capital items of $218.6 million. Refer to the table below for additional detail of the impact of each line on net cash provided by operating activities. The following chart displays the impact of working capital items on cash during 2019 and 2018, respectively: The following table displays the impact of income taxes on cash during 2019 and 2018, respectively: Investing Activities: The decrease in net cash used in investing activities in 2019 compared with 2018 was primarily due to a $538.9 million decrease in cash used for acquisitions, partially offset by a $28.0 million increase in cash used in capital expenditures and a $14 million decrease in cash proceeds from the divestiture of the ICT Business completed in 2018. Financing Activities: The decrease in net cash used by financing activities in 2019 compared with 2018 was primarily due to a decrease in net borrowings of $695.7 million. Net borrowings were higher in 2018 due to the funding of the Cone Drive and Rollon acquisitions. The decrease was partially offset by an increase in cash used for share repurchases of $35.8 million and an increase in proceeds from stock option activity of $14.7 million during 2019 compared with 2018. LIQUIDITY AND CAPITAL RESOURCES Reconciliation of total debt to net debt and the ratio of net debt to capital: Net Debt: Ratio of Net Debt to Capital: The Company presents net debt because it believes net debt is more representative of the Company's financial position than total debt due to the amount of cash and cash equivalents held by the Company and the ability to utilize such cash and cash equivalents to reduce debt if needed. The Company has a $100 million Amended and Restated Asset Securitization Agreement (the "Accounts Receivable Facility"), which matures on November 30, 2021. The Accounts Receivable Facility is subject to certain borrowing base limitations and is secured by certain domestic accounts receivable of the Company. Borrowings under the Accounts Receivable Facility were not reduced by any such borrowing base limitations at December 31, 2019. As of December 31, 2019, the Company had $100.0 million in outstanding borrowings, which reduced the availability under the facility to zero. The interest rate on the Accounts Receivable Facility is variable and was 2.77% as of December 31, 2019, which reflects the prevailing commercial paper rate plus facility fees. On June 25, 2019, the Company entered into a Fourth Amended and Restated Credit Agreement (the "Senior Credit Facility"), which is a $650.0 million unsecured revolving credit facility that matures on June 25, 2024. The Senior Credit Facility amends and restates the Company's previous credit agreement, dated as of June 19, 2015. At December 31, 2019, the Senior Credit Facility had outstanding borrowings of $132.7 million, which reduced the availability to $517.3 million. The Senior Credit Facility has two financial covenants: a consolidated leverage ratio and a consolidated interest coverage ratio. The maximum consolidated leverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0 (increasing for a limited time period following the qualifying acquisitions). As of December 31, 2019, the Company’s consolidated leverage ratio was 2.40 to 1.0. The minimum consolidated interest coverage ratio permitted under the Senior Credit Facility is 3.5 to 1.0. As of December 31, 2019, the Company’s consolidated interest coverage ratio was 10.53 to 1.0. The interest rate under the Senior Credit Facility is variable with a spread based on the Company’s credit rating. The average rate on outstanding U.S. dollar borrowings was 2.85% and the average rate on outstanding Euro borrowings was 1.00% as of December 31, 2019. In addition, the Company pays a facility fee based on the Company's credit rating multiplied by the aggregate commitments of all of the lenders under the Senior Credit Facility. As of December 31, 2019, the Company’s credit ratings were investment grade with Standard and Poor's (BBB), Moody's (Baa3) and Fitch (BBB). Other sources of liquidity include short-term lines of credit for certain of the Company’s foreign subsidiaries, which provide for borrowings up to approximately $268.9 million. At December 31, 2019, the Company had borrowings outstanding of $15.5 million and bank guarantees of $0.5 million, which reduced the aggregate availability under these facilities to $252.9 million. On September 6, 2018, the Company issued $400 million aggregate principal amount of fixed-rate 4.50% senior unsecured notes that mature on December 15, 2028 (the "2028 Notes"). On September 11, 2018, the Company entered into a $350 million variable-rate term loan that matures on September 11, 2023 (the "2023 Term Loan"). Proceeds from the 2028 Notes and the 2023 Term Loan were used to fund the acquisitions of Cone Drive and Rollon, which closed on September 1, 2018 and September 18, 2018, respectively. On July 12, 2019, the Company amended the terms of the 2023 Term Loan to, among other things, align covenants and other terms with the Company's Senior Credit Facility. Refer to Note 11 - Financing Arrangements to the Notes to the Consolidated Financial Statements for additional information. On September 7, 2017, the Company issued €150 million aggregate principal amount of senior unsecured notes with a fixed interest rate of 2.02% that mature on September 7, 2027 in the aggregate principal amount of €150 million. On September 18, 2017, the Company entered into a variable-rate €100 million term loan that matures on September 18, 2020 (the "2020 Term Loan"). During the second quarter of 2019, the Company repaid approximately €51.5 million under the 2020 Term Loan, reducing the principal balance to €48.5 million as of December 31, 2019. The 2020 Term Loan was classified as a current portion of long-term debt as of December 31, 2019. The Company expects to service interest and repay the remaining principal balance of the 2020 Term Loan with cash held or generated outside the U.S. At December 31, 2019, $207.2 million of the Company's $209.5 million of cash and cash equivalents resided in jurisdictions outside the U.S. It is the Company's practice to use available cash in the U.S. to pay down its Senior Credit Facility or Accounts Receivable Facility in order to minimize total interest expense. Repatriation of non-U.S. cash could be subject to taxes and some portion may be subject to governmental restrictions. Part of the Company's strategy is to grow in attractive market sectors, many of which are outside the U.S. This strategy includes making investments in facilities, equipment and potential new acquisitions. The Company plans to fund these investments, as well as meet working capital requirements, with cash and cash equivalents and unused lines of credit within the geographic location of these investments where feasible. The Company expects that any cash requirements in excess of cash on hand and cash generated from operating activities will be met by the committed funds available under its Accounts Receivable Facility and Senior Credit Facility. Management believes it has sufficient liquidity to meet its obligations through the term of the Senior Credit Facility. At December 31, 2019, the Company was in full compliance with all applicable covenants on its outstanding debt, and the Company expects to remain in full compliance with its debt covenants. However, the Company may need to limit its borrowings under the Senior Credit Facility or other facilities from time to time in order to remain in compliance. As of December 31, 2019, the Company could have borrowed the full amounts available under the Senior Credit Facility and Accounts Receivable Facility and still would have been in compliance with its debt covenants. The Company expects to generate operating cash of approximately $585 million in 2020, an increase from 2019 of approximately $35 million or 6%, as the Company anticipates lower pension and medical benefit plan payments, partially offset by less cash generated from working capital and higher capital expenditures. The Company expects capital expenditures to be approximately $160 million in 2020, compared with $141 million in 2019. CONTRACTUAL OBLIGATIONS The Company’s contractual debt obligations and contractual commitments outstanding as of December 31, 2019 were as follows: Payments due by period: The interest payments beyond five years primarily relate to long-term fixed-rate notes. Refer to Note 11 - Financing Arrangements in the Notes to the Consolidated Financial Statements for additional information. Purchase commitments are defined as an agreement to purchase goods or services that are enforceable and legally binding on the Company. Included in purchase commitments above are certain obligations related to take-or-pay contracts, capital commitments, service agreements and utilities. Many of these commitments relate to take-or-pay contracts in which the Company guarantees payment to ensure availability of products or services. These purchase commitments do not represent the entire anticipated purchases in the future, but represent only those items that the Company is contractually obligated to purchase. The majority of the products and services purchased by the Company are purchased as needed, with no commitment. In order to maintain minimum funding requirements, the Company is required to make contributions to the trusts established for its defined benefit pension plans and other postretirement benefit plans. The table above shows the expected future minimum cash contributions to the trusts for the funded plans as well as estimated future benefit payments to participants for the unfunded plans. Those minimum funding requirements and estimated benefit payments can vary significantly. The amounts in the table above are based on actuarial estimates using current assumptions for, among other things, discount rates, expected return on assets and health care cost trend rates. During 2019, the Company made cash contributions and payments of approximately $35.4 million to its global defined benefit pension plans and $8.0 million to its other postretirement benefit plans. Refer to Note 14 - Retirement Benefit Plans and Note 15 - Other Postretirement Benefit Plans in the Notes to the Consolidated Financial Statements for additional information. Refer to Note 5 - Income Taxes and Note 12 - Contingencies in the Notes to the Consolidated Financial Statements for additional information regarding the Company's exposure for certain tax and legal matters. In the ordinary course of business, the Company utilizes standby letters of credit issued by financial institutions to guarantee certain obligations, most of which relate to insurance contracts. At December 31, 2019, outstanding letters of credit totaled $42.4 million, primarily having expiration dates within 12 months. New Accounting Guidance Issued and Not Yet Adopted Information required for this Item is incorporated by reference to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The following paragraphs include a discussion of some critical areas that require a higher degree of judgment, estimates and complexity. Revenue recognition: A contract exists when it has approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. Revenue is recognized when performance obligations under the terms of a contract with a customer of the Company are satisfied. Refer to Note 1 - Significant Accounting Policies in the Notes to the Consolidated Financial Statements for further discussion around the Company's revenue policy. Inventory: Inventories are valued at the lower of cost or market, with approximately 59% valued by the first-in, first-out ("FIFO") method and the remaining 41% valued by the last-in, first-out ("LIFO") method. The majority of the Company’s domestic inventories are valued by the LIFO method, while all of the Company’s international inventories are valued by the FIFO method. An actual valuation of the inventory under the LIFO method can be made only at the end of each year based on the inventory levels and costs at that time. Accordingly, interim LIFO calculations are based on management’s estimates of expected year-end inventory levels and costs. Because these are subject to many factors beyond management’s control, annual results may differ from interim results as they are subject to the final year-end LIFO inventory valuation. The Company recognized a decrease in its LIFO reserve of $5.0 million during 2019 compared to an increase in its LIFO reserve of $6.2 million during 2018. Goodwill and Indefinite-lived Intangible Assets: The Company tests goodwill and indefinite-lived intangible assets for impairment at least annually, performing its annual impairment test as of October 1st. Furthermore, goodwill and indefinite-lived intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Each interim period, the Company assesses whether or not an indicator of impairment is present that would necessitate a goodwill and indefinite-lived intangible assets impairment analysis be performed in an interim period other than during the fourth quarter. The Company reviews goodwill for impairment at the reporting unit level. The Mobile Industries segment has four reporting units and the Process Industries segment has two reporting units. The reporting units within the Mobile Industries segment are Mobile Industries, Lubrication Systems, Aerospace Drive Systems and Aerospace Bearing Inspection. The reporting units within the Process Industries segment are Process Industries and Industrial Services. Accounting guidance permits an entity to first assess qualitative factors to determine whether additional indefinite-lived intangible asset impairment testing, including goodwill, is required. The Company chose to utilize this qualitative assessment in the annual indefinite-lived asset impairment testing, including the goodwill of the Mobile Industries, Aerospace Bearing Inspection, Process Industries, Industrial Services and Lubrication Systems reporting units and other material indefinite-lived intangible trade name assets in the fourth quarter of 2019. Based on this qualitative assessment, the Company concluded that it was more likely than not that the fair values of these reporting units and trade names exceeded their respective carrying values. The Company chose to perform a quantitative goodwill impairment analysis in the annual goodwill impairment testing of the Aerospace Drive Systems reporting unit having a goodwill balance of $1.8 million. The quantitative goodwill impairment analysis compares the carrying amount of the reporting unit to its estimated fair value. To the extent that the carrying value of the reporting unit exceeds its estimated fair value, impairment exists and must be recognized. The quantitative analysis performed in 2019 resulted in an estimated fair value that was less than the carrying value, such that full impairment of the $1.8 million goodwill balance in the Aerospace Drive Systems reporting unit was recorded during the fourth quarter. Further analysis of the undiscounted cash flows for the reporting unit determined there was no impairment of long-lived assets held by the Aerospace Drive Systems reporting unit. As of December 31, 2019, the Company had $993.7 million of goodwill on its Consolidated Balance Sheet, of which $361.3 million was attributable to the Mobile Industries segment and $632.4 million was attributable to the Process Industries segment. See Note 9 - Goodwill and Other Intangibles in the Notes to the Consolidated Financial Statements for movements in the carrying amount of goodwill by segment. Income taxes: Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, valuation allowances against deferred tax assets, and accruals for uncertain tax positions. The Company, which is subject to income taxes in the U.S. and numerous non-U.S. jurisdictions, accounts for income taxes in accordance with Accounting Standards Codification ("ASC") Topic 740, “Income Taxes.” Deferred tax assets and liabilities are recorded for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as net operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. Deferred tax assets relate primarily to pension and postretirement benefit obligations in the U.S., which the Company believes are more likely than not to result in future tax benefits. In determining the need for a valuation allowance, the historical and projected financial performance of the entity recording the net deferred tax asset is considered along with any other pertinent information. The Company recorded $44.5 million in 2019 and $12.6 million in 2017 of tax benefits related to the reversal of valuation allowances. There were no valuation allowance reversals in 2018. Refer to Note 5 - Income Taxes in the Notes to the Consolidated Financial Statements for further discussion on the valuation allowance reversals. In the ordinary course of the Company’s business, there are many transactions and calculations where the ultimate income tax determination is uncertain. The Company is regularly under audit by tax authorities. Accruals for uncertain tax positions are provided for in accordance with the requirements of ASC Topic 740. The Company records interest and penalties related to uncertain tax positions as a component of income tax expense. In 2019, the Company recorded $9.6 million of net tax expense for uncertain tax positions, which consisted of $12.1 million of interest and increases to current and prior year uncertain tax positions. This expense was partially offset by $2.5 million related to the net reversal of accruals for prior year uncertain tax positions and settlements with tax authorities. The Company also recorded $2.9 million of uncertain tax positions related to prior years for acquisitions made during 2019 and $2.8 million of uncertain tax positions related to deferred tax liabilities. Purchase accounting and business combinations: Assets acquired and liabilities assumed as part of a business combination are recognized at their acquisition date fair values. In determining these fair values, the Company utilized various forms of the income, cost and market approaches depending on the asset or liability being valued. The Company used a discounted cash flow model to measure the trade names, customer relationship, and technology and know-how-related intangible assets. The estimation of fair value required significant judgment related to future net cash flows based on assumptions related to revenue and EBITDA growth rates, discount rates, and royalty rates. Inputs were generally determined by taking into account competitive trends, market comparisons, independent appraisals, and historical data, among other factors, and were supplemented by current and anticipated market conditions. Refer to Note 1 - Significant Accounting Policies for further discussion regarding the fair value process. Benefit Plans: The Company sponsors a number of defined benefit pension plans that cover eligible employees. The Company also sponsors several funded and unfunded postretirement plans that provide health care and life insurance benefits for eligible retirees and their dependents. These plans are accounted for in accordance with ASC Topic 715-30, "Defined Benefit Plans - Pension," and ASC Topic 715-60, "Defined Benefit Plans - Other Postretirement." The measurement of liabilities related to these plans is based on management's assumptions related to future events, including discount rates and health care cost trend rates. Management regularly evaluates these assumptions and adjusts them as required and appropriate. Other plan assumptions also are reviewed on a regular basis to reflect recent experience and the Company's future expectations. Actual experience that differs from these assumptions may affect future liquidity, expense and the overall financial position of the Company. While the Company believes that current assumptions are appropriate, significant differences in actual experience or significant changes in these assumptions may affect materially the Company's pension and other postretirement employee benefit obligations and its future expense and cash flow. The discount rate is used to calculate the present value of expected future pension and postretirement cash flows as of the measurement date. The Company establishes the discount rate by constructing a notional portfolio of high-quality corporate bonds and matching the coupon payments and bond maturities to projected benefit payments under the Company's pension and postretirement welfare plans. The bonds included in the portfolio generally are non-callable. A lower discount rate will result in a higher benefit obligation; conversely, a higher discount rate will result in a lower benefit obligation. The discount rate also is used to calculate the annual interest cost, which is a component of net periodic benefit cost. The expected rate of return on plan assets is determined by analyzing the historical long-term performance of the Company's pension plan assets, as well as the mix of plan assets between equities, fixed-income securities and other investments, the expected long-term rate of return expected for those asset classes and long-term inflation rates. Short-term asset performance can differ significantly from the expected rate of return, especially in volatile markets. A lower-than-expected rate of return on pension plan assets will increase pension expense and future contributions. The Company recognizes actuarial gains and losses immediately through net periodic benefit cost upon the annual remeasurement in the fourth quarter, or on an interim basis if specific events trigger a remeasurement. Defined Benefit Pension Plans: The Company recognized net periodic benefit cost of $22.7 million during 2019 for defined benefit pension plans, compared to net periodic benefit cost of $35.0 million during 2018. The Company recognized actuarial losses of $13.9 million during 2019 compared to $38.8 million during 2018, partially offset by a curtailment gain of $10.2 million recognized in 2018. Actuarial losses in 2019 were primarily due to the impact of a net reduction in the discount rate used to measure its defined benefit pension obligations of $100.9 million and the impact of experience losses and other changes in valuation assumptions of $3.1 million, partially offset by higher than expected returns on plan assets of $90.1 million. The impact of the net reduction in the discount rate used to measure the Company's defined benefit obligation was primarily driven by a 86 basis point reduction in the weighted-average discount rate used to measure its U.S. defined benefit plan obligations, which decreased from 4.36% in 2018 to 3.50% in 2019. In 2020, the Company expects net periodic benefit cost of $6.6 million for defined benefit pension plans, compared with net periodic benefit cost of $22.7 million in 2019. Net periodic benefit cost for 2020 does not include Mark-to-Market charges that will be recognized immediately through earnings in the fourth quarter of 2020, or on an interim basis if specific events trigger a remeasurement. Excluding the actuarial losses of $13.9 million recognized in 2019, the expected net periodic benefit cost of $6.6 million in 2020 compares to net periodic benefit cost of $8.8 million in 2019 as the Company expects lower interest costs of $4.1 million, partially offset by lower expected return on plan assets of $1.7 million. The Company expects to contribute to its defined benefit pension plans or pay directly to participants of defined benefit plans approximately $11.8 million in 2020 compared with $35.4 million of contributions and payments in 2019. The decrease in 2020 planned employer contributions/payments is primarily due to the 2019 payout of deferred compensation to a former executive officer of the Company. For expense purposes in 2019, the Company applied a weighted-average discount rate of 4.36% to its U.S. defined benefit pension plans. For expense purposes in 2020, the Company will apply a weighted-average discount rate of 3.50% to its U.S. defined benefit pension plans. For expense purposes in 2019, the Company applied an expected weighted-average rate of return of 6.12% for the Company’s U.S. pension plan assets. For expense purposes in 2020, the Company will apply an expected weighted-average rate of return on plan assets of 5.22%. The following table presents the sensitivity of the Company's U.S. projected pension benefit obligation ("PBO") and 2019 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the PBO by $20.2 million and decrease income before income taxes by $20.2 million. Defined benefit pension plans in the U.S. represent 66% of the Company's benefit obligation and 65% of the fair value of the Company's plan assets at December 31, 2019. Other Postretirement Benefit Plans: The Company recognized net periodic benefit credit of $20.5 million during 2019 for other postretirement benefit plans, compared to net periodic benefit credit of $14.3 million during 2018. The Company recognized prior service credits of $5.4 million during 2019 compared to $1.7 million during 2018. During July 2019, the Company announced changes to the medical plan offerings for certain of its postretirement benefit plans, effective January 1, 2020, which will impact the benefits provided to certain retirees. This plan amendment resulted in a $92.8 million reduction in the postretirement benefit obligation and a corresponding pretax adjustment to accumulated other comprehensive loss. Starting with the three months ended September 30, 2019, the pretax adjustment of $92.8 million will be amortized from accumulated other comprehensive loss into net periodic benefit cost (as a benefit) over the next twelve years. In 2020, the Company expects net periodic benefit credit of $7.9 million for other postretirement benefit plans, compared to net periodic benefit credit of $20.5 million in 2019. Net periodic benefit credit for 2020 does not include Mark-to-Market charges that will be recognized immediately through earnings in the fourth quarter of 2020, or on an interim basis if specific events trigger a remeasurement. Excluding the actuarial gain of $18.0 million recognized in 2019, the expected net periodic benefit credit of $7.9 million in 2020 compares to net periodic benefit credit of $2.5 million in 2019 as the Company expects higher amortization of prior service credit of $4.4 million in 2020 related to the plan amendment in 2019. In January 2020, the Company established a second Voluntary Employee Beneficiary Association ("VEBA") trust for certain active employees’ medical benefits. The Company transferred $50 million from the existing VEBA trust to fund this new VEBA trust. The $50 million that was transferred will primarily be classified as other current assets based on the portfolio of the assets in the trust. The Company expects to fully utilize the assets of the new trust in 2020 for the payout of certain active employees’ medical benefits. For expense purposes in 2019, the Company applied a discount rate of 3.48% to 4.30% to its other postretirement benefit plans. For expense purposes in 2020, the Company will apply a discount rate of 3.43% to its other postretirement benefit plans. For expense purposes in 2019, the Company applied an expected rate of return of 4.85% to the VEBA trust assets. For expense purposes in 2020, the Company will apply an expected rate of return of 3.00% to the VEBA trust assets. The following table presents the sensitivity of the Company's accumulated other postretirement benefit obligation ("APBO") and 2019 expense to the indicated increase/decrease in key assumptions: In the table above, a 25 basis point decrease in the discount rate will increase the APBO by $1.3 million and decrease income before income taxes by $1.3 million. For measurement purposes, the Company assumed a weighted-average annual rate of increase in the per capita cost (health care cost trend rate) for medical benefits of 5.8% for 2020, declining gradually to 5.0% in 2023 and thereafter for medical and prescription drug benefits. For Medicare Advantage benefits, actual contract rates have been set for 2020 through 2022, and are assumed to increase by 7.3% for 2023, declining gradually to 5.0% in 2031 and thereafter. The assumed health care cost trend rate may have a significant effect on the amounts reported. A one percentage point increase in the assumed health care cost trend rate would have increased the 2019 total service and interest cost components by $0.1 million and would have increased the postretirement benefit obligation by $2.4 million. A one percentage point decrease would provide corresponding reductions of $0.1 million and $2.0 million, respectively. Other loss reserves: The Company has a number of loss exposures that are incurred in the ordinary course of business such as environmental clean-up, product liability, product warranty, litigation and accounts receivable reserves. Establishing loss reserves for these matters requires management’s judgment with regards to estimating risk exposure and ultimate liability or realization. These loss reserves are reviewed periodically and adjustments are made to reflect the most recent facts and circumstances. OTHER DISCLOSURES: Foreign Currency: Assets and liabilities of subsidiaries are translated at the rate of exchange in effect on the balance sheet date; income and expenses are translated at the average rates of exchange prevailing during the reporting period. Related translation adjustments are reflected as a separate component of accumulated other comprehensive loss. Foreign currency gains and losses resulting from transactions are included in the Consolidated Statements of Income. Net of related derivative activity, the Company recognized a foreign currency exchange gain resulting from transactions of $6.1 million for the year ended December 31, 2019, and recognized a gain of $3.6 million and a loss of $3.7 million for the years ended December 31, 2018 and 2017, respectively. For the year ended December 31, 2019, the Company recorded a negative non-cash foreign currency translation adjustment of $19.7 million that decreased shareholders’ equity, compared with a negative non-cash foreign currency translation adjustment of $60.5 million that decreased shareholders’ equity for the year ended December 31, 2018. The foreign currency translation adjustments for the year ended December 31, 2019 were impacted negatively by the strengthening of the U.S. dollar relative to other currencies as of December 31, 2019 compared to December 31, 2018. Trade Law Enforcement: The U.S. government has an antidumping duty order in effect covering tapered roller bearings from China. The Company is a producer of these bearings, as well as ball bearings and other bearing types, in the U.S. Quarterly Dividend: On February 7, 2020, the Company’s Board of Directors declared a quarterly cash dividend of $0.28 per common share. The quarterly dividend will be paid on March 4, 2020 to shareholders of record as of February 21, 2020. This will be the 391st consecutive quarterly dividend paid on the common shares of the Company. Forward-Looking Statements Certain statements set forth in this Annual Report on Form 10-K and in the Company’s 2019 Annual Report to Shareholders that are not historical in nature (including the Company’s forecasts, beliefs and expectations) are “forward-looking” statements within the meaning of the Private Securities Litigation Reform Act of 1995. In particular, Management’s Discussion and Analysis contains numerous forward-looking statements. Forward-looking statements generally will be accompanied by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “outlook,” “intend,” “may,” “possible,” “potential,” “predict,” “project” or other similar words, phrases or expressions. You are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K. The Company cautions readers that actual results may differ materially from those expressed or implied in forward-looking statements made by or on behalf of the Company due to a variety of factors, such as: (a) deterioration in world economic conditions, or in economic conditions in any of the geographic regions in which the Company or its customers or suppliers conduct business, including adverse effects from a global economic slowdown, terrorism, pandemics or hostilities. This includes: political risks associated with the potential instability of governments and legal systems in countries in which the Company or its customers or suppliers conduct business, changes in currency valuations and recent world events that have increased the risks posed by international trade disputes, tariffs and sanctions; (b) the effects of fluctuations in customer demand on sales, product mix and prices in the industries in which the Company operates. This includes: the ability of the Company to respond to rapid changes in customer demand, the effects of customer or supplier bankruptcies or liquidations, the impact of changes in industrial business cycles, the effects of distributor inventory corrections reflecting de-stocking of the supply chain and whether conditions of fair trade continue in our markets; (c) competitive factors, including changes in market penetration, increasing price competition by existing or new foreign and domestic competitors, the introduction of new products or services by existing and new competitors, and new technology that may impact the way the Company’s products are produced, sold or distributed; (d) changes in operating costs. This includes: the effect of changes in the Company’s manufacturing processes; changes in costs associated with varying levels of operations and manufacturing capacity; availability and cost of raw materials and energy; changes in the expected costs associated with product warranty claims; changes resulting from inventory management and cost reduction initiatives; the effects of unplanned plant shutdowns or natural disasters; and changes in the cost of labor and benefits; (e) the success of the Company’s operating plans, announced programs, initiatives and capital investments; the ability to integrate acquired companies; and the ability of acquired companies to achieve satisfactory operating results, including results being accretive to earnings; (f) the Company’s ability to maintain appropriate relations with unions or works councils that represent Company employees in certain locations in order to avoid disruptions of business and to maintain the continued service of our management and other key employees; (g) unanticipated litigation, claims or assessments. This includes: claims, investigations or problems related to intellectual property, product liability or warranty, foreign export and trade laws, competition and anti-bribery laws, environmental or health and safety issues, data privacy and taxes; (h) changes in worldwide financial and capital markets, including availability of financing and interest rates on satisfactory terms, which affect: the Company’s cost of funds and/or ability to raise capital; as well as customer demand and the ability of customers to obtain financing to purchase the Company’s products or equipment that contain the Company’s products; (i) the Company's ability to satisfy its obligations under its debt agreements and maintain favorable credit ratings, as well as its ability to renew or refinance borrowings on favorable terms; (j) the impact on the Company's pension obligations and assets due to changes in interest rates, investment performance and other tactics designed to reduce risk; and (k) those items identified under Item 1A. Risk Factors on pages 6 through 11. Additional risks relating to the Company’s business, the industries in which the Company operates or the Company’s common shares may be described from time to time in the Company’s filings with the SEC. All of these risk factors are difficult to predict, are subject to material uncertainties that may affect actual results and may be beyond the Company’s control. Readers are cautioned that it is not possible to predict or identify all of the risks, uncertainties and other factors that may affect future results and that the above list should not be considered to be a complete list. Except as required by the federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

<s>[INST] OVERVIEW Introduction: The Timken Company designs and manufactures a growing portfolio of engineered bearings and power transmission products. With more than a century of knowledge and innovation, the Company continuously improves the reliability and efficiency of global machinery and equipment to move the world forward. Timken posted $3.8 billion in sales in 2019 and employs more than 18,000 people globally, operating in 42 countries. The Company operates under two reportable segments: (1) Mobile Industries and (2) Process Industries. The following further describes these business segments: Mobile Industries serves OEM customers that manufacture offhighway equipment for the agricultural, mining and construction markets; onhighway vehicles including passenger cars, light trucks, and medium and heavyduty trucks; rail cars and locomotives; outdoor power equipment; rotorcraft and fixedwing aircraft; and other mobile equipment. Beyond service parts sold to OEMs, aftermarket sales and services to individual end users, equipment owners, operators and maintenance shops are handled directly or through the Company's extensive network of authorized distributors. Process Industries serves OEM and enduser customers in industries that place heavy demands on the fixed operating equipment they make or use in heavy and other general industrial sectors. This includes metals, cement and aggregate production; power generation and renewable energy sources; oil and gas extraction and refining; pulp and paper and food processing; automation and robotics; and health and critical motion control equipment. Other applications include marine equipment, gear drives, cranes, hoists and conveyors. This segment also supports aftermarket sales and service needs through its global network of authorized industrial distributors and through the provision of services directly to end users. Timken creates value by understanding customer needs and applying its knowhow to serve a broad range of customers in attractive markets and industries across the globe. The Company’s business strengths include its product technology, endmarket diversity, geographic reach and aftermarket mix. Timken collaborates with OEMs to improve equipment efficiency with its engineered products and captures subsequent equipment replacement cycles by selling largely through independent channels in the aftermarket. Timken focuses its international efforts and footprint in regions of the world where strong macroeconomic factors such as urbanization, infrastructure development and sustainability create demand for its products and services. The Company's strategy has three primary elements: Profitable Growth. The Company intends to expand into new and existing markets by leveraging its collective knowledge of metallurgy, friction management and power transmission to create value for Timken customers. Using a highly collaborative technical selling approach, the Company places particular emphasis on creating unique solutions for challenging and/or demanding applications. The Company intends to grow in attractive market sectors around the world, emphasizing those spaces that are highly fragmented, demand high service and value the reliability and efficiency offered by Timken products. The Company also targets applications that offer significant aftermarket demand, thereby providing product and services revenue throughout the equipment’s lifetime. Operational Excellence. Timken operates with a relentless drive for exceptional results and a passion for superior execution. The Company embraces a continuous improvement culture that is charged with increasing efficiency, lowering costs, eliminating waste, encouraging organizational agility and building greater brand equity to fuel growth. This requires the Company’s ongoing commitment to attract, retain and develop the best talent across the world. Capital Deployment to Drive Shareholder Value. The Company is intently focused on providing the highest returns for shareholders through its capital allocation framework, which includes: (1) investing in the core business through capital expenditures, research and development and other organic growth initiatives; (2) pursuing strategic acquisitions to broaden its portfolio and capabilities across diverse markets, with a focus on bearings, adjacent power transmission products and related services; (3) returning capital to shareholders through dividends and share repurchases; and (4) maintaining a strong balance sheet and sufficient liquidity. As part of this framework, the Company may also restructure, reposition or divest underperforming product lines or assets. The following items highlight certain of the Company's more significant strategic accomplishments in 2019: On November 1, 2019, the Company completed the acquisition of BEKA Lubrication ("BEKA"), a leading global supplier of automatic lubrications systems serving a diverse [/INST] Negative. </s>

BLACK HILLS POWER INC

2015-02-26

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS Non-GAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “non-GAAP financial measure.” Generally, a non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a non-GAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. The following tables provide certain electric utility operating statistics for the years ended December 31 (dollars in thousands): We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a long-term agreement expiring in 2023. On March 21, 2014, we retired the Ben French, Neil Simpson I, and Osage coal-fired power plants. These three plants totaling 81 MW were closed because of federal environmental regulations. On October 1, 2014, we transferred the remaining net book value of these retired plants to a regulatory asset in accordance with an order granted by the SDPUC. These plants are primarily replaced by our share of Cheyenne Prairie. _________________________ (a) Decrease due to scheduling of outages in the current year compared to the prior year 2014 Compared to 2013 Gross margin increased primarily due to a return on additional investments which increased base electric margins by $6.0 million and $1.8 million from the Cheyenne Prairie construction financing rider. An increase in commercial and industrial megawatt hours sold increased gross margins $2.3 million. These increases were partially offset by a $1.1 million decrease in wholesale margins driven by plant outages affecting unit-contingent wholesale contracts. Operations and maintenance increased primarily due to an increase in depreciation, driven by an increased asset base, higher employee costs, property taxes, and a true-up made in the prior year for generation dispatch services billed to a third party. These were partially offset by a decrease in vegetation management expenses. Interest expense, net increased primarily due to the increase in long-term debt from permanent financing put in place for Cheyenne Prairie by the sale of $85 million of first mortgage bonds on October 1, 2014. Other income, net was comparable to the prior year. Income tax expense: The effective rate is higher in the current year due to an unfavorable true-up adjustment and the recording of the 2012 research and development credit in 2013. 2013 Compared to 2012 Gross margin increased primarily due to a return on additional investments which increased base electric margins by $5.5 million and $2.7 million from the Cheyenne Prairie construction financing rider. Operations and maintenance increased primarily due to an increase in vegetation management, plant overhaul and maintenance costs, and employee compensation and benefit costs. Interest expense, net increased primarily due to lower interest income received on affiliate borrowings and increased allocations of corporate debt costs. Other income, net was comparable to the prior year. Income tax expense: The effective tax rate decreased in 2013 primarily due to the result of the retroactive reinstatement of research and development credits. Financing Plans and Activity On September 30, 2014, we repaid in full $12 million in principal on the 5.35% Pollution Control Revenue Bonds originally due to mature on October 1, 2024. In addition, we paid the accrued interest on these bonds of $0.3 million. On October 1, 2014, in a private placement transaction to provide permanent financing for Cheyenne Prairie, we issued $85 million of 4.43% coupon first mortgage bonds due October 20, 2044. Credit Ratings Credit ratings impact our ability to obtain short and long-term financing, the cost of such financing, and vendor payment terms, including collateral requirements. As of December 31, 2014, our credit ratings for our Senior Secured Debt, as assessed by the three major credit rating agencies, were as follows: ______________________ (a) On January 30, 2014, Moody’s upgraded the BHP credit rating to A1 with a stable outlook. (b) On June 13, 2014, Fitch upgraded the BHP credit rating to A with a Stable outlook. Significant Events Cheyenne Prairie On October 1, 2014, Cheyenne Prairie, a jointly owned natural gas-fired generating facility was placed into commercial operation. We own 55 MW and Cheyenne Light owns 40 MW of the facility’s combined-cycle unit. Our cost was approximately $90 million for our share of the combined-cycle unit. Cheyenne Prairie was constructed on time and on budget. Construction financing costs were recovered through construction financing riders. New rates were implemented on October 1, 2014 for our customers in Wyoming, as previously approved by the WPSC, and interim rates were implemented on October 1, 2014 for customers in South Dakota. Bond Issuance On October 1, 2014, we issued $85 million of 4.43% coupon first mortgage bonds due October 20, 2044 to provide permanent financing for Cheyenne Prairie. Proceeds from the bond sale also funded the September 30, 2014 early redemption of our 5.35% $12 million pollution control revenue bonds, originally due October 1, 2024. Regulatory Matters On August 21, 2014, the WPSC approved rate case settlement agreements associated with Cheyenne Prairie authorizing an increase of approximately $2.2 million for annual electric revenue, effective October 1, 2014. The settlement also included a return on equity of 9.9% and a capital structure of 53.3% equity and 46.7% debt. On July 22, 2014, we filed a CPCN with the WPSC to construct a $54 million, 230-kV, 144 mile-long transmission line that would connect the Teckla Substation in northeast Wyoming, to the Lange Substation near Rapid City, South Dakota, for the Wyoming portion of this line. On June 30, 2014, we filed an application with the SDPUC, for a permit to construct the South Dakota portion of this line. We have received approval from the SDPUC to construct the line and approval by the WPSC is anticipated in the second quarter of 2015. On March 31, 2014, we filed a rate request with the SDPUC for an annual revenue increase of $14.6 million to recover operating expenses and infrastructure investments, primarily for Cheyenne Prairie. The filing seeks a return on equity of 10.25%, and a capital structure of approximately 53.3% equity and 46.7% debt. Interim rates were implemented on October 1, 2014 when Cheyenne Prairie commenced commercial operations. A final ruling from the SDPUC is expected in the first quarter of 2015. On March 21, 2014, we retired the Ben French, Neil Simpson I, and Osage coal-fired power plants. These three plants totaling 81 MW were closed because of federal environmental regulations. These plants are primarily replaced by our share of Cheyenne Prairie. On October 1, 2014, we transferred the remaining net book value of these plants to a regulatory asset in accordance with an order granted by the SDPUC. Critical Accounting Estimates We prepare our financial statements in conformity with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in application. There are also areas which require management’s judgment in selecting among available GAAP alternatives. We are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results may differ from our estimates and to the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following accounting estimates are the most critical in understanding and evaluating our reported financial results. The following discussion of our critical accounting estimates should be read in conjunction with Note 1, “Business Description and Summary of Significant Accounting Policies” of our Notes to Financial Statements in this Annual Report on Form 10-K. Pension and Other Postretirement Benefits The Company, as described in Note 8 to the Financial Statements in this Annual Report on Form 10-K, has a defined benefit pension plan and post-retirement healthcare plan. As of December 31, 2012, a Master Trust was established for the investment of assets of the defined benefit pension plans. Each participating retirement plan has an undivided interest in the Master Trust. Accounting for pension and other postretirement benefit obligations involves numerous assumptions, the most significant of which relate to the discount rate for measuring the present value of future plan obligations; expected long-term rates of return on plan assets; rate of future increases in compensation levels; and healthcare cost projections. The determination of our obligation and expenses for pension and other postretirement benefits is dependent on the assumptions determined by management and used by actuaries in calculating the amounts. Although we believe our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions may materially affect our pension and other postretirement obligations and our future expense. The discount rate used to determine annual defined benefit pension costs accruals will be 4.25% in 2015 and the discount rate used in 2014 was 5.1%. In selecting the discount rate, we consider cash flow durations for each plan’s liabilities on high credit fixed income yield curves for comparable durations. We do not pre-fund our non-qualified plans or postretirement healthcare plans. Income Taxes We file a federal income tax return with other members of the Parent consolidated group. For financial statement purposes, federal income taxes are allocated to the individual companies based on amounts calculated on a separate return basis. We use the liability method of accounting for income taxes. Under this method, deferred income taxes are recognized, at currently enacted income tax rates, to reflect the tax effect of temporary differences between the financial and tax basis of assets and liabilities, as well as operating loss and tax credit carryforwards. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. We classify deferred tax assets and liabilities into current and non-current amounts based on the nature of the related assets and liabilities. It is the Parent’s policy to apply the flow-through method of accounting for investment tax credits. Under the flow-through method, investment tax credits are reflected in net income as a reduction to income tax expense in the year they qualify. Another acceptable accounting method and an exception to this general policy is to apply the deferral method whereby the credit is amortized as a reduction of income tax expense over the useful lives of the related property which gave rise to the credits. We recognize interest income or interest expense and penalties related to income tax matters in Income tax (expense) benefit on the Statements of Income. We account for uncertainty in income taxes recognized in the financial statements in accordance with accounting standards for income taxes. The unrecognized tax benefit is classified in Other - non-current liabilities on the accompanying Balance Sheets. See Note 6 in our Notes to Financial Statements in this Annual Report on Form 10-K for additional information. Contingencies When it is probable that an environmental or other legal liability has been incurred, a loss is recognized when the amount of the loss can be reasonably estimated. Estimates of the probability and the amount of loss are made based on currently available facts. Accounting for contingencies requires significant judgment regarding the estimated probabilities and ranges of exposure to potential liability. Our assessment of our exposure to contingencies could change to the extent there are additional future developments, or as more information becomes available. If actual obligations incurred are different from our estimates, the recognition of the actual amounts could have a material impact on our financial position, results of operations and cash flows. We describe any contingencies in Note 11 of the Financial Statements in this Annual Report on Form 10-K.

<s>[INST] NonGAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “nonGAAP financial measure.” Generally, a nonGAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a nonGAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. The following tables provide certain electric utility operating statistics for the years ended December 31 (dollars in thousands): We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a longterm agreement expiring in 2023. On March 21, 2014, we retired the Ben French, Neil Simpson I, and Osage coalfired power plants. These three plants totaling 81 MW were closed because of federal environmental regulations. On October 1, 2014, we transferred the remaining net book value of these retired plants to a regulatory asset in accordance with an order granted by the SDPUC. These plants are primarily replaced by our share of Cheyenne Prairie. _________________________ (a) Decrease due to scheduling of outages in the current year compared to the prior year 2014 Compared to 2013 Gross margin increased primarily due to a return on additional investments which increased base electric margins by $6.0 million and $1.8 million from the Cheyenne Prairie construction financing rider. An increase in commercial and industrial megawatt hours sold increased gross margins $2.3 million. These increases were partially offset by a $1.1 million decrease in wholesale margins driven by plant outages affecting unitcontingent wholesale contracts. Operations and maintenance increased primarily due to an increase in depreciation, driven by an increased asset base, higher employee costs, property taxes, and a trueup made in the prior year for generation dispatch services billed to a third party. These were partially offset by a decrease in vegetation management expenses. Interest expense, net increased primarily due to the increase in longterm debt from permanent financing put in place for Cheyenne Prairie by the sale of $85 million of first mortgage bonds on October 1, 2014. Other income, net was comparable to the prior year. Income tax expense: The effective rate is higher in the current year due to an unfavorable trueup adjustment and the recording of the 2012 research and development credit in 2013. 2013 Compared to 2012 Gross margin increased primarily due to a return on additional investments which increased base electric margins by $5.5 million and $2.7 million from the Cheyenne Prairie construction financing rider. Operations and maintenance increased primarily due to an increase in vegetation management, plant overhaul and maintenance costs, and employee compensation and benefit costs. Interest expense, net increased primarily due to lower interest income received on affiliate borrowings and increased allocations of corporate debt costs. Other income, net was comparable to the prior year. Income tax expense: The effective tax rate decreased in 2013 primarily due to the result of the retroactive reinstatement of research and development credits. Financing Plans and Activity On September 30, 2014, we repaid in full $12 million in principal on the 5.35% Pollution Control Re [/INST] Positive. </s>

BLACK HILLS POWER INC

2016-02-29

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS Non-GAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “non-GAAP financial measure.” Generally, a non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a non-GAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. The following tables provide certain electric utility operating statistics for the years ended December 31 (dollars in thousands): We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a long-term agreement expiring in 2023. On March 21, 2014, we retired the Ben French, Neil Simpson I, and Osage coal-fired power plants. These three plants totaling 81 MW were closed because of federal environmental regulations. On October 1, 2014, we transferred the remaining net book value of these retired plants to a regulatory asset in accordance with an order granted by the SDPUC. These plants are primarily replaced by our share of Cheyenne Prairie. _________________________ (a) 2014 decrease from 2013 was due to the scheduling of outages in 2014 compared to 2013. 2015 Compared to 2014 Gross margin increased primarily due to a return on capital investments in Cheyenne Prairie which increased gross margins by $11.9 million and increased energy cost recoveries by $2.7 million. Retail margins increased $4.7 million primarily due to commercial and industrial load increases from higher MWh sold. These increases are partially offset by an approximately $1.7 million decrease in residential margins driven primarily by a 12% decrease in heating degree days compared to the same period in the prior year. Operations and maintenance increased reflecting an increase in depreciation expense primarily due to a higher asset base and amortization of regulatory plant decommissioning costs. Interest expense, net increased primarily due to interest costs from the $85 million of permanent financing put in place during the fourth quarter of 2014 for Cheyenne Prairie. Other income, net was comparable to the prior year. Income tax expense: The 2015 effective tax rate is comparable to the prior year. 2014 Compared to 2013 Gross margin increased primarily due to a return on additional investments which increased base electric margins by $6.0 million and $1.8 million from the Cheyenne Prairie construction financing rider. An increase in commercial and industrial MWh sold increased gross margins $2.3 million. These increases were partially offset by a $1.1 million decrease in wholesale margins driven by plant outages affecting unit-contingent wholesale contracts. Operations and maintenance increased primarily due to an increase in depreciation, driven by an increased asset base, higher employee costs, property taxes, and a true-up made in the prior year for generation dispatch services billed to a third party. These were partially offset by a decrease in vegetation management expenses. Interest expense, net increased primarily due to the increase in long-term debt from permanent financing put in place for Cheyenne Prairie by the sale of $85 million of first mortgage bonds on October 1, 2014. Other income, net was comparable to the prior year. Income tax expense: The effective rate is higher in 2014 due to an unfavorable true-up adjustment and the recording of the 2012 research and development credit in 2013. Financing Plans and Activity On October 1, 2014, in a private placement transaction to provide permanent financing for Cheyenne Prairie, we issued $85 million of 4.43% coupon first mortgage bonds due October 20, 2044. Proceeds from the bond sale also funded the September 30, 2014 early redemption of our 5.35% $12 million pollution control revenue bonds, originally due October 1, 2024. In addition, we paid the accrued interest on these bonds of $0.3 million. Credit Ratings Credit ratings impact our ability to obtain short and long-term financing, the cost of such financing, and vendor payment terms, including collateral requirements. The following table represents our credit rating from each agency’s review which were in effect at December 31, 2015: Significant Events Regulatory Matters On July 23, 2015, we received approval from the WPSC for a CPCN originally filed on July 22, 2014 to construct the Wyoming portion of a $54 million, 230-kV, 144 mile-long transmission line that would connect the Teckla Substation in northeast Wyoming, to the Lange Substation near Rapid City, South Dakota. We received approval on November 6, 2014 from the SDPUC for a permit to construct the South Dakota portion of this line. Construction commenced in the first quarter of 2016, and the project is expected to be placed in service in 2016. On March 2, 2015, the SDPUC issued an order approving a rate stipulation and agreement authorizing an annual electric revenue increase for us of $6.9 million. The agreement was a Global Settlement and did not stipulate return on equity and capital structure. The SDPUC’s decision provides us a return on our investment in Cheyenne Prairie and associated infrastructure, and provides recovery of our share of operating expenses for this natural gas fired facility. We implemented interim rates on October 1, 2014, coinciding with Cheyenne Prairie’s commercial operation date. Final rates were approved on April 1, 2015, effective October 1, 2014. Critical Accounting Estimates We prepare our financial statements in conformity with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in application. There are also areas which require management’s judgment in selecting among available GAAP alternatives. We are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results may differ from our estimates and to the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following accounting estimates are the most critical in understanding and evaluating our reported financial results. The following discussion of our critical accounting estimates should be read in conjunction with Note 1, “Business Description and Summary of Significant Accounting Policies” of our Notes to Financial Statements in this Annual Report on Form 10-K. Pension and Other Postretirement Benefits The Company, as described in Note 8 to the Financial Statements in this Annual Report on Form 10-K, has a defined benefit pension plan and post-retirement healthcare plan. As of December 31, 2012, a Master Trust was established for the investment of assets of the defined benefit pension plans. Each participating retirement plan has an undivided interest in the Master Trust. Accounting for pension and other postretirement benefit obligations involves numerous assumptions, the most significant of which relate to the discount rate for measuring the present value of future plan obligations; expected long-term rates of return on plan assets; rate of future increases in compensation levels; and healthcare cost projections. The determination of our obligation and expenses for pension and other postretirement benefits is dependent on the assumptions determined by management and used by actuaries in calculating the amounts. Although we believe our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions may materially affect our pension and other postretirement obligations and our future expense. The discount rate used to determine annual defined benefit pension costs accruals will be 4.25% in 2016 and the discount rate used in 2015 was 4.25%. In selecting the discount rate, we consider cash flow durations for each plan’s liabilities on high credit fixed income yield curves for comparable durations. We do not pre-fund our non-qualified plans or postretirement healthcare plans. Beginning in 2016, the Company will change the method used to estimate the service and interest cost components of the net periodic pension, supplemental non-qualified defined benefit and other postretirement benefit costs. The new method uses the spot yield curve approach to estimate the service and interest costs by applying the specific spot rates along the yield curve used to determine the benefit obligations to relevant projected cash outflows. Prior to 2016, the service and interest costs were determined using a single weighted-average discount rate based on hypothetical AA Above Median yield curves used to measure the benefit obligation at the beginning of the period. The change does not affect the measurement of the total benefit obligations as the change in service and interest costs offsets the actuarial gains and losses recorded in other comprehensive income. The Company changed to the new method to provide a more precise measure of interest and service costs by improving the correlation between the projected benefit cash flows and the discrete spot yield curve rates. The company will account for this change as a change in estimate prospectively beginning in the first quarter of 2016. The discount rates used to measure the 2016 service costs are 4.81%, 4.88% and 4.18% for pension, supplemental non-qualified defined benefit and other postretirement benefit costs, respectively. The discount rates used to measure the 2016 interest costs are 3.90%, 3.82% and 3.17% for pension, supplemental non-qualified defined benefit and other postretirement benefit costs, respectively. The previous method would have used a discount rate for both service and interest costs of 4.63% for pension, 4.50% for supplemental non-qualified defined benefit and 4.03% for other postretirement benefit costs. The decrease in the 2016 service and interest costs is approximately $0.5 million, $0.03 million and $0.1 million for the pension, supplemental non-qualified defined benefit and other postretirement benefit costs, respectively, as compared to the previous method. Income Taxes We file a federal income tax return with other members of the Parent consolidated group. For financial statement purposes, federal income taxes are allocated to the individual companies based on amounts calculated on a separate return basis. We use the asset and liability method of accounting for income taxes. Under this method, deferred income taxes are recognized, at currently enacted income tax rates, to reflect the tax effect of temporary differences between the financial and tax basis of assets and liabilities, as well as net operating loss and tax credit carryforwards. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. We have chosen to early adopt on a prospective basis ASU 2015-17. As of December 31, 2015, we classify all deferred tax assets and liabilities as non-current amounts. The prior period is presented under the previous guidance for classifying deferred tax assets and deferred tax liabilities as current and non-current. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized and provides any necessary valuation allowances as required. If we determine that we will be unable to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretations of tax laws and the resolution of current and any future tax audits could significantly impact the amounts provided for income taxes in our consolidated financial statements. With respect to changes in tax law, the Protecting Americans from Tax Hikes Act of 2015, which was enacted December 18, 2015, did not have a material impact on the amounts provided for income taxes including our ability to realize deferred tax assets. The Tax Increase Prevention Act (TIPA), which was enacted December 19, 2014, did not have a material impact on the amounts provided for income taxes including our ability to realize deferred tax assets. Certain provisions of the TIPA involving primarily the extension of 50 percent bonus depreciation resulted in the generation of a NOL for federal income tax purposes in 2014. In September 2013, the U.S. Treasury issued final regulations addressing the tax consequences associated with amounts paid to acquire, produce, or improve tangible property. The regulations had the effect of a change in law and as a result the impact was taken into account in the period of adoption. In general, such regulations apply to tax years beginning on or after January 1, 2014, with early adoption permitted. We implemented all of the provisions of the final regulations with the filing of the 2013 federal income tax return in September 2014. The adoption of the final regulations did not have a material impact on our financial statements. See Note 6 in our Notes to Financial Statements in this Annual Report on Form 10-K for additional information. Contingencies When it is probable that an environmental or other legal liability has been incurred, a loss is recognized when the amount of the loss can be reasonably estimated. Estimates of the probability and the amount of loss are made based on currently available facts. Accounting for contingencies requires significant judgment regarding the estimated probabilities and ranges of exposure to potential liability. Our assessment of our exposure to contingencies could change to the extent there are additional future developments, or as more information becomes available. If actual obligations incurred are different from our estimates, the recognition of the actual amounts could have a material impact on our financial position, results of operations and cash flows. We describe any contingencies in Note 11 of the Financial Statements in this Annual Report on Form 10-K.

<s>[INST] NonGAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “nonGAAP financial measure.” Generally, a nonGAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a nonGAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. The following tables provide certain electric utility operating statistics for the years ended December 31 (dollars in thousands): We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a longterm agreement expiring in 2023. On March 21, 2014, we retired the Ben French, Neil Simpson I, and Osage coalfired power plants. These three plants totaling 81 MW were closed because of federal environmental regulations. On October 1, 2014, we transferred the remaining net book value of these retired plants to a regulatory asset in accordance with an order granted by the SDPUC. These plants are primarily replaced by our share of Cheyenne Prairie. _________________________ (a) 2014 decrease from 2013 was due to the scheduling of outages in 2014 compared to 2013. 2015 Compared to 2014 Gross margin increased primarily due to a return on capital investments in Cheyenne Prairie which increased gross margins by $11.9 million and increased energy cost recoveries by $2.7 million. Retail margins increased $4.7 million primarily due to commercial and industrial load increases from higher MWh sold. These increases are partially offset by an approximately $1.7 million decrease in residential margins driven primarily by a 12% decrease in heating degree days compared to the same period in the prior year. Operations and maintenance increased reflecting an increase in depreciation expense primarily due to a higher asset base and amortization of regulatory plant decommissioning costs. Interest expense, net increased primarily due to interest costs from the $85 million of permanent financing put in place during the fourth quarter of 2014 for Cheyenne Prairie. Other income, net was comparable to the prior year. Income tax expense: The 2015 effective tax rate is comparable to the prior year. 2014 Compared to 2013 Gross margin increased primarily due to a return on additional investments which increased base electric margins by $6.0 million and $1.8 million from the Cheyenne Prairie construction financing rider. An increase in commercial and industrial MWh sold increased gross margins $2.3 million. These increases were partially offset by a $1.1 million decrease in wholesale margins driven by plant outages affecting unitcontingent wholesale contracts. Operations and maintenance increased primarily due to an increase in depreciation, driven by an increased asset base, higher employee costs, property taxes, and a trueup made in the prior year for generation dispatch services billed to a third party. These were partially offset by a decrease in vegetation management expenses. Interest expense, net increased primarily due to the increase in longterm debt from permanent financing put in place for Cheyenne Prairie by the sale of $85 million of first mortgage bonds on October 1, 2014. Other income, net was comparable to the prior year. Income tax expense: The effective rate [/INST] Negative. </s>

BLACK HILLS POWER INC

2017-03-01

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS Significant Events Name Rebranding We now operate with the trade name Black Hills Energy South Dakota. BHC rebranded all of its regulated utilities to operate under the name Black Hills Energy. Regulatory Matters During the first quarter of 2016, we commenced construction of the $54 million, 230-kV, 144 mile transmission line that will connect the Teckla Substation in northeast Wyoming, to the Lange Substation near Rapid City, South Dakota. The first segment of this project connecting Teckla to Osage, Wyoming was energized on August 31, 2016. The second segment of the project is expected to be placed in service in the first half of 2017. On March 2, 2015, the SDPUC issued an order approving a rate stipulation and agreement authorizing an annual electric revenue increase for us of $6.9 million. The agreement was a Global Settlement and did not stipulate return on equity and capital structure. The SDPUC’s decision provides us a return on our investment in Cheyenne Prairie and associated infrastructure, and provides recovery of our share of operating expenses for this natural gas-fired facility. We implemented interim rates on October 1, 2014, coinciding with Cheyenne Prairie’s commercial operation date. Final rates were approved on April 1, 2015, effective October 1, 2014. Non-GAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “non-GAAP financial measure.” Generally, a non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a non-GAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. The following tables provide certain electric utility operating statistics for the years ended December 31 (dollars in thousands): _________________________ (a) Decrease in 2016 is driven by weaker market conditions We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a long-term agreement expiring in 2023. On March 21, 2014, we retired the Ben French, Neil Simpson I, and Osage coal-fired power plants. These three plants totaling 81 MW were closed because of federal environmental regulations. On October 1, 2014, we transferred the remaining net book value of these retired plants to a regulatory asset in accordance with an order granted by the SDPUC. These plants are primarily replaced by our share of Cheyenne Prairie. _________________________ (a) 2016 reflects planned and unplanned outages. (b) 2014 reflects scheduled outages. ______________ (a) 30-year average is from NOAA Climate Normals 2016 Compared to 2015 Gross margin decreased primarily due to a prior year return on invested capital of $1.2 million from a rate case, and a $1.3 million decrease due to third party billing true-ups related to the current and prior years, partially offset by the weather impact from the increase in cooling degree days compared to the same period in the prior year. Operations and maintenance increased primarily due to higher depreciation expense driven by additional plant in service compared to the same period in the prior year, partially offset by lower employee costs driven by a change in operating expense allocations impacting us as a result of our Parent Company integrating the acquired SourceGas utilities. Interest expense, net decreased primarily due to higher AFUDC income in the current year driven by higher construction work-in-process balances compared to the same period in the prior year. Other income, net was comparable to the prior year. Income tax expense: The 2016 effective tax rate is comparable to the prior year. 2015 Compared to 2014 Gross margin increased primarily due to a return on capital investments in Cheyenne Prairie which increased gross margins by $11.9 million and increased energy cost recoveries by $2.7 million. Retail margins increased $4.7 million primarily due to commercial and industrial load increases from higher MWh sold. These increases are partially offset by an approximately $1.7 million decrease in residential margins driven primarily by a 12% decrease in heating degree days compared to the same period in the prior year. Operations and maintenance increased reflecting an increase in depreciation expense primarily due to a higher asset base and amortization of regulatory plant decommissioning costs. Interest expense, net increased primarily due to interest costs from the $85 million of permanent financing put in place during the fourth quarter of 2014 for Cheyenne Prairie. Other income, net was comparable to the prior year. Income tax expense: The 2015 effective tax rate is comparable to the prior year. Credit Ratings Credit ratings impact our ability to obtain short and long-term financing, the cost of such financing, and vendor payment terms, including collateral requirements. The following table represents our credit rating from each agency’s review which were in effect at December 31, 2016: Critical Accounting Estimates We prepare our financial statements in conformity with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in application. There are also areas which require management’s judgment in selecting among available GAAP alternatives. We are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results may differ from our estimates and to the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following accounting estimates are the most critical in understanding and evaluating our reported financial results. The following discussion of our critical accounting estimates should be read in conjunction with Note 1, “Business Description and Summary of Significant Accounting Policies” of the Notes to Financial Statements in this Annual Report on Form 10-K. Pension and Other Postretirement Benefits The Company, as described in Note 8 of the Financial Statements in this Annual Report on Form 10-K, has a defined benefit pension plan, a post-retirement healthcare plan and a non-qualified retirement plan. A Master Trust was established for the investment of assets of the defined benefit pension plan. Accounting for pension and other postretirement benefit obligations involves numerous assumptions, the most significant of which relate to the discount rates, health care cost trend rates, expected return on plan assets, compensation increases, retirement rates and mortality rates. The determination of our obligation and expenses for pension and other postretirement benefits is dependent on the assumptions determined by management and used by actuaries in calculating the amounts. Although we believe our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions may materially affect our pension and other postretirement obligations and our future expense. The pension benefit cost for 2017 for our non-contributory funded pension plan is expected to be approximately $0.6 million compared to $1.5 million in 2016. The decrease in pension benefit cost is driven by the merging of three of Black Hills Corporation’s defined benefit pension plans into one, improved mortality rates and better than expected return on plan assets partially offset by a decrease in the discount rate. Beginning in 2016, the Company changed the method used to estimate the service and interest cost components of the net periodic pension, supplemental non-qualified defined benefit and other postretirement benefit costs. The new method used the spot yield curve approach to estimate the service and interest costs by applying the specific spot rates along the yield curve used to determine the benefit obligations to relevant projected cash outflows. Prior to 2016, the service and interest costs were determined using a single weighted-average discount rate based on hypothetical AA Above Median yield curves used to measure the benefit obligation at the beginning of the period. The change does not affect the measurement of the total benefit obligations as the change in service and interest costs offsets the actuarial gains and losses recorded in other comprehensive income. The Company changed to the new method to provide a more precise measure of service and interest costs by improving the correlation between the projected benefit cash flows and the discrete spot yield curve rates. The Company accounted for this change as a change in estimate prospectively beginning in 2016. The effect of hypothetical changes to selected assumptions on the pension and other postretirement benefit plans would be as follows in thousands of dollars: __________________________ (a) Projected benefit obligation for pension plans and accumulated postretirement benefit obligation (APBO) for OPEB plans. (b) Impact on service cost, interest cost and amortization of gains or losses. Regulation Our utility operations are subject to regulation with respect to rates, service area, accounting, and various other matters by state and federal regulatory authorities. The accounting regulations provide that rate-regulated public utilities account and report assets and liabilities consistent with the economic effects of the manner in which independent third-party regulators establish rates. Regulatory assets generally represent incurred or accrued costs that have been deferred when future recovery from customers is probable. Regulatory liabilities generally represent amounts that are expected to be refunded to customers in future rates or amounts collected in current rates for future costs. Management continually assesses the probability of future recoveries and obligations associated with regulatory assets and liabilities. Factors such as the current regulatory environment, recently issued rate orders, and historical precedents are considered. As a result, we believe that the accounting prescribed under rate-based regulation remains appropriate and our regulatory assets are probable for recovery in current rates or in future rate proceedings. Unbilled Revenue Revenues attributable to energy delivered to customers, but not yet billed under the cycle billing method, are estimated and accrued and the related costs are charged to expense. Factors influencing the determination of unbilled revenues may include estimates of delivered sales volumes based on weather information and customer consumption trends. Income Taxes We file a federal income tax return with other members of the Parent consolidated group. For financial statement purposes, federal income taxes are allocated to the individual companies based on amounts calculated on a separate return basis. We use the asset and liability method of accounting for income taxes. Under this method, deferred income taxes are recognized, at currently enacted income tax rates, to reflect the tax effect of temporary differences between the financial and tax basis of assets and liabilities, as well as net operating loss and tax credit carryforwards. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized and provides any necessary valuation allowances as required. If we determine that we will be unable to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretations of tax laws and the resolution of current and any future tax audits could significantly impact the amounts provided for income taxes in our financial statements. See Note 6 of the Notes to Financial Statements in this Annual Report on Form 10-K for additional information.

<s>[INST] Significant Events Name Rebranding We now operate with the trade name Black Hills Energy South Dakota. BHC rebranded all of its regulated utilities to operate under the name Black Hills Energy. Regulatory Matters During the first quarter of 2016, we commenced construction of the $54 million, 230kV, 144 mile transmission line that will connect the Teckla Substation in northeast Wyoming, to the Lange Substation near Rapid City, South Dakota. The first segment of this project connecting Teckla to Osage, Wyoming was energized on August 31, 2016. The second segment of the project is expected to be placed in service in the first half of 2017. On March 2, 2015, the SDPUC issued an order approving a rate stipulation and agreement authorizing an annual electric revenue increase for us of $6.9 million. The agreement was a Global Settlement and did not stipulate return on equity and capital structure. The SDPUC’s decision provides us a return on our investment in Cheyenne Prairie and associated infrastructure, and provides recovery of our share of operating expenses for this natural gasfired facility. We implemented interim rates on October 1, 2014, coinciding with Cheyenne Prairie’s commercial operation date. Final rates were approved on April 1, 2015, effective October 1, 2014. NonGAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “nonGAAP financial measure.” Generally, a nonGAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a nonGAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. The following tables provide certain electric utility operating statistics for the years ended December 31 (dollars in thousands): _________________________ (a) Decrease in 2016 is driven by weaker market conditions We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a longterm agreement expiring in 2023. On March 21, 2014, we retired the Ben French, Neil Simpson I, and Osage coalfired power plants. These three plants totaling 81 MW were closed because of federal environmental regulations. On October 1, 2014, we transferred the remaining net book value of these retired plants to a regulatory asset in accordance with an order granted by the SDPUC. These plants are primarily replaced by our share of Cheyenne Prairie. _________________________ (a) 2016 reflects planned and unplanned outages. (b) 2014 reflects scheduled outages. ______________ (a) 30year average is from NOAA Climate Normals 2016 Compared to 2015 Gross margin decreased primarily due to a prior year return on invested capital of $1.2 million from a rate case, and a $1.3 million decrease due to third party billing trueups related to the current and prior years, partially offset by the weather impact from the increase in cooling degree days compared to the same period in the prior year. Operations and maintenance increased primarily due to higher depreciation expense driven by additional plant in service compared to the same period in the [/INST] Positive. </s>

BLACK HILLS POWER INC

2018-02-27

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS Significant Events Settlement On June 16, 2017, South Dakota Electric received approval from the SDPUC on a settlement reached with the SDPUC staff agreeing to a six-year moratorium period effective July 1, 2017. As part of this agreement, South Dakota Electric will not increase base rates, absent an extraordinary event. The moratorium period also includes a suspension of both the TFA and the EIA, and a $1.0 million increase to the annual power marketing margin guarantee during this period. Additionally, existing regulatory asset balances of approximately $13 million related to decommissioning and Winter Storm Atlas are being amortized over the moratorium period. These balances were previously amortized over a 10-year period ending September 30, 2024. The vegetation management regulatory asset of $14 million, previously unamortized, is being amortized over the moratorium period. The change in amortization periods for these costs increased annual amortization expense by approximately $2.7 million. The June 16, 2017 settlement had no impact to base rates. Transmission Construction was completed on the 144 mile-long transmission line connecting the Teckla Substation in northeast Wyoming to the Lange Substation near Rapid City, South Dakota. The first segment of this project connecting Teckla to Osage, WY was placed in service on August 31, 2016. The second segment connecting Osage to Lange was placed in service on May 30, 2017. Non-GAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “non-GAAP financial measure.” Generally, a non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a non-GAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. 2017 Compared to 2016 Gross margin increased over the prior year reflecting a $5.6 million increase in rider revenues primarily related to transmission investment recovery. Higher cooling and heating degree days and higher customer counts were slightly offset by lower usage per customer and lower commercial and industrial demand. Both heating and cooling degree days’ variances from normal were favorable when compared to prior year comparisons to normal. Operations and maintenance increased primarily due to $4.0 million in higher vegetation management expenses, $3.2 million in increased maintenance costs from higher outages, higher employee costs as a result of prior year integration activities and transition expenses charged to our Parent Company related to its prior year acquisition of SourceGas, and increased amortization expenses as a result of the SDPUC settlement. Interest expense, net and other income, net were comparable to the same period in the prior year. Income tax expense: The effective tax rate decreased in 2017 due to a tax benefit of $6.0 million resulting from re-measurement of net deferred tax liabilities in accordance with the ASC 740 and the enactment of the Tax Cuts and Jobs Act on December 22, 2017. This benefit was primarily related to the repricing of net operating losses and other tax basis items not included in the ratemaking construct. 2016 Compared to 2015 Gross margin decreased primarily due to a prior year return on invested capital of $1.2 million from a rate case, and a $1.3 million decrease due to third party billing true-ups related to the current and prior years, partially offset by the weather impact from the increase in cooling degree days compared to the same period in the prior year. Operations and maintenance increased primarily due to higher depreciation expense driven by additional plant in service compared to the same period in the prior year, partially offset by lower employee costs driven by a change in operating expense allocations impacting us as a result of our Parent Company integrating the acquired SourceGas utilities. Interest expense, net decreased primarily due to higher AFUDC income in the current year driven by higher construction work-in-process balances compared to the same period in the prior year. Other income, net was comparable to the prior year. Income tax expense: The 2016 effective tax rate is comparable to the prior year. The following tables provide certain electric utility operating statistics for the years ended December 31: _________________________ (a) Increase in 2017 is primarily driven by resource needs from a new 50 MW power sales agreement effective January 1, 2017. (b) Increase in 2017 is primarily due to higher transmission revenues. _________________________ (a) Increase in 2017 is primarily driven by resource needs from a new 50 MW power sales agreement effective January 1, 2017. (b) Decrease in 2017 was primarily driven by commodity prices that impacted power marketing sales. (c) Includes company uses, line losses, and excess exchange production. We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a long-term agreement expiring in 2023. _________________________ (a) Both 2017 and 2016 included outages. 2017 included planned outages at Neil Simpson II, Wyodak and Wygen II, and 2016 included a planned outage at Wygen III and an extended planned outage at Wyodak. _________________________ (a) Change in 2017 is driven by the ability to purchase excess generation in the open market at a lower cost than to generate. (b) Increase in 2017 is driven primarily by resource needs from a new 50 MW power sales agreement effective January 1, 2017. ______________ (a) 30-year average is from NOAA Climate Normals Credit Ratings Credit ratings impact our ability to obtain short and long-term financing, the cost of such financing, and vendor payment terms, including collateral requirements. The following table represents our credit rating from each agency’s review which were in effect at December 31, 2017: Critical Accounting Estimates We prepare our financial statements in conformity with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in application. There are also areas which require management’s judgment in selecting among available GAAP alternatives. We are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results may differ from our estimates and to the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following accounting estimates are the most critical in understanding and evaluating our reported financial results. The following discussion of our critical accounting estimates should be read in conjunction with Note 1, “Business Description and Summary of Significant Accounting Policies” of the Notes to Financial Statements in this Annual Report on Form 10-K. Pension and Other Postretirement Benefits As described in Note 8 of the Financial Statements in this Annual Report on Form 10-K, we have a defined benefit pension plan, a post-retirement healthcare plan and a non-qualified retirement plan. A Master Trust was established for the investment of assets of the defined benefit pension plan. Accounting for pension and other postretirement benefit obligations involves numerous assumptions, the most significant of which relate to the discount rates, health care cost trend rates, expected return on plan assets, compensation increases, retirement rates and mortality rates. The determination of our obligation and expenses for pension and other postretirement benefits is dependent on the assumptions determined by management and used by actuaries in calculating the amounts. Although we believe our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions may materially affect our pension and other postretirement obligations and our future expense. The pension benefit cost for 2018 for our non-contributory funded pension plan is expected to be approximately $1.3 million compared to $0.6 million in 2017. The increase in pension benefit cost is driven primarily by an increase in the discount rate. Beginning in 2016, the Company changed the method used to estimate the service and interest cost components of the net periodic pension, supplemental non-qualified defined benefit and other postretirement benefit costs. The new method used the spot yield curve approach to estimate the service and interest costs by applying the specific spot rates along the yield curve used to determine the benefit obligations to relevant projected cash outflows. Prior to 2016, the service and interest costs were determined using a single weighted-average discount rate based on hypothetical AA Above Median yield curves used to measure the benefit obligation at the beginning of the period. The change does not affect the measurement of the total benefit obligations as the change in service and interest costs offsets the actuarial gains and losses recorded in other comprehensive income. The Company changed to the new method to provide a more precise measure of service and interest costs by improving the correlation between the projected benefit cash flows and the discrete spot yield curve rates. The Company accounted for this change as a change in estimate prospectively beginning in 2016. The effect of hypothetical changes to selected assumptions on the pension and other postretirement benefit plans would be as follows in thousands of dollars: December 31, Assumptions Percentage Change Increase/(Decrease) PBO/APBO (a) Increase/(Decrease) Expense - Pretax Pension Discount rate (b) +/- 0.5 (3,995)/4,402 (665)/639 Expected return on assets +/- 0.5 N/A (284)/284 OPEB Discount rate (b) +/- 0.5 (260)/284 9/(9) Expected return on assets +/- 0.5 N/A N/A Health care cost trend rate (b) +/- 1.0 186/(174) 21/(20) __________________________ (a) Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for OPEB plans. (b) Impact on service cost, interest cost and amortization of gains or losses. Regulation Our utility operations are subject to regulation with respect to rates, service area, accounting, and various other matters by state and federal regulatory authorities. The accounting regulations provide that rate-regulated public utilities account and report assets and liabilities consistent with the economic effects of the manner in which independent third-party regulators establish rates. Regulatory assets generally represent incurred or accrued costs that have been deferred when future recovery from customers is probable. Regulatory liabilities generally represent amounts that are expected to be refunded to customers in future rates or amounts collected in current rates for future costs. Management continually assesses the probability of future recoveries and obligations associated with regulatory assets and liabilities. Factors such as the current regulatory environment, recently issued rate orders, and historical precedents are considered. As a result, we believe that the accounting prescribed under rate-based regulation remains appropriate and our regulatory assets are probable for recovery in current rates or in future rate proceedings. Income Taxes We file a federal income tax return with other members of the Parent consolidated group. For financial statement purposes, federal income taxes are allocated to the individual companies based on amounts calculated on a separate return basis. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the TCJA. The TCJA makes broad and complex changes to the U.S. tax code, including, but not limited to reducing the U.S. federal corporate tax rate from 35% to 21%. The Company uses the asset and liability method in accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized at currently enacted income tax rates, to reflect the tax effect of temporary differences between the financial and tax basis of assets and liabilities as well as operating loss and tax credit carryforwards. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. As such, the Company has revalued the deferred income taxes at the 21% federal tax rate as of December 31, 2017 and as a result, deferred tax assets and liabilities were reduced by approximately $103 million. Of the $103 million, approximately $97 million is related to our regulated utilities and was reclassified to a regulatory liability. This regulatory liability will generally be amortized over the remaining life of the related assets using the normalization principles as specifically prescribed in the TCJA. As allowed under SEC Staff Accounting Bulletin No. 118 (SAB 118), the Company has recorded provisional income tax amounts as of December 31, 2017 for changes pursuant to the TCJA related to depreciation for which the impacts could not be finalized upon issuance of the Company’s financial statements, but reasonable estimates could be determined. The provisional amounts may change as the Company finalizes the analysis and computations and such changes could be material to the Company’s future results of operations, cash flows or financial position. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized and provides any necessary valuation allowances as required. If we determine that we will be unable to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretations of tax laws and the resolution of current and any future tax audits could significantly impact the amounts provided for income taxes in our financial statements. See Note 6 of the Notes to Financial Statements in this Annual Report on Form 10-K for additional information.

<s>[INST] Significant Events Settlement On June 16, 2017, South Dakota Electric received approval from the SDPUC on a settlement reached with the SDPUC staff agreeing to a sixyear moratorium period effective July 1, 2017. As part of this agreement, South Dakota Electric will not increase base rates, absent an extraordinary event. The moratorium period also includes a suspension of both the TFA and the EIA, and a $1.0 million increase to the annual power marketing margin guarantee during this period. Additionally, existing regulatory asset balances of approximately $13 million related to decommissioning and Winter Storm Atlas are being amortized over the moratorium period. These balances were previously amortized over a 10year period ending September 30, 2024. The vegetation management regulatory asset of $14 million, previously unamortized, is being amortized over the moratorium period. The change in amortization periods for these costs increased annual amortization expense by approximately $2.7 million. The June 16, 2017 settlement had no impact to base rates. Transmission Construction was completed on the 144 milelong transmission line connecting the Teckla Substation in northeast Wyoming to the Lange Substation near Rapid City, South Dakota. The first segment of this project connecting Teckla to Osage, WY was placed in service on August 31, 2016. The second segment connecting Osage to Lange was placed in service on May 30, 2017. NonGAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “nonGAAP financial measure.” Generally, a nonGAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a nonGAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. 2017 Compared to 2016 Gross margin increased over the prior year reflecting a $5.6 million increase in rider revenues primarily related to transmission investment recovery. Higher cooling and heating degree days and higher customer counts were slightly offset by lower usage per customer and lower commercial and industrial demand. Both heating and cooling degree days’ variances from normal were favorable when compared to prior year comparisons to normal. Operations and maintenance increased primarily due to $4.0 million in higher vegetation management expenses, $3.2 million in increased maintenance costs from higher outages, higher employee costs as a result of prior year integration activities and transition expenses charged to our Parent Company related to its prior year acquisition of SourceGas, and increased amortization expenses as a result of the SDPUC settlement. Interest expense, net and other income, net were comparable to the same period in the prior year. Income tax expense: The effective tax rate decreased in 2017 due to a tax benefit of $6.0 million resulting from remeasurement of net deferred tax liabilities in accordance with the ASC 740 and the enactment of the Tax Cuts and Jobs Act on December 22, 2017. This benefit was primarily related to the repricing of net operating losses and other tax basis items not included in the ratemaking construct. 2016 Compared to 2015 Gross margin decreased primarily due to a prior year return on invested capital of $ [/INST] Positive. </s>

BLACK HILLS POWER INC

2019-02-21

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS Significant Events 2018 Overview On December 17, 2018, South Dakota Electric and Wyoming Electric filed for approval with the SDPUC and WPSC new, voluntary renewable energy tariffs to serve customer requests for renewable energy resources. In addition, South Dakota Electric and Wyoming Electric filed a joint application with the WPSC for a CPCN to construct a $57 million, 40 MW wind generation project near Cheyenne, Wyoming. On December 12, 2018, Moody’s affirmed South Dakota Electric’s credit rating at A1. On November 20, 2018, we placed in service a 33-mile segment of a $70 million, 175-mile, 230-kilovolt transmission line from Rapid City, South Dakota, to Stegall, Nebraska. The first 48-mile segment was placed in service on July 25, 2018. The remaining 94-mile segment is expected to be in service by the end of 2019. On September 4, 2018, the SDPUC approved a settlement agreement for South Dakota Electric allowing the Company to pass on the benefits of a lower corporate federal income tax rate to our South Dakota retail customers. The aggregate 2018 benefit of approximately $7.6 million was delivered to customers in October 2018. On August 16, 2018, we entered into a PPA with Platte River Power Authority (PRPA) to purchase up to 12 MW of wind energy through PRPA’s agreement with Silver Sage. This agreement will expire September 30, 2029. On August 9, 2018, S&P upgraded South Dakota Electric’s credit rating to A. On July 19, 2018, Fitch affirmed South Dakota Electric’s credit rating at A. 2017 Overview On June 16, 2017, South Dakota Electric received approval from the SDPUC on a settlement reached with the SDPUC staff agreeing to a six-year moratorium period effective July 1, 2017. As part of this agreement, South Dakota Electric will not increase base rates, absent an extraordinary event. The moratorium period also includes a suspension of both the TFA and the EIA, and a $1.0 million increase to the annual power marketing margin guarantee during this period. Additionally, existing regulatory asset balances of approximately $13 million related to decommissioning and Winter Storm Atlas are being amortized over the moratorium period. These balances were previously amortized over a 10-year period ending September 30, 2024. The vegetation management regulatory asset of $14 million, previously unamortized, is being amortized over the moratorium period. The change in amortization periods for these costs increased annual amortization expense by approximately $2.7 million. The June 16, 2017 settlement had no impact to base rates. Construction was completed on the 144 mile-long transmission line connecting the Teckla Substation in northeast Wyoming to the Lange Substation near Rapid City, South Dakota. The first segment of this project connecting Teckla to Osage, WY was placed in service on August 31, 2016. The second segment connecting Osage to Lange was placed in service on May 30, 2017. Non-GAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “non-GAAP financial measure.” Generally, a non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a non-GAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and natural gas and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. (a) Non-GAAP measure 2018 Compared to 2017 Gross margin increased primarily due to $9.8 million of Horizon Point shared facility revenue, higher power marketing and wholesale revenue of $3.0 million, higher rider revenues of $2.3 million primarily related to transmission investment recovery, and a $1.7 million increase in residential margins primarily from higher usage per customer. These increases were partially offset by a $10.3 million reserve to revenue to reflect the reduction of the lower federal income tax rate from the TCJA on our existing rate tariffs and lower commercial and industrial demand volume of $2.1 million. Operations and maintenance increased due to higher depreciation and property taxes of $4.4 million from higher asset base driven by the prior year additions of Horizon Point and the Teckla-Lange transmission line. Vegetation management expenses increased by $3.4 million compared to the prior year, and higher employee and facility costs comprise the remainder of the increase compared to the the prior year. Interest expense, net increased due to higher prior year AFUDC associated with higher prior year capital spend. Other income, net decreased due to the presentation change of non-service pension costs to Other income (expense), net in the current year, previously reported in Operations and maintenance, and higher prior year AFUDC associated with higher prior year capital spend. Income tax expense: The effective tax rate decreased from the prior year due to the reduction in the federal corporate income tax rate from 35 percent to 21 percent from the enactment of the TCJA on December 22, 2017. Additionally, in 2018, we recorded $0.9 million of income tax expense associated with changes in the prior estimated impact of tax reform on deferred income taxes compared to a net tax benefit of $6.0 million in 2017 as a result of the revaluation of deferred tax balances due to the decrease in the statutory Federal income tax rate as a result of the TCJA. 2017 Compared to 2016 Gross margin increased over the prior year reflecting a $5.6 million increase in rider revenues primarily related to transmission investment recovery. Higher cooling and heating degree days and higher customer counts were slightly offset by lower usage per customer and lower commercial and industrial demand. Both heating and cooling degree days’ variances from normal were favorable when compared to prior year comparisons to normal. Operations and maintenance increased primarily due to $4.0 million in higher vegetation management expenses, $3.2 million in increased maintenance costs from higher outages, higher employee costs as a result of prior year integration activities, transition expenses charged to BHC related to its 2016 acquisition of SourceGas and increased amortization expenses as a result of the SDPUC settlement. Interest expense, net and other income, net were comparable to the same period in the prior year. Income tax expense: The effective tax rate decreased in 2017 due to a tax benefit of $6.0 million resulting from re-measurement of net deferred tax liabilities in accordance with the ASC 740 and the enactment of the TCJA on December 22, 2017. This benefit was primarily related to the repricing of net operating losses and other tax basis items not included in the ratemaking construct. The following tables provide certain electric utility operating statistics for the years ended December 31: _________________________ (a) Increases in 2018 and 2017 were primarily driven by higher volumes sold on long-term wholesale contracts. (b) Increase in 2018 was due to higher trading volume opportunities. (c) Increase in 2017 is primarily due to higher transmission revenues. _________________________ (a) Increases in 2018 and 2017 were primarily driven by higher volumes sold on long-term wholesale contracts. (b) Decrease in 2017 was primarily driven by commodity prices that impacted power marketing sales. (c) Includes company uses, line losses, and excess exchange production. We own approximately 445 MW of electric utility generating capacity and purchase an additional 50 MW under a long-term agreement expiring in 2023. _________________________ (a) Both 2017 and 2016 included outages. 2017 included planned outages at Neil Simpson II, Wyodak and Wygen II, and 2016 included a planned outage at Wygen III and an extended planned outage at Wyodak. _________________________ (a) Decrease in 2017 is driven by the ability to purchase excess generation in the open market at a lower cost than to generate. (b) Increase in 2018 is primarily due to low natural gas prices and the ability to generate at a lower cost than to purchase excess generation on the open market. (c) Increase in 2017 and 2018 is driven by increased volumes on long-term wholesale contracts. ______________ (a) 30-year average is from NOAA Climate Normals Credit Ratings Credit ratings impact our ability to obtain short and long-term financing, the cost of such financing, and vendor payment terms, including collateral requirements. The following table represents our credit rating from each agency’s review which were in effect at December 31, 2018: Critical Accounting Estimates We prepare our financial statements in conformity with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in application. There are also areas which require management’s judgment in selecting among available GAAP alternatives. We are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results may differ from our estimates and to the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following accounting estimates are the most critical in understanding and evaluating our reported financial results. The following discussion of our critical accounting estimates should be read in conjunction with Note 1, “Business Description and Summary of Significant Accounting Policies” of the Notes to Financial Statements in this Annual Report on Form 10-K. Regulation Our utility operations are subject to regulation with respect to rates, service area, accounting, and various other matters by state and federal regulatory authorities. The accounting regulations provide that rate-regulated public utilities account and report assets and liabilities consistent with the economic effects of the manner in which independent third-party regulators establish rates. Regulatory assets generally represent incurred or accrued costs that have been deferred when future recovery from customers is probable. Regulatory liabilities generally represent amounts that are expected to be refunded to customers in future rates or amounts collected in current rates for future costs. Management continually assesses the probability of future recoveries and obligations associated with regulatory assets and liabilities. Factors such as the current regulatory environment, recently issued rate orders, and historical precedents are considered. As a result, we believe that the accounting prescribed under rate-based regulation remains appropriate and our regulatory assets are probable for recovery in current rates or in future rate proceedings. Income Taxes We file a federal income tax return with other members of the Parent consolidated group. For financial statement purposes, federal income taxes are allocated to the individual companies based on amounts calculated on a separate return basis. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the TCJA. The TCJA makes broad and complex changes to the U.S. tax code, including, but not limited to reducing the U.S. federal corporate tax rate from 35% to 21%. The Company uses the asset and liability method in accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized at currently enacted income tax rates, to reflect the tax effect of temporary differences between the financial and tax basis of assets and liabilities as well as operating loss and tax credit carryforwards. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. The Company has revalued the deferred income taxes at the 21% federal tax rate as of December 31, 2017 and as a result, deferred tax assets and liabilities were reduced by approximately $103 million. Of the $103 million, approximately $97 million was reclassified to a regulatory liability. As of December 31, 2018, the Company has a regulatory liability associated with TCJA related items of $100 million, completing the revaluation of deferred taxes pursuant to the TCJA. A significant portion of the excess deferred taxes are subject to the average rate assumption method, as prescribed by the IRS, and will generally be amortized as a reduction of customer rates over the remaining lives of the related assets. As of December 31, 2018, the Company has amortized $0.9 million of regulatory liability. The portion that was eligible for amortization under the average rate assumption method in 2018, but is awaiting resolution of the treatment of these amounts in future regulatory proceedings, has not been recognized and may be refunded in customer rates at any time in accordance with the resolution of pending or future regulatory proceedings. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized and provides any necessary valuation allowances as required. If we determine that we will be unable to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretations of tax laws and the resolution of current and any future tax audits could significantly impact the amounts provided for income taxes in our financial statements. See Note 6 of the Notes to Financial Statements in this Annual Report on Form 10-K for additional information. Pension and Other Postretirement Benefits As described in Note 8 of the Financial Statements in this Annual Report on Form 10-K, we have a defined benefit pension plan, a post-retirement healthcare plan and non-qualified retirement plans. A Master Trust was established for the investment of assets of the defined benefit pension plan. Accounting for pension and other postretirement benefit obligations involves numerous assumptions, the most significant of which relate to the discount rates, health care cost trend rates, expected return on plan assets, compensation increases, retirement rates and mortality rates. The determination of our obligation and expenses for pension and other postretirement benefits is dependent on the assumptions determined by management and used by actuaries in calculating the amounts. Although we believe our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions may materially affect our pension and other postretirement obligations and our future expense. The pension benefit cost for 2019 for our non-contributory funded pension plan is expected to be $0.6 million compared to $1.3 million in 2018. The decrease in pension benefit cost is driven primarily by an increase in the discount rate. The effect of hypothetical changes to selected assumptions on the pension and other postretirement benefit plans would be as follows in thousands of dollars: __________________________ (a) Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for OPEB plans. (b) Impact on service cost, interest cost and amortization of gains or losses.

<s>[INST] Significant Events 2018 Overview On December 17, 2018, South Dakota Electric and Wyoming Electric filed for approval with the SDPUC and WPSC new, voluntary renewable energy tariffs to serve customer requests for renewable energy resources. In addition, South Dakota Electric and Wyoming Electric filed a joint application with the WPSC for a CPCN to construct a $57 million, 40 MW wind generation project near Cheyenne, Wyoming. On December 12, 2018, Moody’s affirmed South Dakota Electric’s credit rating at A1. On November 20, 2018, we placed in service a 33mile segment of a $70 million, 175mile, 230kilovolt transmission line from Rapid City, South Dakota, to Stegall, Nebraska. The first 48mile segment was placed in service on July 25, 2018. The remaining 94mile segment is expected to be in service by the end of 2019. On September 4, 2018, the SDPUC approved a settlement agreement for South Dakota Electric allowing the Company to pass on the benefits of a lower corporate federal income tax rate to our South Dakota retail customers. The aggregate 2018 benefit of approximately $7.6 million was delivered to customers in October 2018. On August 16, 2018, we entered into a PPA with Platte River Power Authority (PRPA) to purchase up to 12 MW of wind energy through PRPA’s agreement with Silver Sage. This agreement will expire September 30, 2029. On August 9, 2018, S&P upgraded South Dakota Electric’s credit rating to A. On July 19, 2018, Fitch affirmed South Dakota Electric’s credit rating at A. 2017 Overview On June 16, 2017, South Dakota Electric received approval from the SDPUC on a settlement reached with the SDPUC staff agreeing to a sixyear moratorium period effective July 1, 2017. As part of this agreement, South Dakota Electric will not increase base rates, absent an extraordinary event. The moratorium period also includes a suspension of both the TFA and the EIA, and a $1.0 million increase to the annual power marketing margin guarantee during this period. Additionally, existing regulatory asset balances of approximately $13 million related to decommissioning and Winter Storm Atlas are being amortized over the moratorium period. These balances were previously amortized over a 10year period ending September 30, 2024. The vegetation management regulatory asset of $14 million, previously unamortized, is being amortized over the moratorium period. The change in amortization periods for these costs increased annual amortization expense by approximately $2.7 million. The June 16, 2017 settlement had no impact to base rates. Construction was completed on the 144 milelong transmission line connecting the Teckla Substation in northeast Wyoming to the Lange Substation near Rapid City, South Dakota. The first segment of this project connecting Teckla to Osage, WY was placed in service on August 31, 2016. The second segment connecting Osage to Lange was placed in service on May 30, 2017. NonGAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “nonGAAP financial measure.” Generally, a nonGAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a nonGAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. In our Management’s Discussion and Analysis of Results of Operations, gross margin is calculated as operating revenue less cost of fuel and [/INST] Positive. </s>

BLACK HILLS POWER INC

2020-02-18

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS Our discussion and analysis for the year ended December 31, 2019 compared to 2018 is included herein. For discussion and analysis for the year ended December 31, 2018 compared to 2017, please refer to Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2018, which was filed with the SEC on February 20, 2019. All amounts are presented on a pre-tax basis unless otherwise indicated. Significant Events 2019 Overview • On September 17, 2019, South Dakota Electric completed construction on the final 94-mile segment of a 175-mile electric transmission line from Rapid City, South Dakota, to Stegall, Nebraska. The first 48-mile segment was placed in service on July 25, 2018, and the second 33-mile segment was placed in service on November 20, 2018. • In July 2019, South Dakota Electric and Wyoming Electric received approvals for the Renewable Ready program and jointly-filed CPCN to construct Corriedale. The wind project will be jointly owned by the two electric utilities to deliver renewable energy for large commercial, industrial and governmental agency customers. In November 2019, South Dakota Electric received approval from SDPUC to increase the offering under the program by 12.5 MW to 32.5 MW. The two electric utilities also received a determination from the WPSC to increase the project to 52.5 MW. The $79 million project is expected to be in service by year-end 2020. Non-GAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “non-GAAP financial measure.” Generally, a non-GAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a non-GAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. Gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. Results of Operations Operating results were as follows (in thousands): (a) 2019 revenue and purchased power, as well as associated quantities, for a certain wholesale contract have been presented on a net basis. This resulted in a decrease of $12 million to both 2019 revenue and fuel and purchased power. Prior year amounts were presented on a gross basis and, due to their immaterial nature, were not revised. This 2019 presentation change has no impact on Gross margin. 2019 Compared to 2018 Gross margin increased primarily due to $6.5 million of reduced purchased power capacity charges, $3.4 million of increased rider revenues from new investments and $3.1 million of increased commercial and industrial demand. Operations and maintenance expense increased primarily due to higher employee costs and outside services expenses. Other income (expense), net. For the year ended December 31, 2019, we expensed $5.4 million of development costs related to projects we no longer intend to construct. Income tax expense decreased primarily due to tax benefits for excess deferred tax amortization related to tax reform. _________________________ (a) Availability is calculated using a weighted average based on capacity of our generating fleet. (b) 2019 included planned outages at Neil Simpson II and Wygen III and unplanned outages at Wyodak Plant and Wygen III. (c) 2019 included planned outages at Neil Simpson CT and Lange CT. Credit Ratings Credit ratings impact our ability to obtain short and long-term financing, the cost of such financing, and vendor payment terms, including collateral requirements. The following table represents our credit rating from each agency’s review which were in effect at December 31, 2019: __________ (a) On April 30, 2019, S&P affirmed A rating. (b) On December 20, 2019, Moody’s affirmed A1 rating. (c) On August 29, 2019, Fitch affirmed A rating. Critical Accounting Policies Involving Significant Accounting Estimates We prepare our financial statements in conformity with GAAP. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in application. There are also areas which require management’s judgment in selecting among available GAAP alternatives. We are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. Actual results may differ from our estimates and to the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following accounting estimates are the most critical in understanding and evaluating our reported financial results. The following discussion of our critical accounting estimates should be read in conjunction with Note 1, “Business Description and Summary of Significant Accounting Policies” of the Notes to the Financial Statements in this Annual Report on Form 10-K. Regulation Our utility operations are subject to cost-of-service regulation and earnings oversight from federal and state utility commissions. This regulatory treatment does not provide any assurance as to achievement of desired earnings levels. Our retail electric rates are regulated on a state-by-state basis by the relevant state regulatory commissions based on an analysis of our costs, as reviewed and approved in a regulatory proceeding. The rates that we are allowed to charge may or may not match our related costs and allowed return on invested capital at any given time. Management continually assesses the probability of future recoveries associated with regulatory assets and future obligations associated with liabilities. Factors such as the current regulatory environment, recently issued rate orders, and historical precedents are considered. As a result, we believe that the accounting prescribed under rate-based regulation remains appropriate and our regulatory assets are probable for recovery in current rates or in future rate proceedings. To some degree, we are permitted to recover certain costs (such as increased fuel and purchased power costs) without having to file a rate review. To the extent we are able to pass through such costs to our customers, and a state public utility commission subsequently determines that such costs should not have been paid by the customers, we may be required to refund such costs. Any such costs not recovered through rates, or any such refund, could adversely affect our results of operations, financial position or cash flows. As of December 31, 2019 and 2018, we had total regulatory assets of $76 million and $76 million respectively, and total regulatory liabilities of $166 million and $163 million respectively. See Note 7 of the Notes to the Financial Statements for further information. Income Taxes We file a federal income tax return with other members of the Parent consolidated group. Each tax-paying entity records income taxes as if it were a separate taxpayer for both federal and state income tax purposes and consolidating adjustments are allocated to the subsidiaries based on separate company computations of taxable income or loss. We use the asset and liability method in accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized at currently enacted income tax rates, to reflect the tax effect of temporary differences between the financial and tax basis of assets and liabilities as well as operating loss and tax credit carryforwards. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. As of December 31, 2019, we have a regulatory liability associated with TCJA related items of $98 million, completing our accounting for the revaluation of deferred taxes pursuant to the TCJA. A significant portion of the excess deferred taxes are subject to the average rate assumption method, as prescribed by the IRS, and will generally be amortized as a reduction of customer rates over the remaining lives of the related assets. As of December 31, 2019, the Company has amortized $3.1 million of regulatory liability associated with TCJA related items. The portion that was eligible for amortization under the average rate assumption method in 2019, but is awaiting resolution of the treatment of these amounts in future regulatory proceedings, has not been recognized and may be refunded in customer rates at any time in accordance with the resolution of pending or future regulatory proceedings. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized and provides any necessary valuation allowances as required. If we determine that we will be unable to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. Although we believe our assumptions, judgments and estimates are reasonable, changes in tax laws or our interpretations of tax laws and the resolution of current and any future tax audits could significantly impact the amounts provided for income taxes in our financial statements. See Note 9 of the Notes to the Financial Statements in this Annual Report on Form 10-K for additional information. Pension and Other Postretirement Benefits As described in Note 12 of the Financial Statements in this Annual Report on Form 10-K, we have a defined benefit pension plan, a post-retirement healthcare plan and non-qualified retirement plans. A Master Trust was established for the investment of assets of the defined benefit pension plan. Accounting for pension and other postretirement benefit obligations involves numerous assumptions, the most significant of which relate to the discount rates, health care cost trend rates, expected return on plan assets, compensation increases, retirement rates and mortality rates. The determination of our obligation and expenses for pension and other postretirement benefits is dependent on the assumptions determined by management and used by actuaries in calculating the amounts. Although we believe our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions may materially affect our pension and other postretirement obligations and our future expense. The 2020 pension benefit cost for our non-contributory funded pension plan is expected to be $2.1 million compared to $0.6 million in 2019. The increase in pension benefit cost is driven primarily by a decrease in the discount rate and lower expected return on assets. The effect of hypothetical changes to selected assumptions on the pension and other postretirement benefit plans would be as follows in thousands of dollars: __________________________ (a) Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for OPEB plans. (b) Impact on service cost, interest cost and amortization of gains or losses. New Accounting Pronouncements See Note 1 of our Notes to the Financial Statements in this Annual Report on Form 10-K for information on new accounting standards adopted in 2019 or pending adoption.

<s>[INST] Our discussion and analysis for the year ended December 31, 2019 compared to 2018 is included herein. For discussion and analysis for the year ended December 31, 2018 compared to 2017, please refer to Item 7 of Part II, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10K for the year ended December 31, 2018, which was filed with the SEC on February 20, 2019. All amounts are presented on a pretax basis unless otherwise indicated. Significant Events 2019 Overview On September 17, 2019, South Dakota Electric completed construction on the final 94mile segment of a 175mile electric transmission line from Rapid City, South Dakota, to Stegall, Nebraska. The first 48mile segment was placed in service on July 25, 2018, and the second 33mile segment was placed in service on November 20, 2018. In July 2019, South Dakota Electric and Wyoming Electric received approvals for the Renewable Ready program and jointlyfiled CPCN to construct Corriedale. The wind project will be jointly owned by the two electric utilities to deliver renewable energy for large commercial, industrial and governmental agency customers. In November 2019, South Dakota Electric received approval from SDPUC to increase the offering under the program by 12.5 MW to 32.5 MW. The two electric utilities also received a determination from the WPSC to increase the project to 52.5 MW. The $79 million project is expected to be in service by yearend 2020. NonGAAP Financial Measure The following discussion includes financial information prepared in accordance with GAAP, as well as another financial measure, gross margin, that is considered a “nonGAAP financial measure.” Generally, a nonGAAP financial measure is a numerical measure of a company’s financial performance, financial position or cash flows that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. Gross margin (revenue less cost of sales) is a nonGAAP financial measure due to the exclusion of depreciation from the measure. The presentation of gross margin is intended to supplement investors’ understanding of our operating performance. Gross margin is calculated as operating revenue less cost of fuel and purchased power. Our gross margin is impacted by the fluctuations in power purchases and other fuel supply costs. However, while these fluctuating costs impact gross margin as a percentage of revenue, they only impact total gross margin if the costs cannot be passed through to our customers. Our gross margin measure may not be comparable to other companies’ gross margin measure. Furthermore, this measure is not intended to replace operating income as determined in accordance with GAAP as an indicator of operating performance. Results of Operations Operating results were as follows (in thousands): (a) 2019 revenue and purchased power, as well as associated quantities, for a certain wholesale contract have been presented on a net basis. This resulted in a decrease of $12 million to both 2019 revenue and fuel and purchased power. Prior year amounts were presented on a gross basis and, due to their immaterial nature, were not revised. This 2019 presentation change has no impact on Gross margin. 2019 Compared to 2018 Gross margin increased primarily due to $6.5 million of reduced purchased power capacity charges, $3.4 million of increased rider revenues from new investments and $3.1 million of increased commercial and industrial demand. Operations and maintenance expense increased primarily due to higher employee costs and outside services expenses. Other income (expense), net. For the year ended December 31, 2019, we expensed $5.4 million of development costs related to projects we no longer intend to construct. Income tax expense decreased primarily due to tax benefits for excess deferred tax amortization related to tax reform. _________________________ (a) Availability is calculated using a weighted average based on capacity of our generating fleet. (b) 20 [/INST] Negative. </s>

SEABOARD CORP /DE/

2020-02-19

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations OVERVIEW Sales and costs of Seaboard’s segments are significantly influenced by worldwide fluctuations in commodity prices and changes in foreign political and economic conditions. Accordingly, sales, operating income and cash flows can fluctuate significantly from year to year. As each segment operates in a distinct industry and a different geographic location, management evaluates their operations separately. Seaboard’s reporting segments are based on information used by Seaboard’s Chief Executive Officer to determine allocation of resources and assess performance, in his capacity as chief operating decision maker. Pork Segment The Pork segment primarily produces hogs to process and sells fresh and frozen pork products to further processors, foodservice operators, distributors and grocery stores throughout the U.S. and to foreign markets. This segment also produces biodiesel from pork fats and other animal fat and vegetable oils for sale to third parties. Sales prices are directly affected by both domestic and worldwide supply and demand for pork products and other proteins. Feed accounts for the largest input cost in raising hogs and is materially affected by price changes for corn and soybean meal. Market prices for hogs purchased from third parties for processing at the plant also represent a major cost factor. Within the portfolio of Seaboard’s businesses, management believes profitability of the Pork segment is most susceptible to commodity price fluctuations. As a result, this segment’s operating income and cash flows can materially fluctuate from year to year, significantly affecting Seaboard’s consolidated operating income and cash flows. This segment is Seaboard’s most capital-intensive segment, representing approximately 53% of Seaboard’s total fixed assets, in addition to approximately 41% of total inventories. With the plant generally operating at capacity, Seaboard is continually looking for ways to enhance the plant’s operational efficiency, while also looking to increase margins by introducing new, higher value products. CT&M Segment The CT&M segment provides integrated agricultural commodity trading, processing and logistics services. The majority of the CT&M segment’s sales are derived from sourcing agricultural commodities from multiple origins which are delivered to third-party and affiliate customers in various international locations. The execution of these purchase and delivery transactions have long cycles of completion, which may extend for several months with a high degree of price volatility. As a result, these factors can significantly affect sales volumes, operating income, working capital and related cash flows from period to period. This segment represents approximately 52% of Seaboard’s total inventories. This segment owns three vessels, but the majority of the trading business is transacted with chartered ships. Consolidated and non-consolidated affiliates operate the grain processing business in foreign countries that are, in most cases, lesser developed. Foreign operations can be significantly impacted by changes in local crop production, political instability and local government policies, as well as fluctuations in economic and industry conditions and foreign currency exchange rates. This segment’s sales are also significantly affected by fluctuating prices of various commodities, such as wheat, corn, soybeans and soybean meal. Exports from various countries can exacerbate volatile market conditions that may have a significant impact on both the trading and milling businesses’ sales and operating income. Profit margins are sometimes protected by using commodity derivatives and other risk management practices. The CT&M segment has invested in several entities in recent years and continues to seek opportunities to expand its trading, milling and agro-processing businesses. Marine Segment The Marine segment provides cargo shipping services in the U.S., the Caribbean and Central and South America. Fluctuations in economic conditions and political instability in the regions or countries in which this segment operates may affect trade volumes and operating profits. In addition, cargo rates can fluctuate depending on regional supply and demand for shipping services. Since the Marine segment time-charters the majority of its ocean cargo vessels, it is affected by fluctuations in charter hire rates as well as fuel costs. This segment continues to explore ways to increase volumes on existing routes while seeking opportunities to broaden its route structure in the regions it serves. Sugar and Alcohol Segment The Sugar and Alcohol segment produces and processes sugar and alcohol in Argentina, primarily to be marketed locally. The Sugar and Alcohol segment’s sales and operating income are significantly affected by local and worldwide sugar and alcohol prices. Domestic sugar production levels in Argentina affect the local price. Global sugar price fluctuations, to a lesser extent, have an impact in Argentina as well. Historically, the functional currency of this segment was the Argentine peso, but during the third quarter of 2018 highly inflationary accounting was adopted and the U.S. dollar became the functional currency for U.S. generally accepted accounting principles (“GAAP”) purposes. See Note 1 to the consolidated financial statements for discussion on highly inflationary accounting. The currency exchange rate can have an impact on reported U.S. dollar sales, operating income and cash flows. Power Segment The Power segment is an independent power producer in the Dominican Republic operating a power generating barge. Supply of power in the Dominican Republic is determined by a government body and is subject to fluctuations based on governmental budgetary constraints. While fuel is this segment’s largest cost component and is subject to price fluctuations, higher fuel costs generally have been passed on to customers. Turkey Segment The Turkey segment, accounted for using the equity method, produces turkeys to process and sells branded and non-branded turkey products. Sales prices are directly affected by both domestic and worldwide supply and demand for turkey products and other proteins. Feed accounts for the largest input cost in raising turkeys and is materially affected by price changes for corn and soybean meal. As a result, commodity price fluctuations can significantly affect the profitability and cash flows of Butterball. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2019, Seaboard had cash and short-term investments of $1.6 billion and additional total working capital of $602 million. Accordingly, management believes Seaboard’s combination of internally generated cash, liquidity, capital resources and borrowing capabilities will be adequate for its existing operations and any currently known potential plans for expansion of existing operations or business segments for the next twelve months. As of December 31, 2019, $195 million of the $1.6 billion of cash and short-term investments were held by Seaboard’s foreign subsidiaries. Historically, Seaboard has considered substantially all foreign profits as being permanently invested in its foreign operations, including all cash and short-term investments held by foreign subsidiaries. Seaboard intends to continue permanently reinvesting the majority of these funds outside the U.S. as current plans do not demonstrate a need to repatriate them to fund Seaboard’s U.S. operations. For any planned repatriation to the U.S., Seaboard would record applicable deferred taxes for state or foreign withholding taxes. See Note 14 for discussion of repatriation. Summary of Sources and Uses of Cash Cash and short-term investments as of December 31, 2019 increased $29 million from December 31, 2018. The increase was primarily the result of $171 million of net cash from operating activities, $132 million net proceeds from short-term investments, $42 million net proceeds from long-term debt and lines of credit and $24 million proceeds from sale of a non-consolidated affiliate. Partially offsetting the increase was cash used for capital expenditures of $349 million. Cash from operating activities decreased $67 million from 2018, primarily due to lower adjusted earnings for unrealized gains on short-term investments and significant cash outlays for inventories. Capital Expenditures, Acquisitions and Other Investing Activities During 2019, Seaboard invested $349 million in property, plant and equipment, of which $164 million was in the Pork segment, $23 million in the CT&M segment, $26 million in the Marine segment, $15 million in the Sugar and Alcohol segment and $121 million in the Power segment. The Pork segment expenditures were primarily for the expansion of the Oklahoma pork processing plant and the purchase and modifications of an idle ethanol plant and its related assets in Hugoton, Kansas. The CT&M segment expenditures were primarily for milling assets. The Sugar and Alcohol expenditures were primarily for alcohol fermentation expansion. The Power segment expenditures were primarily for its power generating barge under construction. All other capital expenditures were primarily of a normal recurring nature such as replacements of machinery and equipment and general facility modernizations and upgrades. The total budget for 2020 capital expenditures is $313 million. The Pork segment budgeted $215 million primarily for the expansion of the pork processing plant that is expected to be completed in the first half of 2020 and the modifications to convert the Hugoton, Kansas plant to a renewable diesel production facility, with operations expected to begin in 2022. The estimated cost of the conversion is expected to be between approximately $220 million and $270 million, depending upon finalization of construction contracts. The CT&M segment budgeted $25 million primarily for milling assets, including a new mixing plant, and other improvements to existing facilities and related equipment. The Marine segment budgeted $37 million primarily for additional cargo carrying and handling equipment. The Sugar and Alcohol segment budgeted $14 million primarily for general plant improvements and production process updates. The Power segment budgeted $22 million for further capital expenditures associated with the new power barge. Seaboard’s Power segment continues to explore strategic alternatives for the existing barge, including selling, relocating or operating in conjunction with the new barge at the current site. The estimated total cost of the project is expected to be between approximately $185 million to $210 million, depending upon the alternative selected. Management anticipates paying for these capital expenditures from a combination of available cash, the use of available short-term investments and Seaboard’s available borrowing capacity. Seaboard has acquired businesses in 2019, 2018 and 2017, and intends to continue to look for opportunities to further grow and diversify its operations. Also, from time to time, Seaboard may fund capital calls and borrowings for its equity method investments based on the specific facts and circumstances. During 2019, Seaboard contributed $20 million to STF, a non-consolidated affiliate of the Pork segment, for working capital needs. Financing Activities The following table presents a summary of Seaboard’s available borrowing capacity: Seaboard has long-term debt of $793 million, which includes a term loan of $691 million and foreign subsidiary obligations of $102 million. Seaboard has capacity under existing Term Loan Credit Agreement debt covenants to undertake additional debt financings of approximately $1,326 million as of December 31, 2019. See Note 8 to the consolidated financial statements for discussion of lines of credit and long-term debt. Management intends to continue seeking opportunities for expansion in the industries in which Seaboard operates, utilizing existing liquidity, available borrowing capacity and other financing alternatives. The terms and availability of such financing may be impacted by economic and financial market conditions, as well as Seaboard's financial condition and results of operations at the time Seaboard seeks such financing, and there can be no assurances that Seaboard will be able to obtain such financing on terms that will be acceptable or advantageous. Seaboard’s Board of Directors intends that Seaboard will continue to pay quarterly dividends for the reasonably foreseeable future, with the amount of any dividends being dependent upon such factors as Seaboard’s financial condition, results of operations and current and anticipated cash needs, including capital requirements. Also, Seaboard may repurchase shares of its common stock from time to time. Contractual Obligations and Off-Balance Sheet Arrangements Several of Seaboard’s segments have long-term contractual obligations, including purchase commitments and non-cancelable lease agreements. See Notes 9 and 6 to the consolidated financial statements for discussion on purchase commitments and leases, respectively. The following table provides a summary of Seaboard’s long-term contractual obligations as of December 31, 2019: (a)  Interest payments in the table above include expected cash payments for interest on variable and fixed rate long-term debt. Variable interest rates are based on interest rates as of December 31, 2019. (b)  Retirement benefit payments in the table above represent expected benefit payments for various non-qualified pension plans and supplemental retirement arrangements as discussed in Note 10 to the consolidated financial statements, which are unfunded obligations that are deemed to be employer contributions. No contributions are planned at this time to the qualified pension plan. (c)  U.S. federal income tax on mandatory deemed repatriation pursuant to the 2017 Tax Act. Deferred income taxes and certain other long-term liabilities in the consolidated balance sheets are not included in the table above as management is unable to reliably estimate the timing of the payments for these items. RESULTS OF OPERATIONS Net sales for the years ended December 31, 2019, 2018 and 2017 were $6.8 billion, $6.6 billion and $5.8 billion, respectively. The increase for 2019 compared to 2018 primarily reflected higher volumes of certain commodities in the CT&M segment and higher prices for pork products sold in the Pork segment, partially offset by lower biodiesel revenue in the Pork segment and lower volumes and prices of sugar and alcohol sold in the Sugar and Alcohol segment. The increase for 2018 compared to 2017 primarily reflected higher volumes and sales prices for certain commodities in the CT&M segment, higher biodiesel revenue and higher volumes of market hogs and pork products sold in the Pork segment and higher cargo volumes and rates in the Marine segment. Operating income for the years ended December 31, 2019, 2018 and 2017 was $104 million, $209 million and $240 million, respectively. The decrease for 2019 compared to 2018 primarily reflected derivative contract losses and lower margins on biodiesel sales in the Pork segment, lower alcohol margins in the Sugar and Alcohol segment and higher voyage costs in the Marine segment. The decrease for 2018 compared to 2017 primarily reflected lower prices on pork products sold and higher feed costs in the Pork segment, partially offset by higher margins from biodiesel sales in the Pork segment, higher margins on third-party sales in the CT&M segment and higher spot market rates in the Power segment. Pork Segment Net sales for the Pork segment increased $77 million for the year ended December 31, 2019 compared to 2018. The increase was primarily the result of higher volumes and prices of market hogs sold, higher prices and volumes for pork products sold and the recognition of the federal blender’s credits of $60 million in December 2019 for biodiesel production in tax years 2018 and 2019, partially offset by lower biodiesel prices and volumes. In the first quarter of 2018, the Pork segment received $42 million of revenue related to 2017 biodiesel production. Operating income for the Pork segment decreased $63 million for the year ended December 31, 2019 compared to 2018. The decrease was primarily due to derivative contract losses, lower margins on biodiesel sales and a $14 million expense related to the withdrawal liability from a multi-employer pension fund as discussed in Note 10 to the consolidated financial statements, partially offset by higher margins on pork product sales and the increase in federal blender’s credits received. Margins on pork product sales increased as higher sales prices were only partially offset by higher production and processing costs. Seaboard sells pork to international customers located in China, among other countries, and incremental tariffs, the duration of which is uncertain, continue to have a negative impact on earnings. Management is unable to predict future market prices for pork products, the cost of feed or third-party hogs; however, management anticipates positive operating income for this segment in 2020. Loss from affiliates decreased $8 million for the year ended December 31, 2019 compared to 2018, primarily due to the commencement of a second shift in October 2018 at the STF plant. Net sales for the Pork segment increased $165 million for the year ended December 31, 2018 compared to 2017. The increase was primarily the result of higher overall increased volumes of pork products sold, increased volumes and prices of biodiesel sales, the recognition of the federal blender’s credits of $42 million and higher sales of market hogs to third parties and affiliates. The increase was partially offset by lower prices for both pork products and market hogs sold. Operating income for the Pork segment decreased $76 million for the year ended December 31, 2018 compared to 2017. The decrease was primarily the result of lower prices for pork products along with higher feed costs, partially offset by higher volumes of pork products sold and the federal blender’s credits of $42 million. Loss from affiliates increased $20 million for the year ended December 31, 2018 compared to 2017, primarily due to the start-up of STF operations, which began in September 2017. Commodity Trading and Milling Segment Net sales for the CT&M segment increased $244 million for the year ended December 31, 2019 compared to 2018. The increase primarily reflected higher volumes of certain commodities for third-party customers, including sales for a business acquired in January 2018 with certain entities on a three-month lag and another business acquired in October 2019, and higher wheat, corn and other commodity prices, partially offset by lower affiliate volumes and sales prices. Operating income for the CT&M segment increased $16 million for the year ended December 31, 2019 compared to 2018. The increase primarily reflected higher margins on third-party sales, partially offset by higher selling, general and administrative costs related to the business acquired. Due to worldwide commodity price fluctuations, the uncertain political and economic conditions in the countries in which this segment operates, and the volatility in the commodity markets, management is unable to predict future sales and operating results for this segment. However, management anticipates positive operating income for this segment in 2020, excluding the effects of marking to market derivative contracts. Had Seaboard not applied mark-to-market accounting to its derivative instruments, operating income for this segment would have been higher by $5 and $3 million in 2019 and 2018, respectively, and lower by $4 million in 2017. While management believes its commodity futures, options and foreign exchange contracts are primarily economic hedges of its firm purchase and sales contracts or anticipated sales contracts, Seaboard does not perform the extensive record-keeping required to account for these transactions as hedges for accounting purposes. Accordingly, while the changes in value of the derivative instruments were marked to market, the changes in value of the firm purchase or sales contracts were not. As products are delivered to customers, these existing mark-to-market adjustments should be primarily offset by realized margins or losses as revenue is recognized over time and therefore, these mark-to-market adjustments could reverse in fiscal 2020. Management believes eliminating these mark-to-market adjustments provides a more reasonable presentation to compare and evaluate period-to-period financial results for this segment. Loss from affiliates for the CT&M segment decreased by $6 million for the year ended December 31, 2019 compared to 2018. Based on the uncertainty of local political and economic environments in the countries in which Seaboard’s affiliates operate, management cannot predict future results. Net sales for the CT&M segment increased $483 million for the year ended December 31, 2018 compared to 2017. The increase primarily reflected higher volumes of third-party sales, including sales for a business acquired in January 2018, and higher affiliate sales prices, partially offset by lower third-party sales prices. Operating income for the CT&M segment increased $21 million for the year ended December 31, 2018 compared to 2017. The increase primarily reflected higher margins on third-party sales, predominantly related to the business acquired, partially offset by higher selling, general and administrative costs related to the business acquired. Excluding the effects of the mark-to-market adjustments for derivative contracts, operating income increased $28 million. Income from affiliates for the CT&M segment decreased $18 million for the year ended December 31, 2018 compared to 2017. The decrease primarily reflected price and volume volatility in local markets of certain Seaboard affiliates, including losses at an equity method investment located in the Democratic Republic of Congo. Marine Segment Net sales for the Marine segment increased $4 million for the year ended December 31, 2019 compared to 2018. The increase was primarily the result of a change in cargo mix, with more reefer containers that generally have a higher rate, partially offset by lower cargo volumes. Operating income for the Marine segment decreased $21 million for the year ended December 31, 2019 compared to 2018. The decrease was primarily the result of higher voyage costs related to charter hire rates, terminal costs and fuel costs. The reduced global sulfur emissions cap from 3.5% to 0.5% became effective on January 1, 2020 and resulted in higher fuel costs as purchases of low-sulfur fuel began in late 2019. Management cannot predict changes in future cargo volumes, cargo rates and fuel costs or to what extent changes in economic conditions in markets served will affect net sales or operating income. Based on market conditions, management currently cannot predict if this segment will be profitable in 2020. Net sales for the Marine segment increased $101 million for the year ended December 31, 2018 compared to 2017. The increase was primarily the result of higher volumes and rates in certain markets during 2018 compared to 2017. Operating income for the Marine segment increased $4 million for the year ended December 31, 2018 compared to 2017. The increase was primarily the result of higher revenues, partially offset by higher voyage costs related to fuel price increases and other expenses. Income from affiliates increased $9 million for the year ended December 31, 2018 compared to 2017, primarily due to an other-than-temporary impairment charge of $6 million incurred in 2017. Sugar and Alcohol Segment Net sales for the Sugar and Alcohol segment decreased $63 million for the year ended December 31, 2019 compared to 2018. The decrease primarily reflected lower volumes and prices of sugar and alcohol sold. Sugar and alcohol sales are denominated in Argentine pesos, and an increase in local sales prices was offset by exchange rate changes as the Argentine peso continued to weaken against the U.S. dollar. Management cannot predict local sugar and alcohol prices or the volatility in the currency exchange rate. Argentina was determined by management to be a highly inflationary economy in the second quarter of 2018, and as a result, this segment’s functional currency is the U.S. dollar effective in the third quarter of 2018 until the economic environment stabilizes. Operating income for the Sugar and Alcohol decreased $25 million for the year ended December 31, 2019 compared to 2018. The decrease primarily reflected lower margins on alcohol, partially offset by lower selling, general and administrative expenses. Based on market conditions, management cannot predict if this segment will be profitable in 2020. Net sales for the Sugar and Alcohol segment decreased $2 million for the year ended December 31, 2018 compared to 2017. The decrease primarily reflected lower prices of sugar and alcohol sold, partially offset by higher volumes of sugar and alcohol sold. Operating income for the Sugar and Alcohol segment decreased $12 million for the year ended December 31, 2018 compared to 2017. The decrease primarily reflected lower margins on sugar, alcohol and cogeneration, partially offset by lower selling, general and administrative expenses related to salaries and benefits. Power Segment Net sales for the Power segment decreased $5 million for the year ended December 31, 2019 compared to 2018. The decrease primarily reflected lower spot market rates as a result of lower fuel prices. Operating income for the Power segment increased $6 million for the year ended December 31, 2019 compared to 2018 primarily due to lower fuel costs, partially offset by lower revenues. Management cannot predict future fuel costs or the extent that spot market rates will fluctuate compared to fuel costs; however, management anticipates positive operating income for this segment in 2020. Net sales for the Power segment increased $25 million for the year ended December 31, 2018 compared to 2017. The increase primarily reflected higher spot market rates. Operating income for the Power segment increased $12 million for the year ended December 31, 2018 compared to 2017 primarily due to higher spot market rates, partially offset by higher fuel costs. Turkey Segment The Turkey segment, accounted for using the equity method, represents Seaboard’s investment in Butterball. The increase in loss from affiliate for 2019 compared to 2018 was primarily the result of higher production and other costs, including interest, partially offset by higher prices for turkey products sold. Management is unable to predict future market prices for turkey products or the cost of feed. Based on market conditions, management currently cannot predict if this segment will be profitable in 2020. The increase in income from affiliate for 2018 compared to 2017 was primarily the result of higher logistics and production costs and lower volumes of turkey products sold in 2018, partially offset by Seaboard’s proportionate share of the Illinois plant closure during 2017. Butterball closed a further processing plant located in Illinois and recognized fixed asset impairment charges and accrued severance. Seaboard’s proportionate share of these charges, recognized in income (loss) from affiliates, was $18 million, all recorded in 2017. Selling, General and Administrative Expenses Selling, general and administrative (“SG&A”) expenses for the year ended December 31, 2019 increased $22 million compared to 2018. The increase was primarily the result of increased personnel-related costs, including higher costs related to Seaboard’s deferred compensation program and the businesses acquired. The deferred compensation program costs are offset by the effect of the mark-to-market on investments recorded in other investment income (loss). SG&A expenses for the year ended December 31, 2018 increased $5 million compared to 2017. The increase was primarily the result of increased personnel-related costs in the CT&M segment, related to the business acquired in January 2018, partially offset by lower costs related to Seaboard’s deferred compensation program. As a percentage of revenues, SG&A was 5% for 2019, 2018 and 2017. Interest Expense Interest expense totaled $36 million, $44 million and $29 million for the years ended December 31, 2019, 2018 and 2017, respectively. The decrease in interest expense for 2019 compared to 2018 primarily related to lower interest rates on outstanding debt for the Sugar and Alcohol segment and more capitalized interest related to capital expenditure investments, partially offset by higher debt outstanding related to the Term Loan due 2028 amended in September 2018. The increase in interest expense for 2018 compared to 2017 primarily related to more debt outstanding, an increase in interest rates and less capitalized interest. Interest Income Interest income totaled $28 million, $11 million and $15 million for the years ended December 31, 2019, 2018 and 2017, respectively. The increase for 2019 compared to 2018 was primarily due to increased investments in debt securities. Interest Income from Affiliates Interest income from affiliates totaled $2 million, $3 million and $22 million for the years ended December 31, 2019, 2018 and 2017, respectively. The decrease for 2018 compared 2017 primarily related to the Butterball note receivable, which was repaid in December 2017. Other Investment Income (Loss), Net Other investment income (loss), net totaled $225 million, $(152) million and $177 million for the years ended December 31, 2019, 2018 and 2017, respectively. The changes primarily reflect mark-to-market fluctuations on short-term investments. Foreign Currency Gains, Net Foreign currency gains, net totaled $0 million, $4 million and $14 million for the years ended December 31, 2019, 2018 and 2017, respectively. The decrease in foreign currency gains for 2019 compared to 2018 primarily reflected losses in the Argentine peso, partially offset by fluctuations of other currency exchange rates in several foreign countries. The decrease in foreign currency gains for 2018 compared to 2017 primarily reflected losses in the euro and British pound on Seaboard’s short-term investments and the Zambian kwacha, partially offset by gains in the Argentine peso, among fluctuations of other currency exchange rates in several foreign countries. The Sugar and Alcohol segment’s functional currency became the U.S. dollar in mid-2018 due to highly inflationary accounting and any translation gains or losses are recorded in the income statement rather than other comprehensive income. Income Tax Expense The 2019 effective tax rate was lower than the 2018 effective tax rate primarily due to increased federal investment tax credits and more tax-exempt income from the retroactive extension of the federal blender’s credits in December 2019 for both 2018 and 2019. Also, the 2018 rate was impacted by the change in tax classification of a wholly owned subsidiary from a partnership to a corporation and an adjustment to the Tax Cuts and Jobs Act (“2017 Tax Act”) income tax liability. The 2018 effective tax rate was lower than 2017 primarily due to a current year loss versus prior year earnings, tax exempt income from the retroactive extension of the 2017 federal blender’s credits during the first quarter of 2018 and the lower statutory U.S. federal income tax rate per the 2017 Tax Act. The decrease was partially offset by a tax classification entity change, additional tax related to the 2017 Tax Act and a change in mix of domestic and foreign earnings from the prior year. See Note 14 to the consolidated financial statements for further information on Seaboard’s income taxes. OTHER FINANCIAL INFORMATION See Note 1 to the consolidated financial statements for a discussion of recently issued accounting standards. CRITICAL ACCOUNTING ESTIMATES This discussion and analysis of financial condition and results of operations is based upon Seaboard’s consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires Seaboard to make estimates, judgments, and assumptions that can have a meaningful effect on the reporting of consolidated financial statements. See Note 1 for a discussion of significant accounting policies. Management has identified the accounting estimates believed to be the most important to the portrayal of Seaboard’s financial condition and results, and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management has reviewed these critical accounting estimates with the Audit Committee of the Board of Directors. Allowance for Doubtful Accounts - Seaboard primarily uses a specific identification approach to evaluate the adequacy of this reserve for estimated uncollectible receivables at the consolidated balance sheet date. Changes in estimates, developing trends and other new information can have a material effect on future evaluations. Furthermore, Seaboard’s total gross current receivables are weighted toward foreign receivables ($390 million or 59% as of December 31, 2019), including foreign receivables due from affiliates ($81 million as of December 31, 2019), which generally represent more of a collection risk than its domestic receivables. Receivables due from affiliates are generally associated with entities located in foreign countries considered less developed than the U.S. that can experience conditions causing sudden changes to their ability to pay such receivables on a timely basis or in full. Based on various historical experiences, future collections of receivables or lack thereof could result in a material charge or credit to earnings depending on the ultimate resolution of each individual customer past due receivable. Bad debt expense for the years ended December 31, 2019, 2018 and 2017 was $5 million, $7 million and $12 million, respectively. Valuation of Inventories - Inventories are generally valued at the lower of cost and net realizable value. In determining net realizable value, management makes assumptions regarding estimated sales prices, estimated costs to complete and estimated disposal costs. For commodity trading inventories, when contract performance by a customer becomes a concern, management must also evaluate available options to dispose of the inventory, including assumptions about potential negotiated changes to sales contracts, sales prices in alternative markets in various foreign countries and potentially additional transportation costs. At times, management must consider probability, weighting various viable alternatives, in its determination of the net realizable value of the inventories. These assumptions and probabilities are subjective in nature and are based on management’s best estimates and judgments existing at the time of preparation. Changes in future market prices or facts and circumstances could result in a material write down in the value of inventory or decreased future margins on the sale of inventory. Impairment of Long-Lived Assets - The recoverability of long-lived assets, primarily property, plant and equipment and definite-lived intangibles, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Some of the key assumptions utilized in determining future projected cash flows include estimated growth rates, expected future sales prices, estimated costs, royalty rates and terminal values. In some cases, judgment is also required in assigning probability weighting to the various future cash flow scenarios. The probability weighting percentages used, and the various future projected cash flow models prepared by management are based on facts and circumstances existing at the time of preparation and management’s best estimates and judgment of future operating results. Seaboard cannot predict the occurrence of certain future events that might adversely affect the reported value of long-lived assets, which include, but are not limited to, a change in the business climate, government incentives, a negative change in relationships with significant customers, and changes to strategic decisions made in response to economic and competitive conditions. Changes in these facts, circumstances and management’s estimates and judgment could result in an impairment of property, plant and equipment or definite-lived intangibles, resulting in a material charge to earnings. Lease liabilities and right of use assets - For leases other than short-term leases, Seaboard recognizes right of use assets and lease liabilities based primarily on the present value of future minimum lease payments over the lease term at lease commencement. As Seaboard’s leases do not have readily determinable implicit discount rates, Seaboard adjusts its incremental borrowing rate to determine the present value of the lease payments. The incremental borrowing rate represents an estimate of the interest rate that would be required to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. Seaboard determines the incremental borrowing rates for its leases by adjusting the local risk-free interest rate on its Term Loan due 2028 with a credit risk premium corresponding to Seaboard’s unreported credit rating. Estimation of the incremental borrowing rate requires judgment by management and reflects an assessment of Seaboard’s credit standing to derive an implied secured credit rating and corresponding yield curve. The discount rate is further impacted by Seaboard’s global footprint, operating in more than 45 countries with diverse economies, and related foreign currency rates. Changes in management’s estimates of discount rate assumptions could result in a significant overstatement or understatement of right of use assets or lease liabilities, resulting in an adverse impact to Seaboard’s financial position. Equity Method Investments - Seaboard has numerous investments in and advances to various businesses that it owns 50% or less and are accounted for using the equity method. In addition, for some of these investments, Seaboard also has notes receivable for loans it provided to these businesses. For the CT&M segment, these investments are primarily in foreign countries, which are less developed than the U.S., and therefore, expose Seaboard to greater financial risks. At certain times when there are ongoing operating losses, local economies are depressed, commodity-based markets are less stable, or foreign governments cause challenging business conditions, the fair value of the equity method investment is evaluated by management. The fair value of these investments is not readily determinable as almost all of these investments are not publicly traded. Management will use other methods to determine fair value such as estimated future cash flows, including assumptions on growth rates, for the business and consideration of other local business conditions as applicable. In addition, Seaboard may need to write down any affiliate or notes receivables to estimated realizable value. Information and events creating uncertainty about the realization of recorded amounts for notes include, but are not limited to, the estimated cash flows to be generated by the affiliate’s business, the sufficiency of collateral securing the amounts, the creditworthiness of the counterparties involved, and the consideration of other local business conditions as applicable. Changes in facts, circumstances and management’s estimates and judgment could result in a material charge to earnings. Income Taxes - Income taxes are determined by management based on current tax regulations in the various worldwide taxing jurisdictions in which Seaboard conducts its business. In various situations, accruals have been made for estimates of the tax effects for certain transactions, business structures, the estimated reversal of timing differences and future projected profitability of Seaboard’s various business units based on management’s interpretation of existing facts, circumstances and tax regulations. Should new evidence come to management’s attention that could alter previous conclusions or if taxing authorities disagree with the positions taken by Seaboard, the change in estimate could result in a material adverse or favorable impact on the financial statements. Accrued Pension Liability - The measurement of Seaboard’s pension liability and related expense is dependent on a variety of assumptions and estimates regarding future events. These assumptions include discount rates, assumed rate of return on plan assets, compensation increases, mortality rates and retirement rates. The discount rate and return on plan assets are important elements of liability and expense measurement and are reviewed on an annual basis. The effect of decreasing both the discount rate and assumed rate of return on plan assets by 50 basis points would be a decrease in pension expense of approximately $1 million per year. The effects of actual results differing from the assumptions (i.e. gains or losses) are primarily accumulated in accrued pension liability and amortized over future periods if it exceeds the 10% corridor and, therefore, could affect Seaboard’s recognized pension expense in such future periods, as permitted under GAAP. See Note 10 to the consolidated financial statements for discussion of the pension rates and assumptions.

<s>[INST] Sales and costs of Seaboard’s segments are significantly influenced by worldwide fluctuations in commodity prices and changes in foreign political and economic conditions. Accordingly, sales, operating income and cash flows can fluctuate significantly from year to year. As each segment operates in a distinct industry and a different geographic location, management evaluates their operations separately. Seaboard’s reporting segments are based on information used by Seaboard’s Chief Executive Officer to determine allocation of resources and assess performance, in his capacity as chief operating decision maker. Pork Segment The Pork segment primarily produces hogs to process and sells fresh and frozen pork products to further processors, foodservice operators, distributors and grocery stores throughout the U.S. and to foreign markets. This segment also produces biodiesel from pork fats and other animal fat and vegetable oils for sale to third parties. Sales prices are directly affected by both domestic and worldwide supply and demand for pork products and other proteins. Feed accounts for the largest input cost in raising hogs and is materially affected by price changes for corn and soybean meal. Market prices for hogs purchased from third parties for processing at the plant also represent a major cost factor. Within the portfolio of Seaboard’s businesses, management believes profitability of the Pork segment is most susceptible to commodity price fluctuations. As a result, this segment’s operating income and cash flows can materially fluctuate from year to year, significantly affecting Seaboard’s consolidated operating income and cash flows. This segment is Seaboard’s most capitalintensive segment, representing approximately 53% of Seaboard’s total fixed assets, in addition to approximately 41% of total inventories. With the plant generally operating at capacity, Seaboard is continually looking for ways to enhance the plant’s operational efficiency, while also looking to increase margins by introducing new, higher value products. CT&M Segment The CT&M segment provides integrated agricultural commodity trading, processing and logistics services. The majority of the CT&M segment’s sales are derived from sourcing agricultural commodities from multiple origins which are delivered to thirdparty and affiliate customers in various international locations. The execution of these purchase and delivery transactions have long cycles of completion, which may extend for several months with a high degree of price volatility. As a result, these factors can significantly affect sales volumes, operating income, working capital and related cash flows from period to period. This segment represents approximately 52% of Seaboard’s total inventories. This segment owns three vessels, but the majority of the trading business is transacted with chartered ships. Consolidated and nonconsolidated affiliates operate the grain processing business in foreign countries that are, in most cases, lesser developed. Foreign operations can be significantly impacted by changes in local crop production, political instability and local government policies, as well as fluctuations in economic and industry conditions and foreign currency exchange rates. This segment’s sales are also significantly affected by fluctuating prices of various commodities, such as wheat, corn, soybeans and soybean meal. Exports from various countries can exacerbate volatile market conditions that may have a significant impact on both the trading and milling businesses’ sales and operating income. Profit margins are sometimes protected by using commodity derivatives and other risk management practices. The CT&M segment has invested in several entities in recent years and continues to seek opportunities to expand its trading, milling and agroprocessing businesses. Marine Segment The Marine segment provides cargo shipping services in the U.S., the Caribbean and Central and South America. Fluctuations in economic conditions and political instability in the regions or countries in which this segment operates may affect trade volumes and operating profits. In addition, cargo rates can fluctuate depending on regional supply and demand for shipping services. Since the Marine segment timecharters the majority of its ocean cargo vessels, it is affected by fluctuations in charter hire rates as well as fuel costs. This segment continues to explore ways to increase volumes on existing routes while seeking opportunities to broaden its route structure in the regions it serves. Sugar and Alcohol Segment The Sugar and Alcohol segment produces and processes sugar and alcohol in Argentina, primarily to be marketed locally. The Sugar and Alcohol segment’s sales [/INST] Positive. </s>

RAMCO GERSHENSON PROPERTIES TRUST

2015-02-27

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements, the notes thereto, and the comparative summary of selected financial data appearing elsewhere in this report. Discontinued operations are discussed in Note 5 of the notes to the consolidated financial statements in Item 8. The financial information in this MD&A is based on results from continuing operations. Overview We are a fully integrated, self-administered, publicly-traded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multi-anchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2014, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 80 shopping centers and one office building, with approximately 16.9 million square feet of gross leasable area owned by us and our joint ventures. We also owned interests in three parcels of land available for development and five parcels of land available for sale. We are predominantly a community shopping center company with a focus on managing and adding value to our portfolio of centers that are primarily multi-anchored by grocery stores and/or nationally recognized discount department stores. We believe that centers with a grocery and/or discount component attract consumers seeking value-priced products. Since these products are required to satisfy everyday needs, customers usually visit the centers on a weekly basis. Over half of our shopping centers are anchored by tenants that sell groceries. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger and Sprouts. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Home Depot and Kohl’s. Our shopping centers are primarily located in a dozen of the largest metropolitan markets in the United States. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics. Throughout our primary regions, we have concentrated a number of centers in reasonable proximity to each other in order to achieve efficiencies in management, leasing and acquiring new properties. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, the results of operations of an acquired property are included in our results of operations from the date of acquisition. Estimates of fair values are based upon future cash flows and other valuation techniques in accordance with our fair value measurements policy, which are used to record the purchase price of acquired property among land, buildings on an “as if vacant” basis, tenant improvements, identifiable intangibles and any gain on purchase. Identifiable intangible assets and liabilities include the effect of above-and below-market leases, the value of having leases in place (“as-is” versus “as if vacant” and absorption costs), other intangible assets such as assumed tax increment revenue bonds and out-of-market assumed mortgages. Depreciation and amortization is computed using the straight-line method over the estimated useful lives of 40 years for buildings, over the remaining terms of any intangible asset contracts and the respective tenant leases, which may include bargain review options. The impact of these estimates, including incorrect estimates in connection with acquisition values and estimated useful lives, could result in significant differences related to the purchased assets, liabilities and subsequent depreciation or amortization expense. For more information, refer to Note 1, Organization and Summary of Significant Accounting Policies subtopic Real Estate of the notes to the consolidated financial statements. Impairment We review our investment in real estate, including any related intangible assets, for impairment on a property-by-property basis whenever events or changes in circumstances indicate that the carrying value of the property may not be recoverable. These changes in circumstances include, but are not limited to, changes in occupancy, rental rates, tenant sales, net operating income, geographic location, real estate values and expected holding period. The viability of all projects under construction or development, including those owned by unconsolidated joint ventures, are regularly evaluated under applicable accounting requirements, including requirements relating to abandonment of assets or changes in use. To the extent a project, or individual components of the project, are no longer considered to have value, the related capitalized costs are charged against operations. Impairment provisions resulting from any event or change in circumstances, including changes in our intentions or our analysis of varying scenarios, could be material to our consolidated financial statements. We recognize an impairment of an investment in real estate when the estimated discounted or undiscounted cash flow is less than the net carrying value of the property. If it is determined that an investment in real estate is impaired, then the carrying value is reduced to the estimated fair value as determined by cash flow models and discount rates or comparable sales in accordance with our fair value measurement policy. Refer to Note 6 of the notes to the consolidated financial statements for further information. Revenue Recognition and Accounts Receivable Most of our leases contain non-contingent rent escalations for which we recognize income on a straight-line basis over the non-cancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straight-line rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straight-line rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. An allowance to write down the straight-line receivable balance is taken in the period that future collectability is uncertain. Additionally, we provide for bad debt expense based upon the allowance method of accounting. We continuously monitor the collectability of our accounts receivable from specific tenants, analyze historical bad debts, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the adequacy of the allowance for bad debts. Allowances are taken for those balances that we have reason to believe will be uncollectible. For more information refer to Note 1 Organization and Summary of Significant Accounting Policies, Revenue Recognition and Accounts Receivable subtopics of the notes to the consolidated financial statements. Results of Operations Comparison of the Year Ended December 31, 2014 to the Year Ended December 31, 2013 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items that have significantly changed during the year ended December 31, 2014 as compared to 2013: Total revenue in 2014 increased $48.3 million, or 28.4% from 2013. The increase is primarily due to the following: • $43.7 million increase related to acquisitions completed in 2014 and 2013; • $4.6 million increase at existing centers; and • $1.8 million increase in lease termination income primarily due to the early departure of an office tenant at our office building; offset by • $1.8 million decrease related to properties sold in 2014, reduced management fee income and properties in redevelopment. Operating expense in 2014 increased $7.8 million, or 33.4% from 2013. The increase is primarily due to the following: • $5.7 million related to increases in recoverable operating expenses due to our 2014 and 2013 acquisitions; and • $1.5 million related to increase in recoverable operating expenses at existing centers. Real estate tax expense in 2014 increased $8.3 million, or 35.9% from 2013, primarily due to our 2014 and 2013 acquisitions. Depreciation and amortization expense in 2014 increased $24.9 million, or 44.2%, from 2013. The increase was primarily due to our acquisitions in 2014 and 2013, new development completion and other capital activities. General and administrative expense in 2014 increased $0.7 million or 3.4% from 2013. The increase was primarily due to: • $0.9 million related to an increase in costs associated with our long-term incentive plans which are based on our stock price performance relative to a group of our peers (see Note 16 for additional information); offset in part by • higher capitalization of development and leasing salaries and related costs in 2014. Salaries capitalized in 2014 and 2013 represented approximately 19% and 18%, respectively, of total salaries. Impairment provisions of $27.9 million recorded in 2014 related to the decision to market certain income-producing properties for sale and adjustments to the sales price assumptions for certain undeveloped land parcels available for sale at several of our development properties. In 2013 our impairment provisions totaled $9.7 million. Refer to Note 6 of the notes to the consolidated financial statements for a detailed discussion of these charges. Gain on sale of real estate was $10.9 million in 2014 primarily due to the sale of five income-producing properties and four individual outparcel sales. In the comparable period in 2013 we had a gain of $4.3 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on the sales. Earnings from unconsolidated joint ventures in 2014 increased $4.8 million from 2013. In 2013 we acquired our partner's 70% interest in 12 shopping centers held in the Ramco/Lion Venture LP. The sale resulted in a loss of $21.5 million to the joint venture of which our share was $6.4 million. Interest expense and amortization of deferred financing fees increased in 2014 by $4.7 million, or 15.3% from 2013, primarily due to the following: • $6.1 million increase in loan interest due to the issuance of $200.0 million in senior unsecured notes in the second half of 2014; offset in part by • $0.6 million increase in the amortization of mortgage premiums; and • $0.7 million increase in capitalized interest due to our development/redevelopment projects. In 2014 we recorded a deferred gain of $0.1 million which related to a property sold in 2007 to a joint venture in which we had a 20% non-controlling interest. Due to our continuing involvement we deferred the portion of the gain related to our 20% interest. The property was conveyed to the lender in 2014 and we recognized the previously deferred gain. In 2013, we recorded a deferred gain of $5.3 million. Loss on extinguishment of debt of approximately $0.9 million in 2014 related to the write-off of unamortized deferred financing costs associated with the early payoff of $120.0 million in unsecured term loan debt. In 2013 we recorded a loss of $0.3 million related to a prepayment penalty incurred to repay two mortgages. Comparison of the Year Ended December 31, 2013 to the Year Ended December 31, 2012 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items which have significantly changed during the year ended December 31, 2013 as compared to 2012: Total revenue in 2013 increased $44.8 million, or 35.8% from 2012. The increase is primarily due to the following: • $43.6 million increase related to our acquisitions completed in 2013 and 2012; • $3.1 million increase income related to increases at existing centers; • $1.0 million increase related to the completion of Phase I of the Parkway shops development; offset in part by • a decrease in revenue at properties under redevelopment and lower fee income due to our acquisition of a portfolio of properties from a joint venture in which we hold a 30% interest. In 2013 operating expenses increased by $5.0 million, or 27.1%, real estate tax expense increased $6.5 million, or 38.7%, and depreciation and amortization expense increased by $17.6 million, or 45.6% from 2012 primarily due to our acquisitions completed in 2013 and 2012. General and administrative expense in 2013 increased $1.8 million or 9.5% from 2012. The increase was primarily due to: • $1.8 million related to an increase in costs associated with our long-term incentive plans which are based on our stock price performance relative to a group of our peers (see Note 16 for additional information) offset in part by higher capitalization of development and leasing salaries and related costs in 2013. Salaries capitalized in 2013 and 2012 represented approximately 18% of total salaries. Impairment provisions of $9.7 million were recorded in 2013 related to adjustments to the sales price assumptions for certain undeveloped land parcels available for sale at several of our development properties and other-than-temporary declines in the fair market value of various equity investments in unconsolidated joint ventures. In 2012 our impairment provisions totaled $1.8 million. Refer to Note 6 of the notes to the consolidated financial statements for a detailed discussion of these charges. Gain on sale of real estate was $4.3 million in 2013 primarily due to a $3.0 million gain on sale of land at our Roseville Towne Center to Wal-Mart, an anchor tenant, and a net gain on the sale of multiple outparcels at several other properties. Refer to Note 4 of the notes to the consolidated financial statements for detail of the indvidual sales. (Loss) earnings from unconsolidated joint ventures decreased in 2013 by $8.0 million from 2012. The decrease was related to the acquisition of our partner's 70% interest in 12 shopping centers held in the Ramco/Lion Venture LP. The sale resulted in a loss of $21.5 million to the joint venture of which our share was $6.4 million. Interest expense in 2013 increased $3.2 million, or 11.6% from 2012, primarily due to the following: • $1.1 million increase in mortgage interest related to the assumption of loans as part our 2013 acquisitions; • $3.4 million increase in loan interest due to the issuance of senior unsecured notes in July 2013; offset in part by • $1.1 million decrease in interest related to our junior subordinated notes. In January, 2013 the notes converted from a fixed interest rate of 7.9% to a variable interest rate of LIBOR plus 3.3% (3.5% at December 31, 2013); • lower average balances on our revolving credit facility; and • $0.2 million increase in capitalized interest due to our development/redevelopment projects. In 2013, we recorded a deferred gain of $5.3 million which related to a property sold in 2007 to the Ramco/Lion Venture, LP, a joint venture in which we have a 30% non-controlling interest. Due to our continuing involvement we deferred the portion of the gain related to our 30% interest. In 2013 we acquired our partners' 70% interest in the property and recognized the previously deferred gain. In 2012 we recognized a previously deferred gain of $0.8 million. Loss on extinguishment of debt of approximately $0.3 million in 2013 related to a prepayment penalty incurred to repay two mortgages. There was no similar charge in 2012. Liquidity and Capital Resources The majority of our cash is generated from operations and is dependent on the rents that we are able to charge and collect from our tenants. The principal uses of our liquidity and capital resources are for operations, developments, redevelopments, including expansion and renovation programs, acquisitions, and debt repayment. In addition, we make quarterly dividend payments in accordance with REIT requirements for distributing the substantial majority of our taxable income on an annual basis. We anticipate that the combination of cash on hand, cash from operations, availability under our credit facilities, additional financings, equity offerings, and the sale of existing properties will satisfy our expected working capital requirements through at least the next 12 months. Although we believe that the combination of factors discussed above will provide sufficient liquidity, no such assurance can be given. At December 31, 2014 and 2013, we had $17.5 million and $9.2 million, respectively, in cash and cash equivalents and restricted cash. Restricted cash was comprised primarily of funds held in escrow by lenders to pay real estate taxes, insurance premiums, and certain capital expenditures. Short-Term Liquidity Requirements Our short-term liquidity needs are met primarily from rental income and recoveries and consist primarily of funds necessary to pay operating expenses associated with our operating properties, interest and scheduled principal payments on our debt, quarterly dividend payments (including distributions to OP unit holders) and capital expenditures related to tenant improvements and redevelopment activities. We have five mortgages maturing from June through December 2015 totaling $86.1 million, which includes scheduled amortization payments. We continually search for investment opportunities that may require additional capital and/or liquidity. As of December 31, 2014, we had no proposed property acquisitions under contract. Long-Term Liquidity Requirements Our long-term liquidity needs consist primarily of funds necessary to pay indebtedness at maturity, potential acquisitions of properties, redevelopment of existing properties, the development of land and non-recurring capital expenditures. The following is a summary of our cash flow activities: Operating Activities We anticipate that cash on hand, operating cash flows, borrowings under our revolving credit facility, issuance of equity, as well as other debt and equity alternatives, will provide the necessary capital that we require to operate. Net cash flow provided by operating activities increased $25.0 million in 2014 compared to 2013 primarily due to: • Net operating income increased $27.7 million as a result of our acquisitions (net of dispositions) and leasing activity at our shopping centers; offset by • Net accounts receivable increase of $0.7 million; and • An increase in net interest expense of approximately $4.7 million primarily due to the issuance of senior notes. Investing Activities Net cash used for investing activities decreased $40.0 million compared to 2013 primarily due to: • Acquisitions of real estate decreased $77.8 million; • Investment in unconsolidated joint ventures decreased $5.0 million. In the previous year we had made contributions to fund debt repayment. In addition in 2013 we received a distribution of $1.7 million for the sale of joint venture property; offset by • Restricted cash decreased $5.1 million; and • Additions to real estate increased $36.1 million, as a result of an increase in development funding by $25.1 million, capital expenditures of $9.3 million, and $1.7 million in deferred leasing costs. Financing Activities Cash flows provided by financing activities were $208.7 million as compared to $271.7 million in 2013. This difference of $63.1 million is primarily explained by: • an increase in our net borrowing of $53.9 million for debt and deferred financing costs; offset by • a decrease in net proceeds of $103.9 million from common share issuances; • an increase in cash dividends to common shareholders of $14.0 million due to additional shares issued as well as an increase in our per share quarterly dividend payment; and • a decrease in cash paid out for OP unit conversions of $1.2 million. As of December 31, 2014, $335.9 million was available to be drawn on our $350 million unsecured revolving credit facility subject to certain covenants. It is anticipated that additional funds borrowed under our credit facilities will be used for general corporate purposes, including working capital, capital expenditures, the repayment of indebtedness or other corporate activities. For further information on the credit facilities and other debt, refer to Note 9 of the consolidated financial statements. Dividends and Equity We currently qualify, and intend to continue to qualify in the future, as a REIT under the Internal Revenue Code of 1986, as amended (the "Code”). Under the Code, as a REIT we must distribute to our shareholders at least 90% of our REIT taxable income annually, excluding net capital gain. Distributions paid are at the discretion of our Board and depend on our actual net income available to common shareholders, cash flow, financial condition, capital requirements, restrictions in financing arrangements, the annual distribution requirements under REIT provisions of the Code and such other factors as our Board deems relevant. We paid cash dividends of $0.7625 per common share to shareholders in 2014. In the third quarter we increased our quarterly dividend 6.7% to $0.20 per share, or an annualized amount of $0.80 per share. Cash dividends for 2013 and 2012 were $0.6923 and $0.653 per common share, respectively. Our dividend policy is to make distributions to shareholders of at least 90% of our REIT taxable income, excluding net capital gain, in order to maintain qualification as a REIT. On an annualized basis, our current dividend is above our estimated minimum required distribution. Distributions paid by us are funded from cash flows from operating activities. To the extent that cash flows from operating activities were insufficient to pay total distributions for any period, alternative funding sources would be used. Examples of alternative funding sources may include proceeds from sales of real estate and bank borrowings. Although we may use alternative sources of cash to fund distributions in a given period, we expect that distribution requirements for an entire year will be met with cash flows from operating activities. In August 2014, we issued 6.9 million common shares of beneficial interest. Our total net proceeds, after deducting expenses, were approximately $108.7 million and were used to fund a portion of the consideration for our acquisitions in the third quarter 2014. In addition, during 2014, we issued 3.8 million common shares through our controlled equity offerings generating $61.7 million in net proceeds, after sales commissions and fees of $0.9 million. We used the net proceeds for general corporate purposes including the repayment of debt. We have registered up to 8.0 million common shares for issuance from time to time, at our sole discretion, through our controlled equity offering sales agreement, of which 4.0 million shares remained unsold as of December 31, 2014. The shares issued in the controlled equity offering are registered with the Securities and Exchange Commission (“SEC”) on our registration statement on Form S-3. Off Balance Sheet Arrangements Real Estate Joint Ventures As of December 31, 2014, we had four equity investments in unconsolidated joint venture entities in which we owned 30% or less of the total ownership interest. We account for these entities under the equity method. We have a 20% ownership interest in Ramco 450 which owns a portfolio of eight properties totaling 1.7 million square feet of GLA. As of December 31, 2014, the properties had consolidated equity of $137.3 million. Our total investment in the venture at December 31, 2014 was $17.2 million. The Ramco 450 venture has total debt obligations of approximately $140.3 million with maturity dates ranging from December 2015 through September 2023. Our proportionate share of the total debt is $28.1 million. Such debt is non-recourse to the venture, subject to carve-outs customary to such types of mortgage financing. We have a 30% ownership interest in Ramco/Lion which owns a portfolio of three properties totaling 0.8 million square feet of GLA. As of December 31, 2014, the properties in the portfolio had consolidated equity of $57.6 million. Our total investment in the venture at December 31, 2014 was $8.8 million. Ramco/Lion has one property with a mortgage payable obligation of approximately $30.0 million with maturity date of October 2015. Our proportionate share of the total debt is $9.0 million. Such debt is non-recourse to the venture, subject to carve-outs customary to such types of mortgage financing. We also have ownership interests of 7% in two smaller joint ventures that each own one property. As of December 31, 2014, these properties have combined equity of $45.1 million. Our total investment in these ventures was $2.8 million. Refer to Note 7 of the notes to the consolidated financial statements for more information regarding our equity investments in joint ventures. Contractual Obligations The following are our contractual cash obligations as of December 31, 2014: (1) Excludes $8.9 million of unamortized mortgage debt premium. (2) Variable rate debt interest is calculated using rates at December 31, 2014. We anticipate that the combination of cash on hand, cash provided from operating activities, the availability under our credit facility ($335.9 million at December 31, 2014 subject to covenants), our access to the capital markets and the sale of existing properties will satisfy our expected working capital requirements through at least the next 12 months. At December 31, 2014, we did not have any contractual obligations that required or allowed settlement, in whole or in part, with consideration other than cash. Mortgages and notes payable See the analysis of our debt included in “Liquidity and Capital Resources” above. Employment Contracts At December 31, 2014, we had employment contracts with our Chief Executive and Chief Financial Officers that contain minimum guaranteed compensation. All other employees are subject to at-will employment. Operating and Capital Leases We lease office space for our corporate headquarters under an operating lease. We have an operating lease for land at one of our shopping centers. At December 31, 2014 we had a capital lease at our Gaines Marketplace shopping center that provides the option to purchase the land parcel for approximately $0.7 million. Refer to Note 19 - Subsequent Events of the notes to the consolidated financial statements for more information. In addition we have a capital lease at our Buttermilk Towne Center with the City of Crescent Springs, Kentucky. The lease provides for fixed annual payments of $0.1 million through maturity in December 2032, at which time we can acquire the center for one dollar. Construction Costs In connection with the development and expansion of various shopping centers as of December 31, 2014, we have entered into agreements for construction activities with an aggregate cost of approximately $10.1 million. Planned Capital Spending We are focused on our core strength of enhancing the value of our existing portfolio of shopping centers through successful leasing efforts and the completion of our redevelopment projects currently in process. For 2015, we anticipate spending approximately $57.5 million for capital expenditures, of which $10.1 million is reflected in the construction commitments in the above contractual obligations table. Of the total anticipated spending, approximately $3.3 million is for development costs and approximately $54.2 million is for redevelopment projects, tenant improvements, and leasing costs. Estimates for future spending will change as new projects are approved. Capitalization At December 31, 2014 our total market capitalization was $2.5 billion and is detailed below: At December 31, 2014, noncontrolling interests represented a 2.8% ownership in the Operating Partnership. The OP Units may, under certain circumstances, be exchanged for our common shares of beneficial interest on a one-for-one basis. We, as sole general partner of the Operating Partnership, have the option, but not the obligation, to settle exchanged OP Units held by others in cash. Assuming the exchange of all OP Units, there would have been 79,820,122 of our common shares of beneficial interest outstanding at December 31, 2014, with a market value of approximately $1.5 billion. Non-GAAP Financial Measures Certain of our key performance indicators are considered non-GAAP financial measures. Management uses these measures along with our GAAP financial statements in order to evaluate our operations results. We believe these additional measures provide users of our financial information additional comparable indicators of our industry, as well as, our performance. Funds From Operations We consider funds from operations, also known as “FFO”, to be an appropriate supplemental measure of the financial performance of an equity REIT. Under the NAREIT definition, FFO represents net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of depreciable property and excluding impairment provisions on depreciable real estate or on investments in non-consolidated investees that are driven by measurable decreases in the fair value of depreciable real estate held by the investee, plus depreciation and amortization, (excluding amortization of financing costs). Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect funds from operations on the same basis. Also, we consider “Operating FFO” a meaningful, additional measure of financial performance because it excludes acquisition costs and periodic items such as impairment provisions on land available for development or sale, bargain purchase gains, and gains or losses on extinguishment of debt that are not adjusted under the current NAREIT definition of FFO. We provide a reconciliation of FFO to Operating FFO. FFO and Operating FFO should not be considered alternatives to GAAP net income available to common shareholders or as alternatives to cash flow as measures of liquidity. While we consider FFO and Operating FFO useful measures for reviewing our comparative operating and financial performance between periods or to compare our performance to different REITs, our computations of FFO and Operating FFO may differ from the computations utilized by other real estate companies, and therefore, may not be comparable. We recognize the limitations of FFO and Operating FFO when compared to GAAP net income available to common shareholders. FFO and Operating FFO do not represent amounts available for needed capital replacement or expansion, debt service obligations, or other commitments and uncertainties. In addition, FFO and Operating FFO do not represent cash generated from operating activities in accordance with GAAP and are not necessarily indicative of cash available to fund cash needs, including the payment of dividends. FFO and Operating FFO are simply used as additional indicators of our operating performance. The following table illustrates the calculations of FFO and Operating FFO: (1) Amount included in earnings (loss) from unconsolidated joint ventures. (2) The total noncontrolling interest reflects OP units convertible 1:1 into common shares. (3) Series D convertible preferred shares were dilutive for FFO for the year ended December 31, 2013 and anti-dilutive for the comparable periods in 2014 and 2012. (4) Prior periods have been restated to reflect the add back of acquisition costs beginning in 1Q14. (5) Series D convertible preferred shares were dilutive for Operating FFO for years ended December 31, 2014 and 2013 and anti-dilutive for the comparable period in 2012. Same Property Operating Income Same Property Operating Income ("Same Property NOI") is a supplemental non-GAAP financial measure of real estate companies' operating performance. Same Property NOI is considered by management to be a relevant performance measure of our operations because it includes only the NOI of comparable properties for the reporting period. Same Property NOI is calculated using consolidated operating income and adjusted to exclude management and other fee income, depreciation and amortization, general and administrative expense, provision for impairment and non-comparable income/expense adjustments such as straight-line rents, lease termination fees, above/below market rents, and other non-comparable operating income and expense adjustments. Same Property NOI should not be considered an alternative to net income in accordance with GAAP or as a measure of liquidity. Our method of calculating Same Property NOI may differ from methods used by other REITs and, accordingly, may not be comparable to such other REITs. The following is a summary of our wholly owned properties by classification: Acquisition and redevelopment properties removed from the pool will not be added until owned and operated or construction is complete for the entirety of both periods being compared. The following is a reconciliation of our Operating Income to Same Property NOI: (1) Includes $2.1 million in lease termination income received from an office tenant. Inflation Inflation has been relatively low in recent years and has not had a significant detrimental impact on the results of our operations. Should inflation rates increase in the future, substantially all of our tenant leases contain provisions designed to partially mitigate the negative impact of inflation in the near term. Such lease provisions include clauses that require our tenants to reimburse us for real estate taxes and many of the operating expenses we incur. Also, many of our leases provide for periodic increases in base rent which are either of a fixed amount or based on changes in the consumer price index and/or percentage rents (where the tenant pays us rent based on a percentage of its sales). Significant inflation rate increases over a prolonged period of time may have a material adverse impact on our business. Recent Accounting Pronouncements Refer to Note 2 of the notes to the consolidated financial statements for a discussion of Recent Accounting Pronouncements.

<s>[INST] Overview We are a fully integrated, selfadministered, publiclytraded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multianchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2014, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 80 shopping centers and one office building, with approximately 16.9 million square feet of gross leasable area owned by us and our joint ventures. We also owned interests in three parcels of land available for development and five parcels of land available for sale. We are predominantly a community shopping center company with a focus on managing and adding value to our portfolio of centers that are primarily multianchored by grocery stores and/or nationally recognized discount department stores. We believe that centers with a grocery and/or discount component attract consumers seeking valuepriced products. Since these products are required to satisfy everyday needs, customers usually visit the centers on a weekly basis. Over half of our shopping centers are anchored by tenants that sell groceries. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger and Sprouts. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Home Depot and Kohl’s. Our shopping centers are primarily located in a dozen of the largest metropolitan markets in the United States. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics. Throughout our primary regions, we have concentrated a number of centers in reasonable proximity to each other in order to achieve efficiencies in management, leasing and acquiring new properties. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations are based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, the results of operations of an acquired property are included in our results of operations from the date of acquisition. Estimates of fair values are based upon future cash flows and other valuation techniques in accordance with our fair value measurements policy, which are used to record the purchase price of acquired property among land, buildings on an “as if vacant” basis, tenant improvements, identifiable intangibles and any gain on purchase. Identifiable intangible assets and liabilities include the effect of aboveand belowmarket leases, the value of having leases in place (“asis” versus “as if vacant” and absorption costs), other intangible assets such as assumed tax increment revenue bonds and outofmarket assumed mortgages. Depreciation and amortization is computed using the straightline method over the estimated useful lives of 40 years for buildings, over the remaining terms of any intangible asset contracts and the respective tenant leases, which may include bargain review options. The impact of these estimates, including incorrect estimates in connection with acquisition values and estimated useful lives, could result in significant differences related to the purchased assets, liabilities and subsequent depreciation or amortization expense. For more information, refer to Note 1, Organization and Summary of Significant Accounting Policies subtopic Real Estate of the notes to the consolidated financial statements. Impairment We review our investment in real estate, including any related intangible assets, for impairment on a propertybyproperty basis whenever events or changes in circumstances indicate [/INST] Positive. </s>

RAMCO GERSHENSON PROPERTIES TRUST

2016-02-29

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements, the notes thereto, and the comparative summary of selected financial data appearing elsewhere in this report. Discontinued operations are discussed in Note 5 of the notes to the consolidated financial statements in Item 8. The financial information in this MD&A is based on results from continuing operations. Overview We are a fully integrated, self-administered, publicly-traded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multi-anchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2015, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 73 shopping centers and one office building, with approximately 15.9 million square feet of gross leasable area owned by us and our joint ventures. We also own various parcels of land available for development or for sale, the majority of which are adjacent to certain of our existing developed properties. We are predominantly a community shopping center company with a focus on managing and adding value to our portfolio of centers that are primarily multi-anchored by grocery stores and/or nationally recognized discount department stores. We believe that centers with a grocery and/or discount component attract consumers seeking value-priced products. Since these products are required to satisfy everyday needs, customers often visit the centers on a weekly basis. Over half of our shopping centers are anchored by tenants that sell groceries. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger and Sprouts. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Home Depot and Dick's Sporting Goods. Our shopping centers are primarily located in a number of the largest metropolitan markets in the central United States. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics. Throughout our primary regions, we have concentrated a number of centers in reasonable proximity to each other in order to achieve efficiencies in management, leasing and acquiring new properties. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain non-contingent rent escalations for which we recognize income on a straight-line basis over the non-cancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straight-line rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straight-line rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. An allowance to write down the straight-line receivable balance is taken in the period that future collectability is uncertain. Additionally, we provide for bad debt expense based upon the allowance method of accounting. We continuously monitor the collectability of our accounts receivable from specific tenants, analyze historical bad debts, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the adequacy of the allowance for bad debts. Allowances are taken for those balances that we have reason to believe will be uncollectible. For more information refer to Note 1 Organization and Summary of Significant Accounting Policies, Revenue Recognition and Accounts Receivable subtopics of the notes to the consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, the results of operations of an acquired property are included in our results of operations from the date of acquisition. Estimates of fair values are based upon future cash flows and other valuation techniques in accordance with our fair value measurements policy, which are used to allocate the purchase price of acquired property among land, buildings on an “as if vacant” basis, tenant improvements, identifiable intangibles and any gain on purchase. Identifiable intangible assets and liabilities include the effect of above-and below-market leases, the value of having leases in place (“as-is” versus “as if vacant” and absorption costs), other intangible assets such as assumed tax increment revenue bonds and out-of-market assumed mortgages. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of 40 years for buildings, and over the remaining terms of any intangible asset contracts and the respective tenant leases, which may include bargain review options. The impact of these estimates, including incorrect estimates in connection with acquisition values and estimated useful lives, could result in significant differences related to the purchased assets, liabilities and subsequent depreciation or amortization expense. For more information, refer to Note 1, Organization and Summary of Significant Accounting Policies - Real Estate of the notes to the consolidated financial statements. Impairment We review our investment in real estate, including any related intangible assets, for impairment on a property-by-property basis whenever events or changes in circumstances indicate that the carrying value of the property may not be recoverable. These changes in circumstances include, but are not limited to, changes in occupancy, rental rates, tenant sales, net operating income, geographic location, real estate values and expected holding period. The viability of all projects under construction or development, including those owned by unconsolidated joint ventures, is regularly evaluated under applicable accounting requirements, including requirements relating to abandonment of assets or changes in use. To the extent a project, or individual components of the project, are no longer considered to have value, the related capitalized costs are charged against operations. Impairment provisions resulting from any event or change in circumstances, including changes in our intentions or our analysis of varying scenarios, could be material to our consolidated financial statements. We recognize an impairment of an investment in real estate when the estimated discounted or undiscounted cash flow is less than the net carrying value of the property. If it is determined that an investment in real estate is impaired, then the carrying value is reduced to the estimated fair value as determined by cash flow models and discount rates or comparable sales in accordance with our fair value measurement policy. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets for further information regarding impairment provisions. Results of Operations Comparison of the Year Ended December 31, 2015 to the Year Ended December 31, 2014 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items that have significantly changed during the year ended December 31, 2015 as compared to 2014: NM - Not Meaningful Total revenue in 2015 increased $33.4 million, or 15.3% from 2014. The increase is primarily due to the following: • $32.3 million increase related to acquisitions completed in 2015 and 2014; • $2.9 million increase due to the completion of Phase I of Lakeland Park Center; • $4.0 million increase at existing centers primarily related to redevelopment and re-tenanting activities; offset by • $5.8 million decrease related to properties sold in 2014 and reduced management fee income and lower office tenant revenue in 2015. Operating expense in 2015 increased $3.9 million, or 12.7%, from 2014 primarily due to our 2015 and 2014 acquisitions. Real estate tax expense in 2015 increased $7.3 million, or 23.1%, from 2014, primarily due to our 2015 and 2014 acquisitions. Depreciation and amortization expense in 2015 increased $8.3 million, or 10.2%, from 2014. The increase was primarily related to a $14.8 million increase from our acquisitions in 2015 and 2014, new development completion and other capital activities offset by a decrease of $6.5 million related to sold properties and accelerated depreciation for demolition of certain centers undergoing redevelopment in 2014. General and administrative expense in 2015 decreased $1.6 million, or 7.4%, from 2014. The decrease was primarily due to lower costs associated with our long-term incentive plans which are based on our stock price performance relative to a group of our peers. The reversal of share based and long-term compensation expense related to the previous Chief Financial Officer offset in part by a bonus payment for a new Chief Financial Officer. Impairment provisions of $2.5 million, recorded in 2015, related to developable land that was subsequently sold in the second quarter of 2015. The adjustment was triggered by unforeseen increases in development costs and changes in the associated sales price assumptions. In 2014 our impairment provisions totaled $27.9 million related to our plan to sell certain land parcels that we had previously intended to develop. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $17.6 million in 2015. In the comparable period in 2014 we had a gain of $10.9 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2015 increased $17.6 million from 2014. The increase was primarily related to our proportionate share of gains totaling $16.5 million generated by the sale of ten properties owned by two of our joint ventures. In addition, in 2014, we recorded accelerated depreciation expense as a result of the demolition of a portion of centers for redevelopment and additional proceeds related to the 2011 sale of a joint venture property. Refer to Note 7 of the notes to the consolidated financial statements for additional information regarding our unconsolidated joint venture sales activity. Interest expense and amortization of deferred financing fees increased in 2015 by $7.0 million, or 20.0% from 2014, primarily due to the issuance of new senior unsecured notes and higher average loan balances on our credit facility. Gain on remeasurement of unconsolidated joint ventures in 2015 was $7.9 million, triggered by our acquisition of our partner's equity interest in seven properties. The gain on remeasurement represents the difference between the carrying value and the fair value of our previously held equity investment in the properties. In 2014 we recognized a similar gain of $0.1 million. Gain on extinguishment of debt of approximately $1.4 million in 2015 was related to the write-off of debt premiums associated with two mortgages that were repaid compared to a loss of $0.9 million in 2014 related to the write-off of deferred financing costs associated with the early payoff of unsecured term loan debt. Comparison of the Year Ended December 31, 2014 to the Year Ended December 31, 2013 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items which have significantly changed during the year ended December 31, 2014 as compared to 2013: Total revenue in 2014 increased $48.3 million, or 28.4%, from 2013. The increase is primarily due to the following: • $43.7 million increase related to acquisitions completed in 2014 and 2013; • $4.6 million increase at existing centers; and • $1.8 million increase in lease termination income primarily due to the early departure of an office tenant at our office building; offset by • $1.8 million decrease related to properties sold in 2014, reduced management fee income and properties in redevelopment. Operating expense in 2014 increased $7.8 million, or 33.4%, from 2013. The increase is primarily due to the following: • $5.7 million related to increases in recoverable operating expenses due to our 2014 and 2013 acquisitions; and • $1.5 million related to increase in recoverable operating expenses at existing centers. Real estate tax expense in 2014 increased $8.3 million, or 35.9%, from 2013, primarily due to our 2014 and 2013 acquisitions. Depreciation and amortization expense in 2014 increased $24.9 million, or 44.2%, from 2013. The increase was primarily due to our acquisitions in 2014 and 2013, new development completion and other capital activities. General and administrative expense in 2014 increased $0.7 million, or 3.4%, from 2013. The increase was primarily due to: • $0.9 million related to an increase in costs associated with our long-term incentive plans which are based on our stock price performance relative to a group of our peers (see Note 16 of the notes to the consolidated financial statements for additional information); offset in part by • higher capitalization of development and leasing salaries and related costs in 2014. Salaries capitalized in 2014 and 2013 represented approximately 19% and 18%, respectively, of total salaries. Impairment provisions of $27.9 million recorded in 2014 related to the decision to market certain income-producing properties for sale that we had previously planned to develop and adjustments to the sales price assumptions for certain undeveloped land parcels available for sale at several of our development properties. In 2013 our impairment provisions totaled $9.7 million. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $10.9 million in 2014 primarily due to the sale of five income-producing properties and four individual outparcel sales. In the comparable period in 2013 we had a gain of $4.3 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2014 increased $4.8 million from 2013. In 2013 we acquired our partner's 70% interest in 12 shopping centers held in the Ramco/Lion Venture LP. The sale resulted in a loss of $21.5 million to the joint venture of which our share was $6.4 million. Interest expense and amortization of deferred financing fees increased in 2014 by $4.7 million, or 15.3% from 2013, primarily due to the following: • $6.1 million increase in loan interest due to the issuance of $200.0 million in senior unsecured notes in the second half of 2014; offset in part by • $0.6 million increase in the amortization of mortgage premiums; and • $0.7 million increase in capitalized interest due to our development/redevelopment projects. In 2014 we recorded a deferred gain of $0.1 million which related to a property sold in 2007 to a joint venture in which we had a 20% non-controlling interest. Due to our continuing involvement we deferred the portion of the gain related to our 20% interest. The property was conveyed to the lender in 2014 and we recognized the previously deferred gain. In 2013, we recorded a deferred gain of $5.3 million. Loss on extinguishment of debt of approximately $0.9 million in 2014 related to the write-off of unamortized deferred financing costs associated with the early payoff of $120.0 million in unsecured term loan debt. In 2013 we recorded a loss of $0.3 million related to a prepayment penalty incurred to repay two mortgages. Liquidity and Capital Resources The majority of our cash is generated from operations and is dependent on the rents that we are able to charge and collect from our tenants. The principal uses of our liquidity and capital resources are for operations, developments, redevelopments, including expansion and renovation programs, acquisitions, and debt repayment. In addition, we make quarterly dividend payments in accordance with REIT requirements for distributing the substantial majority of our taxable income on an annual basis. We anticipate that the combination of cash on hand, cash from operations, availability under our credit facilities, additional financings, equity offerings, and the sale of existing properties will satisfy our expected working capital requirements through at least the next 12 months. Although we believe that the combination of factors discussed above will provide sufficient liquidity, no such assurance can be given. At December 31, 2015 and 2014, we had $15.4 million and $17.5 million, respectively, in cash and cash equivalents and restricted cash. Restricted cash was comprised primarily of funds held in escrow by lenders to pay real estate taxes, insurance premiums, and certain capital expenditures. Short-Term Liquidity Requirements Our short-term liquidity needs are met primarily from rental income and recoveries and consist primarily of funds necessary to pay operating expenses associated with our operating properties, interest and scheduled principal payments on our debt, quarterly dividend payments (including distributions to OP unit holders) and capital expenditures related to tenant improvements and redevelopment activities. We believe that our retained cash flow from operations along with availability under our revolving credit facility is sufficient to meet these obligations. We have two mortgages maturing in June 2016 totaling $35.8 million, which includes scheduled amortization payments. As opportunities arise and market conditions permit, we will look to repay these mortgages by issuing unsecured debt, utilizing cash flow from operating activities or funding from availability under our credit facility. As of December 31, 2015 we had $286.5 million available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. We will continue to pursue the strategy of selling mature properties or non-core assets that no longer meet our investment criteria. Our ability to obtain acceptable selling prices and satisfactory terms and financing will impact the timing of future sales. We anticipate using net proceeds from the sale of properties to reduce outstanding debt and support current and future growth initiatives. We continually search for investment opportunities that may require additional capital and/or liquidity. As of December 31, 2015, we had no proposed property acquisitions under contract and one property disposition under contract, subject to due diligence contingencies. Long-Term Liquidity Requirements Our long-term liquidity needs consist primarily of funds necessary to pay indebtedness at maturity, potential acquisitions of properties, redevelopment of existing properties, the development of land and non-recurring capital expenditures. The following is a summary of our cash flow activities: Operating Activities We anticipate that cash on hand, operating cash flows, borrowings under our revolving credit facility, issuance of equity, as well as other debt and equity alternatives, will provide the necessary capital that we require to operate. Net cash flow provided by operating activities decreased $5.4 million in 2015 compared to 2014 primarily due to: • Operating income, adjusted for non-cash activity, increased $17.4 million as a result of our acquisitions (net of dispositions), redevelopment and leasing activities at our shopping centers; • net accounts receivable increased $4.4 million; • accounts payable and other liabilities decreased approximately $8.5 million; • long-term and share-based compensation expense decreased $3.0 million; and • net interest expense increased approximately $7.0 million primarily due to higher average loan balances as a result of acquisitions. Investing Activities Net cash used for investing activities decreased $161.4 million compared to 2014 primarily due to: • Acquisitions of real estate decreased $111.5 million; • Additions to real estate decreased $19.8 million due to lower new construction activity; • Net proceeds from the sale of real estate increased $11.8 million; and • Distributions from sales of joint venture properties increased $14.1 million; and • Restricted cash decreased $4.2 million. Financing Activities Cash flows provided by financing activities were $46.5 million as compared to $208.7 million in 2014. This difference of $162.2 million is primarily explained by: • net proceeds from common share issuances decreased $153.3 million; • an increase in cash dividends to common shareholders of $9.8 million due to additional shares issued as well as an increase in our per share quarterly dividend payment; and • an increase in cash paid for OP unit conversions of $3.7 million; offset in part by • an increase in net borrowings of $5.3 million. As of December 31, 2015, $286.5 million was available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. It is anticipated that additional funds borrowed under our credit facilities will be used for general corporate purposes, including working capital, capital expenditures, the repayment of indebtedness or other corporate activities. For further information on the credit facilities and other debt, refer to Note 9 of notes to the consolidated financial statements for further information regarding debt. Dividends and Equity We currently qualify, and intend to continue to qualify in the future, as a REIT under the Code. As a REIT, we must distribute to our shareholders at least 90% of our REIT taxable income annually, excluding net capital gain. Distributions paid are at the discretion of our Board and depend on our actual net income available to common shareholders, cash flow, financial condition, capital requirements, restrictions in financing arrangements, the annual distribution requirements under REIT provisions of the Code and such other factors as our Board deems relevant. We paid cash dividends of $0.81 per common share to shareholders in 2015. In the third quarter we increased our quarterly dividend 5.0% to $0.21 per share, or an annualized amount of $0.84 per share. Cash dividends for 2014 and 2013 were $0.7625 and $0.6923 per common share, respectively. Our dividend policy is to make distributions to shareholders of at least 90% of our REIT taxable income, excluding net capital gain, in order to maintain qualification as a REIT. On an annualized basis, our current dividend is above our estimated minimum required distribution. Distributions paid by us are funded from cash flows from operating activities. To the extent that cash flows from operating activities were insufficient to pay total distributions for any period, alternative funding sources would be used. Examples of alternative funding sources may include proceeds from sales of real estate and bank borrowings. Although we may use alternative sources of cash to fund distributions in a given period, we expect that distribution requirements for an entire year will be met with cash flows from operating activities. In addition, during 2015, we issued 0.9 million common shares through our controlled equity offering generating $17.2 million in net proceeds, after sales commissions and fees of $0.3 million. We used the net proceeds for general corporate purposes including the repayment of debt. We have registered up to 8.0 million common shares for issuance from time to time, at our sole discretion, through our controlled equity offering sales agreement, of which 3.1 million shares remained unsold as of December 31, 2015. The shares issued in the controlled equity offering are registered with the Securities and Exchange Commission (“SEC”) on our registration statement on Form S-3. Off Balance Sheet Arrangements Real Estate Joint Ventures We consolidate entities in which we own less than 100% equity interest if we have a controlling interest or are the primary beneficiary in a variable interest entity, as defined in the Consolidation Topic of FASB ASC 810. From time to time, we enter into joint venture arrangements from which we believe we can benefit by owning a partial interest in one or more properties. As of December 31, 2015, our investments in unconsolidated joint ventures were approximately $4.3 million representing our ownership interest in three shopping centers. We accounted for these entities under the equity method. Refer to Note 7 of the notes to the consolidated financial statements for further information regarding our equity investments in unconsolidated joint ventures. We are engaged by our joint ventures to provide asset management, property management, leasing and investing services for such ventures' respective properties. We receive fees for our services, including a property management fee calculated as a percentage of gross revenues received. Contractual Obligations The following are our contractual cash obligations as of December 31, 2015: (1) Excludes $6.9 million of unamortized mortgage debt premium and $3.8 million in deferred financing costs. (2) Variable rate debt interest is calculated using rates at December 31, 2015. We anticipate that the combination of cash on hand, cash provided from operating activities, the availability under our credit facility ($286.5 million at December 31, 2015 subject to our compliance with certain covenants), our access to the capital markets and the sale of existing properties will satisfy our expected working capital requirements through at least the next 12 months. At December 31, 2015, we did not have any contractual obligations that required or allowed settlement, in whole or in part, with consideration other than cash. Mortgages and notes payable See the analysis of our debt included in “Liquidity and Capital Resources” above. Employment Contracts At December 31, 2015, we had employment contracts with our Chief Executive, Chief Financial and Chief Operating Officers, that contain minimum guaranteed compensation. All other employees are subject to at-will employment. Operating and Capital Leases We lease office space for our corporate headquarters under an operating lease that expires in August 2019. We have a capital lease at our Buttermilk Towne Center with the City of Crescent Springs, Kentucky. The lease provides for fixed annual payments of $0.1 million through maturity in December 2032, at which time we can acquire the center for one dollar. Construction Costs In connection with the development and expansion of various shopping centers as of December 31, 2015, we have entered into agreements for construction activities with an aggregate cost of approximately $10.6 million. Planned Capital Spending We are focused on our core strength of enhancing the value of our existing portfolio of shopping centers through successful leasing efforts and the completion of our redevelopment projects currently in process. For 2016, we anticipate spending approximately $62.5 million for capital expenditures, of which $10.6 million is reflected in the construction commitments in the above contractual obligations table. The total anticipated spending relates to redevelopment projects, tenant improvements, and leasing costs. Estimates for future spending will change as new projects are approved. Capitalization At December 31, 2015 our total market capitalization was $2.5 billion and is detailed below: At December 31, 2015, noncontrolling interests represented a 2.4% ownership in the Operating Partnership. The OP Units may, under certain circumstances, be exchanged for our common shares of beneficial interest on a one-for-one basis. We, as sole general partner of the Operating Partnership, have the option, but not the obligation, to settle exchanged OP Units held by others in cash. Assuming the exchange of all OP Units, there would have been 81,163,819 of our common shares of beneficial interest outstanding at December 31, 2015, with a market value of approximately $1.3 billion. Non-GAAP Financial Measures Certain of our key performance indicators are considered non-GAAP financial measures. Management uses these measures along with our GAAP financial statements in order to evaluate our operations results. We believe these additional measures provide users of our financial information additional comparable indicators of our industry, as well as our performance. Funds From Operations We consider funds from operations, also known as “FFO”, to be an appropriate supplemental measure of the financial performance of an equity REIT. Under the NAREIT definition, FFO represents net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of depreciable property and impairment provisions on depreciable real estate or on investments in non-consolidated investees that are driven by measurable decreases in the fair value of depreciable real estate held by the investee, plus depreciation and amortization, (excluding amortization of financing costs). Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect funds from operations on the same basis. In addition to FFO available to common shareholders, we include Operating FFO available to common shareholders as an additional measure of our financial and operating performance. Operating FFO excludes acquisition costs and periodic items such as impairment provisions on land available for development or sale, bargain purchase gains, and gains or losses on extinguishment of debt that are not adjusted under the current NAREIT definition of FFO. We provide a reconciliation of FFO to Operating FFO. FFO and Operating FFO should not be considered alternatives to GAAP net income available to common shareholders or as alternatives to cash flow as measures of liquidity. While we consider FFO available to common shareholders and Operating FFO available to common shareholders useful measures for reviewing our comparative operating and financial performance between periods or to compare our performance to different REITs, our computations of FFO and Operating FFO may differ from the computations utilized by other real estate companies, and therefore, may not be comparable. We recognize the limitations of FFO and Operating FFO when compared to GAAP net income available to common shareholders. FFO and Operating FFO available to common shareholders do not represent amounts available for needed capital replacement or expansion, debt service obligations, or other commitments and uncertainties. In addition, FFO and Operating FFO do not represent cash generated from operating activities in accordance with GAAP and are not necessarily indicative of cash available to fund cash needs, including the payment of dividends. FFO and Operating FFO are simply used as additional indicators of our operating performance. The following table illustrates the calculations of FFO and Operating FFO: (1) Amount included in earnings (loss) from unconsolidated joint ventures. (2) During the third quarter 2015, we purchased our partner's interest in six properties owned by Ramco 450 Venture LLC and one property owned by Ramco/Lion Venture L.P. The total gain of $7.9 million represents the difference between the carrying value and the fair value of our previously held equity investment in the properties. (3) The total noncontrolling interest reflects OP units convertible 1:1 into common shares. (4) Series D convertible preferred shares were dilutive for FFO for the years ended December 31, 2015 and 2013 and were anti-dilutive for the comparable period in 2014. In 2015, our Series D convertible preferred shares paid annual dividends of $6.7 million and are currently convertible into approximately 6.7 million shares of common stock. They are dilutive only when earnings or FFO exceed approximately $1.04 per diluted share per year The conversion ratio is subject to adjustment based upon a number of factors, and such adjustment could affect the dilutive impact of the Series D convertible preferred shares on FFO and earnings per share in future periods. (5) Series D convertible preferred shares were dilutive for Operating FFO for year ended December 31, 2014. (6) The denominator to calculate diluted earnings per share excludes shares issuable upon conversion of Operating Partnership Units and preferred shares for all periods reported. (7) The year ended December 31, 2015 includes $0.04 per share primarily attributable to gain on sale of land at Gaines Marketplace. Same Property Operating Income Same Property Operating Income ("Same Property NOI") is a supplemental non-GAAP financial measure of real estate companies' operating performance. Same Property NOI is considered by management to be a relevant performance measure of our operations because it includes only the NOI of comparable properties for the reporting period. Same Property NOI is calculated using consolidated operating income as defined by GAAP adjusted to exclude management and other fee income, depreciation and amortization, acquisition costs, general and administrative expense, provision for impairment, GAAP income adjustments such as straight-line rents, net of reserves, above/below market rents, other non-comparable operating income/expense adjustments, and the effect of lease termination income/expense. Same Property NOI should not be considered an alternative to net income in accordance with GAAP or as a measure of liquidity. Our method of calculating Same Property NOI may differ from methods used by other REITs and, accordingly, may not be comparable to such other REITs. The following is a summary of our wholly owned properties by classification: Acquisition and redevelopment/development properties removed from the pool will not be added until owned and operated or construction is complete for the entirety of both periods being compared. The following is a reconciliation of our Operating Income to Same Property NOI: (1) Includes adjustments for items that affect the comparability of the same center NOI results. Such items include straight-line rents, net of reserves, above/below market rents, other non-comparable operating income/expense adjustments, and the effect of lease termination income/expense. Inflation Inflation has been relatively low in recent years and has not had a significant detrimental impact on the results of our operations. Should inflation rates increase in the future, substantially all of our tenant leases contain provisions designed to partially mitigate the negative impact of inflation in the near term. Such lease provisions include clauses that require our tenants to reimburse us for real estate taxes and many of the operating expenses we incur. Also, many of our leases provide for periodic increases in base rent which are either of a fixed amount or based on changes in the consumer price index and/or percentage rents (where the tenant pays us rent based on a percentage of its sales). Significant inflation rate increases over a prolonged period of time may have a material adverse impact on our business. Recent Accounting Pronouncements Refer to Note 2 of the notes to the consolidated financial statements for a discussion of Recent Accounting Pronouncements.

<s>[INST] Overview We are a fully integrated, selfadministered, publiclytraded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multianchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2015, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 73 shopping centers and one office building, with approximately 15.9 million square feet of gross leasable area owned by us and our joint ventures. We also own various parcels of land available for development or for sale, the majority of which are adjacent to certain of our existing developed properties. We are predominantly a community shopping center company with a focus on managing and adding value to our portfolio of centers that are primarily multianchored by grocery stores and/or nationally recognized discount department stores. We believe that centers with a grocery and/or discount component attract consumers seeking valuepriced products. Since these products are required to satisfy everyday needs, customers often visit the centers on a weekly basis. Over half of our shopping centers are anchored by tenants that sell groceries. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger and Sprouts. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Home Depot and Dick's Sporting Goods. Our shopping centers are primarily located in a number of the largest metropolitan markets in the central United States. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics. Throughout our primary regions, we have concentrated a number of centers in reasonable proximity to each other in order to achieve efficiencies in management, leasing and acquiring new properties. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain noncontingent rent escalations for which we recognize income on a straightline basis over the noncancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straightline rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straightline rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. An allowance to write down the straightline receivable balance is taken in the period that future collectability is uncertain. Additionally, we provide for bad debt expense based upon the allowance method of accounting. We continuously monitor the collectability of our accounts receivable from specific tenants, analyze historical bad debts, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the adequacy of the allowance for bad debts. Allowances are taken for those balances that we have reason to believe will be uncollectible. For more information refer to Note 1 Organization and Summary of Significant Accounting Policies, Revenue Recognition and Accounts Receivable subtopics of the notes to the consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, the results of operations [/INST] Negative. </s>

RAMCO GERSHENSON PROPERTIES TRUST

2017-02-24

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements, the notes thereto, and the comparative summary of selected financial data appearing elsewhere in this report. The financial information in this MD&A is based on results from continuing operations. Overview We are a fully integrated, self-administered, publicly-traded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multi-anchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2016, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 67 shopping centers, with approximately 15.0 million square feet of gross leasable area owned by us and our joint ventures. We also own various parcels of land available for development or for sale, the majority of which are adjacent to certain of our existing developed properties. We are predominantly a community shopping center company with a focus on managing and adding value to our portfolio of centers that are primarily multi-anchored by grocery stores and/or nationally recognized discount department stores. We believe that centers with a grocery and/or discount component attract consumers seeking value-priced products. Since these products are required to satisfy everyday needs, customers often visit the centers on a weekly basis. Over half of our shopping centers are anchored by tenants that sell groceries. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger and Sprouts. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Home Depot and Dick's Sporting Goods. Our shopping centers are primarily located in a number of the largest metropolitan markets in the central United States. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics. Throughout our primary regions, we have concentrated a number of centers in reasonable proximity to each other in order to achieve efficiencies in management, leasing and acquiring new properties. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain non-contingent rent escalations for which we recognize income on a straight-line basis over the non-cancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straight-line rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straight-line rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. An allowance to write down the straight-line receivable balance is taken in the period that future collectability is uncertain. Additionally, we provide for bad debt expense based upon the allowance method of accounting. We continuously monitor the collectability of our accounts receivable from specific tenants, analyze historical bad debts, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the adequacy of the allowance for bad debts. Allowances are taken for those balances that we have reason to believe will be uncollectible. For more information refer to Note 1 Organization and Summary of Significant Accounting Policies, Revenue Recognition and Accounts Receivable subtopics of the notes to the consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, the results of operations of an acquired property are included in our results of operations from the date of acquisition. Estimates of fair values are based upon future cash flows and other valuation techniques in accordance with our fair value measurements policy, which are used to allocate the purchase price of acquired property among land, buildings on an “as if vacant” basis, tenant improvements, identifiable intangibles and any gain on purchase. Identifiable intangible assets and liabilities include the effect of above-and below-market leases, the value of having leases in place (“as-is” versus “as if vacant” and absorption costs), other intangible assets such as assumed tax increment revenue bonds and out-of-market assumed mortgages. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of 40 years for buildings, and over the remaining terms of any intangible asset contracts and the respective tenant leases, which may include bargain renewal options. The impact of these estimates, including estimates in connection with acquisition values and estimated useful lives, could result in significant differences related to the purchased assets, liabilities and subsequent depreciation or amortization expense. For more information, refer to Note 1, Organization and Summary of Significant Accounting Policies - Real Estate of the notes to the consolidated financial statements. Impairment We review our investment in real estate, including any related intangible assets, for impairment on a property-by-property basis whenever events or changes in circumstances indicate that the carrying value of the property may not be recoverable. These changes in circumstances include, but are not limited to, changes in occupancy, rental rates, tenant sales, net operating income, geographic location, real estate values and expected holding period. The viability of all projects under construction or development, including those owned by unconsolidated joint ventures, is regularly evaluated under applicable accounting requirements, including requirements relating to abandonment of assets or changes in use. To the extent a project or an individual component of the project, is no longer considered to have value, the related capitalized costs are charged against operations. Impairment provisions resulting from any event or change in circumstances, including changes in our intentions or our analysis of varying scenarios, could be material to our consolidated financial statements. We recognize an impairment of an investment in real estate when the estimated discounted or undiscounted cash flow is less than the net carrying value of the property. If it is determined that an investment in real estate is impaired, then the carrying value is reduced to the estimated fair value as determined by cash flow models and discount rates or comparable sales in accordance with our fair value measurement policy. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets for further information regarding impairment provisions. Results of Operations Comparison of the Year Ended December 31, 2016 to the Year Ended December 31, 2015 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items that have significantly changed during the year ended December 31, 2016 as compared to 2015: Total revenue in 2016 increased $9.1 million, or 3.6% from 2015. The increase is primarily due to the following: • $16.0 million increase related to acquisitions completed in 2016 and 2015; • $3.9 million increase at existing centers; offset by • $9.2 million decrease related to properties sold in 2016 and 2015; • $1.2 million decrease in management and other fee income; and • $0.4 million decrease related to the disposal of our office building. Operating expense in 2016 decreased $1.7 million, or 4.9%, from 2015 primarily due to certain operating costs direct billed to tenants by the service provider which were previously part of the Company’s recovery cost, lower bad debt expense and our dispositions which were partially offset by the impact of a full year from our 2015 acquisitions. Real estate tax expense in 2016 increased $3.0 million, or 7.7%, from 2015, primarily due to our 2015 acquisitions and incremental tax increases within existing properties, partially offset by dispositions. Depreciation and amortization expense in 2016 increased $2.4 million, or 2.6%, from 2015. The increase was primarily related to a $4.5 million increase from our nine acquisitions in 2015, one acquisition in 2016, new development completion and other capital activities offset by a decrease of $2.2 million related to properties disposed of. General and administrative expense in 2016 increased $2.0 million, or 9.8%, from 2015. The increase was primarily due to increased costs associated with our long-term incentive plans, including increased stock compensation in 2016 related to a one-time award to our current Chief Financial Officer in December 2015. By way of contrast, general and administration expense in 2015 included a reversal of expense attributable to the resignation of our former Chief Financial Officer. Impairment provisions of $1.0 million recorded in 2016 related to developable land held for sale triggered by unforeseen increases in development costs and changes in the associated sales price assumptions. In 2015 our impairment provisions totaled $2.5 million related to our plan to sell certain land parcels that we had previously intended to develop. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $35.8 million in 2016. In the comparable period in 2015 we had a gain of $17.6 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2016 decreased $17.2 million from 2015. The decrease was primarily due to the reduced level of properties in unconsolidated joint ventures following sales in 2015. Interest expense and amortization of deferred financing fees increased in 2016 by $2.3 million, or 5.5% from 2015, primarily due to changes in the composition between senior unsecured notes and mortgage debt, as well as higher average balances on our term loan and revolving credit facility. Gain on remeasurement of unconsolidated joint ventures in 2016 was $0.2 million, primarily due to the reduced level of activity in our unconsolidated joint ventures. In 2015 we acquired our partners' interest in seven properties. The gain on remeasurement represents the difference between the carrying value and the fair value of our previously held equity investment in the properties. In 2016 only a single property was disposed of by a joint venture. Loss on extinguishment of debt of approximately $1.3 million in 2016 resulted from a $0.9 million loss upon the conveyance of our Aquia office property to the lender and a $0.4 million cash prepayment penalty on a mortgage payoff in 2016 with an original maturity of April 2017 compared to a gain of $1.4 million in 2015 related to the write-off of debt premiums associated with the early payoff of corresponding debt. Comparison of the Year Ended December 31, 2015 to the Year Ended December 31, 2014 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items which have significantly changed during the year ended December 31, 2015 as compared to 2014: Total revenue in 2015 increased $33.4 million, or 15.3%, from 2014. The increase is primarily due to the following: • $32.3 million increase related to acquisitions completed in 2015 and 2014; • $2.9 million increase due to the completion of Phase I of Lakeland Park Center; • $4.0 million increase at existing centers primarily related to redevelopment or re-tenanting activities; offset by • $5.8 million decrease related to properties sold in 2014 and reduced management fee income and lower office tenant revenue in 2015. Operating expense in 2015 increased $3.9 million, or 12.7%, from 2014 primarily due to our 2015 and 2014 acquisitions. Real estate tax expense in 2015 increased $7.3 million, or 23.1%, from 2014, primarily due to our 2015 and 2014 acquisitions. Depreciation and amortization expense in 2015 increased $8.3 million, or 10.2%, from 2014. The increase was primarily related to a $14.8 million increase from our acquisitions in 2015 and 2014, new development completion and other capital activities offset by a decrease of $6.5 million related to sold properties and accelerated depreciation for demolition of certain centers undergoing redevelopment in 2014. General and administrative expense in 2015 decreased $1.6 million, or 7.4%, from 2014. The decrease was primarily due to lower costs associated with our long-term incentive plans which are based on our stock price performance relative to a group of our peers and the reversal of share based and long-term compensation expense related to the previous Chief Financial Officer offset in part by a one-time award to our new Chief Financial Officer. Impairment provisions of $2.5 million recorded in 2015 related to developable land that was subsequently sold in the second quarter of 2015. In 2014 our impairment provisions totaled $27.9 million. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $17.6 million in 2015. In the comparable period in 2014 we had a gain of $10.9 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2015 increased $17.6 million from 2014. The increase was primarily related to our proportionate share of gains totaling $16.5 million generated by the sale of ten properties owned by two of our joint ventures. In addition, in 2014 we recorded accelerated depreciation expense as a result of the demolition of a portion of centers for redevelopment and additional proceeds related to the 2011 sale of a joint venture property. Refer to Note 7 of the notes to the consolidated financial statements for additional information regarding our unconsolidated joint venture sales activity. Interest expense and amortization of deferred financing fees increased in 2015 by $7.0 million, or 20% from 2014, primarily due to the issuance of new senior unsecured notes and higher average loan balances on our credit facility. Gain on remeasurement of unconsolidated joint ventures in 2015 was $7.9 million, triggered by our acquisition of our partner's equity interest in seven properties. The gain on remeasurement represents the difference between the carrying value and the fair value of our previously held equity investment in the properties. In 2014, we recognized a similar gain of $0.1 million. Gain on extinguishment of debt of approximately $1.4 million in 2015 was related to the write-off of debt premiums associated with two mortgages that were repaid compared to a loss of $0.9 million in 2014 related to write-off of deferred financing costs associated with the early payoff of unsecured term loan debt. Liquidity and Capital Resources The majority of our cash is generated from operations and is dependent on the rents that we are able to charge and collect from our tenants. The principal uses of our liquidity and capital resources are for operations, developments, redevelopments, including expansion and renovation programs, acquisitions and debt repayment. In addition, we make quarterly dividend payments in accordance with REIT requirements for distributing the substantial majority of our taxable income on an annual basis. We anticipate that the combination of cash on hand, cash from operations, availability under our credit facilities, additional financings, equity offerings and the sale of existing properties will satisfy our expected working capital requirements through at least the next 12 months. Although we believe that the combination of factors discussed above will provide sufficient liquidity, no such assurance can be given. At December 31, 2016 and 2015, we had $14.7 million and $15.4 million, respectively, in cash and cash equivalents and restricted cash. Restricted cash was comprised primarily of funds held in escrow by lenders to pay real estate taxes, insurance premiums and certain capital expenditures, in addition to deposits on future acquisitions. Short-Term Liquidity Requirements Our short-term liquidity needs are met primarily from rental income and expense recoveries and consist primarily of funds necessary to pay operating expenses associated with our properties, interest and scheduled principal payments on our debt, quarterly dividend payments (including distributions to OP unit holders) and capital expenditures related to tenant improvements and redevelopment activities, as well as general corporate expenses. We believe that our cash on hand, retained cash flow from operations along with, availability under our revolving credit facility, issuance of equity, as well as other debt and equity alternatives is sufficient to meet these obligations. As of December 31, 2016 we had $263.5 million available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. We will continue to pursue the strategy of selling mature properties or non-core assets that no longer meet our investment criteria. Our ability to obtain acceptable selling prices and satisfactory terms and financing will impact the timing of future sales. We anticipate using net proceeds from the sale of properties to reduce outstanding debt and support current and future growth initiatives. We continually search for investment opportunities that may require additional capital and/or liquidity. As of December 31, 2016, we had one proposed property acquisition under contract and one property disposition under contract, subject to due diligence contingencies. Long-Term Liquidity Requirements Our long-term liquidity needs consist primarily of funds necessary to pay indebtedness at maturity, potential acquisitions of properties, redevelopment of existing properties, the development of land and non-recurring capital expenditures. The following is a summary of our cash flow activities: Operating Activities We anticipate that cash on hand, operating cash flows, borrowings under our revolving credit facility, issuance of equity, as well as other debt and equity alternatives, will provide the necessary capital that we require to operate. Net cash flow provided by operating activities increased $11.9 million in 2016 compared to 2015 primarily due to the following: • Operating income, adjusted for non-cash activity, increased $3.0 million; • net accounts receivable decreased $8.6 million; • accounts payable, accrued expenses and other liabilities, and other assets decreased approximately $1.5 million; • long-term and share-based compensation expense increased $1.9 million; and • net interest expense increased approximately $2.3 million due to the composition between senior unsecured notes and mortgage debt, as well as a higher average balances of our term loan and revolving credit facility. Investing Activities Net cash from investing activities increased $162.1 million compared to 2015 primarily due to: • Acquisitions of real estate decreased $139.9 million; • Development and capital improvements to real estate increased $11.1 million; • Net proceeds from the sale of real estate increased $45.0 million; and • Distributions from sales of joint venture properties decreased $12.8 million; and • Restricted cash increased $1.0 million. Financing Activities Cash flows used in financing activities were $127.9 million as compared to cash flows provided by financing activities of $46.5 million in 2015. This difference of $174.4 million is primarily explained by: • net proceeds from common share issuances decreased $17.3 million; • an increase in cash dividends to common shareholders of $3.7 million due an increase in our per share quarterly dividend payment; and • a decrease in cash paid for OP unit redemptions of $2.3 million; offset in part by • a decrease in net borrowings of $157.2 million including debt extinguishment costs and deferred financing costs. As of December 31, 2016, $263.5 million was available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. It is anticipated that additional funds borrowed under our credit facilities will be used for general corporate purposes, including working capital, capital expenditures, the repayment of indebtedness or other corporate activities. For further information on the credit facilities and other debt, refer to Note 8 of notes to the consolidated financial statements. Dividends and Equity We currently qualify, and intend to continue to qualify in the future, as a REIT under the Code. As a REIT, we must distribute to our shareholders at least 90% of our REIT taxable income annually, excluding net capital gain. Distributions paid are at the discretion of our Board and depend on our actual net income available to common shareholders, cash flow, financial condition, capital requirements, restrictions in financing arrangements, the annual distribution requirements under REIT provisions of the Code and such other factors as our Board deems relevant. We paid cash dividends of $0.85 per common share to shareholders in 2016. In the third quarter we increased our quarterly dividend 4.8% to $0.22 per share, or an annualized amount of $0.88 per share. Cash dividends for 2015 and 2014 were $0.8100 and $0.7625 per common share, respectively. Our dividend policy is to make distributions to shareholders of at least 90% of our REIT taxable income, excluding net capital gain, in order to maintain qualification as a REIT. On an annualized basis, our current dividend is above our estimated minimum required distribution. Distributions paid by us are funded from cash flows from operating activities. To the extent that cash flows from operating activities are insufficient to pay total distributions for any period, alternative funding sources could be used. Examples of alternative funding sources may include proceeds from sales of real estate and bank borrowings. Although we may use alternative sources of cash to fund distributions in a given period, we expect that distribution requirements for an entire year will be met with cash flows from operating activities. In June 2016, we terminated our previous controlled equity offering arrangement and commenced a new distribution agreement that registered up to 8.0 million common shares for issuance from time to time, in our sole discretion. The shares issuable in the new distribution agreement are registered with the Securities and Exchange Commission on our registration statement on Form S-3 (No. 333-211925). Off Balance Sheet Arrangements Real Estate Joint Ventures We consolidate entities in which we own less than 100% equity interest if we have a controlling interest or are the primary beneficiary in a variable interest entity, as defined in the Consolidation Topic of FASB ASC 810. From time to time, we enter into joint venture arrangements from which we believe we can benefit by owning a partial interest in one or more properties. As of December 31, 2016, our investments in unconsolidated joint ventures were approximately $3.2 million representing our ownership interest in three joint ventures. We accounted for these entities under the equity method. Refer to Note 6 of the notes to the consolidated financial statements for further information regarding our equity investments in unconsolidated joint ventures. We are engaged by our joint ventures to provide asset management, property management, leasing and investing services for such ventures' respective properties. We receive fees for our services, including a property management fee calculated as a percentage of gross revenues received. Contractual Obligations The following are our contractual cash obligations as of December 31, 2016: (1) Excludes $5.1 million of unamortized mortgage debt premium and $3.7 million in deferred financing costs. (2) Variable rate debt interest is calculated using rates at December 31, 2016. We anticipate that the combination of cash on hand, cash provided from operating activities, the availability under our credit facility ($263.5 million at December 31, 2016 subject to our compliance with certain covenants), our access to the capital markets and the potential sale of existing properties will satisfy our expected working capital requirements through at least the next 12 months. At December 31, 2016, we did not have any contractual obligations that required or allowed settlement, in whole or in part, with consideration other than cash. Mortgages and notes payable See the analysis of our debt included in “Liquidity and Capital Resources” above. Employment Contracts At December 31, 2016, we had employment contracts with our Chief Executive, Chief Financial and Chief Operating Officers, that contain minimum guaranteed compensation. All other employees are subject to at-will employment. Operating and Capital Leases We lease office space for our corporate headquarters under an operating lease that expires in August 2019. We have a capital lease at our Buttermilk Towne Center with the City of Crescent Springs, Kentucky. The lease provides for fixed annual payments of $0.1 million through maturity in December 2032, at which time we can acquire the center for one dollar. We also have a ground lease at Centennial Shops located in Edina, Minnesota. The lease includes rent escalations throughout the lease period and expires in April 2105. Construction Costs In connection with the development and expansion of various shopping centers as of December 31, 2016, we have entered into agreements for construction activities with an aggregate cost of approximately $5.9 million. Planned Capital Spending We are focused on our core strength of enhancing the value of our existing portfolio of shopping centers through successful leasing efforts and the completion of our redevelopment projects currently in process. For 2017, we anticipate spending between $60.0 million and $70.0 million for capital expenditures, of which $5.9 million is reflected in the construction commitments in the above contractual obligations table. The total anticipated spending relates to redevelopment projects, tenant improvements and leasing costs. Estimates for future spending will change as new projects are approved. Capitalization At December 31, 2016 our total market capitalization was $2.5 billion and is detailed below: At December 31, 2016, noncontrolling interests represented a 2.4% ownership in the Operating Partnership. The OP Units may, under certain circumstances, be exchanged for our common shares of beneficial interest on a one-for-one basis. We, as sole general partner of the Operating Partnership, have the option, but not the obligation, to settle exchanged OP Units held by others in cash. Assuming the exchange of all OP Units, there would have been 81,188,919 of our common shares of beneficial interest outstanding at December 31, 2016, with a market value of approximately $1.3 billion. Non-GAAP Financial Measures Certain of our key performance indicators are considered non-GAAP financial measures. Management uses these measures along with our GAAP financial statements in order to evaluate our operations results. We believe these additional measures provide users of our financial information additional comparable indicators of our industry, as well as our performance. Funds From Operations We consider funds from operations, also known as “FFO,” to be an appropriate supplemental measure of the financial performance of an equity REIT. Under the NAREIT definition, FFO represents net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of depreciable property and impairment provisions on depreciable real estate or on investments in non-consolidated investees that are driven by measurable decreases in the fair value of depreciable real estate held by the investee, plus depreciation and amortization, (excluding amortization of financing costs). Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect funds from operations on the same basis. In addition to FFO available to common shareholders, we include Operating FFO available to common shareholders as an additional measure of our financial and operating performance. Operating FFO excludes acquisition costs and periodic items such as impairment provisions on land available for development or sale, bargain purchase gains, accelerated amortization of debt premiums and gains or losses on extinguishment of debt that are not adjusted under the current NAREIT definition of FFO. We provide a reconciliation of FFO to Operating FFO. FFO and Operating FFO should not be considered alternatives to GAAP net income available to common shareholders or as alternatives to cash flow as measures of liquidity. While we consider FFO available to common shareholders and Operating FFO available to common shareholders useful measures for reviewing our comparative operating and financial performance between periods or to compare our performance to different REITs, our computations of FFO and Operating FFO may differ from the computations utilized by other real estate companies, and therefore, may not be comparable. We recognize the limitations of FFO and Operating FFO when compared to GAAP net income available to common shareholders. FFO and Operating FFO available to common shareholders do not represent amounts available for needed capital replacement or expansion, debt service obligations, or other commitments and uncertainties. In addition, FFO and Operating FFO do not represent cash generated from operating activities in accordance with GAAP and are not necessarily indicative of cash available to fund cash needs, including the payment of dividends. FFO and Operating FFO are simply used as additional indicators of our operating performance. The following table illustrates the calculations of FFO and Operating FFO: (1) Amount included in earnings (loss) from unconsolidated joint ventures. (2) The gain represents the difference between the carrying value and the fair value of our previously held equity investment in the joint properties triggered by disposals of joint venture properties. (3) The total noncontrolling interest reflects OP units convertible 1:1 into common shares. (4) Series D convertible preferred shares were dilutive for FFO for the years ended December 31, 2016 and 2015, were anti-dilutive for the comparable period in 2014. In 2016, our Series D convertible preferred shares paid annual dividends of $6.7 million and are currently convertible into approximately 6.6 million shares of common stock. They are dilutive only when earnings or FFO exceed approximately $1.01 per diluted share per year The conversion ratio is subject to adjustment based upon a number of factors, and such adjustment could affect the dilutive impact of the Series D convertible preferred shares on FFO and earnings per share in future periods. (5) The denominator to calculate diluted earnings per share excludes shares issuable upon conversion of Operating Partnership Units and preferred shares for all periods reported. In addition, the denominator to calculate diluted earnings per share also for the year ended December 31,2014 also excludes restricted share awards under the treasury method. Same Property Operating Income Same Property Operating Income ("Same Property NOI") is a supplemental non-GAAP financial measure of real estate companies' operating performance. Same Property NOI is considered by management to be a relevant performance measure of our operations because it includes only the NOI of comparable properties for the reporting period. Same Property NOI excludes acquisitions, dispositions and redevelopment properties. A property is designated as redevelopment when projected costs exceed $1.0 million, and the construction impacts approximately 20% or more of the income producing property's gross leasable area ("GLA") or the location and nature of the construction significantly impacts or disrupts the daily operations of the property. Redevelopment may also include a portion of certain properties designated as same property for which we are adding additional GLA or retenanting space. Same Property NOI is calculated using consolidated operating income and adjusted to exclude management and other fee income, depreciation and amortization, general and administrative expense, provision for impairment and non-comparable income/expense adjustments such as straight-line rents, lease termination fees, above/below market rents, and other non-comparable operating income and expense adjustments. Acquisition and redevelopment properties removed from the pool will not be added until owned and operated or construction is complete for the entirety of both periods being compared. Same Property NOI should not be considered an alternative to net income in accordance with GAAP or as a measure of liquidity. Our method of calculating Same Property NOI may differ from methods used by other REITs and, accordingly, may not be comparable to such other REITs. The following is a summary of our wholly owned properties for the periods noted with consistent classification in the prior period for presentation of Same Property NOI: The following is a reconciliation of our Operating Income to Same Property NOI: (1) Includes adjustments for items that affect the comparability of the same center NOI results. Such items include straight-line rents, net of reserves, above/below market rents, other non-comparable operating income/expense adjustments, and the effect of lease termination income/expense. (2) In Q416, the Company recorded a reserve adjustment to recovery income of $483 related to a three year utility billing dispute. Because the reserve adjustment consists of activity for a three year period and not Q416 specifically, the Company has made proforma adjustments for the amounts presented such that each of the periods are comparable. The proforma adjustments for the three months ended December 31, 2016 and 2015 result in a comparable reserve of $40 and the proforma adjustments for the twelve months ended December 31, 2016 and 2015 result in a comparable reserve of $161. The following table summarizing GLA and NOI at properties for which we are adding additional GLA or retenanting space. The property is included in same property NOI, however a portion of GLA and NOI is excluded. Inflation Inflation has been relatively low in recent years and has not had a significant impact on the results of our operations. Should inflation rates increase in the future, substantially all of our tenant leases contain provisions designed to partially mitigate the negative impact of inflation in the near term. Such lease provisions include clauses that require our tenants to reimburse us for real estate taxes and many of the operating expenses we incur. Also, many of our leases provide for periodic increases in base rent which are either of a fixed amount or based on changes in the consumer price index and/or percentage rents (where the tenant pays us rent based on a percentage of its sales). Significant inflation rate increases over a prolonged period of time may have a material adverse impact on our business. Recent Accounting Pronouncements Refer to Note 2 of the notes to the consolidated financial statements for a discussion of Recent Accounting Pronouncements.

<s>[INST] Overview We are a fully integrated, selfadministered, publiclytraded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multianchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2016, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 67 shopping centers, with approximately 15.0 million square feet of gross leasable area owned by us and our joint ventures. We also own various parcels of land available for development or for sale, the majority of which are adjacent to certain of our existing developed properties. We are predominantly a community shopping center company with a focus on managing and adding value to our portfolio of centers that are primarily multianchored by grocery stores and/or nationally recognized discount department stores. We believe that centers with a grocery and/or discount component attract consumers seeking valuepriced products. Since these products are required to satisfy everyday needs, customers often visit the centers on a weekly basis. Over half of our shopping centers are anchored by tenants that sell groceries. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger and Sprouts. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Home Depot and Dick's Sporting Goods. Our shopping centers are primarily located in a number of the largest metropolitan markets in the central United States. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics. Throughout our primary regions, we have concentrated a number of centers in reasonable proximity to each other in order to achieve efficiencies in management, leasing and acquiring new properties. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain noncontingent rent escalations for which we recognize income on a straightline basis over the noncancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straightline rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straightline rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. An allowance to write down the straightline receivable balance is taken in the period that future collectability is uncertain. Additionally, we provide for bad debt expense based upon the allowance method of accounting. We continuously monitor the collectability of our accounts receivable from specific tenants, analyze historical bad debts, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the adequacy of the allowance for bad debts. Allowances are taken for those balances that we have reason to believe will be uncollectible. For more information refer to Note 1 Organization and Summary of Significant Accounting Policies, Revenue Recognition and Accounts Receivable subtopics of the notes to the consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, the results of operations of an acquired property [/INST] Negative. </s>

RAMCO GERSHENSON PROPERTIES TRUST

2018-02-23

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements, the notes thereto, and the comparative summary of selected financial data appearing elsewhere in this report. Overview We are a fully integrated, self-administered, publicly-traded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multi-anchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage certain centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2017, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 59 shopping centers, with approximately 14.3 million square feet of gross leasable area owned by us and our joint ventures. We also own various parcels of land available for development or for sale, the majority of which are adjacent to certain of our existing developed properties. Our portfolio consists of town center and urban-infill neighborhood and power center properties that include national chain store tenants, market leading supermarket tenants, as well as a strong-line-up of smaller national retailers to optimize the overall merchandise mix. Our centers also include entertainment components, including theaters, fitness centers and restaurants, which, in addition to supermarkets, are daily drivers of consumer traffic at our properties. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Dick’s Sporting Goods, and Home Depot. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger, Aldi, and Sprouts. Theater, fitness and restaurant tenants include, among others, Regal Cinema, LA Fitness, Starbucks, Panera, and Rusty Bucket. Our shopping centers are primarily located in key growth markets in the 40 largest metropolitan markets in the United States such as Metro Detroit, Southeast Florida, Greater Denver, Cincinnati, St. Louis, Jacksonville, Tampa/Lakeland, Milwaukee, Chicago, Atlanta, and Minneapolis-St. Paul. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics and potentially take advantage of additional acquisition opportunities in these markets. Our consolidated portfolio was 93.3% leased at December 31, 2017 as compared to 94.4% at December 31, 2016. The decline in leased occupancy is primarily a result of the Gander Mountain, MC Sporting Goods and rue21 bankruptcies. Hurricane Irma In September 2017 Hurricane Irma made landfall in Florida where several of our shopping centers are located. Certain of these centers incurred minimal damage, primarily to rooftops, signage and landscaping, as a result of high winds. Overall, repair costs were less than $0.4 million which were partially offset by recovery income in accordance with our current tenant recovery rates. No centers incurred repairs that exceeded our insurance deductible. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain non-contingent rent escalations for which we recognize income on a straight-line basis over the non-cancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straight-line rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straight-line rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. An allowance to write down the straight-line receivable balance is taken in the period that future collectability is uncertain. Additionally, we provide for bad debt expense based upon the allowance method of accounting. We continuously monitor the collectability of our accounts receivable from specific tenants, analyze historical bad debts, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the adequacy of the allowance for bad debts. Allowances are taken for those balances that we have reason to believe will be uncollectible. For more information refer to Note 1 Organization and Summary of Significant Accounting Policies, Revenue Recognition and Accounts Receivable subtopics of the notes to the consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method and, accordingly, the results of operations of an acquired property are included in our results of operations from the date of acquisition. Estimates of fair values are based upon future cash flows and other valuation techniques in accordance with our fair value measurements policy, which are used to allocate the purchase price of acquired property among land, buildings on an “as if vacant” basis, tenant improvements, identifiable intangibles and any gain on purchase. Identifiable intangible assets and liabilities include the effect of above-and below-market leases, the value of having leases in place (“as-is” versus “as if vacant” and absorption costs), other intangible assets such as assumed tax increment revenue bonds and out-of-market assumed mortgages. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of 40 years for buildings, and over the remaining terms of any intangible asset contracts and the respective tenant leases, which may include bargain renewal options. The impact of these estimates, including estimates in connection with acquisition values and estimated useful lives, could result in significant differences related to the purchased assets, liabilities and subsequent depreciation or amortization expense. For more information, refer to Note 1, Organization and Summary of Significant Accounting Policies - Real Estate of the notes to the consolidated financial statements. Impairment We review our investment in real estate, including any related intangible assets, for impairment on a property-by-property basis whenever events or changes in circumstances indicate that the carrying value of the property may not be recoverable. These changes in circumstances include, but are not limited to, changes in occupancy, rental rates, tenant sales, net operating income, geographic location, real estate values and expected holding period. The viability of all projects under construction or development, including those owned by unconsolidated joint ventures, is regularly evaluated under applicable accounting requirements, including requirements relating to abandonment of assets or changes in use. To the extent a project or an individual component of the project, is no longer considered to have value, the related capitalized costs are charged against operations. Impairment provisions resulting from any event or change in circumstances, including changes in our intentions or our analysis of varying scenarios, could be material to our consolidated financial statements. We recognize an impairment of an investment in real estate when the estimated discounted or undiscounted cash flow is less than the net carrying value of the property. If it is determined that an investment in real estate is impaired, then the carrying value is reduced to the estimated fair value as determined by cash flow models and discount rates or comparable sales in accordance with our fair value measurement policy. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets for further information regarding impairment provisions. Results of Operations Comparison of the Year Ended December 31, 2017 to the Year Ended December 31, 2016 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items that have significantly changed during the year ended December 31, 2017 as compared to 2016: Total revenue in 2017 increased $4.2 million, or 1.6% from 2016. The increase is primarily due to the following: • $17.3 million increase related to acquisitions completed in 2017 and 2016; • $3.1 million increase at existing centers; offset by • $14.8 million decrease related to properties sold in 2017 and 2016; • $1.1 million decrease related to disposal of our office building; and a • $0.1 million decrease in management and other fee income The $3.1 million increase at existing centers was primarily the result of higher minimum rent. Recovery income from tenants decreased $1.4 million, or 2.2%, primarily due to lower net recoverable operating expenses and real estate taxes of $1.0 million. Recoverable operating expense in 2017 decreased $1.9 million, or (6.5)%, from 2016 primarily due to a decrease at existing centers of $1.3 million, as a result of lower spending, as well as a net decrease in operating expenses from acquisition and disposition activity of $0.6 million. Non-recoverable operating expense in 2017 increased $0.9 million, or 24.4%, from 2016 primarily due to ground rent expense at a property acquired in the fourth quarter of 2016. Real estate tax expense in 2017 increased $0.9 million, or 2.3%, from 2016, primarily due to incremental tax increases within existing properties of $0.6 million, as well as net tax increases from acquisition and disposition activity of $0.3 million. Depreciation and amortization expense in 2017 decreased $(0.5) million, or (0.5)%, from 2016. The net decrease was primarily attributable to tenant bankruptcy and vacancy write-offs in 2017 resulting in partial year expense recognition, lease origination costs reaching full amortization and a reduction in expense from property dispositions. The net decrease was partially offset by depreciation and amortization on new building and improvement assets and lease origination costs from the 2017 and 2016 acquisitions. General and administrative expense in 2017 increased $4.1 million, or 18.7%, from 2016. The increase was primarily due to increased costs associated with professional fees, the change in performance-based executive compensation recognized in the respective periods and an increase in wages. During 2017 we recorded an impairment provision totaling $9.4 million, of which $8.4 million was on shopping centers classified as income producing and $1.0 million on land held for development or sale. The adjustments were triggered by changes in associated sales price assumptions, a purchase price reduction at one property and changes in the expected use of the land. Impairment provisions of $1.0 million recorded in 2016 related to developable land held for sale triggered by unforeseen increases in development costs and changes in the associated sales price assumptions. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $52.8 million in 2017. In the comparable period in 2016 we had a gain of $35.8 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2017 decreased $0.2 million from 2016. The decrease was primarily due to the reduced level of properties in unconsolidated joint ventures for the majority of 2017 as compared to 2016. Interest expense increased in 2017 by $0.4 million, or 0.8% from 2016, primarily due to a 7% increase in our average outstanding debt and lower debt premium amortization, offset partially by a 30 basis point decline in our weighted average interest rate. Loss on extinguishment of debt of approximately $1.3 million in 2016 resulted from a $0.9 million loss upon the conveyance of our Aquia office property to the lender and a $0.4 million cash prepayment penalty on a mortgage payoff in 2016. There was no loss on extinguishment of debt in 2017. Comparison of the Year Ended December 31, 2016 to the Year Ended December 31, 2015 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items which have significantly changed during the year ended December 31, 2016 as compared to 2015: Total revenue in 2016 increased $9.1 million, or 3.6%, from 2015. The increase is primarily due to the following: • $16.0 million increase related to acquisitions completed in 2016 and 2015; • $3.9 million increase at existing centers; offset by • $9.2 million decrease related to properties sold in 2016 and 2015; • $1.2 million decrease in management and other fee income; and • $0.4 million decrease related to the disposal of our office building. Operating expense in 2016 decreased $1.7 million, or 4.9%, from 2015 primarily due to certain operating costs direct billed to tenants by the service provider which were previously part of the Company’s recovery cost, lower bad debt expense and our dispositions which were partially offset by the impact of a full year from our 2015 acquisitions. Real estate tax expense in 2016 increased $3.0 million, or 7.7%, from 2015, primarily due to our 2015 acquisitions and incremental tax increases within existing properties, partially offset by dispositions. Depreciation and amortization expense in 2016 increased $2.4 million, or 2.6%, from 2015. The increase was primarily related to a $4.5 million increase from our nine acquisitions in 2015, one acquisition in 2016, new development completion and other capital activities offset by a decrease of $2.2 million related to properties disposed of. General and administrative expense in 2016 increased $2.0 million, or 9.8%, from 2015. The increase was primarily due to increased costs associated with our long-term incentive plans, including increased stock compensation in 2016 related to a one-time award to our current Chief Financial Officer in December 2015. By way of contrast, general and administration expense in 2015 included a reversal of expense attributable to the resignation of our former Chief Financial Officer. Impairment provisions of $1.0 million recorded in 2016 related to developable land held for sale triggered by unforeseen increases in development costs and changes in the associated sales price assumptions. In 2015 our impairment provisions totaled $2.5 million related to our plan to sell certain land parcels that we had previously intended to develop. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $35.8 million in 2016. In the comparable period in 2015 we had a gain of $17.6 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2016 decreased $17.2 million from 2015. The decrease was primarily due to the reduced level of properties in unconsolidated joint ventures following sales in 2015. Interest expense increased in 2016 by $2.3 million, or 5.5% from 2015, primarily due to an 8% increase in our average outstanding debt, offset partially by a 15 basis point decline in our weighted average interest rate. Other gain on unconsolidated joint ventures in 2016 was $0.2 million, primarily due to the reduced level of activity in our unconsolidated joint ventures. In 2015 we acquired our partners' interest in seven properties. The 2015 gain of $7.9 million represents the difference between the carrying value and the fair value of our previously held equity investment in the seven properties. In 2016 only a single property was disposed of by a joint venture. Loss on extinguishment of debt of approximately $1.3 million in 2016 resulted from a $0.9 million loss upon the conveyance of our Aquia office property to the lender and a $0.4 million cash prepayment penalty on a mortgage payoff in 2016 with an original maturity of April 2017 in order to issue unsecured long term financing at a lower interest rate. The gain of $1.4 million in 2015 related to the write-off of debt premiums associated with the early payoff of corresponding debt. Liquidity and Capital Resources Our primary uses of capital include principal and interest payments on our outstanding indebtedness, recurring capital expenditures such as tenant improvements, leasing commissions, improvements made to individual properties, shareholder dividends, redevelopments, operating expenses of our business, debt maturities, acquisitions and developments. We generally strive to cover our principal and interest payments, operating expenses, shareholder distributions, and recurring capital expenditures from cash flow from operations, although from time to time we may borrow or sell assets to finance a portion of those uses. We believe the combination of cash flow from operations, cash balances, available borrowings under our Unsecured Credit Facility, issuance of long-term debt, property dispositions, and issuance of equity securities will provide adequate capital resources to fund all of our expected uses over at least the next 12 months. Although we believe that the combination of factors discussed above will provide sufficient liquidity, no such assurance can be given. We believe our current capital structure provides us with the financial flexibility to fund our current capital needs. We intend to continue to enhance our financial and operational flexibility by extending the duration of our debt, appropriately ladder our debt maturities and further expand our unencumbered asset base. In addition, we believe we have access to multiple forms of capital which includes unsecured corporate debt, preferred and common equity including our at-the-market equity program we have in place. At December 31, 2017 and 2016, we had $12.9 million and $14.7 million, respectively, in cash and cash equivalents and restricted cash. Restricted cash was comprised primarily of funds held in escrow by lenders to pay real estate taxes, insurance premiums and certain capital expenditures, in addition to deposits on potential future acquisitions. In the fourth quarter of 2017 we repaid $36.3 million of mortgage debt originally scheduled to mature in early 2018. As of December 31, 2017 we had no debt maturing in 2018. As of December 31, 2017 we had $318.7 million available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. Our long-term liquidity needs consist primarily of funds necessary to pay indebtedness at maturity, potential acquisitions of properties, redevelopment of existing properties, the development of land and non-recurring capital expenditures. We continually search for investment opportunities that may require additional capital and/or liquidity, which will afford us the opportunity to significantly increase our return on total investment. We will continue to pursue the strategy of selling mature properties or non-core assets that no longer meet our investment criteria. Our ability to obtain acceptable selling prices and satisfactory terms and financing will impact the timing of future sales. We anticipate using net proceeds from the sale of properties to reduce outstanding debt and support current and future growth initiatives. To the extent that asset sales are not sufficient to meet our long-term liquidity needs, we expect to meet such needs by incurring debt or issuing equity. The following is a summary of our cash flow activities: Operating Activities Net cash flow provided by operating activities increased $0.3 million in 2017 compared to 2016 primarily due to the following: • Operating income, adjusted for non-cash activity, increased $0.5 million; • net accounts receivable decreased $3.8 million; • accounts payable, accrued expenses and other liabilities, and other assets increased approximately $2.8 million; and • long-term and share-based compensation expense increased $0.9 million. Investing Activities Net cash used in investing activities increased $18.1 million compared to 2016 primarily due to: • Acquisitions of real estate increased $152.9 million; • Development and capital improvements to real estate decreased $8.8 million; • Net proceeds from the sale of real estate increased $125.5 million; • Distributions from sales of joint venture properties decreased $1.3 million; and • Restricted cash increased $1.8 million. In early 2017 we acquired two properties at a combined gross purchase price of $164.3 million, net of $4.0 million paid in the previous year as deposits and three outparcel acquisitions throughout the year with a combined gross purchase price of $1.6 million. In 2016 we acquired one property in the fourth quarter for $32.0 million. Proceeds of $19.0 million from a prior disposal were placed into escrow at closing and subsequently released for the 2016 acquisition under an Internal Revenue Code Section 1031 exchange. At December 31, 2017, we had six properties under redevelopment or expansion that have an estimated cost of $73.7 million, of which $33.9 million remains to be invested. Completion for these projects is expected over the next year. During 2017 we closed eleven property dispositions, a Walgreen’s Data Center and five outparcel sales with aggregate net selling proceeds of $216.5 million. In 2016 we sold six properties and six outparcels with aggregate net selling proceeds of $91.0 million. Refer to Note 4 Property Acquisitions and Dispositions of the notes to the consolidated financial statements for additional information related to dispositions. Financing Activities Net cash used in financing activities decreased $25.4 million compared to 2016 primarily due to: • costs associated with our share distribution agreement decreased $0.2 million; • an increase in cash dividends to common shareholders of $2.5 million primarily due to an increase in our per share quarterly dividend payment; • a decrease in cash paid for OP unit redemptions of $1.5 million; • an increase in cash paid for taxes on restricted stock vesting of (0.1) million; and • a decrease in net borrowings of $26.2 million including debt extinguishment costs and deferred financing costs. As of December 31, 2017, $318.7 million was available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. It is anticipated that additional funds borrowed under our credit facilities will be used for general corporate purposes, including working capital, capital expenditures, the repayment of indebtedness or other corporate activities. For further information on the credit facilities and other debt, refer to Note 8 of notes to the consolidated financial statements. Dividends and Equity We currently qualify, and intend to continue to qualify in the future, as a REIT under the Code. As a REIT, we must distribute to our shareholders at least 90% of our REIT taxable income annually, excluding net capital gain. Distributions paid are at the discretion of our Board and depend on our actual net income available to common shareholders, cash flow, financial condition, capital requirements, restrictions in financing arrangements, the annual distribution requirements under REIT provisions of the Code and such other factors as our Board deems relevant. We paid cash dividends of $0.88 per common share to shareholders in 2017. Cash dividends for 2016 and 2015 were $0.85 and $0.81 per common share, respectively. Our dividend policy is to make distributions to shareholders of at least 90% of our REIT taxable income, excluding net capital gain, in order to maintain qualification as a REIT. On an annualized basis, our current dividend is above our estimated minimum required distribution. Distributions paid by us are expected to be funded from cash flows from operating activities. To the extent that cash flows from operating activities are insufficient to pay total distributions for any period, alternative funding sources could be used. Examples of alternative funding sources may include proceeds from sales of real estate and bank borrowings. As of December 31, 2017 we had $318.7 million available to be drawn on our $350.0 million unsecured revolving credit facility subject to compliance with certain covenants. In June 2016, we terminated our previous controlled equity offering arrangement and commenced a new distribution agreement that registered up to 8.0 million common shares for issuance from time to time, in our sole discretion. The shares issuable in the new distribution agreement are registered with the Securities and Exchange Commission on our registration statement on Form S-3 (No. 333-211925). Debt At December 31, 2017, we had $30.0 million outstanding on our revolving credit facility, $120.9 million of fixed rate mortgage loans encumbering certain properties, $210.0 million of unsecured term loan facilities, $610.0 million in senior unsecured notes and $28.1 million of junior subordinated notes. In 2017, we completed eleven property and five land dispositions, generating net proceeds of approximately $216.5 million. Proceeds from these dispositions were used to fund the acquisition of two properties, net of previous deposits, for $164.3 million and repay borrowings under our revolving credit facility. On September 14, 2017, we closed on our amended and restated $350.0 million unsecured revolving credit facility. The credit facility matures September 2021 and may be extended one year to 2022 through two six-month options. Borrowings on the credit facility will be priced at LIBOR plus a margin of between 1.30% and 1.95% based on our leverage ratio as calculated under the credit facility. Additionally, the facility allows for increased borrowing capacity up to $650.0 million through an accordion feature. In December 2017, we issued $75.0 million senior unsecured notes. The notes were issued in three maturity tranches as follows: $25.0 million, maturing 2022, at a rate of 4.13%; $30.0 million maturing 2027, at a rate of 4.57%; and $20.0 million maturing 2029, at a rate of 4.72%. Proceeds from this issuance were used to repay without penalty $36.3 million of mortgage debt originally scheduled to mature in early 2018 and for general corporate purposes. In November 2017, we amended and repriced our $75.0 million term loan due 2021 to reduce the loans interest rate by 35 basis points for the remainder of the term. In addition, we had interest rate swap derivative instruments in effect for an aggregate notional amount of $270.0 million converting a portion of our floating rate corporate debt to fixed rate debt. After taking into account the impact of converting our variable rate debt to fixed rate debt by use of the interest rate swap agreements, at December 31, 2017, we had $58.1 million of variable rate debt outstanding. Off Balance Sheet Arrangements Real Estate Joint Ventures We consolidate entities in which we own less than 100% equity interest if we have a controlling interest or are the primary beneficiary in a variable interest entity, as defined in the Consolidation Topic of FASB ASC 810. From time to time, we enter into joint venture arrangements from which we believe we can benefit by owning a partial interest in one or more properties. As of December 31, 2017, our investments in unconsolidated joint ventures were approximately $3.5 million representing our ownership interest in four joint ventures. We accounted for these entities under the equity method. Refer to Note 6 of the notes to the consolidated financial statements for further information regarding our equity investments in unconsolidated joint ventures. We are engaged by certain our joint ventures to provide asset management, property management, leasing and investing services for such ventures' respective properties. We receive fees for our services, including a property management fee calculated as a percentage of gross revenues received. Contractual Obligations The following are our contractual cash obligations as of December 31, 2017: (1) Excludes $4.0 million of unamortized mortgage debt premium and $3.8 million in deferred financing costs. (2) Variable rate debt interest is calculated using rates at December 31, 2017. At December 31, 2017, we did not have any contractual obligations that required or allowed settlement, in whole or in part, with consideration other than cash. Mortgages and notes payable See the analysis of our debt included in “Liquidity and Capital Resources” above. Employment Contracts At December 31, 2017, we had employment contracts with our Chief Executive, Chief Financial and Chief Operating Officers, that contain minimum guaranteed compensation. Operating and Capital Leases We lease office space for our corporate headquarters under an operating lease that expires in August 2019. We have a capital ground lease at our Buttermilk Towne Center with the City of Crescent Springs, Kentucky. The lease provides for fixed annual payments of $0.1 million through maturity in December 2032, at which time we can acquire the land for one dollar. We also have an operating ground lease at Centennial Shops located in Edina, Minnesota. The lease includes rent escalations throughout the lease period and expires in April 2105. Construction Costs In connection with the development and expansion of various shopping centers as of December 31, 2017, we have entered into agreements for construction activities with an aggregate cost of approximately $20.8 million. Planned Capital Spending We are focused on enhancing the value of our existing portfolio of shopping centers through successful leasing efforts and the completion of our redevelopment projects currently in process. For 2018, we anticipate spending between $80.0 million and $100.0 million for capital expenditures, of which $20.8 million is reflected in the construction commitments in the above contractual obligations table. The total anticipated spending relates to redevelopment projects, tenant improvements and leasing costs. Estimates for future spending will change as new projects are approved. Capitalization At December 31, 2017 our total market capitalization was $2.3 billion and is detailed below: At December 31, 2017, noncontrolling interests represented a 2.3% ownership in the Operating Partnership. The OP Units may, under certain circumstances, be exchanged for our common shares of beneficial interest on a one-for-one basis. We, as sole general partner of the Operating Partnership, have the option, but not the obligation, to settle exchanged OP Units held by others in cash. Assuming the exchange of all OP Units, there would have been 81,282,641 of our common shares of beneficial interest outstanding at December 31, 2017, with a market value of approximately $1.2 billion. Non-GAAP Financial Measures Certain of our key performance indicators are considered non-GAAP financial measures. Management uses these measures along with our GAAP financial statements in order to evaluate our operations results. We believe these additional measures provide users of our financial information additional comparable indicators of our industry, as well as our performance. Funds From Operations We consider funds from operations, also known as “FFO,” to be an appropriate supplemental measure of the financial performance of an equity REIT. Under the NAREIT definition, FFO represents net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of depreciable property and impairment provisions on depreciable real estate or on investments in non-consolidated investees that are driven by measurable decreases in the fair value of depreciable real estate held by the investee, plus depreciation and amortization, (excluding amortization of financing costs). Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect funds from operations on the same basis. In addition to FFO available to common shareholders, we include Operating FFO available to common shareholders as an additional measure of our financial and operating performance. Operating FFO excludes acquisition costs and periodic items such as impairment provisions on land available for development or sale, bargain purchase gains, accelerated amortization of debt premiums and gains or losses on extinguishment of debt that are not adjusted under the current NAREIT definition of FFO. We provide a reconciliation of FFO to Operating FFO. FFO and Operating FFO should not be considered alternatives to GAAP net income available to common shareholders or as alternatives to cash flow as measures of liquidity. While we consider FFO available to common shareholders and Operating FFO available to common shareholders useful measures for reviewing our comparative operating and financial performance between periods or to compare our performance to different REITs, our computations of FFO and Operating FFO may differ from the computations utilized by other real estate companies, and therefore, may not be comparable. We recognize the limitations of FFO and Operating FFO when compared to GAAP net income available to common shareholders. FFO and Operating FFO available to common shareholders do not represent amounts available for needed capital replacement or expansion, debt service obligations, or other commitments and uncertainties. In addition, FFO and Operating FFO do not represent cash generated from operating activities in accordance with GAAP and are not necessarily indicative of cash available to fund cash needs, including the payment of dividends. FFO and Operating FFO are simply used as additional indicators of our operating performance. The following table illustrates the calculations of FFO and Operating FFO: (1) Amount included in earnings (loss) from unconsolidated joint ventures. (2) The gain represents the difference between the carrying value and the fair value of our previously held equity investment in the joint properties triggered by disposals of joint venture properties. (3) The total noncontrolling interest reflects OP units convertible 1:1 into common shares. (4) In 2017, our Series D convertible preferred shares paid annual dividends of $6.7 million and are currently convertible into approximately 6.7 million shares of common stock. They are dilutive only when earnings or FFO exceed approximately $1.00 per diluted share per year The conversion ratio is subject to adjustment based upon a number of factors, and such adjustment could affect the dilutive impact of the Series D convertible preferred shares on FFO and earnings per share in future periods. (5) The denominator to calculate diluted earnings per share excludes shares issuable upon conversion of Operating Partnership Units and preferred shares for all periods reported. Same Property Operating Income Same Property Operating Income ("Same Property NOI with Redevelopment") is a supplemental non-GAAP financial measure of real estate companies' operating performance. Same Property NOI with Redevelopment is considered by management to be a relevant performance measure of our operations because it includes only the NOI of comparable properties for the reporting period. Same Property NOI with Redevelopment excludes acquisitions and dispositions. Same Property NOI with Redevelopment is calculated using consolidated operating income and adjusted to exclude management and other fee income, depreciation and amortization, general and administrative expense, provision for impairment and non-comparable income/expense adjustments such as straight-line rents, lease termination fees, above/below market rents, and other non-comparable operating income and expense adjustments. In addition to Same Property NOI with Redevelopment, the Company also believes Same Property NOI without Redevelopment to be a relevant performance measure of our operations. Same Property NOI without Redevelopment follows the same methodology as Same Property NOI with Redevelopment, however it excludes redevelopment activity that significantly impacts the entire property, as well as lesser redevelopment activity where we are adding GLA or retenanting a specific space. A property is designated as redevelopment when projected costs exceed $1.0 million, and the construction impacts approximately 20% or more of the income producing property's gross leasable area ("GLA") or the location and nature of the construction significantly impacts or disrupts the daily operations of the property. Redevelopment may also include a portion of certain properties designated as same property for which we are adding additional GLA or retenanting space. Same Property NOI should not be considered an alternative to net income in accordance with GAAP or as a measure of liquidity. Our method of calculating Same Property NOI may differ from methods used by other REITs and, accordingly, may not be comparable to such other REITs. The following is a summary of our wholly owned properties for the periods noted with consistent classification in the prior period for presentation of Same Property NOI: (1) Includes the following properties for the three and twelve months ended December 31, 2017 and 2016: Centennial Shops, Providence Marketplace and Webster Place. (2) Includes the following properties for the three months ended December 31, 2017 and 2016: Deerfield Towne Center, Hunter’s Square, Woodbury Lakes and West Oaks. The entire property indicated for each period is completely excluded from the same property NOI. The following is a reconciliation of our Operating Income to Same Property NOI: (1) The NOI from Redevelopment adjustments represent 100% of the NOI related to Deerfield Towne Center, Hunter’s Square, Woodbury Lakes and West Oaks, and a portion of the NOI related to specific GLA at Spring Meadows, The Shoppes at Fox River II, The Shops on Lane Avenue, Mission Bay, River City Marketplace and Town & Country for the periods presented. Because of the redevelopment activity, the center or specific space is not considered comparable for the periods presented and adjusted out of Same Property NOI with Redevelopment in arriving at Same Property NOI without Redevelopment. The following table summarizing GLA and NOI at properties for which we are adding additional GLA or retenanting space. The property is included in same property NOI, however a portion of GLA and NOI is excluded. Inflation Inflation has been relatively low in recent years and has not had a significant impact on the results of our operations. Should inflation rates increase in the future, substantially all of our tenant leases contain provisions designed to partially mitigate the negative impact of inflation in the near term. Such lease provisions include clauses that require our tenants to reimburse us for real estate taxes and many of the operating expenses we incur. Also, many of our leases provide for periodic increases in base rent which are either of a fixed amount or based on changes in the consumer price index and/or percentage rents (where the tenant pays us rent based on a percentage of its sales). Significant inflation rate increases over a prolonged period of time may have a material adverse impact on our business. Recent Accounting Pronouncements Refer to Note 2 of the notes to the consolidated financial statements for a discussion of Recent Accounting Pronouncements.

<s>[INST] Overview We are a fully integrated, selfadministered, publiclytraded REIT specializing in the ownership, management, development and redevelopment of community shopping centers. Most of our properties are multianchored by supermarkets and/or national chain stores. Our primary business is managing and leasing space to tenants in the shopping centers we own. We also manage certain centers for our unconsolidated joint ventures for which we charge fees. Our credit risk, therefore, is concentrated in the retail industry. At December 31, 2017, we owned and managed, either directly or through our interest in real estate joint ventures, a total of 59 shopping centers, with approximately 14.3 million square feet of gross leasable area owned by us and our joint ventures. We also own various parcels of land available for development or for sale, the majority of which are adjacent to certain of our existing developed properties. Our portfolio consists of town center and urbaninfill neighborhood and power center properties that include national chain store tenants, market leading supermarket tenants, as well as a stronglineup of smaller national retailers to optimize the overall merchandise mix. Our centers also include entertainment components, including theaters, fitness centers and restaurants, which, in addition to supermarkets, are daily drivers of consumer traffic at our properties. National chain anchor tenants in our centers include, among others, TJ Maxx/Marshalls, Bed Bath and Beyond, Dick’s Sporting Goods, and Home Depot. Supermarket anchor tenants in our centers include, among others, Publix Super Market, Whole Foods, Kroger, Aldi, and Sprouts. Theater, fitness and restaurant tenants include, among others, Regal Cinema, LA Fitness, Starbucks, Panera, and Rusty Bucket. Our shopping centers are primarily located in key growth markets in the 40 largest metropolitan markets in the United States such as Metro Detroit, Southeast Florida, Greater Denver, Cincinnati, St. Louis, Jacksonville, Tampa/Lakeland, Milwaukee, Chicago, Atlanta, and MinneapolisSt. Paul. Our focus on these markets has enabled us to develop a thorough understanding of their unique characteristics and potentially take advantage of additional acquisition opportunities in these markets. Our consolidated portfolio was 93.3% leased at December 31, 2017 as compared to 94.4% at December 31, 2016. The decline in leased occupancy is primarily a result of the Gander Mountain, MC Sporting Goods and rue21 bankruptcies. Hurricane Irma In September 2017 Hurricane Irma made landfall in Florida where several of our shopping centers are located. Certain of these centers incurred minimal damage, primarily to rooftops, signage and landscaping, as a result of high winds. Overall, repair costs were less than $0.4 million which were partially offset by recovery income in accordance with our current tenant recovery rates. No centers incurred repairs that exceeded our insurance deductible. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain noncontingent rent escalations for which we recognize income on a straightline basis over the noncancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straightline rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straightline rent receivable balance to [/INST] Positive. </s>

RPT Realty

2019-02-21

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements, the notes thereto, and the comparative summary of selected financial data appearing elsewhere in this report. Overview RPT Realty owns and operates a national portfolio of open-air shopping destinations principally located in top U.S. markets. As of December 31, 2018, our property portfolio consisted of 51 shopping centers (including one shopping center owned through a joint venture) representing 12.4 million square feet of gross leasable area. As of December 31, 2018, the Company's aggregate portfolio was 94.3% leased. In 2018, the new executive management team completed several key foundational objectives which included the streamlining of the organizational platform, resetting the company culture, conducting a strategic asset review that resulted in the decision to sell approximately $200 million of non-core assets, cultivating a redevelopment pipeline and changing the name of the Company to RPT Realty. The asset sale proceeds are expected to be re-allocated into the Company’s balance sheet to lower leverage, as well as fund its near-term accretive internal growth initiatives, including the reconfiguration of anchor boxes and the lease up of small shop occupancy. Our goal is to be a dominant shopping center owner, with a focus on the following: • Own and manage high quality open-air shopping centers predominantly concentrated in the top U.S. metro areas; • Maintain value creation redevelopment and expansion pipeline; • Maximize balance sheet liquidity and flexibility; and • Retain motivated, talented and high performing employees. Key methods to achieve our strategy: • Deliver above average relative shareholder return and generate outsized consistent and sustainable same property NOI and Operating FFO per share growth; • Pursue selective redevelopment projects with significant pre-leasing for which we expect to achieve attractive returns on investment; • Sell assets that no longer meet our long-term strategy and redeploy the proceeds to lease, redevelop and acquire assets in our core markets; • Achieve lower leverage while maintaining low variable interest rate risk; and • Retain access to diverse sources of capital, maintain liquidity through borrowing capacity under our unsecured line of credit and minimize the amount of debt maturities in a single year. The following highlights the Company's significant transactions, events and results that occurred during the year ended December 31, 2018: Financial Results: • Net income available to common shareholders was $10.9 million, or $0.13 per diluted share, for the year ended December 31, 2018, as compared to $62.4 million, or $0.78 per diluted share, for the same period in 2017. • Funds from operations ("FFO") was $109.4 million, or $1.23 per diluted share, for the year ended December 31, 2018, as compared to $118.6 million, or $1.34 per diluted share, for the same period in 2017 (see additional disclosure on FFO beginning on page 36). • Operating funds from operations ("Operating FFO") was $120.1 million, or $1.35 per diluted share, for the year ended December 31, 2018, as compared to $119.6 million, or $1.36 per diluted share, for the same period in 2017 (see additional disclosure on FFO beginning on page 36). • Same property net operating income with redevelopment increased 2.9% for the year ended December 31, 2018, as compared to the same period in 2017 (see additional disclosure on FFO beginning on page 38). • Executed 288 new leases and renewals, totaling approximately 1.6 million square feet. • As of December 31, 2018, the consolidated portfolio leased rate was 94.3%, as compared to 93.3% at December 31, 2017. Acquisition Activity (See Note 4 of the Notes to Consolidated Financial Statements included in this Form 10-K): • Acquired leasehold interest in one operating property for a purchase price of $6.4 million. Disposition Activity (See Note 4 of the Notes to Consolidated Financial Statements included in this Form 10-K): • Disposed of six operating properties and three land parcels for aggregate gross proceeds of $125.1 million. These transactions resulted in (i) an aggregate gain on real estate of $4.0 million and (ii) an aggregate impairment charge of $5.9 million. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain non-contingent rent escalations for which we recognize income on a straight-line basis over the non-cancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straight-line rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straight-line rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. An allowance to write down the straight-line receivable balance is taken in the period that future collectability is uncertain. Additionally, we provide for bad debt expense based upon the allowance method of accounting. We continuously monitor the collectability of our accounts receivable from specific tenants, analyze historical bad debts, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the adequacy of the allowance for bad debts. Allowances are taken for those balances that we have reason to believe will be uncollectible. For more information refer to Note 1 Organization and Summary of Significant Accounting Policies, Revenue Recognition and Accounts Receivable subtopics of the notes to the consolidated financial statements. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method (which requires all assets acquired and liabilities assumed be measured at acquisition date fair value) and, accordingly, the results of operations of an acquired property are included in our results of operations from the date of acquisition. Estimates of fair values are based upon future cash flows and other valuation techniques in accordance with our fair value measurements policy, which are used to allocate the purchase price of acquired property among land, buildings on an “as if vacant” basis, tenant improvements, identifiable intangibles and any gain on purchase. Identifiable intangible assets and liabilities include the effect of above-and below-market leases, the value of having leases in place (“as-is” versus “as if vacant” and absorption costs), other intangible assets such as assumed tax increment revenue bonds and out-of-market assumed mortgages. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of 40 years for buildings, and over the remaining terms of any intangible asset contracts and the respective tenant leases, which may include bargain renewal options. The impact of these estimates, including estimates in connection with acquisition values and estimated useful lives, could result in significant differences related to the purchased assets, liabilities and subsequent depreciation or amortization expense. For more information, refer to Note 1, Organization and Summary of Significant Accounting Policies - Real Estate of the notes to the consolidated financial statements. Impairment We review our investment in real estate, including any related intangible assets, for impairment on a property-by-property basis whenever events or changes in circumstances indicate that the carrying value of the property may not be recoverable. These changes in circumstances include, but are not limited to, changes in occupancy, rental rates, tenant sales, net operating income, geographic location, real estate values and expected holding period. The viability of all projects under construction or development, including those owned by unconsolidated joint ventures, is regularly evaluated under applicable accounting requirements, including requirements relating to abandonment of assets or changes in use. To the extent a project or an individual component of the project, is no longer considered to have value, the related capitalized costs are charged against operations. Impairment provisions resulting from any event or change in circumstances, including changes in our intentions or our analysis of varying scenarios, could be material to our consolidated financial statements. We recognize an impairment of an investment in real estate when the estimated undiscounted cash flow are less than the net carrying value of the property. If it is determined that an investment in real estate is impaired, then the carrying value is reduced to the estimated fair value as determined by cash flow models and discount rates or comparable sales in accordance with our fair value measurement policy. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets for further information regarding impairment provisions. Results of Operations Comparison of the Year Ended December 31, 2018 to the Year Ended December 31, 2017 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items that have significantly changed during the year ended December 31, 2018 as compared to 2017: Total revenue in 2018 decreased $4.5 million, or (1.7)%, from 2017. The decrease is primarily due to the following: • $20.1 million decrease related to properties sold in 2018 and 2017; offset by • $7.7 million increase related to our existing centers largely attributable to changes in estimates associated with recoveries of common area maintenance and real estate taxes, and higher minimum rent; • $5.2 million increase from acceleration of a below market lease attributable to a specific tenant who vacated prior to the original estimated lease termination date; and • $2.7 million increase related to properties acquired in 2017 and a leasehold interest acquired in 2018. Real estate tax expense in 2018 decreased $0.4 million, or (0.9)%, from 2017 primarily due to properties sold during 2018 and 2017, partially offset by properties acquired in 2017 and higher net expense; specifically at two properties as a result of a change in estimates. Recoverable operating expense in 2018 decreased $1.5 million, or (5.3)%, from 2017 primarily due to properties sold during 2018 and 2017, partially offset by additional expense from properties acquired in 2017. Non-recoverable operating expense in 2018 remained flat from 2017. Depreciation and amortization expense in 2018 decreased $4.0 million, or (4.4)%, from 2017. The decrease is primarily a result of properties sold during 2018 and 2017, partially offset by higher asset write offs in 2018 for tenant lease terminations prior to their original estimated term, and higher depreciation expense from acquisitions completed in 2017. During 2018 we recorded acquisition costs of $0.2 million related to legal and professional fees associated with a potential shopping center acquisition that was abandoned during the year. General and administrative expense in 2018 increased $7.9 million, or 30.5%, from 2017. The increase was primarily due to the following: • $9.7 million of executive management reorganization expenses, which included severance costs associated with former executives as well as executive recruiting fees, sign on bonuses and relocation fees associated with the new executive team; • $0.8 million of severance costs resulting from the reduction-in-force associated with the reorganization of the Company's operating structure; offset by • $0.8 million decrease in service-based and performance-based stock compensation expense; and • $0.5 million decrease in other severance costs. During 2018 we recorded an impairment provision totaling $13.7 million, of which $13.4 million was on shopping centers classified as income producing and $0.2 million on land held for development. The adjustments related to shopping centers were triggered by changes in associated market prices and expected hold period assumptions, as well as a purchase price reduction at one property. The provision related to land held for development was triggered by changes in the expected use of the land and higher costs. During 2017 we recorded an impairment provision totaling $9.4 million, of which $8.4 million was on shopping centers classified as income producing and $1.0 million on land held for development. The adjustments were triggered by changes in associated sales price assumptions, a purchase price reduction at one property and changes in the expected use of land. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $4.0 million in 2018. In the comparable period in 2017 we had a gain of $52.8 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2018 increased $0.3 million from 2017. The increase was primarily due to our portion of the gain on sale of the Martin Square property which was disposed of by our joint venture during the year compared to no disposals by our unconsolidated joint ventures in the comparable period. Interest expense decreased in 2018 by $1.4 million, or (3.2)% from 2017. The decrease is primarily a result of an 8% decrease in our average outstanding debt, offset partially by a 45 basis point increase in our weighted average interest rate. The decline in our average outstanding debt is primarily a result of using proceeds from asset sales in the second half of 2017 to paydown our revolving credit line. Other gain on unconsolidated joint ventures increased $5.2 million primarily due to the sale of the Martin Square property by our joint venture during the year. The gain represents the difference between our share of the distributed proceeds and the carrying value of our equity investment in the joint venture. Comparison of the Year Ended December 31, 2017 to the Year Ended December 31, 2016 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items which have significantly changed during the year ended December 31, 2017 as compared to 2016: Total revenue in 2017 increased $4.2 million, or 1.6%, from 2016. The increase is primarily due to the following: • $17.3 million increase related to acquisitions completed in 2017 and 2016; • $3.1 million increase at existing centers; offset by • $14.8 million decrease related to properties sold in 2017 and 2016; • $1.1 million decrease related to disposal of our office building; and a • $0.1 million decrease in management and other fee income. The $3.1 million increase at existing centers was primarily the result of higher minimum rent. Recovery income from tenants decreased $1.4 million, or 2.2%, primarily due to lower net recoverable operating expenses and real estate taxes of $1.0 million. Real estate tax expense in 2017 increased $0.9 million, or 2.3%, from 2016 primarily due to incremental tax increases within existing properties of $0.6 million, as well as net tax increases from acquisition and disposition activity of $0.3 million. Recoverable operating expense in 2017 decreased $1.9 million, or (6.5)%, from 2016 primarily due to a decrease at existing centers of $1.3 million, as a result of lower spending, as well as a net decrease in operating expenses from acquisition and disposition activity of $0.6 million. Non-recoverable operating expense in 2017 increased $1.1 million. or 30.5%, from 2016 primarily due to ground rent expense at a property acquired in the fourth quarter of 2016. Depreciation and amortization expense in 2017 decreased $0.5 million, or (0.5)%, from 2016. The net decrease was primarily attributable to tenant bankruptcy and vacancy write-offs in 2017 resulting in partial year expense recognition, lease origination costs reaching full amortization and a reduction in expense from property dispositions. The net decrease was partially offset by depreciations and amortization on new building and improvement assets and lease origination costs from the 2017 and 2016 acquisitions. General and administrative expense in 2017 increased $3.9 million, or 17.7%, from 2016. The increase was primarily due to increased costs associated with professional fees, the change in performance-based executive compensation recognized in the respective periods and an increase in wages. During 2017 we recorded an impairment provision totaling $9.4 million, of which $8.4 million was on shopping centers classified as income producing and $1.0 million on land held for development or sale. The adjustments were triggered by changes in associated sales price assumptions, a purchase price reduction at one property and changes in the expected use of the land. Impairment provisions of $1.0 million recorded in 2016 related to developable land held for sale triggered by unforeseen increases in development costs and changes in associated sales price assumptions. Refer to Note 1 Organization and Summary of Significant Accounting Policies - Accounting for the Impairment of Long-Lived Assets of the notes to the consolidated financial statements for further information related to impairment provisions. Gain on sale of real estate was $52.8 million in 2017. In the comparable period in 2016 we had a gain of $35.8 million. Refer to Note 4 of the notes to the consolidated financial statements for further detail on dispositions. Earnings from unconsolidated joint ventures in 2017 decreased $0.2 million from 2016. The decrease was primarily due to the reduced level of properties in unconsolidated joint ventures for the majority of 2017 as compared to 2016. Interest expense increased in 2017 by $0.4 million, or 0.8%, from 2016 primarily due to a 7% increase in our average outstanding debt and lower debt premium amortization, offset partially by a 30 basis point decline in our weighted average interest rate. Loss on extinguishment of debt of approximately $1.3 million in 2016 resulted from a $0.9 million loss upon the conveyance of our Aquia office property to the lender and a $0.4 million cash prepayment penalty on a mortgage payoff in 2016. There was no loss on extinguishment of debt in 2017. Liquidity and Capital Resources Our primary uses of capital include principal and interest payments on our outstanding indebtedness, recurring capital expenditures such as tenant improvements, leasing commissions, improvements made to individual properties, shareholder dividends, redevelopments, operating expenses of our business, debt maturities, acquisitions and developments. We generally strive to cover our principal and interest payments, operating expenses, shareholder distributions, and recurring capital expenditures from cash flow from operations, although from time to time we may borrow or sell assets to finance a portion of those uses. We believe the combination of cash flow from operations, cash balances, available borrowings under our Unsecured Credit Facility, issuance of long-term debt, property dispositions, and issuance of equity securities will provide adequate capital resources to fund all of our expected uses over at least the next 12 months. Although we believe that the combination of factors discussed above will provide sufficient liquidity, no such assurance can be given. We believe our current capital structure provides us with the financial flexibility to fund our current capital needs. We intend to continue to enhance our financial and operational flexibility by extending the duration of our debt, appropriately laddering our debt maturities and further expanding our unencumbered asset base. In addition, we believe we have access to multiple forms of capital which includes unsecured corporate debt, preferred equity and common equity including our at-the-market equity program we have in place. At December 31, 2018 and 2017, we had $44.7 million and $12.9 million, respectively, in cash and cash equivalents and restricted cash. Restricted cash of $3.7 million and $4.8 million as of December 31, 2018 and 2017, respectively, was comprised primarily of funds held in escrow by lenders to pay real estate taxes, insurance premiums and certain capital expenditures. As of December 31, 2018 we had no debt maturing in 2019. As of December 31, 2018 we had $349.8 million available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. Our long-term liquidity needs consist primarily of funds necessary to pay indebtedness at maturity, potential acquisitions of properties, redevelopment of existing properties and the development of land. We continually search for investment opportunities that may require additional capital and/or liquidity, which will afford us the opportunity to significantly increase our return on total investment. We will continue to pursue the strategy of selling mature properties and non-core assets that no longer meet our investment criteria. Our ability to obtain acceptable selling prices and satisfactory terms and financing will impact the timing of future sales. We anticipate using net proceeds from the sale of properties to reduce outstanding debt and support current and future growth initiatives. To the extent that asset sales are not sufficient to meet our long-term liquidity needs, we expect to meet such needs by incurring debt or issuing equity. The following is a summary of our cash flow activities: Operating Activities Net cash flow provided by operating activities decreased $11.6 million in 2018 compared to 2017 primarily due to the following: • Decrease of $13.4 million as a result of shopping centers sold in 2017; and • a $4.4 million decrease related to executive management reorganization costs; partially offset by • higher operating cash of $4.1 million from shopping centers owned and operated throughout all of 2017 and 2018. Investing Activities Net cash provided by investing activities was $42.3 million in 2018 compared to net cash used in investing activities of $(16.7) million in 2017. The $58.9 million change in net cash provided by (used in) investing activities was primarily due to: • Acquisitions of real estate decreased $163.5 million; offset by • net proceeds from the sale of real estate, including distributions on joint venture sales, decreased $93.7 million; and • development and capital improvements to real estate increased $13.9 million. In 2018 we acquired the leasehold interest in a ground lease at our existing West Oaks shopping center for approximately $6.4 million. In 2017 we acquired two properties at a combined gross purchase price of $168.3 million and three outparcel acquisitions with a combined gross purchase price of $1.6 million. At December 31, 2018, we had four properties under redevelopment or expansion that have an estimated cost of $8.5 million, of which $5.1 million remains to be invested. Completion for these projects is expected over the next twelve months. In 2018 we sold six properties and three outparcels with aggregate net proceeds of $116.5 million. During 2017 we closed eleven property dispositions, a Walgreen’s Data Center and five outparcel sales with aggregate net proceeds of $216.5 million. Refer to Note 4 Property Acquisitions and Dispositions of the notes to the consolidated financial statements for additional information related to dispositions. Our development and capital improvements spend in 2018 and 2017 included $9.7 million and $6.1 million, respectively, for the retenanting of anchor tenants forced to close as a result of bankruptcy proceedings. Financing Activities Net cash used in financing activities increased $13.7 million compared to 2017 primarily because net borrowings on our mortgages and notes payable decreased $41.0 million, offset partially by lower net paydowns on our revolving credit facility of $26.0 million. As of December 31, 2018, $349.8 million was available to be drawn on our $350.0 million unsecured revolving credit facility subject to our compliance with certain covenants. In addition, as of December 31, 2018, we had $44.7 million in cash and cash equivalents and restricted cash. It is anticipated that additional funds borrowed under our credit facilities will be used for general corporate purposes, including working capital, capital expenditures, the repayment of indebtedness or other corporate activities. For further information on the credit facilities and other debt, refer to Note 8 of notes to the consolidated financial statements. Dividends and Equity We currently qualify, and intend to continue to qualify in the future, as a REIT under the Code. As a REIT, we must distribute to our shareholders at least 90% of our REIT taxable income annually, excluding net capital gain. Distributions paid are at the discretion of our Board and depend on our actual net income available to common shareholders, cash flow, financial condition, capital requirements, restrictions in financing arrangements, the annual distribution requirements under REIT provisions of the Code and such other factors as our Board deems relevant. We paid cash dividends of $0.88 per common share to shareholders in 2018. Cash dividends for 2017 and 2016 were $0.88 and $0.86 per common share, respectively. Our dividend policy is to make distributions to shareholders of at least 90% of our REIT taxable income, excluding net capital gain, in order to maintain qualification as a REIT. On an annualized basis, our current dividend is above our estimated minimum required distribution. Distributions paid by us are generally expected to be funded from cash flows from operating activities. To the extent that cash flows from operating activities are insufficient to pay total distributions for any period, alternative funding sources can be used. Examples of alternative funding sources include proceeds from sales of real estate and bank borrowings. During 2018, the sum of our principal and interest payments, operating expenses, shareholder distributions and recurring capital expenditures exceeded our cash flow, in order to fund our distributions from operations by $18.0 million, and we used other sources of liquidity, including a portion of the proceeds from asset sales. The $18.0 million shortfall was primarily a result of the $11.6 million year-over-year decrease in net cash provided by operating activities due to asset sales and $9.7 million for the retenanting of anchor tenants forced to close as a result of bankruptcy proceedings. Additionally, we paid cash dividends of $3.625 per share of our 7.25% Series D Cumulative Convertible Perpetual Preferred Shares to preferred shareholders in 2018. We have an equity distribution agreement pursuant to which we may sell up to 8.0 million common shares from time to time, in our sole discretion in an at-the-market equity program. For the year ended December 31, 2018, we did not issue any common shares through the arrangement. The sale of such shares issuable pursuant to the distribution agreement is registered with the Securities and Exchange Commission (“SEC”) on our registration statement on Form S-3 (No. 333-211925). Debt At December 31, 2018, we had no outstanding borrowings on our revolving credit facility, $115.1 million of fixed rate mortgage loans encumbering certain properties, $210.0 million of unsecured term loan facilities, $610.0 million in senior unsecured notes and $28.1 million of junior subordinated notes. In September 2017, the Company closed on its amended and restated $350.0 million unsecured revolving credit facility. The credit facility matures September 2021 and can be extended one year to 2022 through two six-month options. Borrowings on the credit facility are priced on a leverage grid ranging from LIBOR plus 130 basis points to LIBOR plus 195 basis points. At December 31, 2018, borrowings were priced at LIBOR plus 130 basis points. Additionally, the facility allows for increased borrowing capacity up to $650.0 million through an accordion feature. Our $115.1 million of fixed rate mortgages have interest rates ranging from 3.76% to 6.50% and are due at various maturity dates from April 2020 through June 2026. The fixed rate mortgage notes are secured by mortgages on properties that have an approximate net book value of $181.4 million as of December 31, 2018. Our $820.0 million of senior unsecured notes and unsecured term loans have interest rates ranging from 2.84% to 4.74% and are due at various maturity dates from May 2020 through December 2029. Our junior subordinated notes have a variable rate of LIBOR plus 3.30%, for an effective rate of 5.82% at December 31, 2018. The maturity date is January 2038. In addition, we had interest rate swap derivative instruments in effect for an aggregate notional amount of $210.0 million converting a portion of our floating rate corporate debt to fixed rate debt. After taking into account the impact of converting our variable rate debt to fixed rate debt by use of the interest rate swap agreements, at December 31, 2018, we had $28.1 million of variable rate debt outstanding. Off Balance Sheet Arrangements Real Estate Joint Ventures We consolidate entities in which we own less than 100% equity interest if we have a controlling interest or are the primary beneficiary in a variable interest entity, as defined in the Consolidation Topic of FASB ASC 810. From time to time, we enter into joint venture arrangements from which we believe we can benefit by owning a partial interest in one or more properties. As of December 31, 2018, our investments in unconsolidated joint ventures were approximately $1.6 million representing our ownership interest in three joint ventures. We accounted for these entities under the equity method. Refer to Note 6 of the notes to the consolidated financial statements for further information regarding our equity investments in unconsolidated joint ventures. We are engaged by certain our joint ventures to provide asset management, property management, leasing and investing services for such ventures' respective properties. We receive fees for our services, including a property management fee calculated as a percentage of gross revenues received. Guarantee A redevelopment agreement was entered into between the City of Jacksonville, the Jacksonville Economic Development Commission and the Company, to construct and develop River City Marketplace in 2005. As part of the agreement, the city agreed to finance up to $12.2 million of bonds. Repayment of the bonds is to be made in accordance with a level-payment amortization schedule over 20 years, and repayments are made out of tax revenues generated by the redevelopment. The remaining debt service payments due over the life of the bonds, including principal and interest, are $10.3 million. As part of the redevelopment, the Company executed a guaranty agreement whereby the Company would fund debt service payments if incremental revenues were not sufficient to fund repayment. There have been no payments made by the Company under this guaranty agreement to date. Contractual Obligations The following are our contractual cash obligations as of December 31, 2018: (1) Excludes $2.9 million of unamortized mortgage debt premium and $3.1 million in deferred financing costs. (2) Variable rate debt interest is calculated using rates at December 31, 2018. At December 31, 2018, we did not have any contractual obligations that required or allowed settlement, in whole or in part, with consideration other than cash. Mortgages and notes payable See the analysis of our debt included in “Liquidity and Capital Resources” above. Employment Contracts At December 31, 2018, we had employment contract obligations with our Chief Executive Officer, Chief Financial Officer, former Chief Executive Officer and former Chief Operating Officer that contain minimum guaranteed compensation. All other employees are subject to at-will employment. Operating and Capital Leases We have an operating ground lease at Centennial Shops located in Edina, Minnesota. The lease includes rent escalations throughout the lease period and expires in April 2105. We have an operating lease for our 29,802 square foot corporate office in Farmington Hills, Michigan, and an operating lease for our 5,629 square foot corporate office in New York, New York. These leases are set to expire in August 2019 and January 2024, respectively. We also have a capital ground lease at our Buttermilk Towne Center with the City of Crescent Springs, Kentucky. The lease provides for fixed annual payments of $0.1 million through maturity in December 2032, at which time we can acquire the land for one dollar. Construction Costs In connection with the development and expansion of various shopping centers as of December 31, 2018, we have entered into agreements for construction activities with an aggregate cost of approximately $6.7 million. Planned Capital Spending We are focused on enhancing the value of our existing portfolio of shopping centers through successful leasing efforts, including the reconfiguration of anchor-space and small shop lease-up, and the completion of our redevelopment projects currently in process. For 2019, we anticipate spending between $50.0 million and $60.0 million for capital expenditures, of which $6.7 million is reflected in the construction commitments in the above contractual obligations table. The total anticipated spending relates to redevelopment projects, tenant improvements and leasing costs. Estimates for future spending will change as new projects are approved. Capitalization At December 31, 2018 our total market capitalization was $2.0 billion and is detailed below: At December 31, 2018, noncontrolling interests represented a 2.3% ownership in the Operating Partnership. The OP Units may, under certain circumstances, be exchanged for our common shares of beneficial interest on a one-for-one basis. We, as sole general partner of the Operating Partnership, have the option, but not the obligation, to settle exchanged OP Units held by others in cash. Assuming the exchange of all OP Units, there would have been approximately 81.6 million of our common shares of beneficial interest outstanding at December 31, 2018, with a market value of approximately $975.6 million. Non-GAAP Financial Measures Certain of our key performance indicators are considered non-GAAP financial measures. Management uses these measures along with our GAAP financial statements in order to evaluate our operations results. We believe these additional measures provide users of our financial information additional comparable indicators of our industry, as well as our performance. Funds From Operations We consider funds from operations, also known as “FFO,” to be an appropriate supplemental measure of the financial performance of an equity REIT. The National Association of Real Estate Investment Trusts "NAREIT" is an industry body public REITs participate in and provides guidance to its members. Under the NAREIT definition, FFO represents net income (computed in accordance with generally accepted accounting principles), excluding gains (or losses) from sales of depreciable property and impairment provisions on depreciable real estate or on investments in non-consolidated investees that are driven by measurable decreases in the fair value of depreciable real estate held by the investee, plus depreciation and amortization, (excluding amortization of financing costs). Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect funds from operations on the same basis. In addition to FFO available to common shareholders, we include Operating FFO available to common shareholders as an additional measure of our financial and operating performance. Operating FFO excludes acquisition costs and periodic items such as impairment provisions on land available for development, bargain purchase gains, accelerated amortization of debt premiums and gains or losses on extinguishment of debt that are not adjusted under the current NAREIT definition of FFO. We provide a reconciliation of FFO to Operating FFO. FFO and Operating FFO should not be considered alternatives to GAAP net income available to common shareholders or as alternatives to cash flow as measures of liquidity. While we consider FFO available to common shareholders and Operating FFO available to common shareholders useful measures for reviewing our comparative operating and financial performance between periods or to compare our performance to different REITs, our computations of FFO and Operating FFO may differ from the computations utilized by other real estate companies, and therefore, may not be comparable. We recognize the limitations of FFO and Operating FFO when compared to GAAP net income available to common shareholders. FFO and Operating FFO available to common shareholders do not represent amounts available for needed capital replacement or expansion, debt service obligations, or other commitments and uncertainties. In addition, FFO and Operating FFO do not represent cash generated from operating activities in accordance with GAAP and are not necessarily indicative of cash available to fund cash needs, including the payment of dividends. FFO and Operating FFO are simply used as additional indicators of our operating performance. The following table illustrates the calculations of FFO and Operating FFO: (1) The total noncontrolling interest reflects OP units convertible 1:1 into common shares. (2) Series D convertible preferred shares paid annual dividends of $6.7 million and are currently convertible into approximately 6.9 million shares of common stock. They are dilutive only when earnings or FFO exceed approximately $0.98 per diluted share per year The conversion ratio is subject to adjustment based upon a number of factors, and such adjustment could affect the dilutive impact of the Series D convertible preferred shares on FFO and earnings per share in future periods. (3) Amounts noted are included in General and Administrative expense. (4) Includes severance, accelerated vesting of restricted stock and performance award charges and the benefit from the forfeiture of unvested restricted stock and performance awards associated with our former executives, in addition to recruiting fees, relocation expenses and cash inducement bonuses related to the Company's current executive team. (5) The $9.7 million reported for the twelve months ended December 31, 2018 includes $0.4 million for the three months ended March 31, 2018 not previously reported. (6) The denominator to calculate diluted earnings per share excludes shares issuable upon conversion of Operating Partnership Units and preferred shares for all periods reported. Same Property Operating Income Same Property Operating Income ("Same Property NOI with Redevelopment") is a supplemental non-GAAP financial measure of real estate companies' operating performance. Same Property NOI with Redevelopment is considered by management to be a relevant performance measure of our operations because it includes only the NOI of comparable properties for the reporting period. Same Property NOI with Redevelopment excludes acquisitions and dispositions. Same Property NOI with Redevelopment is calculated using consolidated operating income and adjusted to exclude management and other fee income, depreciation and amortization, general and administrative expense, provision for impairment and non-comparable income/expense adjustments such as straight-line rents, lease termination fees, above/below market rents, and other non-comparable operating income and expense adjustments. In addition to Same Property NOI with Redevelopment, the Company also believes Same Property NOI without Redevelopment to be a relevant performance measure of our operations. Same Property NOI without Redevelopment follows the same methodology as Same Property NOI with Redevelopment, however it excludes redevelopment activity that significantly impacts the entire property, as well as lesser redevelopment activity where we are adding GLA or retenanting a specific space. A property is designated as redevelopment when projected costs exceed $1.0 million, and the construction impacts approximately 20% or more of the income producing property's gross leasable area ("GLA") or the location and nature of the construction significantly impacts or disrupts the daily operations of the property. Redevelopment may also include a portion of certain properties designated as same property for which we are adding additional GLA or retenanting space. Same Property NOI should not be considered an alternative to net income in accordance with GAAP or as a measure of liquidity. Our method of calculating Same Property NOI may differ from methods used by other REITs and, accordingly, may not be comparable to such other REITs. The following is a summary of our wholly owned properties for the periods noted with consistent classification in the prior period for presentation of Same Property NOI: (1) Includes the following properties for the twelve months ended December 31, 2018 and 2017: Providence Marketplace and Webster Place. (2) Includes the following properties for the three months and twelve months ended December 31, 2018 and 2017: Deerfield Towne Center and Woodbury Lakes. The entire property indicated for each period is completely excluded from the same property NOI without redevelopment. The following is a reconciliation of our Operating Income to Same Property NOI: (1) The NOI from Redevelopment adjustments represent 100% of the NOI related to Deerfield Towne Center and Woodbury Lakes, and a portion of the NOI related to specific GLA at Buttermilk Towne Center, Front Range Village, The Shoppes at Fox River, The Shops on Lane Avenue and Troy Marketplace for all periods presented. A portion of the NOI related to specific GLA at River City Marketplace, Spring Meadows and Town & Country Crossing is adjusted for only the twelve-month periods presented. Because of the redevelopment activity, the center or specific space is not considered comparable for the periods presented and is adjusted out of Same Property NOI with Redevelopment in arriving at Same Property NOI without Redevelopment. The following table summarizes GLA and NOI at properties for which we are adding additional GLA or retenanting space. The property is included in same property NOI, however a portion of GLA and NOI is excluded. Inflation Inflation has been relatively low in recent years and has not had a significant impact on the results of our operations. Should inflation rates increase in the future, substantially all of our tenant leases contain provisions designed to partially mitigate the negative impact of inflation in the near term. Such lease provisions include clauses that require our tenants to reimburse us for real estate taxes and many of the operating expenses we incur. Also, many of our leases provide for periodic increases in base rent which are either of a fixed amount or based on changes in the consumer price index and/or percentage rents (where the tenant pays us rent based on a percentage of its sales). Significant inflation rate increases over a prolonged period of time may have a material adverse impact on our business. Recent Accounting Pronouncements Refer to Note 2 of the notes to the consolidated financial statements for a discussion of Recent Accounting Pronouncements.

<s>[INST] Overview RPT Realty owns and operates a national portfolio of openair shopping destinations principally located in top U.S. markets. As of December 31, 2018, our property portfolio consisted of 51 shopping centers (including one shopping center owned through a joint venture) representing 12.4 million square feet of gross leasable area. As of December 31, 2018, the Company's aggregate portfolio was 94.3% leased. In 2018, the new executive management team completed several key foundational objectives which included the streamlining of the organizational platform, resetting the company culture, conducting a strategic asset review that resulted in the decision to sell approximately $200 million of noncore assets, cultivating a redevelopment pipeline and changing the name of the Company to RPT Realty. The asset sale proceeds are expected to be reallocated into the Company’s balance sheet to lower leverage, as well as fund its nearterm accretive internal growth initiatives, including the reconfiguration of anchor boxes and the lease up of small shop occupancy. Our goal is to be a dominant shopping center owner, with a focus on the following: Own and manage high quality openair shopping centers predominantly concentrated in the top U.S. metro areas; Maintain value creation redevelopment and expansion pipeline; Maximize balance sheet liquidity and flexibility; and Retain motivated, talented and high performing employees. Key methods to achieve our strategy: Deliver above average relative shareholder return and generate outsized consistent and sustainable same property NOI and Operating FFO per share growth; Pursue selective redevelopment projects with significant preleasing for which we expect to achieve attractive returns on investment; Sell assets that no longer meet our longterm strategy and redeploy the proceeds to lease, redevelop and acquire assets in our core markets; Achieve lower leverage while maintaining low variable interest rate risk; and Retain access to diverse sources of capital, maintain liquidity through borrowing capacity under our unsecured line of credit and minimize the amount of debt maturities in a single year. The following highlights the Company's significant transactions, events and results that occurred during the year ended December 31, 2018: Financial Results: Net income available to common shareholders was $10.9 million, or $0.13 per diluted share, for the year ended December 31, 2018, as compared to $62.4 million, or $0.78 per diluted share, for the same period in 2017. Funds from operations ("FFO") was $109.4 million, or $1.23 per diluted share, for the year ended December 31, 2018, as compared to $118.6 million, or $1.34 per diluted share, for the same period in 2017 (see additional disclosure on FFO beginning on page 36). Operating funds from operations ("Operating FFO") was $120.1 million, or $1.35 per diluted share, for the year ended December 31, 2018, as compared to $119.6 million, or $1.36 per diluted share, for the same period in 2017 (see additional disclosure on FFO beginning on page 36). Same property net operating income with redevelopment increased 2.9% for the year ended December 31, 2018, as compared to the same period in 2017 (see additional disclosure on FFO beginning on page 38). Executed 288 new leases and renewals, totaling approximately 1.6 million square feet. As of December 31, 2018, the consolidated portfolio leased rate was 94.3%, as compared to 93.3% at December 31, 2017. Acquisition Activity (See Note 4 of the Notes to Consolidated Financial Statements included in this Form 10K): Acquired leasehold interest in one operating property for a purchase price of $6.4 million. Disposition Activity (See Note 4 of the Notes to Consolidated Financial [/INST] Negative. </s>

RPT Realty

2020-02-20

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements, the notes thereto, and the comparative summary of selected financial data included in this report. Overview RPT Realty owns and operates a national portfolio of open-air shopping destinations principally located in top U.S. markets. The Company's shopping centers offer diverse, locally-curated consumer experiences that reflect the lifestyles of their surrounding communities and meet the modern expectations of the Company's retail partners. As of December 31, 2019, our property portfolio consisted of 49 shopping centers (including five shopping centers owned through R2G) representing 11.9 million square feet of GLA. As of December 31, 2019, the Company's pro-rata share of the aggregate portfolio was 94.7% leased. Our goal is to be a dominant shopping center owner, with a focus on the following: •Own and manage high quality open-air shopping centers predominantly concentrated in the top U.S. MSAs; •Curate our real estate to maximize its value while being aligned with the future of the shopping center industry by leveraging technology, optimizing distribution points for brick-and-mortar and e-commerce purchases, engaging in best-in-practice sustainability programs and developing a personalized appeal to attract and engage the next generation of shoppers; •Maintain value creation redevelopment and expansion pipeline; •Maximize balance sheet liquidity and flexibility; and •Retain motivated, talented and high performing employees. Key methods to achieve our strategy: •Deliver above average relative shareholder return and generate outsized consistent and sustainable Same Property NOI and Operating FFO per share growth; •Pursue selective redevelopment projects with significant pre-leasing for which we expect to achieve attractive returns on investment; •Sell assets that no longer meet our long-term strategy and redeploy the proceeds to lease, redevelop and acquire assets in our core and target markets; •Achieve lower leverage while maintaining low variable interest rate risk; and •Retain access to diverse sources of capital, maintain liquidity through borrowing capacity under our unsecured line of credit and minimize the amount of debt maturities in a single year. The following highlights the Company's significant transactions, events and results that occurred during the year ended December 31, 2019: Financial Results: •Net income available to common shareholders was $84.8 million, or $1.04 per diluted share, for the year ended December 31, 2019, as compared to $10.9 million, or $0.13 per diluted share, for the same period in 2018. •FFO was $88.0 million, or $1.00 per diluted share, for the year ended December 31, 2019, as compared to $109.4 million, or $1.23 per diluted share, for the same period in 2018. •Operating FFO was $94.5 million, or $1.08 per diluted share, for the year ended December 31, 2019, as compared to $120.1 million, or $1.35 per diluted share, for the same period in 2018. •Same property net operating income increased 4.1% for the year ended December 31, 2019, as compared to the same period in 2018. •Executed 210 new leases and renewals, totaling approximately 1.2 million square feet in the aggregate portfolio. •As of December 31, 2019, the Company's aggregate portfolio leased rate was 94.7%, as compared to 94.3% at December 31, 2018. Acquisition Activity (See Note 4 of the notes to consolidated financial statements in this report): •Acquired one operating property for a purchase price of $33.9 million. Disposition Activity (See Note 4 of the notes to consolidated financial statements in this report): •Disposed of two operating properties and one land outparcel for aggregate gross proceeds of $69.4 million. These transactions resulted in an aggregate gain on sale of real estate of $6.1 million. •Contributed five properties valued at $244.0 million to a newly formed joint venture with GIC referred to herein as R2G Venture LLC (“R2G”), and received $118.3 million in gross proceeds for the 48.5% stake in R2G that was acquired by GIC. This transaction resulted in a gain on sale of real estate of $75.8 million. Critical Accounting Policies Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies require our most subjective judgment and use of estimates in the preparation of our consolidated financial statements. Revenue Recognition and Accounts Receivable Most of our leases contain non-contingent rent escalations for which we recognize income on a straight-line basis over the non-cancelable lease term. This method results in rental income in the early years of a lease being higher than actual cash received, creating a straight-line rent receivable asset which is included in the “Other Assets” line item in our consolidated balance sheets. We review our unbilled straight-line rent receivable balance to determine the future collectability of revenue that will not be billed to or collected from tenants due to early lease terminations, lease modifications, bankruptcies and other factors. Our evaluation is based on our assessment of tenant credit risk changes indicating that expected future straight-line rent may not be realized. Depending on circumstances, we may provide a reserve against the previously recognized straight-line rent receivable asset for a portion, up to its full value, that we estimate may not be received. Additionally, we monitor the collectability of our accounts receivable from specific tenants on an ongoing basis, analyze historical experience, customer creditworthiness, current economic trends and changes in tenant payment terms when evaluating the likelihood of tenant payment. For operating leases in which collectibility of rental income is not considered probable, rental income is recognized on a cash basis and allowances are taken for those balances that we have reason to believe may be uncollectible in the period it is determined not to be probable of collection. For more information refer to Note 1 of the notes to the consolidated financial statements in this report. Acquisitions Acquisitions of properties are accounted for utilizing the acquisition method (which requires all assets acquired and liabilities assumed be measured at acquisition date fair value) and, accordingly, the results of operations of an acquired property are included in our results of operations from the date of acquisition. Estimates of fair values are based upon future cash flows and other valuation techniques in accordance with our fair value measurements policy, which are used to allocate the purchase price of acquired property among land, buildings on an “as if vacant” basis, tenant improvements, identifiable intangibles and any gain on purchase. Identifiable intangible assets and liabilities include the effect of above-and below-market leases, the value of having leases in place (“as-is” versus “as if vacant” and absorption costs), other intangible assets such as assumed tax increment revenue bonds and out-of-market assumed mortgages. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of 40 years for buildings, and over the remaining terms of any intangible asset contracts and the respective tenant leases, which may include bargain renewal options. The impact of these estimates, including estimates in connection with acquisition values and estimated useful lives, could result in significant differences related to the purchased assets, liabilities and subsequent depreciation or amortization expense. For more information, refer to Note 1 of the notes to the consolidated financial statements in this report. Impairment We review our investment in real estate, including any related intangible assets, for impairment on a property-by-property basis whenever events or changes in circumstances indicate that the carrying value of the property may not be recoverable. These changes in circumstances include, but are not limited to, changes in occupancy, rental rates, tenant sales, net operating income, geographic location, real estate values and expected holding period. The viability of all projects under construction or development, including those owned by unconsolidated joint ventures, is regularly evaluated under applicable accounting requirements, including requirements relating to abandonment of assets or changes in use. To the extent a project or an individual component of the project, is no longer considered to have value, the related capitalized costs are charged against operations. Impairment provisions resulting from any event or change in circumstances, including changes in our intentions or our analysis of varying scenarios, could be material to our consolidated financial statements. We recognize an impairment of an investment in real estate when the estimated undiscounted cash flow are less than the net carrying value of the property. If it is determined that an investment in real estate is impaired, then the carrying value is reduced to the estimated fair value as determined by cash flow models and discount rates or comparable sales in accordance with our fair value measurement policy. Refer to Note 1 of the notes to the consolidated financial statements in this report. Results of Operations Comparison of the Year Ended December 31, 2019 to the Year Ended December 31, 2018 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items that have significantly changed during the year ended December 31, 2019 as compared to 2018: Total revenue in 2019 decreased $26.5 million, or (10.2)%, from 2018. The decrease is primarily due to the following: •$28.6 million decrease related to properties sold in 2019 and 2018; •$5.2 million decrease from acceleration of a below market lease in the prior period attributable to a specific tenant who vacated prior to the original lease termination date; primarily offset by a •$3.3 million increase from acceleration of below market leases in the current period attributable to tenants who vacated prior to the original estimated lease termination date; and a •$3.8 million increase related to our existing centers largely attributable to higher minimum rent primarily from occupancy gains, contractual rent increases and lease renewals and higher recovery income mainly as a result of an increase in recoverable expenses at existing centers. Real estate tax expense in 2019 decreased by $6.3 million, or (15.0)%, from 2018 primarily due to properties sold during 2019 and 2018. Recoverable operating expense in 2019 decreased by $0.9 million, or (3.5)%, from 2018 primarily due to properties sold during 2019 and 2018, partially offset by higher common area maintenance expenses at existing properties. Non-recoverable operating expense in 2019 increased by $3.0 million, or 41.3%, from 2018 primarily due to higher internal leasing costs as a result of the adoption of ASC 842 which eliminated the capitalization of these costs in the current year as well as higher legal fees associated with a tenant dispute, partially offset by properties sold during 2019 and 2018. Depreciation and amortization expense in 2019 decreased by $8.7 million, or (9.9)%, from 2018. The decrease is primarily a result of properties sold during 2019 and 2018. During 2018 we recorded acquisition costs of $0.2 million related to legal and professional fees associated with a potential shopping center acquisition that was not ultimately pursued during the prior year. General and administrative expense in 2019 decreased by $3.7 million, or (11.9)%, from 2018. The net decrease is primarily a result of lower severance and management reorganization expense, which includes severance costs associated with former executives as well as sign-on bonuses and recruiting fees attributable to the new executive team, partially offset by an increase in bonus expense and higher share-based compensation expense. During 2018 we recorded an impairment provision totaling $13.7 million, of which $13.5 million was on shopping centers classified as income producing and $0.2 million on land held for development. The adjustments related to shopping centers were triggered by changes in associated market prices and expected hold period assumptions, as well as a purchase price reduction at one property. The provision related to land held for development was triggered by changes in the expected use of the land and higher costs. Refer to Note 1 of the notes to the consolidated financial statements in this report for further information related to impairment provisions. We did not record any impairments in 2019. During 2019 the Company wrote off real estate assets that were damaged by a hail storm at one property, which resulted in a charge of $2.3 million, net of $3.5 million of insurance proceeds received as of December 31, 2019. The damage incurred will be fully covered by insurance. Gain on sale of real estate was $81.9 million in 2019. In the comparable period in 2018 we had a gain on sale of real estate of $4.0 million. The increase is primarily a result of properties sold during 2019. Refer to Note 4 of the notes to the consolidated financial statements in this report for further detail on dispositions. Earnings from unconsolidated joint ventures in 2019 remained flat from 2018. Interest expense in 2019 decreased by $3.4 million, or (7.8)%, from 2018. The decrease is primarily a result of a 9.2% decrease in our average outstanding debt, partially offset by lower capitalized interest. The decline in our average outstanding debt is the result of using proceeds from asset sales in the fourth quarter of 2018 and first quarter of 2019 to paydown our revolving credit line and redeem our junior subordinated notes. Other gain on unconsolidated joint ventures in 2019 decreased by $5.0 million primarily due to the sale of the Martin Square property by our joint venture, Ramco/Lion Venture LP, in the prior period. The gain represents the difference between our share of the distributed proceeds and the carrying value of our equity investment in such joint venture. During 2019 we recorded loss on extinguishment of debt of $2.6 million, which represented the write-off of unamortized deferred financing costs associated with the junior subordinated notes that were redeemed in full in April 2019 and term loans that were repaid in November 2019, as well as deferred financing costs and a prepayment penalty associated with our senior unsecured notes that were repaid in December 2019. Comparison of the Year Ended December 31, 2018 to the Year Ended December 31, 2017 The following summarizes certain line items from our audited statements of operations which we believe are important in understanding our operations and/or those items which have significantly changed during the year ended December 31, 2018 as compared to 2017: Total revenue in 2018 decreased by $4.5 million, or (1.7)%, from 2017. The decrease is primarily due to the following: •$20.1 million increase related to acquisitions completed in 2018 and 2017; offset by •$7.7 million increase related to our existing centers largely attributable to changes in estimates associated with recoveries of common areas maintenance and real estate taxes, and higher minimum rent; •$5.2 million increase from acceleration of a below market lease attributable to a specific tenant who vacated prior to the original estimated lease termination date; and •$2.7 million increase related to properties acquired in 2017 and a leasehold interest acquired in 2018. Real estate tax expense in 2018 decreased by $0.4 million, or (0.9)%, from 2017 primarily due to properties sold during 2018 and 2017, partially offset by properties acquired in 2017 and higher net expense; specifically at two properties as a result of a change in estimates. Recoverable operating expense in 2018 decreased by $1.5 million, or (5.3)%, from 2017 primarily due to properties sold during 2018 and 2017, partially offset by additional expense from properties acquired in 2017. Non-recoverable operating expense in 2018 decreased by $0.8 million, or (9.4)%, from 2017 primarily due to a decrease in certain property related compensation, benefits, and travel expenses. Depreciation and amortization expense in 2018 decreased by $4.0 million, or (4.4)%, from 2017. The decrease is primarily a result of properties sold during 2018 and 2017, partially offset by higher asset write offs in 2018 for tenant lease terminations prior to their original estimated term, and higher depreciation expense from acquisitions completed in 2017. During 2018 we recorded acquisition costs of $0.2 million related to legal and professional fees associated with a potential shopping center acquisition that was not ultimately pursued during the year. General and administrative expense in 2018 increased $8.8 million, or 39.1%, from 2017. The increase was primarily due to the following: •$9.7 million of executive management reorganization expenses, which included severance costs associated with former executives as well as executive recruiting fees, sign-on bonuses and relocation fees associated with our new executive team; •$0.8 million of severance costs resulting from the reduction-in-force associated with the reorganization of the Company's operating structure; offset by •$0.8 million decrease in service-based and performance-based stock compensation expense; and •$0.5 million decrease in other severance costs. During 2018 we recorded an impairment provision totaling $13.7 million, of which $13.5 million was on shopping centers classified as income producing and $0.2 million on land held for development. The adjustments related to shopping centers were triggered by changes in associated market prices and expected hold period assumptions, as well as a purchase price reduction at one property. The provision related to land held for development was triggered by changes in the expected use of the land and higher costs. During 2017 we recorded an impairment provision totaling $9.4 million, of which $8.4 million was on shopping centers classified as income producing and $1.0 million on land held for development. The adjustments were triggered by changes in associated sales price assumptions, a purchase price reduction at one property and changes in the expected use of land. Refer to Note 1 of the notes to the consolidated financial statements included in this report for further information related to impairment provisions. Gain on sale of real estate was $4.0 million in 2018. In the comparable period in 2017 we had a gain of $52.8 million. The increase is primarily a result of properties sold during 2018. Refer to Note 4 of the notes to the consolidated financial statements in this report for further detail on dispositions. Earnings from unconsolidated joint ventures in 2018 increased $0.3 million from 2017. The increase was primarily due to our portion of the gain on sale of the Martin Square property which was disposed of by our joint venture, Ramco/Lion Venture LP, during the year compared to no dispositions by any of our unconsolidated joint ventures in the comparable period. Interest expense in 2018 decreased by $1.4 million, or (3.2)%, from 2017. The decrease is primarily a result of an 8.0% decrease in our average outstanding debt, offset partially by a 45 basis point increase in our weighted average interest rate. The decline in our average outstanding debt is primarily a result of using proceeds from asset sales in the second half of 2017 to paydown our revolving credit line. Other gain on unconsolidated joint ventures increased $5.2 million primarily due to the sale of the Martin Square property by our joint venture, Ramco/Lion Venture LP, during the year. The gain represents the difference between our share of the distributed proceeds and the carrying value of our equity investment in such joint venture. Liquidity and Capital Resources Our primary uses of capital include principal and interest payments on our outstanding indebtedness, ongoing capital expenditures such as leasing capital expenditures and building improvements, shareholder distributions, operating expenses of our business, debt maturities, acquisitions and discretionary capital expenditures such as targeted remerchandising, expansions, redevelopment and development. We generally strive to cover our principal and interest payments, operating expenses, shareholder distributions, and ongoing capital expenditures from cash flow from operations, although from time to time we have borrowed or sold assets to finance a portion of those uses. We believe the combination of cash flow from operations, cash balances, available borrowings under our unsecured revolving line of credit, issuance of long-term debt, property dispositions, and issuance of equity securities will provide adequate capital resources to fund all of our expected uses over at least the next 12 months. Although we believe that the combination of factors discussed above will provide sufficient liquidity, no such assurance can be given. We believe our current capital structure provides us with the financial flexibility to fund our current capital needs. We intend to continue to enhance our financial and operational flexibility by extending the duration of our debt, laddering our debt maturities, expanding our unencumbered asset base and improving our leverage profile. In addition, we believe we have access to multiple forms of capital which includes unsecured corporate debt, secured mortgage debt, and preferred and common equity. At December 31, 2019 and 2018, we had $114.6 million and $44.7 million, respectively, in cash and cash equivalents and restricted cash. Restricted cash generally consists of funds held in escrow by lenders to pay real estate taxes, insurance premiums and certain capital expenditures. As of December 31, 2019, we had no debt maturing in 2020 and we had $349.8 million available to be drawn on our $350.0 million unsecured revolving credit facility, subject to our compliance with certain covenants. Our long-term liquidity needs consist primarily of funds necessary to pay indebtedness at maturity, potential acquisitions of properties, redevelopment of existing properties, the development of land and discretionary capital expenditures. We continually search for investment opportunities that may require additional capital and/or liquidity. We will continue to pursue the strategy of selling non-core properties or land that no longer meet our investment criteria or advance our business strategy. Our ability to obtain acceptable selling prices and satisfactory terms and financing will impact the timing of any future sales. We anticipate using net proceeds from the sale of properties or land to reduce outstanding debt and support current and future growth oriented initiatives. To the extent that asset sales are not sufficient to meet our long-term liquidity needs, we expect to meet such needs by raising debt or issuing equity. We have on file with the SEC an automatic shelf registration statement relating to the offer and sale of an indeterminable amount of debt securities, preferred shares, common shares, depository shares, warrant and rights. From time to time, we may issue securities under this registration statement for working capital and other general corporate purposes. The following is a summary of our cash flow activities: Operating Activities Net cash flow provided by operating activities decreased by $15.7 million in 2019 compared to 2018 primarily due to the following: •Impact of shopping centers sold in 2018 and 2019; partially offset by •Higher operating income at existing centers; •Lower executive management and reorganization costs; and •Reduction in interest expense. Investing Activities Net cash provided by investing activities was $95.1 million in 2019 compared to net cash provided by investing activities of $42.3 million in 2018. The $52.8 million change in net cash provided by investing activities was primarily due to: •Net proceeds from the sale of real estate, including those completed by our joint ventures, increased $64.4 million; and •Development and capital improvements decreased $21.3 million; partially offset by •Acquisitions of real estate increased $27.6 million. During 2019, we sold two shopping centers and one land parcel for aggregate net proceeds of $67.9 million. In addition, on December 10, 2019, we announced the formation of R2G. We contributed five properties valued at $244.0 million to R2G and received $118.3 million in gross proceeds ($117.3 million net) for the 48.5% stake in R2G that was acquired by GIC. In 2018 we sold six properties and three outparcels with aggregate net proceeds of $116.5 million. Refer to Note 4 of the notes to the consolidated financial statements in this report for additional information related to dispositions. In 2019 we acquired one property, Lakehills Plaza in Austin, Texas for approximately $33.9 million. In 2018, we acquired the leasehold interest in a ground lease at our existing West Oaks shopping center for approximately $6.4 million. Our development and capital improvements spend in 2019 decreased by $21.3 million compared to 2018. The decrease was primarily a result of lower discretionary capital expenditures such as targeted remerchandising, outlot and GLA expansion and redevelopments. Financing Activities Net cash used in financing activities decreased by $0.9 million compared to 2018 primarily because of: •Redemption of all of our outstanding junior subordinated notes due 2038 for an aggregate purchase price of $28.6 million; and •Payment in 2019 of deferred financing costs of $4.0 million related to the amendment and restatement of the credit agreement and a $50 million private placement of senior unsecured notes; partially offset by •Net repayments in 2018 of $30.0 million on our unsecured revolving line of credit. On November 6, 2019, the Operating Partnership entered into the credit agreement, which consists of an unsecured revolving credit facility of up to $350.0 million and term loan facilities of $310.0 million. A portion of the proceeds from the credit agreement were used to repay our $75.0 million term loan due 2020 and our $75.0 million term loan due 2021 for an aggregate amount of $150.0 million. Also on November 6, 2019, we repaid $100.0 million which constituted repayment in full of the Operating Partnership's $50.0 million 4.16% senior unsecured notes due 2024 and its $50.0 million 4.30% senior unsecured notes due 2026, each issued pursuant to the note purchase agreement dated September 8, 2014, as amended. On December 27, 2019, we entered into a note purchase agreement with the institutional investors named therein and closed a private placement of the Operating Partnership’s $50.0 million aggregate principal amount of 4.15% Senior Guaranteed Notes due December 27, 2029 pursuant thereto. Such notes are unsecured and are guaranteed by the Company and certain subsidiaries of the Operating Partnership. A portion of the proceeds were used to repay $25.0 million aggregate principal amount of our 4.13% Series A Notes due 2022 for an aggregate amount of $26.4 million, which included a prepayment penalty of $1.4 million. A portion of the proceeds were also used to repay the 6.50% fixed rate mortgage loan encumbering West Oaks II and Spring Meadows Place, with an aggregate principal balance of $24.9 million. As of December 31, 2019, $349.8 million was available to be drawn on our $350.0 million unsecured revolving credit facility, subject to our compliance with certain covenants. It is anticipated that additional funds borrowed under our unsecured revolving line of credit will be used for general corporate purposes, including working capital, capital expenditures, the repayment of indebtedness or other corporate activities. For further information on the unsecured revolving line of credit and other debt, refer to Note 8 of notes to the consolidated financial statements in this report. Dividends and Equity We currently qualify, and intend to continue to qualify in the future, as a REIT under the Code. As a REIT, we must distribute to our shareholders at least 90% of our REIT taxable income annually, excluding net capital gains. Distributions paid are at the discretion of our Board and depend on our actual net income available to common shareholders, cash flow, financial condition, capital requirements, restrictions in financing arrangements, the annual distribution requirements under REIT provisions of the Code and such other factors as our Board deems relevant. We paid cash dividends of $0.88 per common share to shareholders in 2019 and 2018. Additionally, we paid cash dividends of $3.625 per share of our 7.25% Series D Cumulative Convertible Perpetual Preferred Shares of Beneficial Interest to preferred shareholders in 2019 and 2018. Our dividend policy is to make distributions to shareholders of at least 90% of our REIT taxable income, excluding net capital gains, in order to maintain qualification as a REIT. On an annualized basis, our current dividend is above our estimated minimum required distribution. Distributions paid by us are generally expected to be funded from cash flows from operating activities. To the extent that cash flows from operating activities are insufficient to pay total distributions for any period, alternative funding sources are used. Examples of alternative funding sources include proceeds from sales of real estate and bank borrowings. During 2019, the sum of our principal and interest payments, operating expenses, shareholder distributions and recurring capital expenditures exceeded our cash flow from operations by $16.7 million, and we used other sources of liquidity, including a portion of the proceeds from assets sales, to meet our cash requirements. The $16.7 million shortfall was primarily a result of selling non-core properties and using proceeds to strengthen the balance sheet and fund organic growth opportunities in the Company's core portfolio. At December 31, 2019, the Company's occupancy rate was 94.3%, up 260 basis points from 91.7% at December 31, 2018. We expect these investments to result in a continued increase in our cash flows from operating activities relative to our dividends, and by the end of 2021, we expect our cash flows from operating activities to exceed our dividends based on our current dividend rate. We had an at-the-market equity program pursuant to which we could sell up to 8.0 million common shares from time to time, in our sole discretion. For the year ended December 31, 2019, we did not issue any common shares through the program. The sale of such common shares issuable pursuant to the program was registered with the SEC on our registration statement on Form S-3, which expired in June 2019. Debt At December 31, 2019, we had $932.6 million of debt outstanding consisting of $535.0 million in senior unsecured notes, $310.0 million of unsecured term loan facilities, and $87.6 million of fixed rate mortgage loans encumbering certain properties. We had no outstanding borrowings on our revolving credit facility as of December 31, 2019. Our $845.0 million of senior unsecured notes and unsecured term loans have interest rates ranging from 2.66% to 4.74% and are due at various maturity dates from June 2021 through December 2029. Our $87.6 million of fixed rate mortgages have interest rates ranging from 3.76% to 5.80% and are due at various maturity dates from February 2022 through June 2026. The fixed rate mortgage notes are secured by mortgages on properties that have an approximate net book value of $151.4 million as of December 31, 2019. In addition, we had interest rate swap derivative instruments in effect for an aggregate notional amount of $360.0 million converting a portion of our floating rate corporate debt to fixed rate debt, including forward starting swaps totaling $150.0 million. After taking into account the impact of converting our variable rate debt to fixed rate debt by use of the interest rate swap agreements, at December 31, 2019, we had $100.0 million of variable rate debt outstanding. Off Balance Sheet Arrangements Real Estate Joint Ventures We consolidate entities in which we own less than 100% equity interest if we have a controlling interest or are the primary beneficiary in a variable interest entity, as defined in the Consolidation Topic of FASB ASC 810. From time to time, we enter into joint venture arrangements from which we believe we can benefit by owning a partial interest in one or more properties. As of December 31, 2019, our investments in unconsolidated joint ventures were approximately $130.3 million representing our ownership interest in four joint ventures. We accounted for these entities under the equity method. Refer to Note 6 of the notes to the consolidated financial statements in this report for further information regarding our equity investments in unconsolidated joint ventures. We are engaged by certain of our joint ventures to provide asset management, property management, construction management, leasing and investing services for such ventures' respective properties. We receive fees for our services, including a property management fee calculated as a percentage of gross revenues received. Guarantee A redevelopment agreement was entered into between the City of Jacksonville, the Jacksonville Economic Development Commission and the Company, to construct and develop River City Marketplace in 2005. As part of the agreement, the city agreed to finance up to $12.2 million of bonds. Repayment of the bonds is to be made in accordance with a level-payment amortization schedule over 20 years, and repayments are made out of tax revenues generated by the redevelopment. The remaining debt service payments due over the life of the bonds, including principal and interest, are $9.1 million. As part of the redevelopment, the Company executed a guaranty agreement whereby the Company would fund debt service payments if incremental revenues were not sufficient to fund repayment. There have been no payments made by the Company under this guaranty agreement to date. Contractual Obligations The following are our contractual cash obligations as of December 31, 2019: (1)Excludes $2.0 million of unamortized mortgage debt premium and $3.8 million in deferred financing costs. (2)Variable rate debt interest is calculated using rates at December 31, 2019. (3)Includes interest payments associated with the finance lease obligation of $0.4 million. (4)Includes interest payments associated with the development obligations of $0.6 million. At December 31, 2019, we did not have any contractual obligations that required or allowed settlement, in whole or in part, with consideration other than cash. Mortgages and Notes Payable See the analysis of our debt included in “Liquidity and Capital Resources” above. Operating and Finance Leases We have an operating ground lease at Centennial Shops located in Edina, Minnesota. The lease includes rent escalations throughout the lease period and expires in April 2105. We have an operating lease for our 5,629 square foot corporate office in New York, New York, and an operating lease for our 12,572 square foot office in Southfield, Michigan. These leases are set to expire in January 2024 and December 2024, respectively. Our New York, New York corporate office lease includes an additional five year renewal to extend the lease through January 2029 and our Southfield, Michigan office lease includes two additional five year renewal options to extend the lease through December 2034. We also have a ground finance lease at our Buttermilk Towne Center with the City of Crescent Springs, Kentucky. The lease provides for fixed annual payments of $0.1 million through maturity in December 2032, at which time we can acquire the land for one dollar. Construction Costs In connection with the development and expansion of various shopping centers as of December 31, 2019, we have entered into agreements for construction activities with an aggregate cost of approximately $6.5 million. Planned Capital Spending We are focused on enhancing the value of our existing portfolio of shopping centers through successful leasing efforts, including the reconfiguration of anchor-space and small shop lease-up, and the completion of our redevelopment projects currently in process. For 2020, we anticipate spending between $40.0 million and $50.0 million for capital expenditures, of which $6.5 million is reflected in the construction commitments in the above contractual obligations table. The total anticipated spending relates to leasing costs, building improvements, targeted remerchandising, outlots/expansion, and development/redevelopment. Estimates for future spending will change as new projects are approved. Capitalization At December 31, 2019 and 2018, our total market capitalization was $2.2 billion and $2.0 billion, respectively, and is detailed below: At December 31, 2019, noncontrolling interests represented a 2.3% ownership in the Operating Partnership. The OP Units may, under certain circumstances, be exchanged for our common shares on a one-for-one basis. We, as sole general partner of the Operating Partnership, have the option, but not the obligation, to settle exchanged OP Units held by others in cash. Assuming the exchange of all OP Units, there would have been approximately 81.8 million of our common shares outstanding at December 31, 2019, with a market value of approximately $1.2 billion. Non-GAAP Financial Measures Certain of our key performance indicators are considered non-GAAP financial measures. Management uses these measures along with our GAAP financial statements in order to evaluate our operations results. We believe these additional measures provide additional and useful means to assess our performance. However, these measures do not represent alternatives to GAAP measures as indicators of performance and a comparison of the Company's presentations to similarly titled measures of other REITs may not necessarily be meaningful due to possible differences in definitions and application by such REITs. Funds From Operations We consider funds from operations, also known as “FFO,” to be an appropriate supplemental measure of the financial performance of an equity REIT. The National Association of Real Estate Investment Trusts (“NAREIT”) is an industry body public REITs participate in and provides guidance to its members. Under the NAREIT definition, FFO represents net income (computed in accordance with GAAP), excluding gains (or losses) from sales of depreciable property and impairment provisions on depreciable real estate or on investments in non-consolidated investees that are driven by measurable decreases in the fair value of depreciable real estate held by the investee, plus depreciation and amortization, (excluding amortization of financing costs). Adjustments for unconsolidated partnerships and joint ventures are calculated to reflect funds from operations on the same basis. We have adopted the NAREIT definition in our computation of FFO. In addition to FFO, we include Operating FFO as an additional measure of our financial and operating performance. Operating FFO excludes acquisition costs and periodic items such as gains (or losses) from sales of land and impairment provisions on land, bargain purchase gains, severance expense, executive management reorganization costs, net, accelerated amortization of debt premiums, gains or losses on extinguishment of debt, and insured expenses, net and R2G Venture LLC related costs that are not adjusted under the current NAREIT definition of FFO. We provide a reconciliation of FFO to Operating FFO. FFO and Operating FFO should not be considered alternatives to GAAP net income available to common shareholders or as alternatives to cash flow as measures of liquidity. While we consider FFO and Operating FFO useful measures for reviewing our comparative operating and financial performance between periods or to compare our performance to different REITs, our computations of FFO and Operating FFO may differ from the computations utilized by other real estate companies, and therefore, may not be comparable. We recognize the limitations of FFO and Operating FFO when compared to GAAP net income available to common shareholders. FFO and Operating FFO do not represent amounts available for needed capital replacement or expansion, debt service obligations, or other commitments and uncertainties. In addition, FFO and Operating FFO do not represent cash generated from operating activities in accordance with GAAP and are not necessarily indicative of cash available to fund cash needs, including the payment of dividends. The following table illustrates the calculations of FFO and Operating FFO: (1)The total noncontrolling interest reflects OP Units convertible on a one-for-one basis into common shares. The Company's net income for the year ended December 31, 2019 (largely driven by gain on sale of real estate), resulted in an income allocation to OP Units which drove an OP Unit ratio of $1.14 (based on 1,909 weighted average OP Units outstanding) as of December 31, 2019. In instances when the OP Unit ratio exceeds basic FFO, the OP Units are considered anti-dilutive, and as a result are not included in the calculation of fully diluted FFO and Operating FFO for the year ended December 31, 2019. (2)7.25% Series D Cumulative Convertible Perpetual Preferred Shares of Beneficial Interest, $0.01 par value per share paid annual dividends of $6.7 million and are currently convertible into approximately 7.0 million common shares. They are dilutive only when earnings or FFO exceed approximately $0.96 per diluted share per year. The conversion ratio is subject to adjustment based upon a number of factors, and such adjustment could affect the dilutive impact of the Series D convertible preferred shares on FFO and earnings per share in future periods. (3)Amounts noted are included in General and administrative expense. (4)For 2019, largely comprised of severance to a former executive officer and performance award expense related to the Company's former Chief Executive Officer. For 2018, includes severance, accelerated vesting of restricted stock and performance award charges and the benefit from the forfeiture of unvested restricted stock and performance awards associated with our former executives, in addition to recruiting fees, relocation expenses and cash inducement bonuses related to the Company's current executive team. (5)For 2019, comprised of special incentive expense related to the execution of the R2G Venture LLC joint venture agreement. NOI, Same Property NOI and NOI from Other Investments NOI consists of (i) rental income and other property income, before straight-line rental income, amortization of lease inducements, amortization of acquired above and below market lease intangibles and lease termination fees less (ii) real estate taxes and all recoverable and non-recoverable operating expenses other than straight-line ground rent expense, in each case, including our share of these items from our R2G Venture LLC unconsolidated joint venture. NOI, Same Property NOI and NOI from Other Investments are supplemental non-GAAP financial measures of real estate companies' operating performance. Same Property NOI is considered by management to be a relevant performance measure of our operations because it includes only the NOI of comparable operating properties for the reporting period. Same Property NOI for the three and twelve months ended December 31, 2019 and 2018 represents NOI from the Company's same property portfolio consisting of 41 consolidated operating properties acquired or placed in service and stabilized prior to January 1, 2018 and five previously consolidated properties contributed to the newly formed joint venture, R2G Venture LLC, in December 2019. Same property NOI from these five properties includes 51.5% of their NOI as a consolidated property for the period January 1, 2018 through December 9, 2019 and 51.5% of their NOI as an unconsolidated property accounted for under the equity method for the period December 10, 2019 through December 31, 2019. Same Property NOI excludes properties under redevelopment or where activities have started in preparation for redevelopment. A property is designated as a redevelopment when planned improvements significantly impact the property. NOI from Other Investments for the three and twelve months ended December 31, 2019 and 2018 represents NOI primarily from (i) properties disposed of and acquired during 2018 and 2019, (ii) 48.5% of the NOI prior to December 10, 2019 from the five previously consolidated properties contributed to the R2G Venture LLC unconsolidated joint venture, (iii) Webster Place and Rivertowne Square where the Company has begun activities in anticipation of future redevelopment, (iv) certain property related employee compensation, benefits, and travel expense and (v) non-comparable operating income and expense adjustments. Same Property NOI and NOI from Other Investments should not be considered alternatives to net income in accordance with GAAP or as measures of liquidity. Our method of calculating these measures may differ from methods used by other REITs and, accordingly, may not be comparable to such other REITs. The following is a summary of our owned properties for the periods noted with consistent classification in the prior period for presentation of Same Property NOI: (1)Includes the following property for the three and twelve months ended December 31, 2019: Lakehills Plaza. (2)Includes the following properties for the three months and twelve months ended December 31, 2019 and 2018: Rivertowne Square and Webster Place. The entire property indicated for each period is completely excluded from the Same Property NOI. The following is a reconciliation of our Operating Income to Same Property NOI at Pro-Rata: (1) Represents 51.5% of the NOI from the five properties contributed to R2G Venture LLC after December 9, 2019. (2) Includes 100.0% of the NOI from the five properties contributed to R2G Venture LLC prior to December 10, 2019 and 51.5% of the NOI from the same five properties after December 9, 2019. (3) Includes 51.5% of the NOI from the five properties contributed to R2G Venture LLC for all periods presented. Inflation Inflation has been relatively low in recent years and has not had a significant impact on the results of our operations. Should inflation rates increase in the future, substantially all of our tenant leases contain provisions designed to partially mitigate the negative impact of inflation in the near term. Such lease provisions include clauses that require our tenants to reimburse us for real estate taxes and many of the operating expenses we incur. Also, many of our leases provide for periodic increases in base rent which are either of a fixed amount or based on changes in the consumer price index and/or percentage rents (where the tenant pays us rent based on a percentage of its sales). Significant inflation rate increases over a prolonged period of time may have a material adverse impact on our business. Recent Accounting Pronouncements Refer to Note 2 of the notes to the consolidated financial statements in this report for a discussion of Recent Accounting Pronouncements.

<s>[INST] Overview RPT Realty owns and operates a national portfolio of openair shopping destinations principally located in top U.S. markets. The Company's shopping centers offer diverse, locallycurated consumer experiences that reflect the lifestyles of their surrounding communities and meet the modern expectations of the Company's retail partners. As of December 31, 2019, our property portfolio consisted of 49 shopping centers (including five shopping centers owned through R2G) representing 11.9 million square feet of GLA. As of December 31, 2019, the Company's prorata share of the aggregate portfolio was 94.7% leased. Our goal is to be a dominant shopping center owner, with a focus on the following: Own and manage high quality openair shopping centers predominantly concentrated in the top U.S. MSAs; Curate our real estate to maximize its value while being aligned with the future of the shopping center industry by leveraging technology, optimizing distribution points for brickandmortar and ecommerce purchases, engaging in bestinpractice sustainability programs and developing a personalized appeal to attract and engage the next generation of shoppers; Maintain value creation redevelopment and expansion pipeline; Maximize balance sheet liquidity and flexibility; and Retain motivated, talented and high performing employees. Key methods to achieve our strategy: Deliver above average relative shareholder return and generate outsized consistent and sustainable Same Property NOI and Operating FFO per share growth; Pursue selective redevelopment projects with significant preleasing for which we expect to achieve attractive returns on investment; Sell assets that no longer meet our longterm strategy and redeploy the proceeds to lease, redevelop and acquire assets in our core and target markets; Achieve lower leverage while maintaining low variable interest rate risk; and Retain access to diverse sources of capital, maintain liquidity through borrowing capacity under our unsecured line of credit and minimize the amount of debt maturities in a single year. The following highlights the Company's significant transactions, events and results that occurred during the year ended December 31, 2019: Financial Results: Net income available to common shareholders was $84.8 million, or $1.04 per diluted share, for the year ended December 31, 2019, as compared to $10.9 million, or $0.13 per diluted share, for the same period in 2018. FFO was $88.0 million, or $1.00 per diluted share, for the year ended December 31, 2019, as compared to $109.4 million, or $1.23 per diluted share, for the same period in 2018. Operating FFO was $94.5 million, or $1.08 per diluted share, for the year ended December 31, 2019, as compared to $120.1 million, or $1.35 per diluted share, for the same period in 2018. Same property net operating income increased 4.1% for the year ended December 31, 2019, as compared to the same period in 2018. Executed 210 new leases and renewals, totaling approximately 1.2 million square feet in the aggregate portfolio. As of December 31, 2019, the Company's aggregate portfolio leased rate was 94.7%, as compared to 94.3% at December 31, 2018. Acquisition Activity (See Note 4 of the notes to consolidated financial statements in this report): Acquired one operating property for a purchase price of $33.9 million. Disposition Activity (See Note 4 of the notes to consolidated financial statements in this report): Disposed of two operating properties and one land outparcel for aggregate gross proceeds of $69.4 million. These transactions resulted in an aggregate gain on sale of real estate of $6.1 million. Contributed five properties valued at $244.0 million to a newly formed joint venture with GIC referred to herein as R2G Venture LLC ( [/INST] Positive. </s>

FIRST FINANCIAL BANKSHARES INC

2015-02-20

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to those listed in “Item 1A - Risk Factors” and in the “Cautionary Statement Regarding Forward-Looking Statements” notice on page 1. Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are interest on these deposits, salaries and related employee benefits. We usually measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2014 and 2013, and consolidated statements of earnings for the years 2012 through 2014 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10-K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisition of Orange Savings Bank, SSB On February 9, 2013, we entered into an agreement and plan of merger to acquire Orange Savings Bank, SSB. On May 31, 2013, the transaction was completed, which we refer to herein as the “Orange acquisition.” Pursuant to the agreement, we paid $39.20 million in cash and issued 840,000 shares of the Company’s common stock in exchange for all of the outstanding shares of Orange Savings Bank, SSB. At closing, Orange Savings Bank, SSB was merged into First Financial Bank, N.A., Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $23.02 million and the Company recorded such excess as goodwill. Consolidation of Bank Charters Effective December 30, 2012, the Company consolidated its eleven bank charters into our Abilene bank charter, First Financial Bank, National Association. The Company cited regulatory, compliance and technology complexities and the opportunity for cost savings as its reason for making this change. The Company operates under its charter as it previously did with eleven charters, with local management and local advisory boards to benefit the customers and communities it serves. Stock Split On April 22, 2014 the Company’s Board of Directors declared a two-for-one stock split in the form of a 100% stock dividend effective for shareholders of record on May 15, 2014 that was distributed on June 2, 2014. All share and per share amounts in this report have been restated to reflect this stock split. An amount equal to the par value of the additional common shares to be issued pursuant to the stock split was reflected as a transfer from retained earnings to common stock on the consolidated financial statements as of and for the year ended December 31, 2014. Results of Operations Performance Summary. Net earnings for 2014 were $89.56 million, an increase of $10.69 million, or 13.55%, over net earnings for 2013 of $78.87 million. Net earnings for 2012 were $74.23 million. The increases in net earnings for 2014 over 2013 and 2013 over 2012 were primarily attributable to growth in net interest income and noninterest income. On a basic net earnings per share basis, net earnings were $1.40 for 2014 as compared to $1.24 for 2013 and $1.18 for 2012. The return on average assets was 1.65% for 2014 as compared to 1.64% for 2013 and 1.75% for 2012. The return on average equity was 14.00% for 2014 as compared to 13.75% for 2013 and 13.85% for 2012. Net Interest Income. Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $213.49 million in 2014 as compared to $189.00 million in 2013 and $169.32 million in 2012. The increases in 2014 compared to 2013 and in 2013 compared to 2012 were largely attributable to increases in the volume of earning assets. Average earning assets were $5.08 billion in 2014, as compared to $4.48 billion in 2013 and $3.95 billion in 2012. Average earning assets increased $602.51 million in 2014, when compared to 2013, with increases in all categories of earning assets, except for short-term investments and Federal funds sold. Average earning assets increased $525.62 million in 2013, when compared to 2012, with increase in all categories of earning assets, except for short-term investments and taxable investment securities. The yield on earning assets decreased 3 basis points in 2014, whereas the rate paid on interest-bearing liabilities decreased 1 basis point when compared to 2013. The yield on earning assets decreased ten basis points in 2013, whereas the rate paid on interest-bearing liabilities decreased six basis points when compared to 2012. Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate. Table 1 - Changes in Interest Income and Interest Expense (in thousands): (1) Computed on tax-equivalent basis assuming marginal tax rate of 35%. (2) Non-accrual loans are included in loans. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2 for the years 2012 through 2014. The net interest margin in 2014 was 4.20%, a decrease of 2 basis points from 2013 which also decreased an additional 6 basis points from 2012. The decrease in our net interest margin in 2014 was largely the result of the extended period of historically low levels of short-term interest rates. The Federal funds rate remained at zero to 0.25% during 2012 to 2014. We have been able to somewhat mitigate the impact of low short-term interest rates by establishing minimum interest rates on certain of our loans, improving the pricing for loan risk, and reducing rates paid on interest bearing liabilities. We expect interest rates to remain at the current low levels based on forward guidance from the Federal Reserve Board which will continue to place pressure on our interest margin. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2. Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): (1) Short-term investments are comprised of Fed Funds sold, interest bearing deposits in banks and interest bearing time deposits in banks. (2) Average balances include unrealized gains and losses on available-for-sale securities. (3) Computed on a tax-equivalent basis assuming a marginal tax rate of 35%. (4) Nonaccrual loans are included in loans. Noninterest Income. Noninterest income for 2014 was $66.62 million, an increase of $4.57 million, or 7.37%, as compared to 2013. Increases in certain categories of noninterest income included (1) ATM, interchange and credit card fees of $2.68 million, (2) trust fees of $2.45 million and (3) net gain on sale of foreclosed assets of $1.06 million. Under the Dodd-Frank Act, the Federal Reserve Board was authorized to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers. While the changes relate only to banks with assets greater than $10 billion, concern exists that the regulation will also impact our Company in the future. The increase in ATM, interchange and credit card fees are primarily a result of increases in the number of net new accounts and debit cards. The increase in trust fees was primarily due to the growth in assets under management over the prior year as well as higher fees generated from mineral management services. The fair value of our trust assets, which are not reflected in our consolidated balance sheets, totaled $3.76 billion at December 31, 2014 compared to $3.36 billion at December 31, 2013. The increase in net gain on sale of foreclosed assets is a result of several gains recognized on sales of foreclosed properties in our Orange and Weatherford regions. Offsetting the increases in 2014 were decreases in real estate mortgage fees of $710 thousand and service charges on deposit accounts of $636 thousand. The decline in real estate mortgage fees is a result of the overall decline in the mortgage refinance market in 2014 when compared to 2013. The decline in service charges is a result of continued declines in NSF fees due to charges in overdraft regulations. Since the third quarter of 2010, a rule issued by the Federal Reserve Board has prohibited financial institutions from charging consumers fees for paying overdrafts on automated teller machine and debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumer’s choices. We continue to monitor the impact of these new regulations and other related developments on our service charge revenue. Noninterest income for 2013 was $62.05 million, an increase of $4.84 million, or 8.47%, as compared to 2012. Increases in certain categories of noninterest income included (1) ATM, interchange and credit card fees of $1.56 million principally as a result of increased use of debit cards, (2) trust fees of $1.85 million, (3) real estate mortgage operations of $1.26 million and (4) service charges on deposit accounts of $853 thousand. Under the Dodd-Frank Act, the Federal Reserve Board was authorized to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers. While the changes relate only to banks with assets greater than $10 billion, concern exists that the regulation will also impact our Company in the future. The increase in trust fees was primarily due to the growth in assets under management over the prior year as well as higher fees generated from oil and gas management. The fair value of our trust assets, which are not reflected in our consolidated balance sheets, totaled $3.36 billion at December 31, 2013 compared to $2.85 billion at December 31, 2012. The increases in income from real estate secondary market mortgage operations reflected a higher level of new home and home sale financing from additional resources devoted to expanding the Company’s mortgage loan operations although we experienced a decrease in such fees in the fourth quarter of 2013. The increase in service charges on deposit accounts was primarily due to our Orange acquisition and to an increase in the number of deposit accounts offset by changes in overdraft regulations. The increases in noninterest income in 2013 were offset by a decrease of $2.63 million in net gain on sale of available-for-sale securities when compared to amounts recorded in 2012. Table 3 - Noninterest Income (in thousands): Noninterest Expense. Total noninterest expense for 2014 was $137.93 million, an increase of $11.91 million, or 9.45%, as compared to 2013. Noninterest expense for 2013 amounted to $126.01 million, an increase of $16.96 million, or 15.56%, as compared to 2012. An important measure in determining whether a banking company effectively manages noninterest expenses is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for 2014 was 49.24% compared to 50.19% for 2013, and 48.14% for 2012. Salaries and employee benefits for 2014 totaled $70.46 million, an increase of $3.93 million, or 5.90%, as compared to 2013. The principal causes of this increase were (1) salary increases, (2) additional employees to staff new branches and compliance related areas and (3) an increase in medical claims. All other categories of noninterest expense for 2014 totaled $67.47 million, an increase of $7.99 million, or 13.43%, as compared to 2013. The increase in noninterest expense was largely attributable to the Company’s recognition of a $2.91 million expense from the partial settlement of its frozen defined benefit pension plan (see Note 11 to the Consolidated Financial Statements for more details) and the recognition of a $2.39 million expense related to a litigation settlement and the deductible from damage sustained in a hail storm in Abilene. Other categories of noninterest expense with increases included ATM, interchange and credit card expenses, equipment expense and net occupancy expense. Salaries and employee benefits for 2013 totaled $66.53 million, an increase of $8.26 million, or 14.18%, as compared to 2012. The principal causes of this increase were (1) additional salaries from our Orange acquisition, (2) additional employees to staff new branches and compliance related areas, (3) an increase in profit sharing expense, and (4) an increase in medical claims. All other categories of noninterest expense for 2013 totaled $59.48 million, an increase of $8.70 million, or 17.14%, as compared to 2012. The increase in noninterest expense was largely the result of increases in other miscellaneous expense of $3.55 million, net occupancy expense of $1.02 million, professional and service fees of $1.10 million and equipment expense of $883 thousand. The increases in other miscellaneous expense and professional and service fees were largely attributable to IT termination and conversion costs associated with our Orange acquisition. The increases in net occupancy and equipment costs were likewise primarily from increased costs from our Orange acquisition. Table 4 - Noninterest Expense (in thousands): Income Taxes. Income tax expense was $29.03 million for 2014 as compared to $25.70 million for 2013 and $25.14 million for 2012. Our effective tax rates on pretax income were 24.48%, 24.58%, and 25.30%, respectively, for the years 2014, 2013 and 2012. The effective tax rates differ from the statutory federal tax rate of 35.0% largely due to tax exempt interest income earned on certain investment securities and loans and the deductibility of dividends paid to our employee stock ownership plan. Balance Sheet Review Loans. Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. Real estate loans represent loans primarily for 1-4 family residences and owner-occupied commercial real estate. The structure of loans in the real estate mortgage area generally provides re-pricing intervals to minimize the interest rate risk inherent in long-term fixed rate loans. As of December 31, 2014, total loans held for investment were $2.93 billion, an increase of $244.90 million, as compared to December 31, 2013. As compared to year-end 2013, real estate loans increased $144.34 million, commercial loans increased $43.22 million, agricultural loans increased $29.77 million and consumer loans increased $27.57 million. Loans averaged $2.79 billion during 2014, an increase of $354.14 million over the 2013 average balances. Table 5 - Composition of Loans (in thousands): As of December 31, 2014, our real estate loans represent approximately 62.23% of our loan portfolio and are comprised of (i) commercial real estate loans of 28.57%, generally owner occupied, (ii) 1-4 family residence loans of 46.63%, (iii) residential development and construction loans of 6.84%, which includes our custom and speculation home construction loans, (iv) commercial development and construction loans of 3.58% and (v) other loans, which includes ranches, hospitals and universities of 14.38%. Loans held for sale, consisting of secondary market mortgage loans, totaled $8.80 million and $5.16 million at December 31, 2014 and 2013, respectively, which were recorded at cost as fair value exceeded cost. The Company has certain lending policies and procedures in place that are designed to maximize loan income with an acceptable level of risk. Management reviews and approves these policies and procedures on an annual basis and makes changes as appropriate. Management receives and reviews monthly reports related to loan originations, quality, concentrations, delinquencies, nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions, both by type of loan and geographic location. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. Underwriting standards are designed to determine whether the borrower possesses sound business ethics and practices and to evaluate current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and, secondarily, on the underlying collateral provided by the borrower. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and include personal guarantees. Agricultural loans are subject to underwriting standards and processes similar to commercial loans. These agricultural loans are based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. Most agricultural loans are secured by the agriculture related assets being financed, such as farm land, cattle or equipment, and include personal guarantees. Real estate loans are also subject to underwriting standards and processes similar to commercial and agricultural loans. These loans are underwritten primarily based on projected cash flows and, secondarily, as loans secured by real estate. The repayment of real estate loans is generally largely dependent on the successful operation of the property securing the loans or the business conducted on the property securing the loan. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s real estate portfolio are generally diverse in terms of type and geographic location within Texas. This diversity helps reduce the exposure to adverse economic events that affect any single market or industry. Generally, real estate loans are owner occupied which further reduces the Company’s risk. Consumer loan underwriting utilizes methodical credit standards and analysis to supplement the Company’s underwriting policies and procedures. The Company’s loan policy addresses types of consumer loans that may be originated and the collateral, if secured, which must be perfected. The relatively smaller individual dollar amounts of consumer loans that are spread over numerous individual borrowers also minimize the Company’s risk. Table 6 - Maturity Distribution and Interest Sensitivity of Loans at December 31, 2014 (in thousands): The following tables summarize maturity and repricing information for the commercial and agricultural and the real estate-construction portion of our loan portfolio as of December 31, 2014: Asset Quality. The loan portfolio of our bank subsidiary is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectibility of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing and restructured loans plus foreclosed assets, were $21.72 million at December 31, 2014, as compared to $31.13 million at December 31, 2013 and $25.46 million at December 31, 2012. As a percent of loans and foreclosed assets, these assets were 0.74% at December 31, 2014, as compared to 1.16% at December 31, 2013 and 1.22% at December 31, 2012. As a percent of total assets, these assets were 0.37% at December 31, 2014, as compared to 0.60% at December 31, 2013 and 0.57% at December 31, 2012. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at December 31, 2014. The increase in dollar amount of nonperforming loans in 2013 was primarily from our Orange acquisition. Table 7 - Nonaccrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): * Includes $2.15 million and $2.71 million, respectively, of purchased credit impaired loans as of December 31, 2014 and 2013. There were no purchased credit impaired loan balances in prior periods. ** Troubled debt restructured loans of $9.07 million, $13.30 million, $14.36 million and $6.55 million, whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans as of December 31, 2014, 2013, 2012 and 2011, respectively. There were no such balances at December 31, 2010. We record interest payments received on non-accrual loans as reductions of principal. Prior to the loans being placed on non-accrual, we recognized interest income on impaired loans as of December 31, 2014 of approximately $97 thousand during the year ended December 31, 2014. If interest on these impaired loans had been recognized on a full accrual basis during the year ended December 31, 2014, such income would have approximated $1.58 million. See Note 3 to the Consolidated Financial Statements beginning on page for more information on these assets. Provision and Allowance for Loan Losses. The allowance for loan losses is the amount we determine as of a specific date to be appropriate to absorb probable losses on existing loans in which full collectability is unlikely based on our review and evaluation of the loan portfolio. For a discussion of our methodology, see our accounting policies in Note 1 to the Consolidated Financial Statements beginning on page. The continued provision for loan losses in 2014 reflects the growth in loans and continuing levels of nonperforming and classified assets. However the general stability of our balances in non-accrual loans and reductions in net charge-offs as a percentage of average loans enabled the Company to not significantly increase provisions in 2014. As a percent of average loans, net loan charge-offs were 0.06% during 2014, 0.15% during 2013 and 0.15% during 2012. The allowance for loan losses as a percent of loans was 1.25% as of December 31, 2014, as compared to 1.26% at December 31, 2013 and 1.67% at December 31, 2012. The decrease in the allowance for loan losses percentage in 2013 is due primarily to the impact of loans acquired in the Orange acquisition, which were initially recorded at fair value with an embedded credit adjustment and no allocated allowance for loan losses. Included in Tables 8 and 9 are further analysis of our allowance for loan losses. Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy or lower employment could result in increased levels of nonaccrual, past due 90 days or more and still accruing, restructured loans, foreclosed assets, charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review the adequacy of our allowance for loan losses. The banking agencies could require additions to the loan loss allowance based on their judgment of information available to them at the time of their examinations of our bank subsidiary. Table 8 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): * Reflects the impact of loans acquired in the Orange Savings Bank, SSB acquisition, which were initially recorded at fair value with no allocated allowance for loan losses. Table 9 - Allocation of Allowance for Loan Losses (in thousands): Percent of Loans in Each Category of Total Loans: Included in our loan portfolio are certain other loans not included in Table 7 that are deemed to be potential problem loans. Potential problem loans are those loans that are currently performing, but for which known information about trends, uncertainties or possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present repayment terms, possibly resulting in the transfer of such loans to nonperforming status. These potential problem loans totaled $1.63 million as of December 31, 2014. Interest-Bearing Deposits in Banks. The Company had interest-bearing deposits in banks of $71.33 million, $57.42 million, and $188.68 million at December 31, 2014, 2013, and 2012, respectively. At December 31, 2014, our interest-bearing deposits in banks included $54.03 million maintained at the Federal Reserve Bank of Dallas, $17.00 million invested in FDIC-insured certificates of deposit and $300 thousand on deposit with the Federal Home Loan Bank of Dallas (FHLB). The change in 2014 and 2013 was due to the Company investing its liquid funds in higher yield assets. The average balance of interest-bearing deposits in banks was $66.68 million, $69.17 million and $123.00 million in 2014, 2013 and 2012, respectively. The average yield on interest-bearing deposits in banks was 0.51%%, 0.67% and 0.61% in 2014, 2013 and 2012, respectively. Available-for-Sale and Held-to-Maturity Securities. At December 31, 2014, securities with a fair value of $2.42 billion were classified as securities available-for-sale and securities with an amortized cost of $441 thousand were classified as securities held-to-maturity. As compared to December 31, 2013, the available-for-sale portfolio at December 31, 2014, reflected (1) an increase of $520 thousand in U. S. Treasury securities; (2) a decrease of $8.33 million in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $176.36 million in obligations of states and political subdivisions; (4) a decrease of $10.28 million in corporate bonds and other; and (5) an increase of $199.87 million in mortgage-backed securities. As compared to December 31, 2012, the available-for-sale portfolio at December 31, 2013, reflected (1) a decrease of $6.09 million in U. S. Treasury securities; (2) a decrease of $85.39 million in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $147.58 million in obligations of states and political subdivisions; (4) a decrease of $14.15 million in corporate bonds and other; and (5) an increase of $196.74 million in mortgage-backed securities. Securities-available-for-sale included fair value adjustments of $77.17 million, $22.60 million and $91.80 million at December 31, 2014, 2013, and 2012, respectively. We did not hold any collateralized mortgage obligations or structured notes as of December 31, 2014 that we consider to be high risk. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies. See Table 10 and Note 2 to the Consolidated Financial Statements for additional disclosures relating to the maturities and fair values of the investment portfolio at December 31, 2014 and 2013. Table 10 - Maturities and Yields of Available-for-Sale Held at December 31, 2014 (in thousands, except percentages): Amounts for held-to-maturity securities are not included herein due to insignificance. All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 35%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date. As of December 31, 2014, the investment portfolio had an overall tax equivalent yield of 3.74%, a weighted average life of 4.63 years and modified duration of 4.11 years. Deposits. Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $4.75 billion as of December 31, 2014, as compared to $4.14 billion as of December 31, 2013 and $3.63 billion as of December 31, 2012. Table 11 provides a breakdown of average deposits and rates paid over the past three years and the remaining maturity of time deposits of $100,000 or more: Table 11 - Composition of Average Deposits and Remaining Maturity of Time Deposits of $100,000 or More (in thousands, except percentages): Short-Term Borrowings. Included in short-term borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $367.11 million, $463.89 million and $259.70 million at December 31, 2014, 2013 and 2012, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the short-term borrowing. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were $397.74 million, $400.55 million and $247.98 million in 2014, 2013 and 2012, respectively. The average rates paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were 0.07%, 0.09% and 0.09% in 2014, 2013 and 2012, respectively. The weighted average interest rate paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was 0.04%, 0.10% and 0.05% at December 31, 2014, 2013 and 2012, respectively. The highest amount of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB at any month end during 2014, 2013 and 2012 was $497.31 million, $532.39 million and $263.35 million, respectively. Capital Resources We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration. Total shareholders’ equity was $681.54 million, or 11.65% of total assets, at December 31, 2014, as compared to $587.65 million, or 11.25% of total assets, at December 31, 2013. During 2014, total shareholders’ equity averaged $639.74 million, or 11.78% of average assets, as compared to $573.39 million, or 11.95% of average assets, during 2013. Banking regulators measure capital adequacy by means of the risk-based capital ratios and leverage ratio. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories ranging from 0% to 100%. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets. Minimum regulatory ratios necessary to be designated “well capitalized” are a total risk-based capital ratio of 10.00%, a Tier 1 risked-based capital ratio of 6.00% and a leverage ratio of 5.00%. As of December 31, 2014, our total risk-based, Tier 1 risked-based and leverage capital ratios on a consolidated basis were 17.16%, 16.05% and 9.89%, respectively, as compared to total risk-based, Tier 1 risked-based and leverage capital ratios of 16.92%, 15.82% and 9.84% as of December 31, 2013. We believe by all measurements our capital ratios remain well above regulatory requirements to be considered “well capitalized” by the regulators. Interest Rate Risk. Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk. Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the repricing and maturity characteristics of the existing and projected balance sheet. As of December 31, 2014, the model simulations projected that 100 and 200 basis point increases in interest rates would result in positive variances in net interest income of 0.89% and 1.17%, respectively, relative to the current financial statement structure over the next twelve months, while decreases in interest rates of 50 basis points would result in a negative variance in a net interest income of 3.18% relative to the current financial statement structure over the next twelve months. We consider the likelihood of a decrease in interest rates beyond 50 basis points after December 31, 2014 remote given current interest rate levels. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics of specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities re-price in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material. Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committee oversees and monitors this risk. Liquidity Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument, as detailed in Tables 12 and 13. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB, which amounted to $367.11 million at December 31, 2014, and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures on June 30, 2015 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $100.00 million. At December 31, 2014, there were no amounts drawn on these lines of credit. Our subsidiary bank also has available a line of credit with the FHLB totaling $901.01 million at December 31, 2014, secured by portions of our loan portfolio and certain investment securities. At December 31, 2014, $1.01 million in advances and $5.00 million in letters of credit issued by the FHLB were outstanding under these lines of credit. These letters of credit were pledged as collateral for public funds held by our subsidiary bank. The Company renewed its loan agreement, effective June 30, 2013, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of credit. Prior to June 30, 2015, interest is paid quarterly at the Wall Street Journal Prime Rate and the line of credit matures June 30, 2015. If a balance exists at June 30, 2015, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at our election at the Wall Street Journal Prime Rate plus 50 basis points or LIBOR plus 250 basis points. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratio. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of consolidated net income in a range of 37% (low) in 1995 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at December 31, 2014. There was no outstanding balance under the line of credit as of December 31, 2014 or 2013. In addition, we anticipate that any future acquisition of financial institutions, expansion of branch locations or offering of new products could also place a demand on our cash resources. Available cash and cash equivalents and securities at our parent company, which totaled $70.09 million at December 31, 2014, investment securities which totaled $12.24 million at December 31, 2014 which matures over 8 to 15 years, available dividends from our subsidiaries which totaled $93.16 million at December 31, 2014, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for potential acquisitions or expansions. Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. Table 12 - Contractual Obligations as of December 31, 2014 (in thousands): Amounts above for deposits do not include related accrued interest. Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in our consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and income-producing commercial properties. Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount. Table 13 - Commitments as of December 31, 2014 (in thousands): We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. Parent Company Funding. Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At December 31, 2014, approximately $93.16 million was available for the payment of intercompany dividends by the subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends of $34.00 million in 2014 and $64.20 million in 2013. The decrease in dividends in 2014 from subsidiaries was due to the Company’s desire to keep more capital at the subsidiary levels. Dividends. Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 39.34%, 41.62% and 41.99% of net earnings, respectively, in 2014, 2013 and 2012. Given our current capital position, projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank’s net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

<s>[INST] Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are interest on these deposits, salaries and related employee benefits. We usually measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2014 and 2013, and consolidated statements of earnings for the years 2012 through 2014 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisition of Orange Savings Bank, SSB On February 9, 2013, we entered into an agreement and plan of merger to acquire Orange Savings Bank, SSB. On May 31, 2013, the transaction was completed, which we refer to herein as the “Orange acquisition.” Pursuant to the agreement, we paid $39.20 million in cash and issued 840,000 shares of the Company’s common stock in exchange for all of the outstanding shares of Orange Savings Bank, SSB. At closing, Orange Savings Bank, SSB was merged into First Financial Bank, N.A., Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $23.02 million and the Company recorded such excess as goodwill. Consolidation of Bank Charters Effective December 30, 2012, the Company consolidated its eleven bank charters into our Abilene bank charter, First Financial Bank, National Association. The Company cited regulatory, compliance and technology complexities and the opportunity for cost savings as its reason for making this change. The Company operates under its charter as it previously did with eleven charters, with local management and local advisory boards to benefit the customers and communities it serves. Stock Split On April 22, 2014 the Company’s Board of Directors declared a twoforone stock split in the form of a 100% stock dividend effective for shareholders of record on May 15, 2014 that was distributed on June 2, 2014. All share and per share amounts in this report have been restated to reflect this stock split. An amount equal to the par value of the additional common shares to be issued pursuant to the stock split was reflected as a transfer from retained earnings to common stock on the consolidated financial statements as of and for the year ended December 31, 2014. [/INST] Positive. </s>

FIRST FINANCIAL BANKSHARES INC

2016-02-19

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to those listed in “Item 1A - Risk Factors” and in the “Cautionary Statement Regarding Forward-Looking Statements” notice on page 1. Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2015 and 2014, and consolidated statements of earnings for the years 2013 through 2015 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10-K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisitions and Asset Purchase On February 9, 2013, we entered into an agreement and plan of merger to acquire Orange Savings Bank, SSB. On May 31, 2013, the transaction was completed, which we refer to herein as the “Orange acquisition.” Pursuant to the agreement, we paid $39.20 million in cash and issued 840,000 shares of the Company’s common stock in exchange for all of the outstanding shares of Orange Savings Bank, SSB. At closing, Orange Savings Bank, SSB was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $23.02 million and the Company recorded such excess as goodwill. On April 1, 2015, we entered into an agreement and plan of reorganization to acquire FBC Bancshares, Inc. and its wholly owned bank subsidiary, First Bank, N.A., Conroe, Texas. On July 31, 2015, the transaction was completed, which we refer to herein as the “Conroe acquisition.” Pursuant to the agreement, we issued 1,755,374 shares of the Company’s common stock in exchange for all of the outstanding shares of FBC Bancshares, Inc. At closing, FBC Bancshares, Inc. was merged into the Company and First Bank, N.A., Conroe, Texas, was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $43.92 million and the Company recorded such excess as goodwill. On April 8, 2015, the Company announced that it had entered into an asset purchase agreement with 4Trust Mortgage, Inc. for a cash purchase price of $1.90 million. The asset purchase was finalized on June 1, 2015, which we refer to herein as the “4Trust asset purchase.” The total asset purchase price exceeded the estimated fair value of assets purchased by approximately $1.75 million and the Company recorded such excess as goodwill. Stock Split On April 22, 2014 the Company’s Board of Directors declared a two-for-one stock split in the form of a 100% stock dividend effective for shareholders of record on May 15, 2014 that was distributed on June 2, 2014. All share and per share amounts in this report have been restated to reflect this stock split. An amount equal to the par value of the additional common shares to be issued pursuant to the stock split was reflected as a transfer from retained earnings to common stock on the consolidated financial statements as of and for the year ended December 31, 2014. Results of Operations Performance Summary. Net earnings for 2015 were $100.38 million, an increase of $10.82 million, or 12.08%, over net earnings for 2014 of $89.56 million. Net earnings for 2013 were $78.87 million. The increases in net earnings for 2015 over 2014 and 2014 over 2013 were primarily attributable to growth in net interest income and noninterest income. On a basic net earnings per share basis, net earnings were $1.55 for 2015 as compared to $1.40 for 2014 and $1.24 for 2013. The return on average assets was 1.61% for 2015 as compared to 1.65% for 2014 and 1.64% for 2013. The return on average equity was 13.60% for 2015 as compared to 14.00% for 2014 and 13.75% for 2013. Net Interest Income. Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $240.48 million in 2015, as compared to $213.49 million in 2014 and $189.00 million in 2013. The increases in 2015 compared to 2014 and in 2014 compared to 2013 were largely attributable to increases in the volume of earning assets. Average earning assets were $5.84 billion in 2015, as compared to $5.08 billion in 2014 and $4.48 billion in 2013. Average earning assets increased $757.55 million in 2015, when compared to 2014, with increases in all categories of earning assets, except for short-term investments. Average earning assets increased $602.51 million in 2014, when compared to 2013, with increases in all categories of earning assets, except for short-term investments. Average interest bearing liabilities were $3.80 billion in 2015, as compared to $3.30 billion in 2014 and $2.91 billion in 2013. The yield on earning assets decreased 9 basis points in 2015, whereas the rate paid on interest-bearing liabilities decreased 2 basis point when compared to 2014, primarily due to the effects of lower interest rates. The yield on earning assets decreased 3 basis points in 2014, whereas the rate paid on interest-bearing liabilities decreased 1 basis points when compared to 2013, also primarily due to the effects of lower interest rates. Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate. Table 1 - Changes in Interest Income and Interest Expense (in thousands): (1) Computed on tax-equivalent basis assuming marginal tax rate of 35%. (2) Non-accrual loans are included in loans. The net interest margin in 2015 was 4.12%, a decrease of 8 basis points from 2014 which also decreased an additional 2 basis points from 2013. The decrease in our net interest margin in 2015 was largely the result of the extended period of historically low levels of short-term interest rates. The Federal funds rate remained at zero to 0.25% during 2013 through the majority of 2015. We have been able to somewhat mitigate the impact of low short-term interest rates by establishing minimum interest rates on certain of our loans, improving the pricing for loan risk, and reducing rates paid on interest bearing liabilities. Although the Federal Reserve slightly increased rates in late 2015 and continues to issue forward guidance plans to increase rates further in 2016 and future years, we expect interest rates to remain at lower levels, which will continue the downward pressure on our interest margin. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2 for the years 2013 through 2015. Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): (1) Short-term investments are comprised of Fed Funds sold, interest bearing deposits in banks and interest bearing time deposits in banks. (2) Average balances include unrealized gains and losses on available-for-sale securities. (3) Computed on a tax-equivalent basis assuming a marginal tax rate of 35%. (4) Nonaccrual loans are included in loans. Noninterest Income. Noninterest income for 2015 was $73.43 million, an increase of $6.81 million, or 10.22%, as compared to 2014. Increases in certain categories of noninterest income included (1) real estate mortgage fees of $3.90 million, (2) ATM, interchange and credit card fees of $2.43 million and (3) trust fees of $486 thousand when compared to 2014. The increase in real estate mortgage fees primarily resulted from a stronger mortgage market and the 4Trust asset purchase on June 1, 2015. The increases in ATM, interchange and credit card fees are primarily a result of increases in the number of net new accounts and debit cards boosted by the Conroe acquisition on July 31, 2015. The increase in trust fees resulted from an increase in assets under management over the prior year offsetting the effect of the decline in oil and gas prices that reduced related trust fees by $1.15 million in 2015 compared to 2014. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $3.87 billion at December 31, 2015 as compared to $3.76 at December 31, 2014. Offsetting the increases in 2015 was a loss on sale of assets of $820 thousand and a decline in net gains on sale of foreclosed assets of $366 thousand when compared to 2014. Noninterest income for 2014 was $66.62 million, an increase of $4.57 million, or 7.37%, as compared to 2013. Increases in certain categories of noninterest income included (1) ATM, interchange and credit card fees of $2.68 million, (2) trust fees of $2.45 million and (3) net gain on sale of foreclosed assets of $1.06 million. The increase in ATM, interchange and credit card fees were primarily a result of increases in the number of net new accounts and debit cards. The increase in trust fees were primarily due to the growth in assets under management over the prior year as well as higher fees generated from mineral management services. The fair value of our trust assets, which are not reflected in our consolidated balance sheets, totaled $3.76 billion at December 31, 2014 compared to $3.36 billion at December 31, 2013. The increase in net gain on sale of foreclosed assets was a result of several gains recognized on sales of foreclosed properties in our Orange and Weatherford regions. Offsetting the increases in 2014 were decreases in real estate mortgage fees of $545 thousand and service charges on deposit accounts of $636 thousand. The decline in real estate mortgage fees was a result of the overall decline in the mortgage refinance market in 2014 when compared to 2013. The decline in service charges was a result of continued declines in NSF fees due to changes in overdraft regulations. Table 3 - Noninterest Income (in thousands): Noninterest Expense. Total noninterest expense for 2015 was $149.46 million, an increase of $11.54 million, or 8.37%, as compared to 2014. Noninterest expense for 2014 amounted to $137.93 million, an increase of $11.91 million, or 9.45%, as compared to 2013. An important measure in determining whether a banking company effectively manages noninterest expenses is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for 2015 was 47.61%, as compared to 49.24% for 2014 and 50.19% for 2013. Salaries and employee benefits for 2015 totaled $81.00 million, an increase of $10.54 million, or 14.96%, as compared to 2014. The increase was largely the result of the addition of employees in compliance-related areas, the addition of employees from the 4Trust asset purchase and Conroe acquisition, increases in healthcare claims and annual pay increases. All other categories of noninterest expense for 2015 totaled $68.47 million, an increase of $996 thousand, or 1.48%, as compared to 2014. The increase in noninterest expense was largely attributable to increases in equipment expense of $1.48 million, net occupancy expense of $1.21 million, legal expense of $1.13 million and software amortization and expense of $696 thousand, largely resulting from the Company’s 4Trust asset purchase and Conroe acquisition in 2015. Offsetting these increases in 2015 were declines in pension expense and the litigation settlement and expenses related to storm damage that were recognized in 2014 and discussed in more detail below. Salaries and employee benefits for 2014 totaled $70.46 million, an increase of $3.93 million, or 5.90%, as compared to 2013. The principal causes of this increase were salary increases, additional employees to staff new branches and compliance related areas and an increase in medical claims. All other categories of noninterest expense for 2014 totaled $67.47 million, an increase of $7.99 million, or 13.43%, as compared to 2013. The increase in noninterest expense was largely attributable to the Company’s recognition of a $2.91 million expense from the partial settlement of its frozen defined benefit pension plan (see Note 12 to the Consolidated Financial Statements for more details) and the recognition of a $2.39 million expense related to a litigation settlement and the deductible from damage sustained in a hail storm in Abilene. Other categories of noninterest expense with increases included ATM, interchange and credit card expenses, equipment expense and net occupancy expense. Table 4 - Noninterest Expense (in thousands): Income Taxes. Income tax expense was $31.44 million for 2015, as compared to $29.03 million for 2014 and $25.70 million for 2013. Our effective tax rates on pretax income were 23.85%, 24.48% and 24.58%, respectively, for the years 2015, 2014 and 2013. The effective tax rates differ from the statutory federal tax rate of 35.0% largely due to tax exempt interest income earned on certain investment securities and loans and the deductibility of dividends paid to our employee stock ownership plan. Balance Sheet Review Loans. Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. Real estate loans represent loans primarily for 1-4 family residences and owner-occupied commercial real estate. The structure of loans in the real estate mortgage area generally provides re-pricing intervals to minimize the interest rate risk inherent in long-term fixed rate loans. As of December 31, 2015, total loans held for investment were $3.32 billion, an increase of $387.86 million, as compared to December 31, 2014. As compared to year-end 2014, real estate loans increased $313.38 million, commercial loans increased $56.21 million, agricultural loans decreased $3.34 million and consumer loans increased $21.62 million. The acquisition of First Bank accounted for $248.38 million of the increase in loans. Loans averaged $3.09 billion during 2015, an increase of $304.53 million over the 2014 average balances. Table 5 - Composition of Loans (in thousands): As of December 31, 2015, our real estate loans represent approximately 64.40% of our loan portfolio and are comprised of (i) commercial real estate loans of 25.36%, generally owner occupied, (ii) 1-4 family residence loans of 44.63%, (iii) residential development and construction loans of 9.65%, which includes our custom and speculation home construction loans, (iv) commercial development and construction loans of 5.16% and (v) other loans, which includes ranches, hospitals and universities of 15.20%. Loans held-for-sale totaled $33.54 million and $8.80 million at December 31, 2015 and 2014, respectively, which are valued using the lower of cost or market method. The Company has certain lending policies and procedures in place that are designed to maximize loan income with an acceptable level of risk. Management reviews and approves these policies and procedures on an annual basis and makes changes as appropriate. Management receives and reviews monthly reports related to loan originations, quality, concentrations, delinquencies, nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions, both by type of loan and geographic location. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. Underwriting standards are designed to determine whether the borrower possesses sound business ethics and practices and to evaluate current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and, secondarily, on the underlying collateral provided by the borrower. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and include personal guarantees. Agricultural loans are subject to underwriting standards and processes similar to commercial loans. These agricultural loans are based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. Most agricultural loans are secured by the agriculture related assets being financed, such as farm land, cattle or equipment, and include personal guarantees. Real estate loans are also subject to underwriting standards and processes similar to commercial and agricultural loans. These loans are underwritten primarily based on projected cash flows and, secondarily, as loans secured by real estate. The repayment of real estate loans is largely dependent on the successful operation of the business conducted on the property securing the loans or the business conducted on the property securing the loan. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s real estate portfolio are generally diverse in terms of type and geographic location within Texas. This diversity helps reduce the exposure to adverse economic events that affect any single market or industry. Generally, real estate loans are owner occupied which further reduces the Company’s risk. Consumer loan underwriting utilizes methodical credit standards and analysis to supplement the Company’s underwriting policies and procedures. The Company’s loan policy addresses types of consumer loans that may be originated and the collateral, if secured, which must be perfected. The relatively smaller individual dollar amounts of consumer loans that are spread over numerous individual borrowers also minimize the Company’s risk. Table 6 - Maturity Distribution and Interest Sensitivity of Loans at December 31, 2015 (in thousands): The following tables summarize maturity and repricing information for the commercial and agricultural and the real estate-construction portion of our loan portfolio as of December 31, 2015: Asset Quality. The loan portfolio of our bank subsidiary is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectability of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing and restructured loans plus foreclosed assets, were $29.77 million at December 31, 2015, as compared to $21.72 million at December 31, 2014 and $31.13 million at December 31, 2013. As a percent of loans and foreclosed assets, these assets were 0.89% at December 31, 2015, as compared to 0.74% at December 31, 2014 and 1.16% at December 31, 2013. As a percent of total assets, these assets were 0.45% at December 31, 2015, as compared to 0.37% at December 31, 2014 and 0.60% at December 31, 2013. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at December 31, 2015. Table 7 - Nonaccrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): * Includes $2.18 million, $2.15 million and $2.71 million, respectively, of purchased credit impaired loans as of December 31, 2015, 2014 and 2013. There were no purchased credit impaired loan balances in 2012 and 2011. ** Troubled debt restructured loans of $6.11 million, $9.07 million, $13.30 million, $14.36 million and $6.55 million, respectively, whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans as of December 31, 2015, 2014, 2013, 2012 and 2011, respectively. We record interest payments received on non-accrual loans as reductions of principal. Prior to the loans being placed on non-accrual, we recognized interest income on impaired loans as of December 31, 2015 of approximately $780 thousand during the year ended December 31, 2015. If interest on these impaired loans had been recognized on a full accrual basis during the year ended December 31, 2015, such income would have approximated $2.74 million. See Note 3 to the Consolidated Financial Statements beginning on page for more information on these assets. Provision and Allowance for Loan Losses. The allowance for loan losses is the amount we determine as of a specific date to be appropriate to absorb probable losses on existing loans in which full collectability is unlikely based on our review and evaluation of the loan portfolio. For a discussion of our methodology, see our accounting policies in Note 1 to the Consolidated Financial Statements beginning on page. The provision for loan losses was $9.69 million in 2015 as compared to $4.47 million in 2014 and $3.75 million in 2013. The continued provision for loan losses in 2015 and 2014 reflects the overall growth in loans and continuing levels of nonperforming and classified assets, including those related to the oil and gas industry. The Company’s direct exposure to the oil and gas industry remained at approximately 2.9% of total loans at December 31, 2015, consistent with December 31, 2014 year-end levels. As a percent of average loans, net loan charge-offs were 0.15% during 2015, 0.06% during 2014 and 0.15% during 2013. The allowance for loan losses as a percent of loans was 1.25% as of December 31, 2015 as compared to 1.25% as of December 31, 2014 and 1.26% at December 31, 2013. Included in Tables 8 and 9 are further analysis of our allowance for loan losses. Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy or lower employment could result in increased levels of nonaccrual, past due 90 days or more and still accruing, restructured loans, foreclosed assets, charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review the adequacy of our allowance for loan losses. The banking agencies could require additions to the loan loss allowance based on their judgment of information available to them at the time of their examinations of our bank subsidiary. Table 8 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): * Reflects the impact of loans acquired in the Orange acquisition in 2013 and the Conroe acquisition in 2015, which were initially recorded at fair value with no allocated allowance for loan losses. Table 9 - Allocation of Allowance for Loan Losses (in thousands): Percent of Loans in Each Category of Total Loans: Included in our loan portfolio are certain other loans not included in Table 7 that are deemed to be potential problem loans. Potential problem loans are those loans that are currently performing, but for which known information about trends, uncertainties or possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present repayment terms, possibly resulting in the transfer of such loans to nonperforming status. These potential problem loans totaled $17.75 million as of December 31, 2015. Interest-Bearing Deposits in Banks. The Company had interest-bearing deposits in banks of $93.43 million, $71.33 million and $57.42 million at December 31, 2015, 2014, and 2013, respectively. At December 31, 2015, our interest-bearing deposits in banks included $89.38 million maintained at the Federal Reserve Bank of Dallas, $3.50 million invested in FDIC-insured certificates of deposit and $554 thousand on deposit with the Federal Home Loan Bank of Dallas (FHLB). The average balance of interest-bearing deposits in banks was $49.69 million, $66.68 million and $69.17 million in 2015, 2014 and 2013, respectively. The average yield on interest-bearing deposits in banks was 0.36%, 0.51% and 0.67% in 2015, 2014 and 2013, respectively. Available-for-Sale and Held-to-Maturity Securities. At December 31, 2015, securities with a fair value of $2.73 billion were classified as securities available-for-sale and securities with an amortized cost of $278 thousand were classified as securities held-to-maturity. As compared to December 31, 2014, the available-for-sale portfolio at December 31, 2015, reflected (1) an increase of $10.28 million in U.S. Treasury securities; (2) an increase of $18.80 million in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $283.50 million in obligations of states and political subdivisions; (4) a decrease of $10.80 million in corporate bonds and other; and (5) an increase of $16.27 million in mortgage-backed securities. As compared to December 31, 2013, the available-for-sale portfolio at December 31, 2014, reflected (1) an increase of $520 thousand in U.S. Treasury securities; (2) a decrease of $8.33 million in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $176.36 million in obligations of states and political subdivisions; (4) a decrease of $10.28 million in corporate bonds and other; and (5) an increase of $16.27 million in mortgage-backed securities. Securities-available-for-sale included fair value adjustments of $79.01 million, $77.17 million and $22.60 million at December 31, 2015, 2014, and 2013, respectively. We did not hold any collateralized mortgage obligations or structured notes as of December 31, 2015 that we consider to be high risk. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies. See Table 10 and Note 2 to the Consolidated Financial Statements for additional disclosures relating to the maturities and fair values of the investment portfolio at December 31, 2015 and 2014. Table 10 - Maturities and Yields of Available-for-Sale Held at December 31, 2015 (in thousands, except percentages): Amounts for held-to-maturity securities are not included herein due to insignificance. All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 35%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date. As of December 31, 2015, the investment portfolio had an overall tax equivalent yield of 3.68%, a weighted average life of 4.35 years and modified duration of 3.87 years. Deposits. Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $5.19 billion as of December 31, 2015, $4.75 billion as compared to December 31, 2014 and $4.14 billion as of December 31, 2013. Table 11 provides a breakdown of average deposits and rates paid over the past three years and the remaining maturity of time deposits of $100,000 or more: Table 11 - Composition of Average Deposits and Remaining Maturity of Time Deposits of $100,000 or More (in thousands, except percentages): Short-Term Borrowings. Included in short-term borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $615.68 million, $367.11 million and $463.89 million at December 31, 2015, 2014 and 2013, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the short-term borrowing. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were $524.37 million, $397.74 million and $400.55 million in 2015, 2014 and 2013, respectively. The average rates paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were 0.08%, 0.07% and 0.09% for the years ended December 31, 2015, 2014 and 2013, respectively. The weighted average interest rate paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was 0.17%, 0.04% and 0.10% at December 31, 2015, 2014 and 2013, respectively. The highest amount of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB at any month end during 2015, 2014 and 2013 was $647.72 million, $497.31 million and $532.39 million, respectively. Capital Resources We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration. Total shareholders’ equity was $804.99 million, or 12.08% of total assets at December 31, 2015, as compared to $681.54 million, or 11.65% of total assets, at December 31, 2014. During 2015, total shareholders’ equity averaged $738.29 million, or 11.86% of average assets, as compared to $639.74 million, or 11.78% of average assets during 2014. Banking regulators measure capital adequacy by means of the risk-based capital ratios and leverage ratio. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets. As of December 31, 2015 and December 31, 2014, we had a total risk-based capital ratio of 16.97% and 17.16%, a Tier 1 capital to risk-weighted assets ratio of 15.90% and 16.05% and a Tier 1 leverage ratio of 9.96% and 9.89%, respectively. At December 31, 2015, we had a common equity Tier 1 to risk-weighted assets ratio of 15.90%. The regulatory capital ratios as of December 31, 2015 were calculated under Basel III rules and the regulatory capital ratios as of December 31, 2014 were calculated under Basel I rules. There is no threshold for well-capitalized status for bank holding companies. We performed an assessment using the new regulatory capital ratios and determined that the Company meets the new requirements specified in the Basel III rules upon full adoption of such requirements. Our subsidiary bank made the election to continue to exclude most accumulated other comprehensive income (“AOCI”) from capital in connection with its March 31, 2015 quarterly financial filing and, in effect, to retain the AOCI treatment under the prior capital rules. Interest Rate Risk. Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk. Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the re-pricing and maturity characteristics of the existing and projected balance sheet. As of December 31, 2015, the model simulations projected that 100 and 200 basis point increases in interest rates would result in variances in net interest income of positive 0.11% and negative 0.18%, respectively, relative to the current financial statement structure over the next twelve months, while a decrease in interest rates of 50 basis points would result in a variance in a net interest income of negative 2.29% relative to the current financial statement structure over the next twelve months. We consider the likelihood of a decrease in interest rates beyond 50 basis points after December 31, 2015 remote given current interest rate levels. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics on specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities re-price in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material. Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committee oversees and monitors this risk. Liquidity Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument, as detailed in Tables 12 and 13. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB, which amounted to $615.68 million at December 31, 2015, and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures on June 2017 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $130.00 million. At December 31, 2015, there were no amounts drawn on these lines of credit. Our subsidiary bank also has available a line of credit with the FHLB totaling $933.30 million at December 31, 2015, secured by portions of our loan portfolio and certain investment securities. At December 31, 2015, $299.02 million in advances was outstanding under this line of credit. The Company renewed its loan agreement, effective June 30, 2015, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of credit. Prior to June 30, 2017, interest is paid quarterly at The Wall Street Journal Prime Rate and the line of credit matures June 30, 2017. If a balance exists at June 30, 2017, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at our election at The Wall Street Journal Prime Rate plus 50 basis points or LIBOR plus 250 basis points. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of our consolidated net income in a range of 37% (low) in 1995 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at December 31, 2015. There was no outstanding balance under the line of credit as of December 31, 2015 or 2014. In addition, we anticipate that any future acquisition of financial institutions, expansion of branch locations or offering of new products could also place a demand on our cash resources. Available cash and cash equivalents and securities at our parent company, which totaled $90.47 million at December 31, 2015, investment securities which totaled $12.06 million at December 31, 2015 which matures over 7 to 14 years, available dividends from our subsidiaries which totaled $129.31 million at December 31, 2015, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for potential acquisitions or expansions. Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. Table 12 - Contractual Obligations as of December 31, 2015 (in thousands): Amounts above for deposits do not include related accrued interest. Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties. Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount. Table 13 - Commitments as of December 31, 2015 (in thousands): We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. Parent Company Funding. Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At December 31, 2015, approximately $129.31 million was available for the payment of intercompany dividends by the subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends to us of $51.20 million in 2015 and $34.00 million in 2014. Dividends. Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 40.20%, 39.34% and 41.62% of net earnings, respectively, in 2015, 2014 and 2013. Given our current capital position, projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank’s net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

<s>[INST] Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2015 and 2014, and consolidated statements of earnings for the years 2013 through 2015 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisitions and Asset Purchase On February 9, 2013, we entered into an agreement and plan of merger to acquire Orange Savings Bank, SSB. On May 31, 2013, the transaction was completed, which we refer to herein as the “Orange acquisition.” Pursuant to the agreement, we paid $39.20 million in cash and issued 840,000 shares of the Company’s common stock in exchange for all of the outstanding shares of Orange Savings Bank, SSB. At closing, Orange Savings Bank, SSB was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $23.02 million and the Company recorded such excess as goodwill. On April 1, 2015, we entered into an agreement and plan of reorganization to acquire FBC Bancshares, Inc. and its wholly owned bank subsidiary, First Bank, N.A., Conroe, Texas. On July 31, 2015, the transaction was completed, which we refer to herein as the “Conroe acquisition.” Pursuant to the agreement, we issued 1,755,374 shares of the Company’s common stock in exchange for all of the outstanding shares of FBC Bancshares, Inc. At closing, FBC Bancshares, Inc. was merged into the Company and First Bank, N.A., Conroe, Texas, was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $43.92 million and the Company recorded such excess as goodwill. On April 8, 2015, the Company announced that it had entered into an asset purchase agreement with 4Trust Mortgage, Inc. for a cash purchase price of $1.90 million. The asset purchase was [/INST] Positive. </s>

FIRST FINANCIAL BANKSHARES INC

2017-02-17

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to those listed in “Item 1A - Risk Factors” and in the “Cautionary Statement Regarding Forward-Looking Statements” notice on page 1. Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2016 and 2015, and consolidated statements of earnings for the years 2014 through 2016 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10-K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisitions and Asset Purchase On April 1, 2015, we entered into an agreement and plan of reorganization to acquire FBC Bancshares, Inc. and its wholly owned bank subsidiary, First Bank, N.A., Conroe, Texas. On July 31, 2015, the transaction was completed, which we refer to herein as the “Conroe acquisition.” Pursuant to the agreement, we issued 1,755,374 shares of the Company’s common stock in exchange for all of the outstanding shares of FBC Bancshares, Inc. At closing, FBC Bancshares, Inc. was merged into the Company and First Bank, N.A., Conroe, Texas, was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $43.92 million and the Company recorded such excess as goodwill. On April 8, 2015, the Company announced that it had entered into an asset purchase agreement with 4Trust Mortgage, Inc. for a cash purchase price of $1.90 million. The asset purchase was finalized on June 1, 2015, which we refer to herein as the “4Trust asset purchase.” The total asset purchase price exceeded the estimated fair value of assets purchased by approximately $1.75 million and the Company recorded such excess as goodwill. Stock Split On April 22, 2014 the Company’s Board of Directors declared a two-for-one stock split in the form of a 100% stock dividend effective for shareholders of record on May 15, 2014 that was distributed on June 2, 2014. All share and per share amounts in this report have been restated to reflect this stock split. An amount equal to the par value of the additional common shares to be issued pursuant to the stock split was reflected as a transfer from retained earnings to common stock on the consolidated financial statements as of and for the year ended December 31, 2014. Results of Operations Performance Summary. Net earnings for 2016 were $104.77 million, an increase of $4.39 million, or 4.38%, over net earnings for 2015 of $100.38 million. Net earnings for 2014 were $89.56 million. The increases in net earnings for 2016 over 2015 and 2015 over 2014 were primarily attributable to growth in net interest income and noninterest income. On a basic net earnings per share basis, net earnings were $1.59 for 2016 as compared to $1.55 for 2015 and $1.40 for 2014. The return on average assets was 1.59% for 2016 as compared to 1.61% for 2015 and 1.65% for 2014. The return on average equity was 12.36% for 2016 as compared to 13.60% for 2015 and 14.00% for 2014. Net Interest Income. Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $251.78 million in 2016, as compared to $240.48 million in 2015 and $213.49 million in 2014. The increases in 2016 compared to 2015 and in 2015 compared to 2014 were largely attributable to increases in the volume of earning assets, primarily from our Conroe acquisition. Average earning assets were $6.17 billion in 2016, as compared to $5.84 billion in 2015 and $5.08 billion in 2014. Average earning assets increased $333.39 million in 2016, when compared to 2015, due primarily from increases in loans and tax exempt securities. Average earning assets increased $757.55 million in 2015, when compared to 2014, with increases in all categories of earning assets, except for short-term investments. Average interest bearing liabilities were $4.02 billion in 2016, as compared to $3.80 billion in 2015 and $3.30 billion in 2014. The yield on earning assets decreased two basis points in 2016, whereas the rate paid on interest-bearing liabilities increased three basis point when compared to 2015. The yield on earning assets decreased nine basis points in 2015, whereas the rate paid on interest-bearing liabilities decreased two basis points when compared to 2014. Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate. Table 1 - Changes in Interest Income and Interest Expense (in thousands): (1) Computed on tax-equivalent basis assuming marginal tax rate of 35%. (2) Non-accrual loans are included in loans. The net interest margin in 2016 was 4.08%, a decrease of four basis points from 2015 which also decreased an additional 8 basis points from 2014. The continued decrease in our net interest margin in 2016 was largely the result of the extended period of historically low levels of short-term interest rates. We have been able to somewhat mitigate the impact of low short-term interest rates by establishing minimum interest rates on certain of our loans, improving the pricing for loan risk, and reducing rates paid on interest bearing liabilities. Although the Federal Reserve increased rates 25 basis points in both December 2016 and December 2015 and continues to issue forward guidance plans to increase rates further in 2017 and future years, we expect interest rates to remain at lower levels, which will continue the downward pressure on our net interest margin. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2 for the years 2014 through 2016. Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): (1) Short-term investments are comprised of Fed Funds sold, interest bearing deposits in banks and interest bearing time deposits in banks. (2) Average balances include unrealized gains and losses on available-for-sale securities. (3) Computed on a tax-equivalent basis assuming a marginal tax rate of 35%. (4) Nonaccrual loans are included in loans. Noninterest Income. Noninterest income for 2016 was $85.13 million, an increase of $11.70 million, or 15.93%, as compared to 2015. Increases in certain categories of noninterest income included (1) real estate mortgage fees of $5.68 million, (2) ATM, interchange and credit card fees of $2.05 million (3) service charges on deposit accounts of $1.22 million and (4) trust fees of $384 thousand when compared to 2015. The increase in real estate mortgage fees primarily resulted from a stronger mortgage market and the 4Trust asset purchase on June 1, 2015. The increases in ATM, interchange and credit card fees and service charges on deposit accounts are primarily a result of increases in the number of net new accounts and debit cards boosted by the Conroe acquisition on July 31, 2015. The increase in trust fees resulted from an increase in assets under management over the prior year offsetting the effect of the decline in oil and gas prices that reduced related trust fees by $296 thousand in 2016 compared to 2015. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $4.37 billion at December 31, 2016 as compared to $3.87 billion at December 31, 2015. Noninterest income for 2015 was $73.43 million, an increase of $6.81 million, or 10.22%, as compared to 2014. Increases in certain categories of noninterest income included (1) real estate mortgage fees of $3.90 million, (2) ATM, interchange and credit card fees of $2.43 million and (3) trust fees of $486 thousand when compared to 2014. The increase in real estate mortgage fees primarily resulted from a stronger mortgage market and the 4Trust asset purchase on June 1, 2015. The increases in ATM, interchange and credit card fees are primarily a result of increases in the number of net new accounts and debit cards boosted by the Conroe acquisition on July 31, 2015. The increase in trust fees resulted from an increase in assets under management over the prior year offsetting the effect of the decline in oil and gas prices that reduced related trust fees by $1.15 million in 2015 compared to 2014. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $3.87 billion at December 31, 2015 as compared to $3.76 at December 31, 2014. Offsetting the increases in 2015 was a loss on sale of assets of $820 thousand and a decline in net gains on sale of foreclosed assets of $366 thousand when compared to 2014. ATM and interchange fees are charges that merchants pay to us and other card-issuing banks for processing electronic payment transactions. ATM and interchange fees consist of income from debit card usage, point of sale income for debit card transactions and ATM service fees. Federal Reserve rules applicable to financial institutions that have assets of $10 billion or more provide that the maximum permissible interchange fee for an electronic debit transaction in the sum of 21 cents per transaction and 5 basis points multiplied by the value of the transaction. While we currently have assets under $10 billion, we are monitoring the effect of this reduction in per transaction fee income as we approach the $10 billion asset level. Table 3 - Noninterest Income (in thousands): Noninterest Expense. Total noninterest expense for 2016 was $165.83 million, an increase of $16.37 million, or 10.95%, as compared to 2015. Noninterest expense for 2015 amounted to $149.46 million, an increase of $11.54 million, or 8.37%, as compared to 2014. An important measure in determining whether a financial institution effectively manages noninterest expenses is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for 2016 was 49.22%, as compared to 47.61% for 2015 and 49.24% for 2014. Salaries and employee benefits for 2016 totaled $90.74 million, an increase of $9.74 million, or 12.02%, as compared to 2015. The increase was primarily driven by the addition of employees from the Conroe acquisition and the 4Trust asset purchase, annual merit pay increases and increases in healthcare claims. Offsetting these increases was a reduction in profit sharing and officer bonus expenses in 2016 when compared to 2015, which was caused by less net income growth in 2016 when compared to the prior year. All other categories of noninterest expense for 2016 totaled $75.09 million, an increase of $6.63 million, or 9.68%, as compared to 2015. The increase in noninterest expense was largely attributable to increases in equipment expense of $1.26 million, largely resulting from the Company’s acquisition of Conroe. Telephone expenses increased $1.05 million due to costs to improve our technology infrastructure and professional and service fees increased $2.05 million due primarily to outsourcing expenses for certain technology providers, which offset salary costs. Offsetting these increases in 2016 were a decrease of $473 thousand in FDIC insurance due to the lower rate charged by the FDIC beginning in the third quarter of 2016. Salaries and employee benefits for 2015 totaled $81.00 million, an increase of $10.54 million, or 14.96%, as compared to 2014. The increase was largely the result of the addition of employees in compliance-related areas, the addition of employees from the 4Trust asset purchase and Conroe acquisition, increases in healthcare claims and annual merit pay increases. All other categories of noninterest expense for 2015 totaled $68.47 million, an increase of $996 thousand, or 1.48%, as compared to 2014. The increase in noninterest expense was largely attributable to increases in equipment expense of $1.48 million, net occupancy expense of $1.21 million, legal expense of $1.13 million and software amortization and expense of $696 thousand, largely resulting from the Company’s 4Trust asset purchase and Conroe acquisition in 2015. Offsetting these increases in 2015 were declines in pension expense and the litigation settlement and expenses related to storm damage that were recognized in 2014. Table 4 - Noninterest Expense (in thousands): Income Taxes. Income tax expense was $31.15 million for 2016, as compared to $31.44 million for 2015 and $29.03 million for 2014. Our effective tax rates on pretax income were 22.92%, 23.85% and 24.48%, respectively, for the years 2016, 2015 and 2014. The effective tax rates differ from the statutory federal tax rate of 35.0% largely due to tax exempt interest income earned on certain investment securities and loans, the deductibility of dividends paid to our employee stock ownership plan and income tax deductions from the partial donation of two of our branch buildings to municipalities. Balance Sheet Review Loans. Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. Real estate loans represent loans primarily for 1-4 family residences and commercial real estate, which are primarily owner-occupied. The structure of loans in the real estate mortgage area generally provides re-pricing intervals to minimize the interest rate risk inherent in long-term fixed rate loans. As of December 31, 2016, total loans held for investment were $3.36 billion, an increase of $40.26 million, as compared to December 31, 2015. As compared to year-end 2015, real estate loans increased $53.61 million, commercial loans decreased $21.75 million, agricultural loans decreased $18.33 million and consumer loans increased $26.73 million. Loans averaged $3.33 billion during 2016, an increase of $242.70 million over the 2015 average balances. Table 5 - Composition of Loans (in thousands): As of December 31, 2016, our real estate loans represent approximately 65.23% of our loan portfolio and are comprised of (i) commercial real estate loans of 23.92%, generally owner occupied, (ii) 1-4 family residence loans of 45.19%, (iii) residential development and construction loans of 8.59%, which includes our custom and speculation home construction loans, (iv) commercial development and construction loans of 5.25% and (v) other loans, which includes ranches, hospitals and universities of 17.05%. Loans held-for-sale, consisting of secondary market mortgage loans, totaled $26.90 million and $33.54 million at December 31, 2016 and 2015, respectively, which are valued using the lower of cost or market method. The Company has certain lending policies and procedures in place that are designed to maximize loan income with an acceptable level of risk. Management reviews and approves these policies and procedures on an annual basis and makes changes as appropriate. Management receives and reviews monthly reports related to loan originations, quality, concentrations, delinquencies, nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions, both by type of loan and geographic location. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. Underwriting standards are designed to determine whether the borrower possesses sound business ethics and practices and to evaluate current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and, secondarily, on the underlying collateral provided by the borrower. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and include personal guarantees. Agricultural loans are subject to underwriting standards and processes similar to commercial loans. These agricultural loans are based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. Most agricultural loans are secured by the agriculture related assets being financed, such as farm land, cattle or equipment, and include personal guarantees. Real estate loans are also subject to underwriting standards and processes similar to commercial and agricultural loans. These loans are underwritten primarily based on projected cash flows and, secondarily, as loans secured by real estate. The repayment of real estate loans is generally largely dependent on the successful operation of the property securing the loans or the business conducted on the property securing the loan. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s real estate portfolio are generally diverse in terms of type and geographic location within Texas. This diversity helps reduce the exposure to adverse economic events that affect any single market or industry. Generally, real estate loans are owner-occupied which further reduces the Company’s risk. Consumer loan underwriting utilizes methodical credit standards and analysis to supplement the Company’s underwriting policies and procedures. The Company’s loan policy addresses types of consumer loans that may be originated and the collateral, if secured, which must be perfected. The relatively smaller individual dollar amounts of consumer loans that are spread over numerous individual borrowers also minimize the Company’s risk. Table 6 - Maturity Distribution and Interest Sensitivity of Loans at December 31, 2016 (in thousands): The following tables summarize maturity and repricing information for the commercial and agricultural and the real estate-construction portion of our loan portfolio as of December 31, 2016: Asset Quality. Our loan portfolio is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectability of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing, and restructured loans plus foreclosed assets were $29.00 million at December 31, 2016, as compared to $29.77 million at December 31, 2015 and $21.72 million at December 31, 2014. As a percent of loans and foreclosed assets, these assets were 0.86% at December 31, 2016, as compared to 0.89% at December 31, 2015 and 0.74% at December 31, 2014. As a percent of total assets, these assets were 0.43% at December 31, 2016, as compared to 0.45% at December 31, 2015 and 0.37% at December 31, 2014. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at December 31, 2016. Supplemental Oil and Gas Information. At December 31, 2016, the Company’s exposure to the oil and gas industry was 2.32% of gross loans, or $78.48 million, down 18.85% from December 31, 2015 year-end levels, and consisted (based on collateral supporting the loan) of (i) development and production loans of 4.55%, (ii) oil and gas field servicing loans of 14.09%, (iii) real estate loans of 42.08%, (iv) accounts receivable and inventory of 22.47% and (v) other of 16.81%. These loans have experienced increased stress due to continued depressed oil and gas prices. The Company has instituted additional monitoring procedures for these loans and has classified, downgraded and charged-off loans as appropriate. The following oil and gas information is as of and for the years ended December 31, 2016 and 2015: Table 7 - Nonaccrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): * Includes $1.26 million, $2.18 million, $2.15 million and $2.71 million, respectively, of purchased credit impaired loans as of December 31, 2016, 2015, 2014 and 2013. There were no purchased credit impaired loan balances in 2012. ** Other troubled debt restructured loans of $6.86 million, $6.11 million, $9.07 million, $13.30 million and $14.36 million, respectively, whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans as of December 31, 2016, 2015, 2014, 2013, and 2012. We record interest payments received on non-accrual loans as reductions of principal. Prior to the loans being placed on non-accrual, we recognized interest income on impaired loans as of December 31, 2016 of approximately $790 thousand during the year ended December 31, 2016. If interest on these impaired loans had been recognized on a full accrual basis during the year ended December 31, 2016, such income would have approximated $2.90 million. See Note 3 to the Consolidated Financial Statements beginning on page for more information on these assets. Provision and Allowance for Loan Losses. The allowance for loan losses is the amount we determine as of a specific date to be appropriate to absorb probable losses on existing loans in which full collectability is unlikely based on our review and evaluation of the loan portfolio. For a discussion of our methodology, see our accounting policies in Note 1 to the Consolidated Financial Statements beginning on page. The provision for loan losses was $10.21 million in 2016 as compared to $9.69 million in 2015 and $4.47 million in 2014. The continued provision for loan losses in 2016 and 2015 reflects the continued levels of nonperforming and classified assets, gross charge-offs, as well as the economic effects related to the oil and gas and cattle industries. As a percent of average loans, net loan charge-offs were 0.19% during 2016, 0.15% during 2015 and 0.06% during 2014. During 2016, the Company charged down $4.3 million related to one commercial loan that is now in liquidation. The allowance for loan losses as a percent of loans was 1.35% as of December 31, 2016 as compared to 1.25% as of December 31, 2015 and 1.25% at December 31, 2014. Included in Tables 8 and 9 are further analysis of our allowance for loan losses. Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy or lower employment could result in increased levels of nonaccrual, past due 90 days or more and still accruing, restructured loans, foreclosed assets, charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review the adequacy of our allowance for loan losses. The banking agencies could require additions to the loan loss allowance based on their judgment of information available to them at the time of their examinations of our bank subsidiary. Table 8 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): * Reflects the impact of loans acquired in the Orange acquisition in 2013 and the Conroe acquisition in 2015, which were initially recorded at fair value with no allocated allowance for loan losses. Table 9 - Allocation of Allowance for Loan Losses (in thousands): Percent of Loans in Each Category of Total Loans: Included in our loan portfolio are certain other loans not included in Table 7 that are deemed to be potential problem loans. Potential problem loans are those loans that are currently performing, but for which known information about trends, uncertainties or possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present repayment terms, possibly resulting in the transfer of such loans to nonperforming status. These potential problem loans totaled $6.58 million as of December 31, 2016. Interest-Bearing Deposits in Banks. The Company had interest-bearing deposits in banks of $50.28 million, $93.43 million and $71.33 million at December 31, 2016, 2015, and 2014, respectively. At December 31, 2016, our interest-bearing deposits in banks included $47.91 million maintained at the Federal Reserve Bank of Dallas, $1.71 million invested in FDIC-insured certificates of deposit and $663 thousand on deposit with the Federal Home Loan Bank of Dallas (FHLB). The average balance of interest-bearing deposits in banks was $58.25 million, $49.69 million and $66.68 million in 2016, 2015 and 2014, respectively. The average yield on interest-bearing deposits in banks was 0.55%, 0.36% and 0.51% in 2016, 2015 and 2014, respectively. Available-for-Sale and Held-to-Maturity Securities. At December 31, 2016, securities with a fair value of $2.86 billion were classified as securities available-for-sale and securities with an amortized cost of $121 thousand were classified as securities held-to-maturity. As compared to December 31, 2015, the available-for-sale portfolio at December 31, 2016, reflected (1) a decrease of $127 thousand in U.S. Treasury securities; (2) a decrease of $34.85 million in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $113.15 million in obligations of states and political subdivisions; (4) a decrease of $35.56 million in corporate bonds and other; and (5) an increase of $84.33 million in mortgage-backed securities. As compared to December 31, 2014, the available-for-sale portfolio at December 31, 2015, reflected (1) an increase of $10.28 million in U.S. Treasury securities; (2) an increase of $18.80 million in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $283.50 million in obligations of states and political subdivisions; (4) a decrease of $10.80 million in corporate bonds and other; and (5) an increase of $16.27 million in mortgage-backed securities. Securities-available-for-sale included fair value adjustments of $33.07 million, $79.01 million and $77.17 million at December 31, 2016, 2015, and 2014, respectively. The decrease in unrealized gain at December 31, 2016 was due to increase in interest rates in the fourth quarter of 2016. We did not hold any collateralized mortgage obligations or structured notes as of December 31, 2016 that we consider to be high risk. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies. See Table 10 and Note 2 to the Consolidated Financial Statements for additional disclosures relating to the maturities and fair values of the investment portfolio at December 31, 2016 and 2015. Table 10 - Maturities and Yields of Available-for-Sale Held at December 31, 2016 (in thousands, except percentages): Amounts for held-to-maturity securities are not included herein due to insignificance. All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 35%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date. As of December 31, 2016, the investment portfolio had an overall tax equivalent yield of 3.60%, a weighted average life of 4.14 years and modified duration of 3.69 years. Deposits. Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $5.48 billion as of December 31, 2016 as compared to $5.19 billion as of December 31, 2015 and $4.75 billion as of December 31, 2014. Table 11 provides a breakdown of average deposits and rates paid over the past three years and the remaining maturity of time deposits of $100,000 or more: Table 11 - Composition of Average Deposits and Remaining Maturity of Time Deposits of $100,000 or More (in thousands, except percentages): Borrowings. Included in borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $445.77 million, $615.68 million and $367.11 million at December 31, 2016, 2015 and 2014, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the short-term borrowing. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were $552.04 million, $524.37 million and $397.74 million in 2016, 2015 and 2014, respectively. The average rates paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were 0.17%, 0.08% and 0.07% for the years ended December 31, 2016, 2015 and 2014, respectively. The weighted average interest rate on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was 0.12%, 0.17% and 0.04% at December 31, 2016, 2015 and 2014, respectively. The highest amount of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB at any month end during 2016, 2015 and 2014 was $598.77 million, $647.72 million and $497.31 million, respectively. Capital Resources We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration. Total shareholders’ equity was $837.89 million, or 12.30% of total assets at December 31, 2016, as compared to $804.99 million, or 12.08% of total assets at December 31, 2015. During 2016, total shareholders’ equity averaged $847.87 million, or 12.85% of average assets, as compared to $738.29 million, or 11.86% of average assets during 2015. Banking regulators measure capital adequacy by means of the risk-based capital ratios and leverage ratio under the Basel III regulatory capital framework and prompt corrective action regulations. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets. Beginning in January 2016, under the Basel III regulatory capital framework, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reaches 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the amount of the buffer will result in restrictions on the Company’s ability to make capital distributions, including divided payments and stock repurchase, and to pay discretionary bonuses to executive officers. As of December 31, 2016 and 2015, we had a total risk-based capital ratio of 18.45% and 16.97%, a Tier 1 capital to risk-weighted assets ratio of 17.30% and 15.90%, a common equity Tier 1 capital to risk-weighted ratio of 17.30% and 15.90% and a Tier 1 leverage ratio of 10.71% and 9.96%, respectively. The regulatory capital ratios as of December 31, 2016 and 2015 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. We performed a preliminary assessment using the regulatory capital estimation tool made available by the OCC and believe the Company and Bank are prepared to meet the new requirements upon adoption of the Basel III that will be effective December 31, 2019. Our subsidiary bank made the election to continue to exclude most AOCI from capital in connection with its March 31, 2015 quarterly financial filing and, in effect, to retain the AOCI treatment under the prior capital rules. Interest Rate Risk. Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk. Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the re-pricing and maturity characteristics of the existing and projected balance sheet. As of December 31, 2016, the model simulations projected that 100 and 200 basis point increases in interest rates would result in variances in net interest income of positive 0.29% and positive 0.31%, respectively, relative to the current financial statement structure over the next twelve months, while a decrease in interest rates of 100 basis points would result in a variance in a net interest income of negative 4.07% relative to the current financial statement structure over the next twelve months. We consider the likelihood of a decrease in interest rates beyond 100 basis points after December 31, 2016 remote given current interest rate levels. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics on specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities re-price in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material. Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committee oversees and monitors this risk. Liquidity Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument, as detailed in Tables 12 and 13. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB, which amounted to $445.77 million at December 31, 2016, and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures on June 2017 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $130.00 million. At December 31, 2016, there were no amounts drawn on these lines of credit. Our subsidiary bank also has available a line of credit with the FHLB totaling $1.15 billion at December 31, 2016, secured by portions of our loan portfolio and certain investment securities. At December 31, 2016, $75.00 million in advances was outstanding under this line of credit. The Company renewed its loan agreement, effective June 30, 2015, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of credit. Prior to June 30, 2017, interest is paid quarterly at The Wall Street Journal Prime Rate and the line of credit matures June 30, 2017. If a balance exists at June 30, 2017, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at our election at The Wall Street Journal Prime Rate plus 50 basis points or LIBOR plus 250 basis points. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of our consolidated net income in a range of 37% (low) in 1995 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at December 31, 2016. There was no outstanding balance under the line of credit as of December 31, 2016 or 2015. In addition, we anticipate that any future acquisition of financial institutions, expansion of branch locations or offering of new products could also place a demand on our cash resources. Available cash and cash equivalents at our parent company, which totaled $93.25 million at December 31, 2016, investment securities which totaled $11.59 million at December 31, 2016 which matures over 7 to 14 years, available dividends from our subsidiaries which totaled $170.73 million at December 31, 2016, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for these potential acquisitions or expansions. Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. Table 12 - Contractual Obligations as of December 31, 2016 (in thousands): Amounts above for deposits do not include related accrued interest. Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties. Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount. Table 13 - Commitments as of December 31, 2016 (in thousands): We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. Parent Company Funding. Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At December 31, 2016, approximately $170.73 million was available for the payment of intercompany dividends by our subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends to us of $48.80 million in 2016 and $51.20 million in 2015. Dividends. Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 44.14%, 40.20% and 39.34% of net earnings, respectively, in 2016, 2015 and 2014. Given our current capital position, projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank’s net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

<s>[INST] Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2016 and 2015, and consolidated statements of earnings for the years 2014 through 2016 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisitions and Asset Purchase On April 1, 2015, we entered into an agreement and plan of reorganization to acquire FBC Bancshares, Inc. and its wholly owned bank subsidiary, First Bank, N.A., Conroe, Texas. On July 31, 2015, the transaction was completed, which we refer to herein as the “Conroe acquisition.” Pursuant to the agreement, we issued 1,755,374 shares of the Company’s common stock in exchange for all of the outstanding shares of FBC Bancshares, Inc. At closing, FBC Bancshares, Inc. was merged into the Company and First Bank, N.A., Conroe, Texas, was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value of assets acquired by approximately $43.92 million and the Company recorded such excess as goodwill. On April 8, 2015, the Company announced that it had entered into an asset purchase agreement with 4Trust Mortgage, Inc. for a cash purchase price of $1.90 million. The asset purchase was finalized on June 1, 2015, which we refer to herein as the “4Trust asset purchase.” The total asset purchase price exceeded the estimated fair value of assets purchased by approximately $1.75 million and the Company recorded such excess as goodwill. Stock Split On April 22, 2014 the Company’s Board of Directors declared a twoforone stock split in the form of a 100% stock dividend effective for shareholders of record on May 15, 2014 that was distributed on June 2, 2014. All share and per share amounts in this report have been restated to reflect this stock split. An amount equal to the par value of the additional common shares to be issued pursuant to the stock split was reflected as a transfer from retained ear [/INST] Positive. </s>

FIRST FINANCIAL BANKSHARES INC

2018-02-16

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to those listed in “Item 1A - Risk Factors” and in the “Cautionary Statement Regarding Forward-Looking Statements” notice on page 1. Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2017 and 2016, and consolidated statements of earnings for the years 2015 through 2017 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10-K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Hurricane Harvey Houston and the surrounding Gulf Coast region were significantly affected by Hurricane Harvey beginning in late August 2017 and continuing into the fourth quarter of 2017. Our Company has locations (i) north of Houston in Conroe, Willis, Tomball, Huntsville, Montgomery, Magnolia, New Waverly and Cut and Shoot and (ii) in Southeast Texas in Orange, Beaumont, Vidor, Newton, Mauriceville and Port Arthur. We continue to evaluate the effect of the hurricane on our branch facilities and our loan and investment portfolios. Our initial assessment of our physical buildings and equipment indicates damage primarily at our Mauriceville branch, and amounts not covered by insurance do not appear to be significant. At December 31, 2017, we had loans totaling $446.62 million in our Conroe region and $396.55 million in the Southeast Texas/Orange region. We are evaluating these loans and the related collateral and business operations underlying such loans. At December 31, 2017, we provided additional allowance for loan losses as deemed appropriate based on this analysis. We continue to evaluate these loans as we learn more information about the damage caused by the hurricane. Our tax exempt municipal bonds in the counties of Texas effected by the hurricane have been evaluated, including insurance on the bonds. At December 31, 2017, our municipal bonds in these counties totaled $458.16 million, but only $92.75 million do not have bond insurance. Based on analysis of these bonds and the related municipality, at December 31, 2017, we do not believe we have any credit related losses other than temporary impairment. Acquisitions and Asset Purchase On October 12, 2017, we entered into an agreement and plan of reorganization to acquire Commercial Bancshares, Inc. and its wholly owned bank subsidiary, Commercial State Bank, Kingwood, Texas. On January 1, 2018, the transaction closed. Pursuant to the agreement, we issued 1,289,371 shares of the Company’s common stock in exchange for all of the outstanding shares of Commercial Bancshares, Inc. In addition, in accordance with the plan of reorganization, Commercial Bancshares, Inc. paid a special dividend totaling $22.08 million to its shareholders prior to the closing of this transaction. At the closing, Kingwood Merger Sub., Inc., a wholly-owned subsidiary of the Company, merged into Commercial Bancshares Inc., with Commercial Bancshares, Inc. surviving as a wholly-owned subsidiary of the Company. Immediately following such merger, Commercial Bancshares, Inc. was merged into the Company and Commercial State Bank, Kingwood, Texas was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value net of assets acquired by approximately $31.24 million and the Company recorded such excess as goodwill. The balance sheet and results of operations of Commercial Bancshares, Inc. will be included in the financial statements of the Company effective January 1, 2018. On April 1, 2015, we entered into an agreement and plan of reorganization to acquire FBC Bancshares, Inc. and its wholly owned bank subsidiary, First Bank, N.A., Conroe, Texas. On July 31, 2015, the transaction was completed, which we refer to herein as the “Conroe acquisition.” Pursuant to the agreement, we issued 1,755,374 shares of the Company’s common stock in exchange for all of the outstanding shares of FBC Bancshares, Inc. At closing, FBC Bancshares, Inc. was merged into the Company and First Bank, N.A., Conroe, Texas, was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value net of assets acquired by approximately $43.92 million and the Company recorded such excess as goodwill. On April 8, 2015, the Company announced that it had entered into an asset purchase agreement with 4Trust Mortgage, Inc. for a cash purchase price of $1.90 million. The asset purchase was finalized on June 1, 2015, which we refer to herein as the “4Trust asset purchase.” The total asset purchase price exceeded the estimated fair value net of assets purchased by approximately $1.75 million and the Company recorded such excess as goodwill. Results of Operations Performance Summary. Net earnings for 2017 were $120.37 million, an increase of $15.60 million over net earnings for 2016 of $104.77 million. Of the $15.60 million increase in net income during 2017 when compared to 2016, $7.65 million resulted from the recent enactment of tax legislation that reduced the corporate income tax rate from 35 percent to 21 percent. This amount represents the net effect of the Company’s revaluation of its deferred tax assets and liabilities using the new tax rate. Net earnings for 2015 were $100.38 million. Disregarding the increase that resulted from the change in tax rates, the increases in net earnings for 2017 over 2016 and 2016 over 2015 were primarily attributable to growth in net interest income and noninterest income. On a basic net earnings per share basis, net earnings were $1.82 for 2017, as compared to $1.59 for 2016 and $1.55 for 2015. The return on average assets was 1.72% for 2017, as compared to 1.59% for 2016 and 1.61% for 2015. The return on average equity was 13.63% for 2017, as compared to 12.36% for 2016 and 13.60% for 2015. Excluding the $7.65 million tax adjustment mentioned above, the Company’s basic earnings per share would have been $1.70, its return on average assets would have been 1.61% and its return on average equity would have been 12.77% for 2017. Net Interest Income. Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $262.18 million in 2017, as compared to $251.78 million in 2016 and $240.48 million in 2015. The increases in 2017 compared to 2016 were largely attributable to increases in the volume of earning assets offset by rate increases on our interest bearing liabilities. Average earning assets were $6.54 billion in 2017, as compared to $6.17 billion in 2016 and $5.84 billion in 2015. Average earning assets increased $373.50 million in 2017, when compared to 2016, due primarily from increases in loans and taxable securities. Average earning assets increased $333.39 million in 2016, when compared to 2015, due primarily from increases in loans and tax exempt securities. Average interest bearing liabilities were $4.21 billion in 2017, as compared to $4.02 billion in 2016 and $3.80 billion in 2015. The yield on earning assets decreased two basis points in 2017 due to the mix of earnings assets, whereas the rate paid on interest-bearing liabilities increased eight basis points when compared to 2016. The yield on earning assets decreased two basis points in 2016, whereas the rate paid on interest-bearing liabilities increased three basis points when compared to 2015. Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate. Table 1 - Changes in Interest Income and Interest Expense (in thousands): (1) Computed on tax-equivalent basis assuming marginal tax rate of 35%. (2) Non-accrual loans are included in loans. The net interest margin in 2017 was 4.01%, a decrease of seven basis points from 2016 which also decreased an additional four basis points from 2015. The continued decrease in our net interest margin in 2017 was largely the result of the extended period of historically low levels of short-term interest rates. We have been able to somewhat mitigate the impact of low short-term interest rates by establishing minimum interest rates on certain of our loans, improving the pricing for loan risk, and minimizing rates paid on interest bearing liabilities. The Federal Reserve increased rates 75 basis points in 2017 and 25 basis points in both 2016 and 2015 and continues to issue forward guidance plans to increase rates further in 2018. Although increasing, we expect interest rates to remain at lower levels, which will continue the downward pressure on our net interest margin. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2 for the years 2015 through 2017. Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): (1) Short-term investments are comprised of Fed Funds sold, interest bearing deposits in banks and interest bearing time deposits in banks. (2) Average balances include unrealized gains and losses on available-for-sale securities. (3) Computed on a tax-equivalent basis assuming a marginal tax rate of 35%. (4) Nonaccrual loans are included in loans. Noninterest Income. Noninterest income for 2017 was $91.02 million, an increase of $5.89 million, or 6.91%, as compared to 2016. Increases in certain categories of noninterest income included (1) trust fees of $4.06 million (2) ATM, interchange and credit card fees of $1.78 million and (3) service charges on deposit accounts of $1.03 million when compared to 2016. The increase in trust fees resulted from an increase in assets under management over the prior year and higher oil and gas prices that increased related to trust fees by $364 thousand over 2016. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $5.13 billion at December 31, 2017, as compared to $4.37 billion at December 31, 2016. The increases in ATM, interchange and credit card fees and service charges on deposit accounts are primarily a result of increases in the number of net new accounts and debit cards. Offsetting these increases were decreases in net recoveries of $984 thousand and real estate mortgage fees of $977 thousand. Noninterest income for 2016 was $85.13 million, an increase of $11.70 million, or 15.93%, as compared to 2015. Increases in certain categories of noninterest income included (1) real estate mortgage fees of $5.68 million, (2) ATM, interchange and credit card fees of $2.05 million, (3) service charges on deposit accounts of $1.22 million and (4) trust fees of $384 thousand when compared to 2015. The increase in real estate mortgage fees primarily resulted from a stronger mortgage market and the 4Trust asset purchase on June 1, 2015. The increases in ATM, interchange and credit card fees and service charges are primarily a result of increases in the number of net new accounts and debit cards boosted by the Conroe acquisition on July 31, 2015. The increase in trust fees resulted from an increase in assets under management over the prior year offsetting the effect of the decline in oil and gas prices that reduced related trust fees by $296 thousand in 2016 compared to 2015. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $4.37 billion at December 31, 2016 as compared to $3.87 billion at December 31, 2015. ATM and interchange fees are charges that merchants pay to us and other card-issuing banks for processing electronic payment transactions. ATM and interchange fees consist of income from debit card usage, point of sale income for debit card transactions and ATM service fees. Federal Reserve rules applicable to financial institutions that have assets of $10 billion or more provide that the maximum permissible interchange fee for an electronic debit transaction in the sum of 21 cents per transaction and five basis points multiplied by the value of the transaction. While we currently have assets under $10 billion, we are monitoring the effect of this reduction in per transaction fee income as we approach the $10 billion asset level. Table 3 - Noninterest Income (in thousands): Noninterest Expense. Total noninterest expense for 2017 was $173.99 million, an increase of $8.16 million, or 4.92%, as compared to 2016. Noninterest expense for 2016 amounted to $165.83 million, an increase of $16.37 million, or 10.95%, as compared to 2015. An important measure in determining whether a financial institution effectively manages noninterest expenses is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for 2017 was 49.26%, as compared to 49.22% for 2016 and 47.61% for 2015. Salaries and employee benefits for 2017 totaled $95.29 million, an increase of $4.55 million, or 5.01%, as compared to 2016. The increase was primarily driven by (i) annual merit pay increases that were effective March 1, 2017 (ii) an increase in our profit sharing expenses and (iii) an increase in stock option and stock grant expense of due to the stock option grant in June 2017 and restricted stock grant in October 2017. All other categories of noninterest expense for 2017 totaled $78.70 million, an increase of $3.61 million, or 4.80%, as compared to 2016. The increase in noninterest expense was largely attributable to increases in software amortization and expense of $1.29 million from the write-off of internally developed software, operational and other losses of $1.02 million due to fraud and weather related losses and professional and service fees of $1.19 million. Offsetting these increases in 2017 were a decrease of $463 thousand in FDIC insurance due to the lower rate charged by the FDIC beginning in the third quarter of 2016. Salaries and employee benefits for 2016 totaled $90.74 million, an increase of $9.74 million, or 12.02%, as compared to 2015. The increase was primarily driven by the addition of employees from the Conroe acquisition and the 4Trust asset purchase, annual merit pay increases and increases in healthcare claims. Offsetting these increases was a reduction in profit sharing and officer bonus expenses in 2016 when compared to 2015, which was caused by less net income growth in 2016 when compared to the prior year. All other categories of noninterest expense for 2016 totaled $75.09 million, an increase of $6.63 million, or 9.68%, as compared to 2015. The increase in noninterest expense was largely attributable to increases in equipment expense of $1.26 million, largely resulting from the Company’s acquisition of Conroe. Telephone expenses increased $1.05 million due to costs to improve our technology infrastructure and professional and service fees increased $2.05 million due primarily to outsourcing expenses for certain technology providers, which offset salary costs. Offsetting these increases in 2016 were a decrease of $473 thousand in FDIC insurance due to the lower rate charged by the FDIC beginning in the third quarter of 2016. Table 4 - Noninterest Expense (in thousands): Income Taxes. Income tax expense was $26.82 million for 2017, as compared to $31.15 million for 2016 and $31.44 million for 2015. Our effective tax rates on pretax income were 18.22%, 22.92% and 23.85%, respectively, for the years 2017, 2016 and 2015. The effective tax rates differ from the statutory federal tax rate of 35.0% largely due to tax exempt interest income earned on certain investment securities and loans, the deductibility of dividends paid to our employee stock ownership plan and income tax deductions from the partial donation of two of our branch buildings to municipalities. On December 22, 2017, the Tax Cuts and Jobs Act was signed into law with sweeping modifications to the Internal Revenue Code. The primary change for the Company was to lower the corporate income tax rate to 21% from 35%. The Company’s deferred tax assets and liabilities were re-measured based on the income tax rates at which they are expected to reverse in the future, which is generally 21%. However, the Company continues to analyze certain aspects of the Act resulting in refinement of the calculation which could potentially affect the measurement of these balances or potentially give rise to new deferred tax amounts. The provisional amount recorded related to the re-measurement of the Company’s deferred tax balance was $7.65 million, a reduction of income tax expense for the year ended December 31, 2017. Balance Sheet Review Loans. Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. Real estate loans represent loans primarily for 1-4 family residences and commercial real estate, which are primarily owner-occupied. The structure of loans in the real estate mortgage area generally provides re-pricing intervals to minimize the interest rate risk inherent in long-term fixed rate loans. As of December 31, 2017, total loans held for investment were $3.49 billion, an increase of $128.26 million, as compared to December 31, 2016. As compared to year-end 2016, real estate loans increased $113.15 million, commercial loans increased $9.69 million, agricultural loans increased $10.52 million and consumer loans decreased $5.10 million. Loans averaged $3.44 billion during 2017, an increase of $102.21 million over the 2016 average balances. Table 5 - Composition of Loans (in thousands): As of December 31, 2017, our real estate loans represent approximately 66.07% of our loan portfolio and are comprised of (i) commercial real estate loans of 24.84%, generally owner occupied, (ii) 1-4 family residence loans of 45.80%, (iii) residential development and construction loans of 8.28%, which includes our custom and speculation home construction loans, (iv) commercial development and construction loans of 6.21% and (v) other loans, which includes ranches, hospitals and universities of 14.87%. Loans held-for-sale, consisting of secondary market mortgage loans, totaled $15.13 million and $26.90 million at December 31, 2017 and 2016, respectively, which are valued using the lower of cost or market method. The Company has certain lending policies and procedures in place that are designed to maximize loan income with an acceptable level of risk. Management reviews and approves these policies and procedures on an annual basis and makes changes as appropriate. Management receives and reviews monthly reports related to loan originations, quality, concentrations, delinquencies, nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions, both by type of loan and geographic location. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. Underwriting standards are designed to determine whether the borrower possesses sound business ethics and practices and to evaluate current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and, secondarily, on the underlying collateral provided by the borrower. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and include personal guarantees. Agricultural loans are subject to underwriting standards and processes similar to commercial loans. These agricultural loans are based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. Most agricultural loans are secured by the agriculture related assets being financed, such as farm land, cattle or equipment, and include personal guarantees. Real estate loans are also subject to underwriting standards and processes similar to commercial and agricultural loans. These loans are underwritten primarily based on projected cash flows and, secondarily, as loans secured by real estate. The repayment of real estate loans is generally largely dependent on the successful operation of the property securing the loans or the business conducted on the property securing the loan. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s real estate portfolio are generally diverse in terms of type and geographic location within Texas. This diversity helps reduce the exposure to adverse economic events that affect any single market or industry. Generally, real estate loans are owner-occupied which further reduces the Company’s risk. Consumer loan underwriting utilizes methodical credit standards and analysis to supplement the Company’s underwriting policies and procedures. The Company’s loan policy addresses types of consumer loans that may be originated and the collateral, if secured, which must be perfected. The relatively smaller individual dollar amounts of consumer loans that are spread over numerous individual borrowers also minimize the Company’s risk. Table 6 - Maturity Distribution and Interest Sensitivity of Loans at December 31, 2017 (in thousands): The following tables summarize maturity and repricing information for the commercial and agricultural and the real estate-construction portion of our loan portfolio as of December 31, 2017: Asset Quality. Our loan portfolio is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectability of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing, and restructured loans plus foreclosed assets were $20.12 million at December 31, 2017, as compared to $29.00 million at December 31, 2016 and $29.77 million at December 31, 2015. As a percent of loans and foreclosed assets, these assets were 0.57% at December 31, 2017, as compared to 0.86% at December 31, 2016 and 0.89% at December 31, 2015. As a percent of total assets, these assets were 0.28% at December 31, 2017, as compared to 0.43% at December 31, 2016 and 0.45% at December 31, 2015. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at December 31, 2017. Supplemental Oil and Gas Information. At December 31, 2017, the Company’s exposure to the oil and gas industry was 1.72% of gross loans, or $60.16 million, down 23.34% from December 31, 2016 year-end levels, and consisted (based on collateral supporting the loan) of (i) development and production loans of 2.72%, (ii) oil and gas field servicing loans of 7.51%, (iii) real estate loans of 47.28%, (iv) accounts receivable and inventory of 24.47% and (v) other of 18.02%. These loans have experienced increased stress due to lower oil and gas prices although such prices improved in 2017. The Company instituted additional monitoring procedures for these loans and has classified, downgraded and charged-off loans as appropriate. The following oil and gas information is as of and for the years ended December 31, 2017 and 2016: Table 7 - Nonaccrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): * Includes $618 thousand, $1.26 million, $2.18 million, $2.15 million and $2.71 million, respectively, of purchased credit impaired loans as of December 31, 2017, 2016, 2015, 2014 and 2013. ** Troubled debt restructured loans of $4.63 million, $6.86 million, $6.11 million, $9.07 million and $13.30 million, respectively, whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans as of December 31, 2017, 2016, 2015, 2014 and 2013. We record interest payments received on non-accrual loans as reductions of principal. Prior to the loans being placed on non-accrual, we recognized interest income on impaired loans as of December 31, 2017 of approximately $263 thousand during the year ended December 31, 2017. If interest on these impaired loans had been recognized on a full accrual basis during the year ended December 31, 2017, such income would have approximated $2.15 million. See Note 3 to the Consolidated Financial Statements beginning on page for more information on these assets. Provision and Allowance for Loan Losses. The allowance for loan losses is the amount we determine as of a specific date to be appropriate to absorb probable losses on existing loans in which full collectability is unlikely based on our review and evaluation of the loan portfolio. For a discussion of our methodology, see our accounting policies in Note 1 to the Consolidated Financial Statements beginning on page. The provision for loan losses was $6.53 million in 2017, as compared to $10.21 million in 2016 and $9.69 million in 2015. The continued provision for loan losses in 2017 reflects the continued growth in the loan portfolio, the continued levels of gross charge-offs and the effects related to Hurricane Harvey on the loan portfolio. As a percent of average loans, net loan charge-offs were 0.12% during 2017, 0.19% during 2016 and 0.15% during 2015. The allowance for loan losses as a percent of loans was 1.38% as of December 31, 2017, as compared to 1.35% as of December 31, 2016, and 1.25% as of December 31, 2015. Included in Tables 8 and 9 are further analysis of our allowance for loan losses. Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy or lower employment could result in increased levels of nonaccrual, past due 90 days or more and still accruing, restructured loans, foreclosed assets, charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review the adequacy of our allowance for loan losses. The banking agencies could require additions to the loan loss allowance based on their judgment of information available to them at the time of their examinations of our bank subsidiary. Table 8 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): * Reflects the impact of loans acquired in the Orange acquisition in 2013 and the Conroe acquisition in 2015, which were initially recorded at fair value with no allocated allowance for loan losses. Table 9 - Allocation of Allowance for Loan Losses (in thousands): Percent of Loans in Each Category of Total Loans: Included in our loan portfolio are certain other loans not included in Table 7 that are deemed to be potential problem loans. Potential problem loans are those loans that are currently performing, but for which known information about trends, uncertainties or possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present repayment terms, possibly resulting in the transfer of such loans to nonperforming status. These potential problem loans totaled $4.37 million as of December 31, 2017. Interest-Bearing Deposits in Banks. The Company had interest-bearing deposits in banks of $164.22 million and $50.28 million at December 31, 2017 and 2016, respectively. At December 31, 2017, our interest-bearing deposits in banks included $162.09 million maintained at the Federal Reserve Bank of Dallas, $1.46 million invested in FDIC-insured certificates of deposit and $677 thousand on deposit with the Federal Home Loan Bank of Dallas (FHLB). The average balance of interest-bearing deposits in banks was $141.37 million, $58.25 million and $49.69 million in 2017, 2016 and 2015, respectively. The average yield on interest-bearing deposits in banks was 1.17%, 0.55% and 0.36% in 2017, 2016 and 2015, respectively. Available-for-Sale and Held-to-Maturity Securities. At December 31, 2017, securities with a fair value of $3.09 billion were classified as securities available-for-sale. There were no securities classified as held-to-maturity at December 31, 2017. As compared to December 31, 2016, the available-for-sale portfolio at December 31, 2017, reflected (1) a decrease of $10.67 million in U.S. Treasury securities; (2) a decrease of $53.37 million in obligations of U.S. government sponsored enterprises and agencies; (3) a decrease of $143.43 million in obligations of states and political subdivisions; (4) a decrease of $40.93 million in corporate bonds and other; and (5) an increase of $475.04 million in mortgage-backed securities. As compared to December 31, 2015, the available-for-sale portfolio at December 31, 2016, reflected (1) a decrease of $127 thousand in U.S. Treasury securities; (2) a decrease of $34.85 million in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $113.15 million in obligations of states and political subdivisions; (4) a decrease of $35.56 million in corporate bonds and other; and (5) an increase of $84.33 million in mortgage-backed securities. Securities-available-for-sale included fair value adjustments of $44.86 million, $33.07 million and $79.01 million at December 31, 2017, 2016 and 2015, respectively. We did not hold any collateralized mortgage obligations or structured notes as of December 31, 2017 that we consider to be high risk. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies. See Table 10 and Note 2 to the Consolidated Financial Statements for additional disclosures relating to the maturities and fair values of the investment portfolio at December 31, 2017 and 2016. Table 10 - Maturities and Yields of Available-for-Sale Held at December 31, 2017 (in thousands, except percentages): Amounts for held-to-maturity securities are not included herein due to insignificance. All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 35%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date. As of December 31, 2017, the investment portfolio had an overall tax equivalent yield of 3.56%, a weighted average life of 4.29 years and modified duration of 3.82 years. Deposits. Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $5.96 billion as of December 31, 2017, as compared to $5.48 billion as of December 31, 2016 and $5.19 billion as of December 31, 2015. Table 11 provides a breakdown of average deposits and rates paid over the past three years and the remaining maturity of time deposits of $100,000 or more: Table 11 - Composition of Average Deposits and Remaining Maturity of Time Deposits of $100,000 or More (in thousands, except percentages): Borrowings. Included in borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $331.00 million, $445.77 million and $615.68 million at December 31, 2017, 2016 and 2015, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the short-term borrowing. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were $422.29 million, $552.04 million and $524.37 million in 2017, 2016 and 2015, respectively. The average rates paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were 0.25%, 0.17% and 0.08% for the years ended December 31, 2017, 2016 and 2015, respectively. The weighted average interest rate on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was 0.10%, 0.12% and 0.17% at December 31, 2017, 2016 and 2015, respectively. The highest amount of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB at any month end during 2017, 2016 and 2015 was $611.30 million, $598.77 million and $647.72 million, respectively. Capital Resources We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration. Total shareholders’ equity was $922.77 million, or 12.72% of total assets at December 31, 2017, as compared to $837.89 million, or 12.30% of total assets at December 31, 2016. During 2017, total shareholders’ equity averaged $882.81 million, or 12.65% of average assets, as compared to $847.87 million, or 12.85% of average assets during 2016. Banking regulators measure capital adequacy by means of the risk-based capital ratios and leverage ratio under the Basel III regulatory capital framework and prompt corrective action regulations. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets. Beginning in January 2016, under the Basel III regulatory capital framework, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reaches 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the amount of the buffer will result in restrictions on the Company’s ability to make capital distributions, including divided payments and stock repurchase, and to pay discretionary bonuses to executive officers. As of December 31, 2017 and 2016, we had a total risk-based capital ratio of 19.85% and 18.45%, a Tier 1 capital to risk-weighted assets ratio of 18.66% and 17.30%, a common equity Tier 1 capital to risk-weighted ratio of 18.66% and 17.30% and a Tier 1 leverage ratio of 11.09% and 10.71%, respectively. The regulatory capital ratios as of December 31, 2017 and 2016 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. We performed a preliminary assessment using the regulatory capital estimation tool made available by the OCC and believe the Company and Bank are prepared to meet the new requirements upon full implementation of the Basel III rules that will be effective December 31, 2019. Our subsidiary bank made the election to continue to exclude most AOCI from capital in connection with its March 31, 2015 quarterly financial filing and, in effect, to retain the AOCI treatment under the prior capital rules. Interest Rate Risk. Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk. Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the re-pricing and maturity characteristics of the existing and projected balance sheet. As of December 31, 2017, the model simulations projected that 100 and 200 basis point increases in interest rates would result in variances in net interest income of positive 0.58% and positive 0.50%, respectively, relative to the current financial statement structure over the next twelve months, while a decrease in interest rates of 100 basis points would result in a variance in a net interest income of negative 3.84% relative to the current financial statement structure over the next twelve months. We consider the likelihood of a decrease in interest rates beyond 100 basis points after December 31, 2017 remote given current interest rate levels. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics on specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities re-price in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material. Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committee oversees and monitors this risk. Liquidity Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument, as detailed in Tables 12 and 13. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB, which amounted to $331.00 million at December 31, 2017, and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures on June 2019 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $130.00 million. At December 31, 2017, there were no amounts drawn on these lines of credit. Our subsidiary bank also has available a line of credit with the FHLB totaling $1.22 billion at December 31, 2017, secured by portions of our loan portfolio and certain investment securities. At December 31, 2017, no amounts were outstanding under this line of credit. The Company renewed its loan agreement, effective June 30, 2017, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of credit. Prior to June 30, 2019, interest is paid quarterly at The Wall Street Journal Prime Rate and the line of credit matures June 30, 2019. If a balance exists at June 30, 2019, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at our election at The Wall Street Journal Prime Rate plus 50 basis points or LIBOR plus 250 basis points. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of our consolidated net income in a range of 37% (low) in 1995 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at December 31, 2017. There was no outstanding balance under the line of credit as of December 31, 2017 or 2016. In addition, we anticipate that any future acquisition of financial institutions, expansion of branch locations or offering of new products could also place a demand on our cash resources. Available cash and cash equivalents at our parent company, which totaled $78.47 million at December 31, 2017, investment securities which totaled $8.52 million at December 31, 2017 which matures over 6 to 13 years, available dividends from our subsidiaries which totaled $205.75 million at December 31, 2017, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for these potential acquisitions or expansions. Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. Table 12 - Contractual Obligations as of December 31, 2017 (in thousands): Amounts above for deposits do not include related accrued interest. Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties. Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount. Table 13 - Commitments as of December 31, 2017 (in thousands): We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. Parent Company Funding. Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At December 31, 2017, approximately $205.75 million was available for the payment of intercompany dividends by our subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends to us of $30.80 million in 2017 and $48.80 million in 2016. Dividends. Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 41.24%, 44.14% and 40.20% of net earnings, respectively, in 2017, 2016 and 2015. Given our current capital position, projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank’s net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

<s>[INST] Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2017 and 2016, and consolidated statements of earnings for the years 2015 through 2017 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Hurricane Harvey Houston and the surrounding Gulf Coast region were significantly affected by Hurricane Harvey beginning in late August 2017 and continuing into the fourth quarter of 2017. Our Company has locations (i) north of Houston in Conroe, Willis, Tomball, Huntsville, Montgomery, Magnolia, New Waverly and Cut and Shoot and (ii) in Southeast Texas in Orange, Beaumont, Vidor, Newton, Mauriceville and Port Arthur. We continue to evaluate the effect of the hurricane on our branch facilities and our loan and investment portfolios. Our initial assessment of our physical buildings and equipment indicates damage primarily at our Mauriceville branch, and amounts not covered by insurance do not appear to be significant. At December 31, 2017, we had loans totaling $446.62 million in our Conroe region and $396.55 million in the Southeast Texas/Orange region. We are evaluating these loans and the related collateral and business operations underlying such loans. At December 31, 2017, we provided additional allowance for loan losses as deemed appropriate based on this analysis. We continue to evaluate these loans as we learn more information about the damage caused by the hurricane. Our tax exempt municipal bonds in the counties of Texas effected by the hurricane have been evaluated, including insurance on the bonds. At December 31, 2017, our municipal bonds in these counties totaled $458.16 million, but only $92.75 million do not have bond insurance. Based on analysis of these bonds and the related municipality, at December 31, 2017, we do not believe we have any credit related losses other than temporary impairment. Acquisitions and Asset Purchase On October 12, 2017, we entered into an agreement and plan of reorganization to acquire Commercial Bancshares, Inc. and its wholly owned bank subsidi [/INST] Negative. </s>

FIRST FINANCIAL BANKSHARES INC

2019-02-19

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to those listed in “Item 1A - Risk Factors” and in the “Cautionary Statement Regarding Forward-Looking Statements” notice on page 1. Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2018 and 2017, and consolidated statements of earnings for the years 2016 through 2018 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10-K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Hurricane Harvey Houston and the surrounding Gulf Coast region were significantly affected by Hurricane Harvey beginning in late August 2017 and continuing into the fourth quarter of 2017. Our Company has locations (i) north of Houston in Conroe, Willis, Tomball, Huntsville, Montgomery, Magnolia, New Waverly and Cut and Shoot and (ii) in Southeast Texas in Orange, Beaumont, Vidor, Newton, Mauriceville and Port Arthur. We continue to evaluate the effect of the hurricane on our branch facilities and our loan and investment portfolios. Our assessment of our physical buildings and equipment indicated damage primarily at our Mauriceville branch and amounts not covered by insurance were not significant. At December 31, 2018, we had loans totaling $474.42 million in our Conroe region and $405.79 million in the Southeast Texas/Orange region. We continue to evaluate these loans and the related collateral and business operations underlying such loans as we learn more information about the damage caused by the hurricane and the impact of such damage on our customers’ ability to repay loans in accordance with their contractual terms. Our tax exempt municipal bonds in the counties of Texas affected by the hurricane have also been evaluated, including insurance on the bonds. At December 31, 2018, our municipal bonds in these counties totaled $422.86 million, but only $109.36 million do not have bond insurance. Based on analysis of these bonds and the related municipality, at December 31, 2018, we do not believe we have any credit related losses other than temporary impairment. Acquisition On October 12, 2017, we entered into an agreement and plan of reorganization to acquire Commercial Bancshares, Inc. and its wholly owned bank subsidiary, Commercial State Bank, Kingwood, Texas. On January 1, 2018, the transaction closed. Pursuant to the agreement, we issued 1,289,371 shares of the Company’s common stock in exchange for all of the outstanding shares of Commercial Bancshares, Inc. In addition, in accordance with the plan of reorganization, Commercial Bancshares, Inc. paid a special dividend totaling $22.08 million to its shareholders prior to the closing of this transaction. At the closing, Kingwood Merger Sub., Inc., a wholly-owned subsidiary of the Company, merged into Commercial Bancshares Inc., with Commercial Bancshares, Inc. surviving as a wholly-owned subsidiary of the Company. Immediately following such merger, Commercial Bancshares, Inc. was merged into the Company and Commercial State Bank, Kingwood, Texas was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value net of assets acquired by approximately $31.59 million and the Company recorded such excess as goodwill. The balance sheet and results of operations of Commercial Bancshares, Inc. are included in the financial statements of the Company effective January 1, 2018. Results of Operations Performance Summary. Net earnings for 2018 were $150.64 million, an increase of $30.27 million, or 25.14%, over net earnings for 2017 of $120.37 million. Net earnings for 2016 were $104.77 million. The increases in net earnings for 2018 over 2017 were primarily attributable to the change in income tax rates and 2017 over 2016 were primarily attributable to growth in net interest income and noninterest income. On a basic net earnings per share basis, net earnings were $2.23 for 2018, as compared to $1.82 for 2017 and $1.59 for 2016. The return on average assets was 1.98% for 2018, as compared to 1.72% for 2017 and 1.59% for 2016. The return on average equity was 15.37% for 2018, as compared to 13.63% for 2017 and 12.36% for 2016. Net Interest Income. Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $281.75 million in 2018, as compared to $262.18 million in 2017 and $251.78 million in 2016. The increases in 2018 compared to 2017 were largely attributable to increases in the volume of earning assets offset by rate increases on our interest-bearing liabilities. Average earning assets were $7.12 billion in 2018, as compared to $6.54 billion in 2017 and $6.17 billion in 2016. Average earning assets increased $570.96 million in 2018, when compared to 2017, due primarily from increases in loans and taxable securities. Average earning assets increased $373.50 million in 2017, when compared to 2016, due primarily from increases in loans and taxable securities. Average interest bearing liabilities were $4.47 billion in 2018, as compared to $4.21 billion in 2017 and $4.02 billion in 2016. The yield on earning assets increased eight basis points in 2018, although this yield was negatively impacted from the change in income tax rate from 35% to 21% and the related effect on the tax-exempt investment securities. The rate paid on interest-bearing liabilities increased twenty basis points when compared to 2017. The yield on earning assets decreased two basis points in 2017, whereas the rate paid on interest-bearing liabilities increased eight basis points when compared to 2016. Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate. Table 1 - Changes in Interest Income and Interest Expense (in thousands): (1) Computed on tax-equivalent basis assuming marginal tax rate of 21% for 2018 and 35% for 2017 and 2016. (2) Non-accrual loans are included in loans. The net interest margin in 2018 was 3.96%, a decrease of five basis points from 2017 which also decreased an additional seven basis points from 2016. The decrease in our net interest margin in 2018 from 2017 was primarily due to (i) the change in the income tax rate from 35% to 21% from the Tax Cuts and Jobs Act and its effect on our tax free municipal bonds and tax free loans and (ii) the result of the extended period of historically low levels of short-term interest rates, although rates have begun to increase in the past 24 months. We have been able to somewhat mitigate the impact of lower short-term interest rates by establishing minimum interest rates on certain of our loans, improving the pricing for loan risk, and minimizing rates paid on interest bearing liabilities. As rates have begun to increase, we are adjusting loan rates, upon maturities, and converting to variable rates when we are able. We have also begun increasing rates paid on our interest-bearing deposits. The Federal Reserve increased rates 100 basis points in 2018, 75 basis points in 2017 and 25 basis points in 2016 and continues to issue forward guidance plans to increase rates further. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2 for the years 2016 through 2018. Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): (1) Short-term investments are comprised of Fed Funds sold, interest bearing deposits in banks and interest bearing time deposits in banks. (2) Average balances include unrealized gains and losses on available-for-sale securities. (3) Computed on a tax-equivalent basis assuming a marginal tax rate of 21% for 2018 and 35% for 2017 and 2016. (4) Nonaccrual loans are included in loans. Noninterest Income. Noninterest income for 2018 was $101.76 million, an increase of $10.75 million, or 11.81%, as compared to 2017. Increases in certain categories of noninterest income included (1) trust fees of $4.49 million (2) ATM, interchange and credit card fees of $2.85 million and (3) service charges on deposit accounts of $2.25 million when compared to 2017. The increase in trust fees resulted from an increase in assets under management over the prior year and an increase in oil and gas production for the majority of 2018 that increased related to trust fees by $2.61 million over 2017. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $5.60 billion at December 31, 2018, as compared to $5.13 billion at December 31, 2017. The increases in ATM, interchange and credit card fees increased due to continued growth in debit cards and the Kingwood acquisition. Service charges on deposit accounts increased primarily due to continued growth in net new accounts, product and pricing changes made to better align the Company’s account offerings and the Kingwood acquisition. Offsetting these increases were decreases in interest on net recoveries of $190 thousand and gains on sale of available-for-sale securities of $474 thousand. Noninterest income for 2017 was $91.02 million, an increase of $5.89 million, or 6.91%, as compared to 2016. Increases in certain categories of noninterest income included (1) trust fees of $4.06 million (2) ATM, interchange and credit card fees of $1.78 million and (3) service charges on deposit accounts of $1.03 million when compared to 2016. The increase in trust fees resulted from an increase in assets under management over the prior year and an increase in oil and gas production that increased related trust fees by $364 thousand over 2016. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $5.13 billion at December 31, 2017, as compared to $4.37 billion at December 31, 2016. The increases in ATM, interchange and credit card fees and service charges on deposit accounts were primarily the result of increases in the number of net new accounts and debit cards. Offsetting these increases were decreases in net recoveries of $984 thousand and real estate mortgage fees of $977 thousand. ATM and interchange fees are charges that merchants pay to us and other card-issuing banks for processing electronic payment transactions. ATM and interchange fees consist of income from debit card usage, point of sale income for debit card transactions and ATM service fees. Federal Reserve rules applicable to financial institutions that have assets of $10 billion or more provide that the maximum permissible interchange fee for an electronic debit transaction in the sum of 21 cents per transaction and five basis points multiplied by the value of the transaction. While we currently have assets under $10 billion, we are monitoring the effect of this reduction in per transaction fee income as we approach the $10 billion asset level. Table 3 - Noninterest Income (in thousands): Noninterest Expense. Total noninterest expense for 2018 was $190.68 million, an increase of $16.70 million, or 9.60%, as compared to 2017. Noninterest expense for 2017 amounted to $173.99 million, an increase of $8.16 million, or 4.92%, as compared to 2016. An important measure in determining whether a financial institution effectively manages noninterest expenses is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for 2018 was 49.72%, as compared to 49.26% for 2017 and 49.22% for 2016. Salaries and employee benefits for 2018 totaled $105.19 million, an increase of $9.90 million, or 10.39%, as compared to 2017. The increase was primarily driven by (i) annual merit pay increases that were effective March 1, 2018, (ii) an increase in our profit sharing expenses, and (iii) increases in all categories from the Kingwood acquisition. All other categories of noninterest expense for 2018 totaled $85.50 million, an increase of $6.80 million, or 8.64%, as compared to 2017. Included in noninterest expense in 2018 was $1.55 million, before income tax, resulting from the Company’s partial settlement of its frozen defined benefit pension plan. Other notable increases in noninterest expense include a $1.83 million increase in ATM, interchange and credit card expenses and a $652 thousand increase in net occupancy expense. In addition, included in other miscellaneous expense for 2018 were technology contract termination and conversion related costs totaling $1,747,000 related to the Kingwood acquisition. Salaries and employee benefits for 2017 totaled $95.29 million, an increase of $4.55 million, or 5.01%, as compared to 2016. The increase was primarily driven by (i) annual merit pay increases that were effective March 1, 2017, (ii) an increase in our profit sharing expenses and (iii) an increase in stock option and stock grant expense due to the stock option grant in June 2017 and restricted stock grant in October 2017. All other categories of noninterest expense for 2017 totaled $78.70 million, an increase of $3.61 million, or 4.80%, as compared to 2016. The increase in noninterest expense was largely attributable to increases in software amortization and expense of $1.29 million from the write-off of internally developed software, operational and other losses of $1.02 million due to fraud and weather related losses and professional and service fees of $1.19 million. Offsetting these increases in 2017 were a decrease of $463 thousand in FDIC insurance due to the lower rate charged by the FDIC beginning in the third quarter of 2016. Table 4 - Noninterest Expense (in thousands): Income Taxes. Income tax expense was $27.54 million for 2018, as compared to $26.82 million for 2017 and $31.15 million for 2016. Our effective tax rates on pretax income were 15.46%, 18.22% and 22.92%, respectively, for the years 2018, 2017 and 2016. The effective tax rates differ from the statutory federal tax rate of 21.0% in 2018 and 2017 and 35.0% in 2016 largely due to tax exempt interest income earned on certain investment securities and loans, the deductibility of dividends paid to our employee stock ownership plan and income tax deductions from the partial donation of two of our branch buildings to municipalities. On December 22, 2017, the Tax Cuts and Jobs Act was signed into law with sweeping modifications to the Internal Revenue Service Code. The primary change for the Company was to lower the corporate income tax rate to 21% from 35%. The Company’s deferred tax assets and liabilities were re-measured based on the income tax rates at which they are expected to reverse in the future, which is generally 21%. The provisional amount recorded related to the re-measurement of the Company’s deferred tax balance was $7.65 million, a reduction of income tax expense for the year ended December 31, 2017. In 2018, the Company continued to analyze certain aspects of the Tax Cuts and Jobs Act resulting in refinement of the calculation and recorded an additional reduction in its deferred tax balance of $664 thousand, which represents a reduction of income tax expense for year ended December 31, 2018. Balance Sheet Review Loans. Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. Real estate loans represent loans primarily for 1-4 family residences and commercial real estate, which are primarily owner-occupied. The structure of loans in the real estate mortgage area generally provides re-pricing intervals to minimize the interest rate risk inherent in long-term fixed rate loans. As of December 31, 2018, total loans held for investment were $3.95 billion, an increase of $468.07 million, as compared to December 31, 2017. As compared to year-end 2017, real estate loans increased $336.35 million, commercial loans increased $160.85 million, agricultural loans increased $2.13 million and consumer loans decreased $31.27 million. Loans averaged $3.83 billion during 2018, an increase of $392.59 million over the 2017 average balances. Table 5 - Composition of Loans (in thousands): As of December 31, 2018, our real estate loans represent approximately 66.76% of our loan portfolio and are comprised of (i) commercial real estate loans of 29.11%, generally owner occupied, (ii) 1-4 family residence loans of 42.32%, (iii) residential development and construction loans of 9.47%, which includes our custom and speculation home construction loans, (iv) commercial development and construction loans of 4.98% and (v) other loans, which includes ranches, hospitals and universities of 14.12%. Loans held-for-sale, consisting of secondary market mortgage loans, totaled $21.67 million and $15.13 million at December 31, 2018 and 2017, respectively. At December 31, 2018, $2.49 million is valued at the lower of cost or fair value, and the remaining amount is valued under the fair value option. All amounts at December 31, 2017 were valued at the lower of cost or fair value. The Company has certain lending policies and procedures in place that are designed to maximize loan income with an acceptable level of risk. Management reviews and approves these policies and procedures on an annual basis and makes changes as appropriate. Management receives and reviews monthly reports related to loan originations, quality, concentrations, delinquencies, nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions, both by type of loan and geographic location. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. Underwriting standards are designed to determine whether the borrower possesses sound business ethics and practices and to evaluate current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and, secondarily, on the underlying collateral provided by the borrower. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and include personal guarantees. Agricultural loans are subject to underwriting standards and processes similar to commercial loans. These agricultural loans are based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. Most agricultural loans are secured by the agriculture related assets being financed, such as farm land, cattle or equipment, and include personal guarantees. Real estate loans are also subject to underwriting standards and processes similar to commercial and agricultural loans. These loans are underwritten primarily based on projected cash flows and, secondarily, as loans secured by real estate. The repayment of real estate loans is generally largely dependent on the successful operation of the property securing the loans or the business conducted on the property securing the loan. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s real estate portfolio are generally diverse in terms of type and geographic location within Texas. This diversity helps reduce the exposure to adverse economic events that affect any single market or industry. Generally, real estate loans are owner-occupied which further reduces the Company’s risk. Consumer loan underwriting utilizes methodical credit standards and analysis to supplement the Company’s underwriting policies and procedures. The Company’s loan policy addresses types of consumer loans that may be originated and the collateral, if secured, which must be perfected. The relatively smaller individual dollar amounts of consumer loans that are spread over numerous individual borrowers also minimize the Company’s risk. Table 6 - Maturity Distribution and Interest Sensitivity of Loans at December 31, 2018 (in thousands): The following tables summarize maturity and repricing information for the commercial and agricultural and the real estate-construction portion of our loan portfolio as of December 31, 2018: Asset Quality. Our loan portfolio is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectability of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing, and restructured loans plus foreclosed assets were $29.63 million at December 31, 2018, as compared to $20.12 million at December 31, 2017 and $29.00 million at December 31, 2016. As a percent of loans and foreclosed assets, these assets were 0.75% at December 31, 2018, as compared to 0.57% at December 31, 2017 and 0.86% at December 31, 2016. As a percent of total assets, these assets were 0.38% at December 31, 2018, as compared to 0.28% at December 31, 2017 and 0.43% at December 31, 2016. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at December 31, 2018. Supplemental Oil and Gas Information. At December 31, 2018, the Company’s exposure to the oil and gas industry was 2.86% of gross loans, or $113.54 million, compared to 1.72% of gross loans, or $60.16 million at December 31, 2017. The increase in 2018 was primarily a result of the Kingwood acquisition. These oil and gas loans consisted (based on collateral supporting the loan) of (i) development and production loans of 0.34%, (ii) oil and gas field servicing loans of 8.52%, (iii) real estate loans of 40.78%, (iv) accounts receivable and inventory of 2.50%, (v) automobile of 39.64% and (vi) other of 8.22%. These loans have experienced increased stress due to lower oil and gas prices although such prices improved in 2018. The Company instituted additional monitoring procedures for these loans and has classified, downgraded and charged-off loans as appropriate. The following oil and gas information is as of and for the years ended December 31, 2018 and 2017: Table 7 - Nonaccrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): * Includes $827 thousand, $618 thousand, $1.26 million, $2.18 million and $2.15 million, respectively, of purchased credit impaired loans as of December 31, 2018, 2017, 2016, 2015 and 2014. ** Troubled debt restructured loans of $3.84 million, $4.63 million, $6.86 million, $6.11 million and $9.07 million, respectively, whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans as of December 31, 2018, 2017, 2016, 2015 and 2014. We record interest payments received on non-accrual loans as reductions of principal. Prior to the loans being placed on non-accrual, we recognized interest income on impaired loans as of December 31, 2018 of approximately $395 thousand during the year ended December 31, 2018. If interest on these impaired loans had been recognized on a full accrual basis during the year ended December 31, 2018, such income would have approximated $2.57 million. See Note 3 to the Consolidated Financial Statements beginning on page for more information on these assets. Provision and Allowance for Loan Losses. The allowance for loan losses is the amount we determine as of a specific date to be appropriate to absorb probable losses on existing loans in which full collectability is unlikely based on our review and evaluation of the loan portfolio. For a discussion of our methodology, see our accounting policies in Note 1 to the Consolidated Financial Statements beginning on page. The provision for loan losses was $5.67 million in 2018, as compared to $6.53 million in 2017 and $10.21 million in 2016. The continued provision for loan losses in 2018 reflects the continued growth in the loan portfolio and the continued levels of gross charge-offs. As a percent of average loans, net loan charge-offs were 0.07% during 2018, 0.12% during 2017 and 0.19% during 2016. The allowance for loan losses as a percent of loans was 1.29% as of December 31, 2018, as compared to 1.38% as of December 31, 2017 and 1.35% as of December 31, 2016. Included in Tables 8 and 9 are further analysis of our allowance for loan losses. Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy or lower employment could result in increased levels of nonaccrual, past due 90 days or more and still accruing, restructured loans, foreclosed assets, charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review the adequacy of our allowance for loan losses. The banking agencies could require additions to the loan loss allowance based on their judgment of information available to them at the time of their examinations of our bank subsidiary. Table 8 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): * Reflects the impact of loans acquired in the Conroe acquisition in 2015 and the Kingwood acquisition in 2018, which were initially recorded at fair value with no allocated allowance for loan losses. Table 9 - Allocation of Allowance for Loan Losses (in thousands): Percent of Loans in Each Category of Total Loans: Included in our loan portfolio are certain other loans not included in Table 7 that are deemed to be potential problem loans. Potential problem loans are those loans that are currently performing, but for which known information about trends, uncertainties or possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present repayment terms, possibly resulting in the transfer of such loans to nonperforming status. These potential problem loans totaled $3.04 million as of December 31, 2018. Interest-Bearing Deposits in Banks. The Company had interest-bearing deposits in banks of $42.27 million at December 31, 2018 and $164.22 million at December 31, 2017, respectively. At December 31, 2018, our interest-bearing deposits in banks included $40.17 million maintained at the Federal Reserve Bank of Dallas, $1.46 million invested in FDIC-insured certificates of deposit and $645 thousand on deposit with the Federal Home Loan Bank of Dallas (FHLB). The average balance of interest-bearing deposits in banks was $87.03 million $141.37 million and $58.25 million in 2018, 2017 and 2016, respectively. The average yield on interest-bearing deposits in banks was 1.79%, 1.17% and 0.55% in 2018, 2017 and 2016, respectively. Available-for-Sale and Held-to-Maturity Securities. At December 31, 2018, securities with a fair value of $3.16 billion were classified as securities available-for-sale. There were no securities classified as held-to-maturity at December 31, 2018. As compared to December 31, 2017, the available-for-sale portfolio at December 31, 2018, reflected (1) an increase of $9.96 million in U.S. Treasury securities; (2) a decrease of $60.03 million in obligations of U.S. government sponsored enterprises and agencies; (3) a decrease of $162.98 million in obligations of states and political subdivisions; (4) a decrease of $6.66 million in corporate bonds and other; and (5) an increase of $291.01 million in mortgage-backed securities. As compared to December 31, 2016, the available-for-sale portfolio at December 31, 2017, reflected (1) a decrease of $10.67 million in U.S. Treasury securities; (2) a decrease of $53.37 million in obligations of U.S. government sponsored enterprises and agencies; (3) an decrease of $143.43 million in obligations of states and political subdivisions; (4) a decrease of $40.93 million in corporate bonds and other; and (5) an increase of $475.04 million in mortgage-backed securities. Securities-available-for-sale included fair value adjustments of $5.21 million, $44.86 million and $33.07 million at December 31, 2018, 2017 and 2016, respectively. We did not hold any collateralized mortgage obligations or structured notes as of December 31, 2018 that we consider to be high risk. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies. See Table 10 and Note 2 to the Consolidated Financial Statements for additional disclosures relating to the maturities and fair values of the investment portfolio at December 31, 2018 and 2017. Table 10 - Maturities and Yields of Available-for-Sale Held at December 31, 2018 (in thousands, except percentages): All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 21%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date. As of December 31, 2018, the investment portfolio had an overall tax equivalent yield of 3.32%, a weighted average life of 4.37 years and modified duration of 3.88 years. Deposits. Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $6.18 billion as of December 31, 2018 as compared to $5.96 billion as of December 31, 2017 and $5.48 billion as of December 31, 2016. Table 11 provides a breakdown of average deposits and rates paid over the past three years and the remaining maturity of time deposits of $100,000 or more: Table 11 - Composition of Average Deposits and Remaining Maturity of Time Deposits of $100,000 or More (in thousands, except percentages): Borrowings. Included in borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $468.71 million, $331.00 million and $445.77 million at December 31, 2018, 2017 and 2016, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the short-term borrowing. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were $418.98 million, $422.29 million and $552.04 million in 2018, 2017 and 2016, respectively. The average rates paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were 0.47%, 0.25% and 0.17% for the years ended December 31, 2018, 2017 and 2016, respectively. The weighted average interest rate on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was 0.78%, 0.10% and 0.12% at December 31, 2018, 2017 and 2016, respectively. The highest amount of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB at any month end during 2018, 2017 and 2016 was $529.64 million, $611.30 million and $598.77 million, respectively. Capital Resources We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration. Total shareholders’ equity was $1.05 billion, or 13.62% of total assets at December 31, 2018, as compared to $922.77 million, or 12.72% of total assets at December 31, 2017. During 2018, total shareholders’ equity averaged $980.21 million, or 12.89% of average assets, as compared to $882.81 million, or 12.65% of average assets during 2017. Banking regulators measure capital adequacy by means of the risk-based capital ratios and leverage ratio under the Basel III regulatory capital framework and prompt corrective action regulations. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets. Beginning in January 2016, under the Basel III regulatory capital framework, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reaches 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the amount of the buffer will result in restrictions on the Company’s ability to make capital distributions, including divided payments and stock repurchase, and to pay discretionary bonuses to executive officers. As of December 31, 2018 and 2017, we had a total risk-based capital ratio of 20.61% and 19.85%, a Tier 1 capital to risk-weighted assets ratio of 19.47% and 18.66%, a common equity Tier 1 capital to risk-weighted ratio of 19.47% and 18.66% and a Tier 1 leverage ratio of 11.85% and 11.09%, respectively. The regulatory capital ratios as of December 31, 2018 and 2017 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. We performed an assessment and believe the Company and Bank meet the requirements upon full implementation of the Basel III rules that will be effective in 2019. Our subsidiary bank made the election to continue to exclude most accumulated other comprehensive income from capital in connection with its March 31, 2015 quarterly financial filing and, in effect, to retain the accumulated other comprehensive income treatment under the prior capital rules. Interest Rate Risk. Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk. Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the re-pricing and maturity characteristics of the existing and projected balance sheet. As of December 31, 2018, the model simulations projected that 100 and 200 basis point increases in interest rates would result in variances in net interest income of positive 1.68% and positive 2.96%, respectively, relative to the current financial statement structure over the next twelve months, while a decrease in interest rates of 100 basis points would result in a variance in a net interest income of negative 5.78% relative to the current financial statement structure over the next twelve months. We consider the likelihood of a decrease in interest rates beyond 100 basis points after December 31, 2018 remote given current interest rate levels. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics on specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities re-price in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material. Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committee oversees and monitors this risk. Liquidity Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument, as detailed in Tables 12 and 13. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB, which amounted to $468.71 million at December 31, 2018, and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures on June 30, 2019 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $130.00 million. At December 31, 2018, there were no amounts drawn on these lines of credit. Our subsidiary bank also has available a line of credit with the FHLB totaling $1.23 billion at December 31, 2018, secured by portions of our loan portfolio and certain investment securities. At December 31, 2018, the Company had $55.00 million in advances outstanding under this line of credit. The Company renewed its loan agreement, effective June 30, 2017, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of credit. Prior to June 30, 2019, interest is paid quarterly at The Wall Street Journal Prime Rate and the line of credit matures June 30, 2019. If a balance exists at June 30, 2019, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at our election at The Wall Street Journal Prime Rate plus 50 basis points or LIBOR plus 250 basis points. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of our consolidated net income in a range of 37% (low) in 1995 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at December 31, 2018. There was no outstanding balance under the line of credit as of December 31, 2018 or 2017. In addition, we anticipate that any future acquisition of financial institutions, expansion of branch locations or offering of new products could also place a demand on our cash resources. Available cash and cash equivalents at the Company, which totaled $101.26 million at December 31, 2018, investment securities which totaled $6.28 million at December 31, 2018 with maturities over 10 to 12 years, available dividends from our subsidiaries which totaled $233.96 million at December 31, 2018, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for these potential acquisitions or expansions. Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. Table 12 - Contractual Obligations as of December 31, 2018 (in thousands): Amounts above for deposits do not include related accrued interest. Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties. Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount. Table 13 - Commitments as of December 31, 2018 (in thousands): We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. Parent Company Funding. Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At December 31, 2018, approximately $233.96 million was available for the payment of intercompany dividends by our subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends to us of $74.10 million in 2018 and $30.80 million in 2017. Dividends. Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 36.84%, 41.24% and 44.14% of net earnings, respectively, in 2018, 2017 and 2016. Given our current capital position, projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank’s net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

<s>[INST] Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2018 and 2017, and consolidated statements of earnings for the years 2016 through 2018 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Hurricane Harvey Houston and the surrounding Gulf Coast region were significantly affected by Hurricane Harvey beginning in late August 2017 and continuing into the fourth quarter of 2017. Our Company has locations (i) north of Houston in Conroe, Willis, Tomball, Huntsville, Montgomery, Magnolia, New Waverly and Cut and Shoot and (ii) in Southeast Texas in Orange, Beaumont, Vidor, Newton, Mauriceville and Port Arthur. We continue to evaluate the effect of the hurricane on our branch facilities and our loan and investment portfolios. Our assessment of our physical buildings and equipment indicated damage primarily at our Mauriceville branch and amounts not covered by insurance were not significant. At December 31, 2018, we had loans totaling $474.42 million in our Conroe region and $405.79 million in the Southeast Texas/Orange region. We continue to evaluate these loans and the related collateral and business operations underlying such loans as we learn more information about the damage caused by the hurricane and the impact of such damage on our customers’ ability to repay loans in accordance with their contractual terms. Our tax exempt municipal bonds in the counties of Texas affected by the hurricane have also been evaluated, including insurance on the bonds. At December 31, 2018, our municipal bonds in these counties totaled $422.86 million, but only $109.36 million do not have bond insurance. Based on analysis of these bonds and the related municipality, at December 31, 2018, we do not believe we have any credit related losses other than temporary impairment. Acquisition On October 12, 2017, we entered into an agreement and plan of reorganization to acquire Commercial Bancshares, Inc. and its wholly owned bank subsidiary, Commercial State Bank, Kingwood, Texas. On January 1, 2018, [/INST] Positive. </s>

FIRST FINANCIAL BANKSHARES INC

2020-02-14

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to those listed in “Item 1A - Risk Factors” and in the “Cautionary Statement Regarding Forward-Looking Statements” notice on page 1. Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2019 and 2018, and consolidated statements of earnings for the years 2017 through 2019 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10-K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisitions On October 12, 2017, we entered into an agreement and plan of reorganization to acquire Commercial Bancshares, Inc. and its wholly owned bank subsidiary, Commercial State Bank, Kingwood, Texas. On January 1, 2018, the transaction closed. Pursuant to the agreement, we issued 1.29 million shares of the Company’s common stock in exchange for all of the outstanding shares of Commercial Bancshares, Inc. In addition, in accordance with the plan of reorganization, Commercial Bancshares, Inc. paid a special dividend totaling $22.08 million to its shareholders prior to the closing of this transaction. At the closing, Kingwood Merger Sub., Inc., a wholly owned subsidiary of the Company, merged into Commercial Bancshares Inc., with Commercial Bancshares, Inc. surviving as a wholly owned subsidiary of the Company. Immediately following such merger, Commercial Bancshares, Inc. was merged into the Company and Commercial State Bank, Kingwood, Texas was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value net of assets acquired by approximately $31.59 million and the Company recorded such excess as goodwill. The balance sheet and results of operations of Commercial Bancshares, Inc. are included in the financial statements of the Company effective January 1, 2018. On September 19, 2019, we entered into an agreement and plan of reorganization to acquire TB&T Bancshares, Inc. and its wholly owned bank subsidiary, The Bank & Trust of Bryan/College Station. On January 1, 2020, the transaction closed. Pursuant to the agreement, we issued 6.28 million shares of the Company’s common stock in exchange for all of the outstanding shares of TB&T Bancshares, Inc. In addition, in accordance with the plan of reorganization, TB&T Bancshares, Inc. paid a special dividend totaling $1.92 million to its shareholders prior to the closing of this transaction. At the closing, Brazos Merger Sub, Inc., a wholly owned subsidiary of the Company, merged into TB&T Bancshares Inc., with TB&T Bancshares, Inc. surviving as a wholly owned subsidiary of the Company. Immediately following such merger, TB&T Bancshares, Inc. was merged into the Company and The Bank & Trust of Bryan/College Station, Texas was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value net of assets acquired by approximately $143.2 million and the Company recorded such excess as goodwill. The balance sheet and results of operations of TB&T Bancshares, Inc. will be included in the financial statements of the Company effective January 1, 2020. At December 31, 2019, The Bank & Trust of Bryan/College Station had gross loans totaling $455.40 million, total deposits of $551.90 million and total assets of $631.10 million. Stock Split and Increase in Authorized Shares On April 23, 2019, the Company’s Board of Directors declared a two-for-one stock split of the Company’s outstanding common shares effective June 3, 2019. In addition, the shareholders of the Company approved an amendment to the Amended and Restated Certificate of Formation to increase the number of authorized shares to 200,000,000. All per share amounts in the annual report on Form 10-K have been restated to reflect this stock split. An amount equal to the par value of the additional common shares to be issued pursuant to the stock split was reflected as a transfer from retained earnings to common stock in the consolidated financial statements as of and for the year ended December 31, 2019. Implementation of New Accounting Standard for Accounting for Allowance for Loan Losses Effective January 1, 2020, the Company implemented the provision of Accounting Standards Update (ASU) 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” ASU 2016-13 represents a comprehensive change in estimating the allowance for loan losses from the current “incurred loss” model of losses inherent in the loan portfolio to a current “expected loss” model, which encompasses losses expected to be incurred over the life of the portfolio. For publicly traded companies, ASU 2016-13 was effective January 1, 2020 and will be effective for the quarter ending March 31, 2020. We are completing our implementation plan with our cross-functional working group, under the direction of our Chief Credit Officer along with our Chief Accounting Officer, Chief Lending Officer and Chief Financial Officer. The working group also included individuals from various functional areas including credit, risk management, accounting and information technology, among others. Our implementation plan included assessment and documentation of processes, internal controls and data sources; model development, documentation and validation; and system configuration, among other things. We contracted with a third-party vendor to assist us in the application of ASU 2016-13. While we continue to analyze and modify our calculations, we currently expect the adoption of ASU 2016-13 will result in an allowance for loan losses amount at January 1, 2020 in the range of $45.0 million to $51.0 million. At December 31, 2019, our allowance for loan losses totaled $52.5 million. In addition, ASU 2016-13 will necessitate that we establish an allowance for expected credit losses for certain debt securities and other financial assets; however, we do not expect these allowances to be significant. Additionally, the adoption of ASU 2016-13 is not expected to have a significant impact on our regulatory capital ratios. The ultimate final impact of adoption of ASU-2016-13 could be significantly different than our current expectation as our modeling process is further refined. Other New Accounting Standards Issued but Not Yet Effective ASU 2017-04, “Intangibles - Goodwill and Other .” ASU 2017-04 will amend and simplify current goodwill impairment testing to eliminate Step 2 from the current provisions. Under the new guidance, an entity should perform the goodwill impairment test by comparing the fair value of a reporting unit with its carrying value and recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. An entity still has the option to perform the quantitative assessment for a reporting unit to determine if a quantitative impairment test is necessary. ASU 2017-04 will be effective for the Company on January 1, 2020 and is not expected to have a significant impact on the Company’s financial statements. ASU 2018-13, “Fair Value Measurement (Topic 820). - Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement.” ASU 2018-13 modifies the disclosure requirements on fair value measurements in Topic 820. The amendments in ASU 2018-13 remove disclosures that no longer are considered cost beneficial, modify/clarify the specific requirements of certain disclosures, and add disclosure requirements identified as relevant. ASU 2018-13 became effective on January 1, 2020 and is not expected to have a significant impact on the Company’s financial statements. Results of Operations Performance Summary . Net earnings for 2019 were $164.81 million, an increase of $14.17 million, or 9.41%, over net earnings for 2018 of $150.64 million. Net earnings for 2017 were $120.37 million. The increase in net earnings for 2019 over 2018 were primarily attributable to the growth in net interest income and noninterest income and the increase in net earnings for 2018 over 2017 was primarily attributable to the change in income tax rates. On a basic net earnings per share basis, net earnings were $1.22 for 2019, as compared to $1.11 for 2018 and $0.91 for 2017. The return on average assets was 2.08% for 2019, as compared to 1.98% for 2018 and 1.72% for 2017. The return on average equity was 14.37% for 2019, as compared to 15.37% for 2018 and to 13.63% for 2017. Net Interest Income . Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $295.88 million in 2019, as compared to $281.75 million in 2018, and $262.18 million in 2017. Average earning assets were $7.44 billion in 2019, as compared to $7.12 billion in 2018 and $6.54 billion in 2017. The increase in tax-equivalent net interest income in 2019 compared to 2018 was largely attributable to increases in interest earning assets. The increase of $326.97 million in average earning assets in 2019 when compared to 2018 was primarily a result of increases in loans of $246.63 million and taxable securities of $156.33 million when compared to 2018. The increase in tax-equivalent net interest income in 2018 compared to 2017 was largely attributable to increases in the volume of interest earning assets offset by rate increases on our interest-bearing liabilities. The increase of $570.96 million in average earning assets in 2018 when compared to 2017 was primarily a result of increases in loans of $392.59 million and taxable securities of $454.46 million. These increases were offset by a decline of $222.01 million in tax-exempt securities. Average interest-bearing liabilities were $4.61 billion in 2019, as compared to $4.47 billion in 2018 and $4.21 billion in 2017. The yield on earning assets increased fifteen basis points in 2019 when compared to 2018 while the rate paid on interest-bearing liabilities increased twenty-three basis points. The yield on earning assets increased eight basis points in 2018 when compared to 2017 while the rate paid on interest-bearing liabilities increased twenty basis points. Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate. Table 1 - Changes in Interest Income and Interest Expense (in thousands): (1) Computed on tax-equivalent basis assuming marginal tax rate of 21% for 2019 and 2018 and 35% for 2017. (2) Non-accrual loans are included in loans. The net interest margin in 2019 was 3.98%, an increase of two basis points from 2018 which decreased five basis points from 2017. We continued to experience downward pressures on our net interest margin in 2019 and 2018 primarily due to (i) the change in the income tax rate from 35% to 21% from the Tax Cuts and Jobs Act and its effect on our tax free municipal bonds and tax free loans, (ii) extended period of fluctuating historically low levels of short-term interest rates, and (iii) flat to inverted yield curve currently being experienced in the bond market. We have been able to somewhat mitigate the impact of these lower short-term interest rates and the flat/inverted yield curve by establishing minimum interest rates on certain of our loans, improving the pricing for loan risk, and minimizing rates paid on interest bearing liabilities. As rates fluctuate, we adjust loan rates as appropriate, upon maturities, and convert to variable rates when we are able. The Federal Reserve increased rates 100 basis points in 2018, 75 basis points in 2017 and 25 basis points in 2016 and 2015, but decreased rates by 75 basis points during 2019. The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2 for the years 2017 through 2019. Table 2 - Average Balances and Average Yields and Rates (in thousands, except percentages): (1) Short-term investments are comprised of Fed Funds sold, interest bearing deposits in banks and interest bearing time deposits in banks. (2) Average balances include unrealized gains and losses on available-for-sale securities. (3) Computed on tax-equivalent basis assuming marginal tax rate of 21% for 2019 and 2018 and 35% for 2017. (4) Nonaccrual loans are included in loans. Noninterest Income . Noninterest income for 2019 was $108.43 million, an increase of $6.66 million, or 6.55%, as compared to 2018. Increases in certain categories of noninterest income included (1) real estate mortgage operations income of $2.99 million, (2) ATM, interchange and credit card fees of $1.33 million, (3) interest on loan recoveries of $1.15 million, (4) service charges on deposit accounts of $376 thousand, and (5) trust fees of $220 thousand when compared to 2018. The increase in real estate mortgage fees was a result of an increase in the volume of loans originated and the Company’s decision to move to mandatory delivery. The increase in ATM, interchange and credit card fees was primarily due to the continued growth in the number of debit cards issued. Interest on loan recoveries increased as a result of several larger loan recoveries in 2019. The increase in service charges on deposit accounts was primarily due to the continued growth in net new accounts. The increase in trust fees resulted from an increase in assets under management over the prior year; however, this was mostly offset by a decrease in income derived from oil and gas production activity when compared to 2018. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $6.75 billion at December 31, 2019, as compared to $5.60 billion at December 31, 2018. Offsetting these increases was a decrease in net gains on sales of available-for-sale securities of $621 thousand. Noninterest income for 2018 was $101.76 million, an increase of $10.75 million, or 11.81%, as compared to 2017. Increases in certain categories of noninterest income included (1) trust fees of $4.49 million, (2) ATM, interchange and credit card fees of $2.85 million, and (3) service charges on deposit accounts of $2.25 million when compared to 2017. The increase in trust fees resulted from an increase in assets under management over the prior year and an increase in oil and gas production and lease fees for the majority of 2018 that increased related trust fees by $2.61 million over 2017. The fair value of our trust assets managed, which are not reflected in our consolidated balance sheets, totaled $5.60 billion at December 31, 2018, as compared to $5.13 billion at December 31, 2017. The increase in ATM, interchange and credit card fees was due to continued growth in the number of debit cards issued and the Kingwood acquisition. Service charges on deposit accounts increased primarily due to continued growth in net new accounts, product and pricing changes made to better align the Company’s account offerings and the Kingwood acquisition. Offsetting these increases were decreases in interest on net recoveries of $190 thousand and gains on sale of available-for-sale securities of $474 thousand. ATM and interchange fees are charges that merchants pay to us and other card-issuing banks for processing electronic payment transactions. ATM and interchange fees consist of income from debit card usage, point of sale income for debit card transactions and ATM service fees. Federal Reserve Board rules applicable to financial institutions that have assets of $10 billion or more provide that the maximum permissible interchange fee for an electronic debit transaction is the sum of 21 cents per transaction and five basis points multiplied by the value of the transaction. While we currently have assets under $10 billion, we are monitoring the effect of this reduction in per transaction fee income as we approach the $10 billion asset level. Table 3 - Noninterest Income (in thousands): Noninterest Expense . Total noninterest expense for 2019 was $196.52 million, an increase of $5.84 million, or 3.06%, as compared to 2018. Noninterest expense for 2018 amounted to $190.68 million, an increase of $16.70 million, or 9.60%, as compared to 2017. An important measure in determining whether a financial institution effectively manages noninterest expenses is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for 2019 was 48.61%, as compared to 49.72% for 2018 and 49.26% for 2017. Salaries and employee benefits for 2019 totaled $112.34 million, an increase of $7.15 million, or 6.79%, as compared to 2018. The increase was primarily driven by (i) annual merit-based pay increases that were effective March 1, 2019, (ii) an increase in our profit sharing expenses, (iii) an increase in our pension plan expenses, and (iv) an increase in medical insurance costs. All other categories of noninterest expense for 2019 totaled $84.19 million, a decrease of $1.31 million, or 1.53%, as compared to 2018. Included in noninterest expense in 2019 was $2.67 million, before income tax, in pension settlement expense resulting from the Company’s settlement and termination of the remaining portion of its defined benefit pension plan obligation. During 2018, the Company recorded $1.55 million, before income tax, in pension settlement expense for a partial settlement of this defined benefit pension obligation. Also included in noninterest expense during 2019 was an increase of $574 thousand in ATM, interchange and credit card expenses when compared to 2018. Offsetting these increases in noninterest expense for 2019 when compared to 2018 was a decrease in FDIC insurance premiums of $1.24 million due to the FDIC assessment credit previously discussed. Salaries and employee benefits for 2018 totaled $105.19 million, an increase of $9.90 million, or 10.39%, as compared to 2017. The increase was primarily driven by (i) annual merit-based pay increases that were effective March 1, 2018, (ii) an increase in our profit sharing expenses, and (iii) increases in all categories from the Kingwood acquisition. All other categories of noninterest expense for 2018 totaled $85.50 million, an increase of $6.80 million, or 8.64%, as compared to 2017. Included in noninterest expense in 2018 was $1.55 million, before income tax, resulting from the Company’s partial settlement of its frozen defined benefit pension plan. Other notable increases in noninterest expense included a $1.83 million increase in ATM, interchange and credit card expenses and a $652 thousand increase in net occupancy expense. In addition, included in other miscellaneous expenses for 2018 were technology contract termination and conversion related costs totaling $1.75 million related to the Kingwood acquisition. Table 4 - Noninterest Expense (in thousands): Income Taxes . Income tax expense was $33.22 million for 2019, as compared to $27.54 million for 2018 and $26.82 million for 2017. Our effective tax rates on pretax income were 16.78%, 15.46% and 18.22%, respectively, for the years 2019, 2018 and 2017. The effective tax rates differ from the statutory federal tax rate of 21.0% in 2019 and 2018 and 35.0% in 2017 largely due to tax exempt interest income earned on certain investment securities and loans, the deductibility of dividends paid to our employee stock ownership plan and income tax deductions from the partial donation of two of our branch buildings to municipalities. On December 22, 2017, the Tax Cuts and Jobs Act was signed into law with sweeping modifications to the Internal Revenue Code. The primary change for the Company was to lower the corporate income tax rate to 21% from 35%. The Company’s deferred tax assets and liabilities were re-measured based on the income tax rates at which they are expected to reverse in the future, which is generally 21%. The provisional amount recorded related to the re-measurement of the Company’s deferred tax balance was $7.65 million, a reduction of income tax expense for the year ended December 31, 2017. At December 31, 2018, final regulations for the Tax Cuts and Jobs Act were still pending; however, the Company updated its estimate of the impact to our deferred tax balances based on the proposed regulations issued to date and recorded an additional reduction of income tax expense for the year ended December 31, 2018 of $664 thousand. No additional adjustment amounts were recorded for the year ended December 31, 2019, and the Company does not anticipate significant revision will be necessary in the future. Balance Sheet Review Loans . Our portfolio is comprised of loans made to businesses, professionals, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary bank. Real estate loans represent loans primarily for 1-4 family residences and commercial real estate. The structure of loans in the real estate mortgage area generally provides re-pricing intervals to minimize the interest rate risk inherent in long-term fixed rate loans. As of December 31, 2019, total loans held for investment were $4.19 billion, an increase of $241.33 million, as compared to December 31, 2018. As compared to year-end 2018, real estate loans increased $184.03 million, commercial loans increased $11.37 million, agricultural loans increased $6.96 million and consumer loans increased $38.97 million. Loans averaged $4.07 billion during 2019, an increase of $246.63 million over the 2018 average balances. Table 5 - Composition of Loans (in thousands): As of December 31, 2019, our real estate loans represent approximately 67.30% of our loan portfolio and are comprised of (i) commercial real estate loans of 29.72%, generally owner occupied, (ii) 1-4 family residence loans of 40.79%, (iii) residential development and construction loans of 9.73%, which includes our custom and speculation home construction loans, (iv) commercial development and construction loans of 6.80%, and (v) other loans, which includes ranches, hospitals and universities of 12.96%. Loans held-for-sale, consisting of secondary market mortgage loans, totaled $28.23 million and $21.67 million at December 31, 2019 and 2018, respectively. At December 31, 2019 and 2018, $5.15 million and $2.49 million are valued at the lower of cost or fair value, and the remaining amount is valued under the fair value option. The Company has certain lending policies and procedures in place that are designed to maximize loan income with an acceptable level of risk. Management reviews and approves these policies and procedures on an annual basis and makes changes as appropriate. Management receives and reviews monthly reports related to loan originations, quality, concentrations, delinquencies, nonperforming and potential problem loans. Diversification in the loan portfolio is a means of managing risk associated with fluctuations in economic conditions, both by type of loan and geographic location. Commercial loans are underwritten after evaluating and understanding the borrower’s ability to operate profitably and effectively. Underwriting standards are designed to determine whether the borrower possesses sound business ethics and practices and to evaluate current and projected cash flows to determine the ability of the borrower to repay their obligations as agreed. Commercial loans are primarily made based on the identified cash flows of the borrower and, secondarily, on the underlying collateral provided by the borrower. Most commercial loans are secured by the assets being financed or other business assets, such as accounts receivable or inventory, and include personal guarantees. Agricultural loans are subject to underwriting standards and processes similar to commercial loans. These agricultural loans are based primarily on the identified cash flows of the borrower and secondarily on the underlying collateral provided by the borrower. Most agricultural loans are secured by the agriculture related assets being financed, such as farm land, cattle or equipment, and include personal guarantees. Real estate loans are also subject to underwriting standards and processes similar to commercial and agricultural loans. These loans are underwritten primarily based on projected cash flows and, secondarily, as loans secured by real estate. The repayment of real estate loans is generally largely dependent on the successful operation of the property securing the loans or the business conducted on the property securing the loan. Real estate loans may be more adversely affected by conditions in the real estate markets or in the general economy. The properties securing the Company’s real estate portfolio are generally diverse in terms of type and geographic location within Texas. This diversity helps reduce the exposure to adverse economic events that affect any single market or industry. Generally, real estate loans are owner-occupied which further reduces the Company’s risk. Consumer loan underwriting utilizes methodical credit standards and analysis to supplement the Company’s underwriting policies and procedures. The Company’s loan policy addresses types of consumer loans that may be originated and the collateral, if secured, which must be perfected. The relatively smaller individual dollar amounts of consumer loans that are spread over numerous individual borrowers also minimize the Company’s risk. Table 6 - Maturity Distribution and Interest Sensitivity of Loans at December 31, 2019 (in thousands): The following tables summarize maturity and repricing information for the commercial and agricultural and the real estate-construction portion of our loan portfolio as of December 31, 2019: Asset Quality . Our loan portfolio is subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectability of principal or interest under the original terms becomes doubtful. Nonaccrual, past due 90 days or more and still accruing, and restructured loans plus foreclosed assets were $25.77 million at December 31, 2019, as compared to $29.63 million at December 31, 2018 and $20.12 million at December 31, 2017. As a percent of loans and foreclosed assets, these assets were 0.61% at December 31, 2019, as compared to 0.75% at December 31, 2018 and 0.57% at December 31, 2017. As a percent of total assets, these assets were 0.31% at December 31, 2019, as compared to 0.38% at December 31, 2018 and 0.28% at December 31, 2017. We believe the level of these assets to be manageable and are not aware of any material classified credits not properly disclosed as nonperforming at December 31, 2019. Supplemental Oil and Gas Information. At December 31, 2019, the Company’s exposure to the oil and gas industry was 2.84% of gross loans, or $119.79 million, compared to 2.86% of gross loans, or $113.54 million at December 31, 2018. These oil and gas loans consisted (based on collateral supporting the loan) of (i) development and production loans of 11.26%, (ii) oil and gas field servicing loans of 15.10%, (iii) real estate loans of 39.37%, (iv) accounts receivable and inventory of 3.74%, (v) automobile of 23.53% and (vi) other of 7.00%. These loans have warranted additional scrutiny because of fluctuating oil and gas prices. The Company instituted additional monitoring procedures for these loans and has classified and downgraded loans as appropriate. The following oil and gas information is as of and for the years ended December 31, 2019 and 2018: Table 7 - Nonaccrual, Past Due 90 Days or More and Still Accruing, Restructured Loans and Foreclosed Assets (in thousands, except percentages): * Includes $251 thousand, $827 thousand, $618 thousand, $1.26 million and $2.18 million, respectively, of purchased credit impaired loans as of December 31, 2019, 2018, 2017, 2016 and 2015. ** Troubled debt restructured loans of $4.79 million, $3.84 million, $4.63 million, $6.86 million and $6.11 million, respectively, whose interest collection, after considering economic and business conditions and collection efforts, is doubtful are included in non-accrual loans as of December 31, 2019, 2018, 2017, 2016 and 2015. We record interest payments received on non-accrual loans as reductions of principal. Prior to the loans being placed on non-accrual, we recognized interest income on impaired loans as of December 31, 2019 of approximately $151 thousand during the year ended December 31, 2019. If interest on these impaired loans had been recognized on a full accrual basis during the year ended December 31, 2019, such income would have approximated $2.39 million. See Note 3 to the Consolidated Financial Statements beginning on page for more information on these assets. Provision and Allowance for Loan Losses . The allowance for loan losses is the amount we determine as of a specific date to be appropriate to absorb probable losses on existing loans in which full collectability is unlikely based on our review and evaluation of the loan portfolio. For a discussion of our methodology, see our accounting policies in Note 1 to the Consolidated Financial Statements beginning on page. The provision for loan losses was $2.97 million, as compared to $5.67 million in 2018 and $6.53 million in 2017. The continued provision for loan losses in 2019 and 2018 reflects primarily the growth in the loan portfolio. As a percent of average loans, net loan charge-offs were 0.04% during 2019, 0.07% during 2018 and 0.12% during 2017. The allowance for loan losses as a percent of loans was 1.24% as of December 31, 2019, as compared to 1.29% as of December 31, 2018 and 1.38% as of December 31, 2017. Included in Tables 8 and 9 are further analysis of our allowance for loan losses. Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy or lower employment could result in increased levels of nonaccrual, past due 90 days or more and still accruing, restructured loans, foreclosed assets, charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review the adequacy of our allowance for loan losses. The banking agencies could require additions to the loan loss allowance based on their judgment of information available to them at the time of their examinations of our bank subsidiary. Table 8 - Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages): * Reflects the impact of loans acquired in the Conroe acquisition in 2015 and the Kingwood acquisition in 2018, which were initially recorded at fair value with no allocated allowance for loan losses. Table 9 - Allocation of Allowance for Loan Losses (in thousands): Percent of Loans in Each Category of Total Loans: Included in our loan portfolio are certain other loans not included in Table 7 that are deemed to be potential problem loans. Potential problem loans are those loans that are currently performing, but for which known information about trends, uncertainties or possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present repayment terms, possibly resulting in the transfer of such loans to nonperforming status. These potential problem loans totaled $6.50 million as of December 31, 2019. Interest-Bearing Deposits in Banks. The Company had interest-bearing deposits in banks of $47.92 million at December 31, 2019 and $42.27 million at December 31, 2018, respectively. At December 31, 2019, our interest-bearing deposits in banks included $47.69 million maintained at the Federal Reserve Bank of Dallas and $232 thousand on deposit with the Federal Home Loan Bank of Dallas (FHLB). The average balance of interest-bearing deposits in banks was $80.81 million, $87.03 million and $141.37 million in 2019, 2018 and 2017, respectively. The average yield on interest-bearing deposits in banks was 2.22%, 1.79% and 1.17% in 2019, 2018 and 2017, respectively. Available-for-Sale and Held-to-Maturity Securities . At December 31, 2019, securities with a fair value of $3.41 billion were classified as securities available-for-sale. There were no securities classified as held-to-maturity at December 31, 2019. As compared to December 31, 2018, the available-for-sale portfolio at December 31, 2019, reflected (1) an increase of $57 thousand in U.S. Treasury securities; (2) a decrease of $301 thousand in obligations of U.S. government sponsored enterprises and agencies; (3) an increase of $31.11 million in obligations of states and political subdivisions; (4) a decrease of $90 thousand in corporate bonds and other; and (5) an increase of $223.76 million in mortgage-backed securities. As compared to December 31, 2017, the available-for-sale portfolio at December 31, 2018, reflected (1) an increase of $9.96 million in U.S. Treasury securities; (2) a decrease of $60.03 million in obligations of U.S. government sponsored enterprises and agencies; (3) a decrease of $162.98 million in obligations of states and political subdivisions; (4) a decrease of $6.66 million in corporate bonds and other; and (5) an increase of $291.01 million in mortgage-backed securities. Securities-available-for-sale included fair value adjustments of $84.51 million, $5.21 million and $44.86 million at December 31, 2019, 2018 and 2017, respectively. We did not hold any collateralized mortgage obligations or structured notes as of December 31, 2019 that we consider to be high risk. Our mortgage related securities are backed by GNMA, FNMA or FHLMC or are collateralized by securities backed by these agencies. See Table 10 and Note 2 to the Consolidated Financial Statements for additional disclosures relating to the maturities and fair values of the investment portfolio at December 31, 2019 and 2018. Table 10 - Maturities and Yields of Available-for-Sale Held at December 31, 2019 (in thousands, except percentages): All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 21%. Yields on available-for-sale securities are based on amortized cost. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages. Maturities of other securities are reported at the earlier of maturity date or call date. As of December 31, 2019, the investment portfolio had an overall tax equivalent yield of 3.17%, a weighted average life of 4.18 years and modified duration of 3.74 years. Deposits . Deposits held by our subsidiary bank represent our primary source of funding. Total deposits were $6.60 billion as of December 31, 2019, as compared to $6.18 billion as of December 31, 2018 and $5.96 billion as of December 31, 2017. Table 11 provides a breakdown of average deposits and rates paid over the past three years and the remaining maturity of time deposits of $100,000 or more: Table 11 - Composition of Average Deposits and Remaining Maturity of Time Deposits of $100,000 or More (in thousands, except percentages): Borrowings. Included in borrowings were federal funds purchased, securities sold under repurchase agreements and advances from the FHLB of $381.36 million, $468.71 million and $331.00 million at December 31, 2019, 2018 and 2017, respectively. Securities sold under repurchase agreements are generally with significant customers of the Company that require short-term liquidity for their funds for which we pledge certain securities that have a fair value equal to at least the amount of the short-term borrowing. The average balances of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were $398.14 million, $418.98 million, and $422.29 million in 2019, 2018 and 2017, respectively. The average rates paid on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB were 0.75%, 0.47% and 0.25% for the years ended December 31, 2019, 2018 and 2017, respectively. The weighted average interest rate on federal funds purchased, securities sold under repurchase agreements and advances from the FHLB was 0.48%, 0.78% and 0.10% at December 31, 2019, 2018 and 2017, respectively. The highest amount of federal funds purchased, securities sold under repurchase agreements and advances from the FHLB at any month end during 2019, 2018 and 2017 was $423.67 million, $529.64 million and $611.30 million, respectively. Capital Resources We evaluate capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration. Total shareholders’ equity was $1.23 billion, or 14.85% of total assets at December 31, 2019, as compared to $1.05 billion, or 13.62% of total assets at December 31, 2018. During 2019, total shareholders’ equity averaged $1.15 billion, or 14.44% of average assets, as compared to $980.21 million, or 12.89% of average assets during 2018. Banking regulators measure capital adequacy by means of the risk-based capital ratios and leverage ratio under the Basel III regulatory capital framework and prompt corrective action regulations. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders’ equity less intangible assets by quarter-to-date average assets less intangible assets. Beginning in January 2016, under the Basel III regulatory capital framework, the implementation of the capital conservation buffer was effective for the Company starting at the 0.625% level and increasing 0.625% each year thereafter, until it reaches 2.5% on January 1, 2019. The capital conservation buffer is designed to absorb losses during periods of economic stress and requires increased capital levels for the purpose of capital distributions and other payments. Failure to meet the amount of the buffer will result in restrictions on the Company’s ability to make capital distributions, including divided payments and stock repurchase, and to pay discretionary bonuses to executive officers. As of December 31, 2019 and 2018, we had a total risk-based capital ratio of 21.13% and 20.61%, a Tier 1 capital to risk-weighted assets ratio of 20.06% and 19.47%, a common equity Tier 1 capital to risk-weighted ratio of 20.06% and 19.47% and a Tier 1 leverage ratio of 12.60% and 11.85%, respectively. The regulatory capital ratios as of December 31, 2019 and 2018 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. Our subsidiary bank made the election to continue to exclude most accumulated other comprehensive income from capital in connection with its March 31, 2015 quarterly financial filing and, in effect, to retain the accumulated other comprehensive income treatment under the prior capital rules. Interest Rate Risk . Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk. Our subsidiary bank has an asset liability management committee that monitors interest rate risk and compliance with investment policies. The subsidiary bank utilizes an earnings simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model quantifies the effects of various interest rate scenarios on projected net interest income and net income over the next twelve months. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the next twelve months. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing and the re-pricing and maturity characteristics of the existing and projected balance sheet. As of December 31, 2019, the model simulations projected that 100 and 200 basis point increases in interest rates would result in variances in net interest income of positive 2.29% and positive 4.00%, respectively, relative to the current financial statement structure over the next twelve months, while a decrease in interest rates of 100 basis points would result in a variance in a net interest income of negative 2.77% relative to the current financial statement structure over the next twelve months. We consider the likelihood of a decrease in interest rates beyond 100 basis points after December 31, 2019 remote given current interest rate levels. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve-month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics on specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. As interest-bearing assets and liabilities re-price in different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions, we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material. Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committee oversees and monitors this risk. Liquidity Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument, as detailed in Tables 12 and 13. Asset liquidity is provided by cash and assets which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary bank. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondent banks, sales of securities under agreements to repurchase and advances from the FHLB, which amounted to $381.36 million at December 31, 2019, and an unfunded $25.00 million revolving line of credit established with Frost Bank, a nonaffiliated bank, which matures on June 30, 2021 (see next paragraph). Our subsidiary bank also has federal funds purchased lines of credit with two non-affiliated banks totaling $130.00 million. At December 31, 2019, there were no amounts drawn on these lines of credit. Our subsidiary bank also has available a line of credit with the FHLB totaling $1.35 billion at December 31, 2019, secured by portions of our loan portfolio and certain investment securities. At December 31, 2019, the Company did not have any balances outstanding under this line of credit. The Company renewed its loan agreement, effective June 30, 2019, with Frost Bank. Under the loan agreement, as renewed and amended, we are permitted to draw up to $25.00 million on a revolving line of credit. Prior to June 30, 2021, interest is paid quarterly at The Wall Street Journal Prime Rate and the line of credit matures June 30, 2021. If a balance exists at June 30, 2021, the principal balance converts to a term facility payable quarterly over five years and interest is paid quarterly at The Wall Street Journal Prime Rate. The line of credit is unsecured. Among other provisions in the credit agreement, we must satisfy certain financial covenants during the term of the loan agreement, including, without limitation, covenants that require us to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, which among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Since 1995, we have historically declared dividends as a percentage of our consolidated net income in a range of 37% (low) in 1995 to 53% (high) in 2003 and 2006. The Company was in compliance with the financial and operational covenants at December 31, 2019. There was no outstanding balance under the line of credit as of December 31, 2019 or 2018. In addition, we anticipate that any future acquisition of financial institutions, expansion of branch locations or offering of new products could also place a demand on our cash resources. Available cash and cash equivalents at the Company, which totaled $125.08 million at December 31, 2019, investment securities which totaled $6.30 million at December 31, 2019 with maturities over 9 to 11 years, available dividends from our subsidiaries which totaled $261.42 million at December 31, 2019, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for these potential acquisitions or expansions. Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary bank, we consider our current liquidity position to be adequate to meet our short-term and long-term liquidity needs. Table 12 - Contractual Obligations as of December 31, 2019 (in thousands): Amounts above for deposits do not include related accrued interest. Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit, commitments to extend credit and federal funds sold to correspondent banks and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance- sheet instruments. Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties. Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount. Table 13 - Commitments as of December 31, 2019 (in thousands): We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements. Parent Company Funding . Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiaries. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiaries. At December 31, 2019, approximately $261.42 million was available for the payment of intercompany dividends by our subsidiaries without the prior approval of regulatory agencies. Our subsidiaries paid aggregate dividends to us of $84.50 million in 2019 and $74.10 million in 2018. Dividends . Our long-term dividend policy is to pay cash dividends to our shareholders of approximately 40% of annual net earnings while maintaining adequate capital to support growth. We are also restricted by a loan covenant within our line of credit agreement with Frost Bank to dividend no greater than 55% of net income, as defined in such loan agreement. The cash dividend payout ratios have amounted to 38.31%, 36.84% and 41.24% of net earnings, respectively, in 2019, 2018 and 2017. Given our current capital position, projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. Our bank subsidiary, which is a national banking association and a member of the Federal Reserve System, is required by federal law to obtain the prior approval of the OCC to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank’s net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. To pay dividends, we and our subsidiary bank must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve Board, the FDIC and the OCC have each indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve Board, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

<s>[INST] The following discussion contains forwardlooking statements that are subject to risks and uncertainties. Actual results may differ materially from those contemplated by the forwardlooking statements as a result of certain factors, including but not limited to those listed in “Item 1A Risk Factors” and in the “Cautionary Statement Regarding ForwardLooking Statements” notice on page 1. Introduction As a financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans and investments are deposits held by our bank subsidiary, First Financial Bank, National Association, Abilene, Texas. Our largest expenses are salaries and related employee benefits. We measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income. The following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2019 and 2018, and consolidated statements of earnings for the years 2017 through 2019 should be read in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10K. Critical Accounting Policies We prepare consolidated financial statements based on generally accepted accounting principles (“GAAP”) and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions. We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements. We deem our most critical accounting policies to be (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period. A discussion of (1) our allowance for loan losses and our provision for loan losses and (2) our valuation of securities is included in Note 1 to our Consolidated Financial Statements beginning on page. Acquisitions On October 12, 2017, we entered into an agreement and plan of reorganization to acquire Commercial Bancshares, Inc. and its wholly owned bank subsidiary, Commercial State Bank, Kingwood, Texas. On January 1, 2018, the transaction closed. Pursuant to the agreement, we issued 1.29 million shares of the Company’s common stock in exchange for all of the outstanding shares of Commercial Bancshares, Inc. In addition, in accordance with the plan of reorganization, Commercial Bancshares, Inc. paid a special dividend totaling $22.08 million to its shareholders prior to the closing of this transaction. At the closing, Kingwood Merger Sub., Inc., a wholly owned subsidiary of the Company, merged into Commercial Bancshares Inc., with Commercial Bancshares, Inc. surviving as a wholly owned subsidiary of the Company. Immediately following such merger, Commercial Bancshares, Inc. was merged into the Company and Commercial State Bank, Kingwood, Texas was merged into First Financial Bank, National Association, Abilene, Texas, a wholly owned subsidiary of the Company. The total purchase price exceeded the estimated fair value net of assets acquired by approximately $31.59 million and the Company recorded such excess as goodwill. The balance sheet and results of operations of Commercial Bancshares, Inc. are included in the financial statements of the Company effective January 1, 2018. On September 19, 2019, we entered into an agreement and plan of re [/INST] Negative. </s>

ARMSTRONG WORLD INDUSTRIES INC

2015-02-23

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this Form 10-K. Overview We are a leading global producer of flooring products and ceiling systems for use primarily in the construction and renovation of residential, commercial and institutional buildings. We design, manufacture and sell flooring products (primarily resilient and wood) and ceiling systems (primarily mineral fiber, fiberglass and metal) around the world. On December 4, 2014, our Board of Directors approved the cessation of funding to our former DLW subsidiary, which was our former European Resilient Flooring business. This decision followed a comprehensive evaluation of the strategic alternatives for the business. As a result of this decision, DLW management concluded that its operations could not be financed and sustained without funding from us and filed for insolvency in Germany on December 11, 2014. See Note 4 to the Consolidated Financial Statements for more information. During 2013, we opened three new manufacturing facilities in China; consisting of two resilient flooring plants and a mineral fiber ceiling plant. As of December 31, 2014, we operated 31 manufacturing plants in eight countries, including 20 plants located throughout the U.S. Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., operates eight additional plants in five countries to produce suspension system (grid) products which we use in our ceiling systems. We report our financial results through the following segments: Building Products, Resilient Flooring, Wood Flooring, and Unallocated Corporate. See “Results of Operations” and “Reportable Segment Results” for additional financial information on our consolidated company and our segments. Factors Affecting Revenues For information on our segments’ 2014 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10-K. Markets. We compete in building material markets around the world. The majority of our sales are in North America. We closely monitor publicly available macroeconomic trends that provide insight to commercial and residential market activity including Gross Domestic Product, the Architecture Billings Index and the Consumer Confidence Index. In addition, we noted several factors and trends within our markets that directly affected our business performance during 2014, including: Americas We noted softness in commercial markets, particularly healthcare and, to a lesser extent, education, as public spending remained constrained. In addition, we saw some regional variability in the office market and some softening in retail markets. These trends impacted both our Building Products and Resilient Flooring businesses, but with greater impact on Resilient Flooring, as a significant portion of our commercial sales in Resilient Flooring originate from the healthcare and education markets. Residential markets softened as builder activity grew, but at a slower rate than in the prior year and renovation activity remained constrained. Softer market conditions drove consumers to trade down to lower value products and led to more aggressive actions by competitors, resulting in pressure on mix and price. These trends, as well as accelerating share shifts within product categories and excess industry capacity, impacted our Wood and Resilient Flooring businesses. Management’s Discussion and Analysis of Financial Condition and Results of Operations Revenues for all our businesses were negatively impacted by severe weather conditions experienced during the first quarter of 2014. Europe, Middle East and Africa (“EMEA”) Continued softness in commercial sectors, such as office, education and healthcare, and the significant devaluation of the Russian Ruble contributed to mixed results in our Building Products business. Pacific Rim Commercial markets for our Building Products businesses in India and Australia grew, while markets in China were soft. Commercial markets for our Resilient Flooring businesses grew in China but declined in Australia. Pricing Initiatives. We periodically modify prices in each of our business segments due to changes in costs for raw materials and energy, and to market conditions and the competitive environment. In certain cases, realized price increases are less than the announced increases because of competitive reactions and changing market conditions. We estimate that pricing actions increased our 2014 consolidated net sales by approximately $57 million, compared to 2013. In response to continued rising input and raw material prices we implemented price increases in the fourth quarter of 2014 in our Building Products business in India and multiple increases in Russia to offset currency devaluations. We also announced price increases on select resilient products in the Americas and in our Building Products businesses in the Americas, EMEA and the Pacific Rim effective in the first quarter of 2015. We may implement additional pricing actions based upon future movements in raw material prices or foreign currency valuations. Mix. Each of our businesses offers a wide assortment of products that are differentiated by style, design and performance attributes. Pricing and margins for products within the assortment vary. Changes in the relative quantity of products purchased at the different price points can impact year-to-year comparisons of net sales and operating income. We estimate that mix improvements increased our 2014 consolidated net sales by approximately $49 million, compared to 2013. Factors Affecting Operating Costs Operating Expenses. Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general and administrative (“SG&A”) expenses. Our largest individual raw material expenditures include lumber and veneers, PVC resins and plasticizers. Natural gas is also a significant input cost. Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results. In 2014, the costs for raw materials, sourced products and energy negatively impacted operating income by approximately $34 million, compared to 2013. During 2014, we incurred approximately $15 million of charges associated with the closure of our Thomastown, Australia resilient flooring plant and the closure of our Kunshan, China engineered wood flooring plant. Production activity for both plants was shifted to our existing facilities in the United States. We continue to evaluate the efficiency of our manufacturing footprint and may take additional actions in support of our cost and standardization initiatives. The charges associated with any additional cost reduction initiatives could include severance and related termination benefits, fixed asset write-downs, asset impairments and accelerated depreciation and may be material to our financial statements. Intangible Asset Impairment. In the fourth quarter of 2014 we recorded a non-cash impairment charge of $10.0 million to reduce the carrying value of a Wood Flooring trademark to its estimated fair value based on the results of our annual impairment test. The estimated fair value was negatively impacted by competitive conditions in the U.S. residential housing market resulting in lower projected profitability. Management’s Discussion and Analysis of Financial Condition and Results of Operations See also “Results of Operations” for further discussion of other significant items affecting operating costs. Employees As of December 31, 2014, we had approximately 7,400 full-time and part-time employees worldwide, compared to approximately 7,800 employees as of December 31, 2013. Most of the decrease related to a reduction in staff at three of our U.S. wood flooring plants, along with the closing of our Kunshan, China and Thomastown, Australia flooring plants. As a result of our exit from the European Resilient Flooring business, we no longer include approximately 900 employees in our reported employee count. During 2014, we negotiated collective bargaining agreements covering approximately 900 employees at four U.S. plants. Collective bargaining agreements covering approximately 500 employees at two U.S. plants will expire during 2015. CRITICAL ACCOUNTING ESTIMATES In preparing our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”), we are required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an on-going basis, using relevant internal and external information. We believe that our estimates and assumptions are reasonable. However, actual results may differ from what was estimated and could have a significant impact on the financial statements. We have identified the following as our critical accounting estimates. We have discussed these critical accounting estimates with our Audit Committee. U.S. Pension Credit and Postretirement Benefit Costs - We maintain pension and postretirement plans throughout the world, with the most significant plans located in the U.S. Our defined benefit pension and postretirement benefit costs are developed from actuarial valuations. These valuations are calculated using a number of assumptions, which represent management’s best estimate of the future. The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets and the estimated inflation in health care costs. These assumptions are generally updated annually. The discount rate is used to determine retirement plan liabilities and to determine the interest cost component of net periodic pension and postretirement cost. Management utilizes the Aon Hewitt AA only above median yield curve, which is a hypothetical AA yield curve comprised of a series of annualized individual discount rates, as the primary basis for determining the discount rate. As of December 31, 2014 and 2013, we assumed discount rates of 4.05% and 4.75%, respectively, for the U.S. defined benefit pension plans. As of December 31, 2014, we assumed a discount rate of 3.90% compared with a discount rate of 4.50% as of December 31, 2013 for the U.S. postretirement plans. The effects of the change in discount rate will be amortized into earnings as described below. Absent any other changes, a one-quarter percentage point decrease in the discount rates for the U.S. pension and postretirement plans would decrease 2015 operating income by $6.8 million and a one-quarter percentage point increase in the discount rates would increase 2015 operating income by $6.5 million. We have two U.S. defined benefit pension plans, a qualified funded plan and a nonqualified unfunded plan. For the qualified funded plan, the expected long-term return on plan assets represents a long-term view of the future estimated investment return on plan assets. This estimate is determined based on the target allocation of plan assets among asset classes and input from investment professionals on the expected performance of the asset classes over 10 to 30 years. Historical asset returns are monitored and considered when we develop our expected long-term return on plan assets. An incremental component is added for the expected return from active management based on historical information obtained from the plan’s investment consultants. These forecasted gross returns are reduced by estimated management fees and expenses, yielding a long-term rate of return assumption of 7.0% per annum for 2015. Over the 10 year period ended December 31, 2014, the historical annualized return was approximately 7.0% Management’s Discussion and Analysis of Financial Condition and Results of Operations compared to an average expected return of 7.5%. The actual return on plan assets achieved for 2014 was 10.3%. The difference between the actual and expected rate of return on plan assets will be amortized into earnings as described below. The expected long-term return on plan assets used in determining our 2014 U.S. pension credit was 7.0%. We have assumed a return on plan assets during 2015 of 7.0%. The 2015 expected return on assets was calculated in a manner consistent with 2014. A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2015 operating income by approximately $5.0 million. Contributions to the unfunded plan were $4.3 million in 2014 and were made on a monthly basis to fund benefit payments. We estimate the 2015 contributions will be approximately $4.0 million. See Note 16 to the Consolidated Financial Statements for more information. The estimated inflation in health care costs represents a 5-10 year view of the expected inflation in our postretirement health care costs. We separately estimate expected health care cost increases for pre-65 retirees and post-65 retirees due to the influence of Medicare coverage at age 65, as illustrated below: The difference between the actual and expected health care costs is amortized into earnings as described below. As of December 31, 2014, health care cost increases are estimated to decrease ratably until 2025, after which they are estimated to be constant at 5%. A one percentage point increase or decrease in the assumed health care cost trend rate would not materially impact 2015 operating income. See Note 16 to the Consolidated Financial Statements for more information. Actual results that differ from our various pension and postretirement plan estimates are captured as actuarial gains/losses. When certain thresholds are met, the gains and losses are amortized into future earnings over the expected remaining service period of plan participants, which is approximately eight years for our U.S. pension plans and our U.S. postretirement plans. Changes in assumptions could have significant effects on earnings in future years. We recognized an increase in net actuarial losses related to our U.S. pension benefit plans of $194.9 million in 2014 primarily due to changes in actuarial assumptions (most significantly a 70 basis point reduction in the discount rate and our adoption of the Society of Actuaries RP-2014 mortality tables). The $194.9 million actuarial loss due to our U.S. pension plans is reflected as a component of other comprehensive income in our Consolidated Statement of Earnings and Comprehensive Income along with actuarial gains and losses from our foreign pension plans and our U.S. postretirement benefit plans. Impairments of Long-Lived Tangible and Intangible Assets - Our indefinite-lived intangibles are primarily trademarks and brand names, which are integral to our corporate identity and expected to contribute indefinitely to our corporate cash flows. Accordingly, they have been assigned an indefinite life. We conduct our annual impairment test for non-amortizable intangible assets during the fourth quarter, although we conduct interim impairment tests if events or circumstances indicate the asset might be impaired. We conduct impairment tests for tangible assets and amortizable intangible assets when indicators of impairment exist, such as operating losses and/or negative cash flows. If an indication of impairment exists, we compare the carrying amount of the asset group to the estimated undiscounted future cash flows expected to be generated by the assets. The estimate of an asset group’s fair value is based on discounted future cash flows expected to be generated by the asset group, or based on management’s estimated exit price assuming the assets could be sold in an orderly transaction between market participants or estimated salvage value if no sale is assumed. If the fair value is less than the carrying value of the asset group, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group. Management’s Discussion and Analysis of Financial Condition and Results of Operations The principal assumption utilized in our impairment tests for definite-lived intangible assets is operating profit adjusted for depreciation and amortization. The principal assumptions utilized in our impairment tests for indefinite-lived intangible assets include revenue growth rate, discount rate and royalty rate. Revenue growth rate and operating profit assumptions are derived from those utilized in our operating plan and strategic planning processes. The discount rate assumption is calculated based upon an estimated weighted average cost of equity which reflects the overall level of inherent risk and the rate of return a market participant would expect to achieve. Methodologies used for valuing our intangible assets did not change from prior periods. The cash flow estimates used in applying our impairment tests are based on management’s analysis of information available at the time of the impairment test. Actual cash flows lower than the estimate could lead to significant future impairments. If subsequent testing indicates that fair values have declined, the carrying values would be reduced and our future statements of income would be affected. During the fourth quarter of 2014, we recorded a non-cash impairment charge of $10.0 million to reduce the carrying amount of a Wood Flooring trademark to its estimated fair value based on the results of our annual impairment test. The fair value was negatively affected by lower expected sales and profits due to the competitive environment in the U.S. residential housing market. The remaining carrying value of the Wood Flooring trademarks at December 31, 2014 was $31.9 million. Continued competitive pressure beyond our expectations could lead to future material impairments of the Wood Flooring intangible assets. There were no impairment charges in 2013 or 2012 related to intangible assets. We tested the tangible assets within the following reporting units for impairment: Based upon the impairment testing in 2014 and 2012, the carrying value of the tangible assets for each of these asset groups was determined to be recoverable (except as discussed below) because the related undiscounted cash flows and/or fair value exceeded the carrying value of assets. During the third quarter of 2014, we recorded an impairment charge of $11.9 million on the tangible assets of the European Resilient Flooring business as a result of disappointing operating results. This charge is reflected within Discontinued Operations due to DLW’s insolvency filing. See Note 4 to the Consolidated Financial Statements for further information. During the second quarter of 2014, we decided to close our resilient flooring plant in Thomastown, Australia and our engineered wood flooring plant in Kunshan, China. During 2014, we recorded $2.2 million in cost of goods sold for accelerated depreciation due to the closure of the resilient flooring plant in Australia. We sold this facility in January 2015. We also recorded $4.0 million in 2014 in cost of goods sold for accelerated depreciation due to the closure of the wood flooring plant in China. During 2014, we also made the decision to dispose of certain idle equipment at five of our wood flooring manufacturing facilities and as a result we recorded a $4.4 million impairment charge in cost of goods sold. During the first quarter of 2012, we made the decision to permanently close a previously idled ceiling tile plant in Mobile, AL. As a result, we recorded accelerated depreciation of $11.0 million for machinery and equipment and a $4.6 million impairment charge for the buildings in cost of goods sold. The fair values were determined by management estimates and an independent valuation based on information available at that time (considered Level 2 inputs in the fair value hierarchy as described in Note 16 to the Consolidated Financial Statements). We sold this facility in the third quarter of 2013. Management’s Discussion and Analysis of Financial Condition and Results of Operations During the fourth quarter of 2012, we made the decision to permanently close a previously idled engineered wood flooring production facility in Statesville, NC. As a result, we recorded accelerated depreciation of $0.6 million for machinery and equipment and a $0.6 million impairment charge for the buildings in cost of goods sold. The fair values were determined by management estimates and an independent valuation based on information available at that time (considered Level 2 inputs in the fair value hierarchy). We sold this facility in January 2015. We cannot predict the occurrence of certain events that might lead to material impairment charges in the future. Such events may include, but are not limited to, the impact of economic environments, particularly related to the commercial and residential construction industries, material adverse changes in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. See Notes 3 and 10 to the Consolidated Financial Statements for further information. Income Taxes - Our effective tax rate is primarily determined based on our pre-tax income and the statutory income tax rates in the jurisdictions in which we operate. The effective tax rate also reflects the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences are temporary, reversing over time, such as depreciation expense. These temporary differences create deferred income tax assets and liabilities. Deferred income tax assets are also recorded for net operating loss (“NOL”) and foreign tax credit (“FTC”) carryforwards. Deferred income tax assets and liabilities are recognized by applying enacted tax rates to temporary differences that exist as of the balance sheet date. We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized. The need to establish valuation allowances for deferred tax assets is assessed quarterly. In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard, we give appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability and foreign source income (“FSI”), the duration of statutory carryforward periods, and our experience with operating loss and tax credit carryforward expirations. A history of cumulative losses is a significant piece of negative evidence used in our assessment. If a history of cumulative losses is incurred for a tax jurisdiction, forecasts of future profitability are not used as positive evidence related to the realization of the deferred tax assets in the assessment. Specifically with respect to the domestic FTC carryforward deferred tax asset of $54.3 million at December 31, 2014, we considered the following positive and negative evidence in assessing the need for a valuation allowance and concluded that a valuation allowance is not required: Positive Evidence • Our emergence from bankruptcy in 2006 created significant NOLs. The last portion of these NOLs was completely utilized during 2012. Starting in 2013, we had domestic taxable income which allowed us to begin utilizing the FTCs; • Under U.S. tax law, approximately $103.5 million of our domestic source income in future years can be characterized as FSI to enable the utilization of our FTCs. This amount primarily represents prior year intercompany dividends associated with the FTC carryforwards. These dividends created domestic taxable income that was reduced by the utilization of domestic NOLs; and • Forecasts of future profitability and FSI. Management’s Discussion and Analysis of Financial Condition and Results of Operations Negative Evidence • Our history of FTC expirations as a result of the carryback and carryforward of the NOLs generated upon emergence from bankruptcy. All FTCs were fully utilized before the bankruptcy NOL carryback. The NOL carryback reduced the taxable income (a portion of which is considered FSI) to zero and thus the FTCs were carried forward along with the remaining portion of the NOL. The utilization of the remaining NOL carryforward reduced taxable income to zero, which caused the expiration of the FTCs; and • Our stated position to permanently reinvest unremitted earnings of our foreign subsidiaries. The ability to fully utilize the FTC carryforwards may be affected by the following factors: • FSI of $155.2 million is needed to fully utilize the FTC carryforward of $54.3 million before they expire in 2022. In addition to the $103.5 million of domestic source income that can be characterized as FSI in future years, $51.7 million of additional foreign source income is needed. • The main factor that could result in our inability to re-characterize domestic source income to foreign source income is a U.S. tax law change. • The main factors that could contribute to lower FSI are decreased export sales and increased allocable expenses. As of December 31, 2014, we have recorded valuation allowances totaling $87.9 million for various federal, state, and foreign deferred tax assets. While we have considered future taxable income in assessing the need for the valuation allowances based on our best available projections, if these estimates and assumptions change in the future or if actual results differ from our projections, we may be required to adjust our valuation allowances accordingly. Such adjustments could be material to our Consolidated Financial Statements. As further described in Note 14 to the Consolidated Financial Statements, our Consolidated Balance Sheet as of December 31, 2014 includes net deferred income tax assets of $243.9 million. Included in this amount are deferred federal income tax assets for FTC carryforwards of $54.3 million, state NOL deferred income tax assets of $41.3 million, and foreign NOL deferred tax assets of $41.8 million. We have established valuation allowances in the amount of $87.9 million consisting of $31.6 million for statutorily limited federal NOL carryovers, $14.6 million for state deferred tax assets, primarily operating loss carryovers, and $41.7 million for foreign deferred tax assets, primarily foreign operating loss carryovers. The federal FTC carryforwards arose primarily as a result of the payment of intercompany dividends from our foreign affiliates from earnings which were previously not considered as permanently reinvested. The state NOLs arose primarily as a result of the amounts paid to the Asbestos PI Trust in 2006. Inherent in determining our effective tax rate are judgments regarding business plans and expectations about future operations. These judgments include the amount and geographic mix of future taxable income, the amount of FSI, limitations on usage of NOL carryforwards, the impact of ongoing or potential tax audits, earnings repatriation plans, and other future tax consequences. We estimate we will need to generate future U.S. taxable income of approximately $1,012.8 million for state income tax purposes during the respective realization periods (ranging from 2015 to 2034) in order to fully realize the net deferred income tax assets. As previously disclosed in prior SEC filings, our ability to utilize deferred tax assets may be impacted by certain future events, such as changes in tax legislation, insufficient future taxable income prior to expiration of certain deferred tax assets, annual limits imposed under Section 382 of the Internal Revenue Code (“Section 382”) or by state law, as a result of an “ownership change.” This “ownership change” is defined as a cumulative increase in certain shareholders’ ownership of the Company by more than 50 percentage points during the previous rolling three year period. Management’s Discussion and Analysis of Financial Condition and Results of Operations The Asbestos PI Trust and TPG collectively sold 5,980,000 shares, 12,057,382 shares, 6,000,000 shares and 3,900,000 shares of the Company’s common shares during the fourth quarter of 2012, the third quarter of 2013, the fourth quarter of 2013, and the first quarter of 2014, respectively. Those sales significantly increase the likelihood that future sales by the Asbestos PI Trust will cause an “ownership change” under Section 382. At this time, we estimate that an additional sale of the Company’s common shares by the Asbestos PI Trust prior to December 2015 would be reasonably likely to cause an “ownership change” under Section 382. An “ownership change” may result in limitations on the utilization of certain tax attributes, primarily our ability to deduct state NOLs against future state taxable income. If such “ownership change” were to occur, then we would be required to record a one-time, non-cash charge in our income statement in the period in which such “ownership change” occurs. We currently estimate that, if such “ownership change” had occurred in the fourth quarter of 2014, based on the factors discussed below, the one-time income tax charge that would have been taken would have reduced our net earnings by an amount between $4.0 million and $8.0 million. This pro forma estimated range of net earnings reduction is based on current management estimates and assumptions that are subject to change over time. The actual amount of the required charge, if any, may differ materially from this current estimate. Key factors impacting the calculation include, but are not limited to, our stock price on the date of the “ownership change”, the applicable tax-exempt interest rate, the tax basis and fair market value of our assets, federal and state tax regulations, projections of future taxable income and prior NOL usage. We recognize the tax benefits of an uncertain tax position if those benefits are more likely than not to be sustained based on existing tax law. Additionally, we establish a reserve for tax positions that are more likely than not to be sustained based on existing tax law, but uncertain in the ultimate benefit to be sustained upon examination by the relevant taxing authorities. Unrecognized tax benefits are subsequently recognized at the time the more likely than not recognition threshold is met, the tax matter is effectively settled or the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired, whichever is earlier. ACCOUNTING PRONOUNCEMENTS EFFECTIVE IN FUTURE PERIODS In April 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-08 “Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity” which is part of ASC 205: Presentation of Financial Statements and Accounting Standards Codification (“ASC”) 360: Property, Plant and Equipment. The amendments in this guidance change the requirements for reporting discontinued operations. Under the new guidance a disposal of a component of an entity or a group of components is required to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results. The guidance is effective prospectively for disposals that occur within annual periods beginning on or after December 15, 2014. We do not expect a material impact to our financial condition, results of operations or cash flows from the adoption of this guidance. In May 2014, the FASB issued ASU 2014-09 “Revenue from Contracts with Customers”. The guidance requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to a customer. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective, January 1, 2017. Early application is not permitted, but the standard permits the use of either the retrospective or cumulative effect transition method. We have not selected a transition method and are currently evaluating the impact this guidance will have on our financial condition, results of operations and cash flows. In June 2014, the FASB issued ASU 2014-12 “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period” which is part of ASC 718: Compensation-Stock Compensation. The guidance requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition and should not be reflected in the estimate of the grant-date fair value of the award. The guidance is effective for annual periods beginning after December 15, 2015. The guidance can be applied prospectively for all awards granted or modified after the effective date or retrospectively to all awards with performance targets outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. We do not expect a material impact on our financial condition, results of operation or cash flows from the adoption of this guidance. Management’s Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS Unless otherwise indicated, net sales in these results of operations are reported based upon the location where the sale was made. Please refer to Notes 3 and 4 to the Consolidated Financial Statements for a reconciliation of segment operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations. 2014 COMPARED TO 2013 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) The decrease in consolidated net sales was driven by the unfavorable impact of foreign exchange of approximately $19 million. Lower volumes of $100 million were more than offset by $106 million of favorable price and mix. The decrease in net sales in the Americas was driven by lower volumes, which were only partially offset by improvements in price and mix. The increase in net sales in the EMEA region was driven primarily by improvements in price, partially offset by the impact of unfavorable mix. Excluding unfavorable foreign exchange impact of approximately $6 million, net sales in the Pacific Rim increased 9% as improvements in volumes and price were partially offset by unfavorable mix. Cost of goods sold was 76.8% of net sales in 2014, compared to 76.5% in 2013. Compared to the prior year, lower manufacturing costs were more than offset by higher input costs. The comparison was impacted by approximately $15 million of charges in 2014 associated with the closure of our Thomastown, Australia resilient flooring plant and the closure of our Kunshan, China engineered wood flooring plant, and approximately $4 million of charges primarily associated with cost reduction actions in the Resilient Flooring business in Australia in 2013. SG&A expenses in 2014 were $398.5 million, or 15.8% of net sales, compared to $386.9 million, or 15.3% of net sales, in 2013. The increase was primarily due to higher promotional spending in both flooring businesses. See Reportable Segment Results for additional information. Equity earnings from our WAVE joint venture were $65.1 million in 2014, compared to $59.4 million in 2013. See Note 9 to the Consolidated Financial Statements for further information. Interest expense was $46.0 million in 2014, compared to $68.7 million in 2013. The decrease was due to the write-off of unamortized debt financing costs associated with the refinancing of our senior credit facility that occurred during the first quarter of 2013 (see Liquidity for further information). Income tax expense was $83.2 million and $71.4 million in 2014 and 2013, respectively. The effective tax rate for 2014 was 44.9% as compared to a rate of 35.9% for 2013. The effective tax rate for 2014 was higher than 2013 primarily due to higher unbenefitted foreign operating losses, lower income in foreign subsidiaries with profits, and an increase in the state valuation allowance for NOLs. Management’s Discussion and Analysis of Financial Condition and Results of Operations As reported in Note 14 to the Consolidated Financial Statements, our foreign operations recorded losses before income taxes of $29.7 million in 2014 compared with income of $12.5 million in 2013. The 2014 losses are related to the expenses incurred in Russia associated with the new manufacturing plant and China and Western Europe losses due to slowing markets. While we believe we will continue to incur overall foreign losses in 2015, we do not believe this indicates a long-term trend. Total other comprehensive income (“OCI”) was a $123.9 million loss for 2014 compared to income of $99.8 million for 2013. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Amounts in 2014 were driven primarily by changes in the exchange rate of the Euro, the British pound and the Australian dollar. Amounts in 2013 were driven primarily by changes in the exchange rate of the Australian dollar. Derivative gain/loss represents the mark to market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. The period changes are primarily due to the mark to market changes related to our natural gas hedges in 2014 and our interest rate swap derivatives in 2013. Pension and postretirement adjustments represent actuarial gains and losses related to our defined-benefit pension and postretirement plans. The amounts in all periods primarily related to the U.S. pension plans. REPORTABLE SEGMENT RESULTS Building Products (dollar amounts in millions) The improvement in Building Products net sales was driven by $46 million of favorable price and mix which more than offset the unfavorable impact of foreign exchange of approximately $10 million and lower volumes of $6 million. Net sales in the Americas increased driven by favorable mix and price which more than offset the impact of lower volumes. Net sales in EMEA markets increased driven by improvements in price which more than offset the impact of unfavorable mix. Net sales in the Pacific Rim increased as volume, mix and price all improved. Operating income increased slightly driven by the benefits of price and mix of $11 million and higher earnings from WAVE of $6 million, which offset the impact of lower volumes of $5 million, higher manufacturing and input costs of $7 million and higher SG&A expenses of $3 million. The increase in manufacturing costs was primarily associated with the construction of our plant in Russia. Management’s Discussion and Analysis of Financial Condition and Results of Operations Resilient Flooring (dollar amounts in millions) The decline in Resilient Flooring net sales was driven by $24 million of lower volume and the unfavorable impact from foreign exchange of $6 million which more than offset favorable price and mix of $13 million. Net sales in the Americas decreased as improvements in mix were unable to offset commercial and residential volume declines. Net sales in the Pacific Rim increased as strong volume growth in China and India was partially offset by market driven sales declines in Australia. Operating income declined primarily due to the margin impact of lower volumes of $10 million and higher SG&A expenses of $8 million driven by higher promotional and marketing expense. These negative impacts were only partially offset by positive mix and price of $2 million and lower manufacturing and input costs of $8 million as strong productivity more than offset higher input costs. The comparison was also impacted by approximately $6 million of charges in 2014 associated with the closure of our Thomastown, Australia resilient flooring plant and $4 million of charges in 2013 associated with cost reduction actions in Australia. Wood Flooring (dollar amounts in millions) The decrease in Wood Flooring net sales was driven primarily by lower volumes of $69 million which more than offset favorable price and mix of $47 million. Volume declines reflected sales lost to competition. The decline in operating income was driven by approximately $9 million of charges primarily associated with the closure of our Kunshan, China engineered wood flooring plant and a non-cash impairment charge of $10 million to reduce the carrying value of a Wood Flooring trademark to its estimated fair value. Gross profit improved driven by the benefit of price and mix of $55 million which more than offset the impact of lower volumes of $27 million, higher SG&A expenses of $3 million and higher manufacturing and input costs of $24 million, as improvements in productivity were more than offset by higher lumber costs. Unallocated Corporate Unallocated corporate expense of $72.3 million decreased from $73.3 million in the prior year, due to lower incentive compensation expense offset by increased spending on outside professional services and higher foreign and domestic pension expenses. FINANCIAL CONDITION AND LIQUIDITY Cash Flow Operating activities for 2014 provided $208.8 million of cash, compared to $213.7 million of cash provided in 2013. The decrease was primarily due to changes in working capital, partially offset by higher cash earnings. The working capital change was primarily driven by accounts payable and accrued expenses due to timing of payments. Management’s Discussion and Analysis of Financial Condition and Results of Operations Net cash used for investing activities was $149.3 million for 2014, compared to $145.8 million in 2013. This change was primarily due to increased purchases of property, plant and equipment, partially offset by higher distributions received from our WAVE joint venture. Net cash provided by financing activities was $3.3 million for 2014, compared to $263.7 million used during 2013. Net cash provided in 2014 was driven by proceeds from exercised stock options and excess tax benefits from share-based awards, partially offset by payments of long-term debt. Net cash used in 2013 included the $261.4 million repurchase of common stock, including associated fees. Liquidity Our liquidity needs for operations vary throughout the year. We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is generally lower during the first and fourth quarters of our fiscal year. In March 2013, we refinanced our $1.3 billion senior credit facility. The amended facility is composed of a $250 million revolving credit facility (with a $150 million sublimit for letters of credit), a $550 million Term Loan A and a $475 million Term Loan B. The terms of the facility resulted in a lower interest rate spread (2.5% vs. 3.0%) than our previous facility. We also extended the maturity of Term Loan A from November 2015 to March 2018 and of Term Loan B from March 2018 to March 2020, and we amended our year end leverage tests (see below). Per the terms of the underlying agreement, this senior credit facility is secured by U.S. personal property, the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first tier foreign subsidiaries. Under the amended senior credit facility we are subject to year-end leverage tests that may trigger mandatory prepayments. If our ratio of consolidated funded indebtedness minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) (“Consolidated Net Leverage Ratio”) is greater than 3.5 to 1.0, the prepayment amount would be 50% of fiscal year Consolidated Excess Cash Flow. These annual payments would be made in the first quarter of the following year. No payment will be required in 2015. In connection with the refinancing, we incurred $8 million for bank, legal, and other fees, of which $7 million was capitalized and is being amortized into interest expense over the life of the loans. Additionally, we wrote off $19 million of unamortized debt financing costs in the first quarter of 2013 related to our previous credit facility to interest expense. The amended senior credit facility includes two financial covenants that require the ratio of consolidated EBITDA to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the Consolidated Net Leverage Ratio to be 4.0 to 1.0 after December 31, 2013 through March 31, 2015 and 3.75 to 1.0 after March 31, 2015. During 2014, we were in compliance with all covenants of the senior credit facility. The Revolving Credit and Term Loan A portions are currently priced at a spread of 2.50% over LIBOR and the Term Loan B portion is priced at 2.50% over LIBOR with a 1.00% LIBOR floor for its entire term. The Term Loan A and Term Loan B were both fully drawn and are currently priced on a variable interest rate basis. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following table summarizes our interest rate swaps (dollar amounts in millions): These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. The unpaid balances of Term Loan A, the Revolving Credit Facility and Term Loan B of the credit facility may be prepaid without penalty at the maturity of their respective interest reset periods. Any amounts prepaid on the Term Loan A or Term Loan B may not be re-borrowed. As of December 31, 2014, there was no outstanding balance on the revolving credit facility. Due to the significant decline in the value of the Russian Ruble, particularly during the fourth quarter of 2014, we received $30.0 million in cash as a result of settling Russian Ruble forward contracts utilized to hedge the currency impact associated with intercompany loans to our Russian subsidiary. Our exposure to changes in the Ruble due to the intercompany loans is unhedged at December 31, 2014. As of December 31, 2014, we had $185.3 million of cash and cash equivalents, $98.6 million in the U.S. and $86.7 million in various foreign jurisdictions. In March 2012, our Board of Directors declared a special cash dividend in the amount of $8.55 per share, or $508 million in the aggregate, of which $502.9 million was paid on April 10, 2012. Additional payments of $3.7 million have been made through December 31, 2014, with most of the outstanding balance to be paid in the first quarter of 2015. The remaining dividends will be paid when the underlying employee awards vest, while vested director awards will be paid upon the Director’s separation from service on the Board of Directors. The dividend was recorded as a reduction of retained earnings to the extent that retained earnings were available at the dividend declaration date. Dividends in excess of the retained earnings were recorded as a reduction in capital in excess of par value. On December 18, 2014, we amended and increased our $75 million Accounts Receivable Securitization Facility with the Bank of Nova Scotia, under which AWI and its subsidiary, Armstrong Hardwood Flooring Company, sell their U.S. receivables to Armstrong Receivables Company LLC (“ARC”), a Delaware entity that is consolidated in these financial statements. The facility now reflects a seasonality clause changing to $100 million from March through September, and $90 million from October through February. The maturity date has been extended from March 2016 to December 2017. As of December 31, 2014, there was no outstanding balance on the accounts receivable securitization facility. On December 31, 2014, we had outstanding letters of credit totaling $67.3 million, of which $7.8 million was issued under the revolving credit facility, $59.3 million was issued under the securitization facility, and $0.2 million was issued by other banks of international subsidiaries. Letters of credit are issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. Management’s Discussion and Analysis of Financial Condition and Results of Operations These lines of credit are uncommitted, and poor operating results or credit concerns at the related foreign subsidiaries could result in the lines being withdrawn by the lenders. We have historically been able to maintain and, as needed, replace credit facilities to support our foreign operations. Since 2009, our Board of Directors has approved the construction of five manufacturing plants. These include a U.S. mineral wool plant to supply our Building Products plants, mineral fiber ceiling plants in Russia and China, and two resilient flooring plants in China. In July 2013, our Board of Directors approved the expansion of our Lancaster, PA flooring plant to include the manufacture of luxury vinyl tile. Total spending for these projects is currently projected to be approximately $380 million. As of December 31, 2014, we have completed construction of the mineral wool plant and three plants in China. Through December 31, 2014, we have incurred approximately $348 million related to these projects. The majority of the remaining spending for the plant in Russia and the Lancaster plant expansion will be incurred in 2015. During the third quarter of 2013, the Asbestos PI Trust and TPG together sold 12,057,382 of their remaining shares in a secondary public offering. In connection with this transaction, we paid $261.4 million, including associated fees, to buy-back 5,057,382 shares, which we currently hold in treasury. The treasury share purchase was funded by existing cash, borrowings under our credit facility and our securitization facility. Funds borrowed to complete this transaction were repaid by the end of the third quarter of 2013. We believe that cash on hand and cash generated from operations, together with lines of credit, availability under our securitization facility and the availability under our $250 million revolving credit facility, will be adequate to address our foreseeable liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations. 2013 COMPARED TO 2012 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) The increase in consolidated net sales was driven by $84 million of higher volume and $50 million of favorable price and mix. Sales comparisons were also negatively impacted by unfavorable foreign exchange of $6 million and $26 million due to our sale of the Patriot wood flooring distribution business which occurred in the third quarter of 2012. The increase in net sales in the Americas was driven primarily by higher volumes in the wood business, and improvements in price and mix. Sales were negatively impacted by the sale of the Patriot wood flooring distribution business. The increase in net sales in the EMEA region was driven primarily by favorable foreign exchange impact of $5 million and favorable mix, which were only partially offset by lower volumes. Excluding unfavorable foreign exchange impact of $7 million, net sales in the Pacific Rim increased 2% as improvements in volumes and price were partially offset by unfavorable mix. Management’s Discussion and Analysis of Financial Condition and Results of Operations Cost of goods sold was 76.5% of net sales in 2013, compared to 75.5% in 2012. The increase was primarily due to raw material inflation, particularly lumber, increased production costs in the wood flooring segment, and plant start-up costs associated with our investments in China and Russia. The comparison was impacted by $4 million associated with cost reduction actions in the Resilient Flooring business in Australia in 2013, and $21 million of costs associated with the closure of our Mobile, AL Building Products facility in 2012. SG&A expenses in 2013 were $386.9 million, or 15.3% of net sales, compared to $364.9 million, or 15.0% of net sales, in 2012. The increase was primarily due to emerging market growth initiatives and increased Unallocated Corporate Expenses. See Reportable Segment Results for additional information. Equity earnings from our WAVE joint venture were $59.4 million in 2013, compared to $55.9 million in 2012. Interest expense was $68.7 million in 2013, compared to $53.6 million in 2012. The increase was due to the write-off of unamortized debt financing costs associated with the refinancing of our senior credit facility that occurred during the first quarter of 2013 partially offset by lower interest expense under the amended credit facility. Income tax expense was $71.4 million and $76.0 million in 2013 and 2012, respectively. The effective tax rate for 2013 was 35.9% as compared to a rate of 32.4% for 2012. The effective tax rate for 2013 was higher than 2012 primarily due to higher unbenefitted foreign operating losses in 2013 and to the release of foreign tax credit valuation allowance in 2012, partially offset by research and development tax credits covering multiple years, domestic production activities, and mix of income in tax jurisdictions. REPORTABLE SEGMENT RESULTS Building Products (dollar amounts in millions) The improvement in Building Products net sales was driven by $29 million of favorable price and mix, and higher volumes of $18 million. Net sales in the Americas increased due to improved price realization and positive mix which more than offset the impact of slightly lower volumes. Excluding favorable foreign exchange impact of $5 million, net sales in EMEA markets increased 3%, driven by improvements in mix and higher volumes. Excluding unfavorable foreign exchange impact of $4 million, net sales in the Pacific Rim increased 8%, driven primarily by higher volumes offset by the impact of unfavorable mix. The increase in operating income was primarily driven by improvements in gross profit, and a reduction in facility closure costs when compared to the prior year. Gross profit increased primarily from the benefits of price and mix of $17 million, and improved volumes of $7 million. Manufacturing costs were flat as improvements in productivity were able to offset costs incurred to support our investments in China and Russia. SG&A expenses increased by $16 million associated with go-to-market investments to support emerging market growth initiatives. During 2013 we recorded higher earnings from WAVE of $4 million. During 2012, we decided to close our Building Products plant in Mobile, AL, and recorded approximately $21 million of accelerated depreciation, impairment and other charges. We sold that facility during the third Management’s Discussion and Analysis of Financial Condition and Results of Operations quarter of 2013 and recorded a pre-tax gain of $4 million within SG&A expense (inclusive of release of unused environmental liabilities and asset retirement obligations). During 2012, we also incurred approximately $4 million of net costs related to the collective bargaining contract settlement with employees at the Marietta, PA Building Products plant. Resilient Flooring (dollar amounts in millions) The decline in Resilient Flooring net sales was primarily driven by $14 million of lower volume and $4 million of unfavorable foreign exchange. Net sales in the Americas decreased as improvements in mix were unable to offset commercial and residential volume declines and unfavorable price. Excluding unfavorable foreign exchange impact of $2 million, net sales in the Pacific Rim decreased 7% as market driven sales declines in Australia offset increased sales in China and India. Operating income was flat in 2013 compared to 2012. Lower input and manufacturing costs of $7 million were due to higher productivity which more than offset costs incurred to support investments in China. SG&A expenses were lower by $2 million. These improvements were offset by the margin impact of lower volumes of $5 million and $4 million associated with cost reduction actions in Australia during 2013. Wood Flooring (dollar amounts in millions) The increase in Wood Flooring net sales was driven primarily by higher volumes of $80 million, in addition to favorable price and mix of $20 million. The higher volumes were driven by strong demand from the home center channel and independent distributors. Sales were also negatively impacted by $26 million resulting from our sale of the Patriot wood flooring distribution business in the third quarter of 2012. The decline in operating income was driven by higher manufacturing and input costs of $64 million, which were only partially offset by the $19 million impact of higher volumes and $12 million impact of improved price and mix. Improvements in price more than offset the dilutive impact of mix driven by increased demand from the builder channel. Increases in manufacturing and input costs were driven by rising lumber costs and higher labor costs as we increased our workforce to respond to increased demand. Unallocated Corporate Unallocated corporate expense of $73.3 million increased from $53.1 million in the prior year. The increase was impacted by higher foreign and domestic pension expense of $13 million, increased spending on outside professional services and higher expense associated with employee benefits. Management’s Discussion and Analysis of Financial Condition and Results of Operations Cash Flow Operating activities for 2013 provided $213.7 million of cash, compared to $220.0 million of cash provided in 2012. The change was due to lower cash earnings partially offset by changes in working capital. The working capital change was driven by an increase in accounts payable. Net cash used for investing activities was $145.8 million for 2013, compared to $91.9 million in 2012. This change was primarily due to lower proceeds from divestitures, increased purchases of property, plant and equipment, and lower proceeds from the sale of assets. Net cash used for financing activities was $263.7 million for 2013, compared to $273.7 million during 2012. Net cash used in 2013 included the $261.4 million re-purchase of common stock, including associated fees. Net cash used in 2012 was impacted by dividend payments of $507.1 million, partially offset by proceeds from the issuance of long-term debt of $250.0 million. OFF-BALANCE SHEET ARRANGEMENTS No disclosures are required pursuant to Item 303(a)(4) of Regulation S-K. CONTRACTUAL OBLIGATIONS As part of our normal operations, we enter into numerous contractual obligations that require specific payments during the term of the various agreements. The following table includes amounts ongoing under contractual obligations existing as of December 31, 2014. Only known payments that are dependent solely on the passage of time are included. Obligations under contracts that contain minimum payment amounts are shown at the minimum payment amount. Contracts that contain variable payment structures without minimum payments are excluded. Purchase orders that are entered into in the normal course of business are also excluded because they are generally cancelable and not legally binding. Amounts are presented below based upon the currently scheduled payment terms. Actual future payments may differ from the amounts presented below due to changes in payment terms or events affecting the payments. (1) For debt with variable interest rates and interest rate swaps, we projected future interest payments based on market-based interest rate swap curves. (2) Lease obligations include the minimum payments due under existing agreements with non-cancelable lease terms in excess of one year. (3) Unconditional purchase obligations include (a) purchase contracts whereby we must make guaranteed minimum payments of a specified amount regardless of how little material is actually purchased (“take or pay” contracts) and (b) service agreements. Unconditional purchase obligations exclude contracts entered into during the normal course of business that are non-cancelable and have fixed per unit fees, but where the monthly commitment varies based upon usage. Cellular phone contracts are an example. (4) Pension contributions include estimated contributions for our defined benefit pension plans. We are not presenting estimated payments in the table above beyond 2015 as funding can vary significantly from year to year based upon changes in the fair value of plan assets, funding regulations and actuarial assumptions. (5) Other obligations include payments under severance agreements. (6) Other obligations, does not include $142.6 million of liabilities under ASC 740 “Income Taxes.” Due to the uncertainty relating to these positions, we are unable to reasonably estimate the ultimate amount or timing of the settlement of these issues. See Note 14 to the Consolidated Financial Statements for more information. Management’s Discussion and Analysis of Financial Condition and Results of Operations This table excludes obligations related to postretirement benefits (retiree health care and life insurance) since we voluntarily provide these benefits. The amount of benefit payments we made in 2014 was $20.7 million. See Note 16 to the Consolidated Financial Statements for additional information regarding future expected cash payments for postretirement benefits. We are party to supply agreements, some of which require the purchase of inventory remaining at the supplier upon termination of the agreement. The last such agreement will expire in 2015. Had these agreements terminated at December 31, 2014, we would have been obligated to purchase approximately $4.6 million of inventory. Historically, due to production planning, we have not had to purchase material amounts of product at the end of similar contracts. Accordingly, no liability has been recorded for these guarantees. We utilize lines of credit and other commercial commitments in order to ensure that adequate funds are available to meet operating requirements. Letters of credit are issued to third-party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of our failure to pay our obligations to the beneficiary. This table summarizes the commitments we have available in the U.S. for use as of December 31, 2014. Letters of credit are currently arranged through our revolving credit facility or our securitization facility. In addition, our foreign subsidiaries had available lines of credit totaling $5.0 million of which $0.3 million was available only for letters of credit and guarantees. There were $0.2 million of letters of credit and guarantees issued under these credit lines as of December 31, 2014, leaving an additional letter of credit availability of $0.1 million. There were no borrowings under these lines of credit as of December 31, 2014, leaving $4.7 million of unused lines of credit available for foreign borrowings. On December 31, 2014, we had a $250 million revolving credit facility with a $150 million sublimit for letters of credit, of which $7.8 million was outstanding. There were no borrowings under the revolving credit facility. Availability under this facility totaled $242.2 million as of December 31, 2014. We also have the $90 million securitization facility which as of December 31, 2014 had letters of credit outstanding of $59.3 million and no borrowings against it. Maximum capacity under this facility was $75.5 million (of which $16.2 million was available), subject to accounts receivable balances and other collateral adjustments. In connection with our disposition of certain assets through a variety of unrelated transactions, we have entered into contracts that included various indemnity provisions, some of which are customary for such transactions, while others hold the acquirer of the assets harmless with respect to liabilities relating to such matters as taxes, environmental and other litigation. Some of these provisions include exposure limits, but many do not. Due to the nature of the indemnities, it is not possible to estimate the potential maximum exposure under these contractual provisions. As of December 31, 2014, we had no liabilities recorded for which an indemnity claim had been received.

<s>[INST] This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forwardlooking statements and risk factors included in this Form 10K. Overview We are a leading global producer of flooring products and ceiling systems for use primarily in the construction and renovation of residential, commercial and institutional buildings. We design, manufacture and sell flooring products (primarily resilient and wood) and ceiling systems (primarily mineral fiber, fiberglass and metal) around the world. On December 4, 2014, our Board of Directors approved the cessation of funding to our former DLW subsidiary, which was our former European Resilient Flooring business. This decision followed a comprehensive evaluation of the strategic alternatives for the business. As a result of this decision, DLW management concluded that its operations could not be financed and sustained without funding from us and filed for insolvency in Germany on December 11, 2014. See Note 4 to the Consolidated Financial Statements for more information. During 2013, we opened three new manufacturing facilities in China; consisting of two resilient flooring plants and a mineral fiber ceiling plant. As of December 31, 2014, we operated 31 manufacturing plants in eight countries, including 20 plants located throughout the U.S. Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., operates eight additional plants in five countries to produce suspension system (grid) products which we use in our ceiling systems. We report our financial results through the following segments: Building Products, Resilient Flooring, Wood Flooring, and Unallocated Corporate. See “Results of Operations” and “Reportable Segment Results” for additional financial information on our consolidated company and our segments. Factors Affecting Revenues For information on our segments’ 2014 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10K. Markets. We compete in building material markets around the world. The majority of our sales are in North America. We closely monitor publicly available macroeconomic trends that provide insight to commercial and residential market activity including Gross Domestic Product, the Architecture Billings Index and the Consumer Confidence Index. In addition, we noted several factors and trends within our markets that directly affected our business performance during 2014, including: Americas We noted softness in commercial markets, particularly healthcare and, to a lesser extent, education, as public spending remained constrained. In addition, we saw some regional variability in the office market and some softening in retail markets. These trends impacted both our Building Products and Resilient Flooring businesses, but with greater impact on Resilient Flooring, as a significant portion of our commercial sales in Resilient Flooring originate from the healthcare and education markets. Residential markets softened as builder activity grew, but at a slower rate than in the prior year and renovation activity remained constrained. Softer market conditions drove consumers to trade down to lower value products and led to more aggressive actions by competitors, resulting in pressure on mix and price. These trends, as well as accelerating share shifts within product categories and excess industry capacity, impacted our Wood and Resilient Flooring businesses. Management’s Discussion and Analysis of Financial Condition and Results of Operations Revenues for all our businesses were negatively impacted by severe weather conditions experienced during the first quarter of 2014. Europe, Middle East and Africa (“EMEA”) Continued softness in commercial sectors, such as office, education and healthcare, and the significant devaluation of the Russian Ruble contributed to mixed results in our Building Products business. Pacific Rim Commercial markets for our Building Products businesses in India and Australia grew, while markets in China were soft. Commercial markets for our Resilient Flooring businesses grew in China but declined in Australia. Pricing Initiatives. We periodically modify prices in each of our business segments due to changes in costs for raw materials and energy, and to market conditions and the competitive environment. In certain cases, realized price increases are less than [/INST] Positive. </s>

ARMSTRONG WORLD INDUSTRIES INC

2016-02-22

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this Form 10-K. Overview We are a leading global producer of flooring products and ceiling systems for use primarily in the construction and renovation of residential, commercial and institutional buildings. We design, manufacture and sell flooring products (primarily resilient and wood) and ceiling systems (primarily mineral fiber, fiberglass and metal) around the world. On February 23, 2015, we announced that our board of directors unanimously approved a plan to separate our Resilient Flooring and Wood Flooring segments from our Building Products (Ceilings) segment. The separation will be effected by allocating the assets and liabilities related primarily to the Resilient Flooring and Wood Flooring segments to Armstrong Flooring, Inc. (“AFI”) and then distributing the common stock of AFI to AWI’s shareholders. The separation and distribution will result in AWI and AFI becoming two independent, publicly-traded companies, with AFI owning and operating the Resilient Flooring and Wood Flooring segments and AWI continuing to own and operate the Building Products (Ceilings) segment. The effective date of the separation is expected to be near the end of the first quarter of 2016. On December 4, 2014, our Board of Directors approved the cessation of funding to our former DLW subsidiary, which was our former European Resilient Flooring business. This decision followed a comprehensive evaluation of the strategic alternatives for the business. As a result of this decision, DLW management concluded that its operations could not be financed and sustained without funding from us and filed for insolvency in Germany on December 11, 2014. See Note 4 to the Consolidated Financial Statements for more information. During 2015 we opened a mineral fiber ceiling plant in Russia. As of December 31, 2015, we operated 32 manufacturing plants in nine countries, including 20 plants located throughout the U.S. Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., operates 10 additional plants in five countries to produce suspension system (grid) products which we use in our ceiling systems. We report our financial results through the following segments: Building Products, Resilient Flooring, Wood Flooring, and Unallocated Corporate. See “Results of Operations” and “Reportable Segment Results” for additional financial information on our consolidated company and our segments. Factors Affecting Revenues For information on our segments’ 2015 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10-K. Markets. We compete in building material markets around the world. The majority of our sales are in North America. We closely monitor publicly available macroeconomic trends that provide insight to commercial and residential market activity including Gross Domestic Product, the Architecture Billings Index and the Consumer Confidence Index. In addition, we noted several factors and trends within our markets that directly affected our business performance during 2015, including: Americas For Building Products, we experienced growth from new construction and a decline in renovation activity. However, we continue to see some regional softness in the U.S. commercial office markets and weakness in retail markets, particularly in Canada as devaluation of the Canadian Dollar impacted market growth. Our Resilient commercial flooring markets saw improvement in education demand but continuing weakness in healthcare, while retail markets showed a slight decline. Management’s Discussion and Analysis of Financial Condition and Results of Operations Residential markets continued to show improvement in both builder activity and renovation activity. However, due to market conditions, we experienced continued competitive pricing actions in our Wood and Resilient Flooring businesses. Europe, Middle East and Africa (“EMEA”) We experienced continued softness in commercial sectors, such as office, education and healthcare. Overall market softness was exacerbated by the decline in global oil prices which heavily impacted market growth opportunities in economies closely linked to oil, such as Russia and the Middle East. These factors combined with the significant volatility in the Russian Ruble and its overall market impact contributed to mixed results across EMEA. These trends impacted our Building Products business. Pacific Rim Commercial markets for our Building Products businesses grew throughout the Pacific Rim with the exception of China where the office market continues to be soft. Commercial markets grew throughout the Pacific Rim for our Resilient Flooring business including slight growth in China, driven by the healthcare and education market segments. Pricing Initiatives. We periodically modify prices in each of our business segments due to changes in costs for raw materials and energy, and to market conditions and the competitive environment. In certain cases, realized price increases are less than the announced increases because of competitive reactions and changing market conditions. We estimate that pricing actions increased our 2015 consolidated net sales by approximately $10 million, compared to 2014. In the fourth quarter of 2015, we implemented price increases in our Building Products business in the Pacific Rim and on select products in our Resilient and Wood Flooring businesses in Canada to offset currency devaluations. We also announced price increases on select Resilient Flooring products in Canada and in our Building Products businesses in the Americas, EMEA, and the Pacific Rim effective in the first quarter of 2016. We may implement additional pricing actions based upon future movements in raw materials prices or foreign currency valuations. Mix. Each of our businesses offers a wide assortment of products that are differentiated by style, design and performance attributes. Pricing and margins for products within the assortment vary. Changes in the relative quantity of products purchased at the different price points can impact year-to-year comparisons of net sales and operating income. We estimate that mix improvements increased our 2015 consolidated net sales by approximately $23 million, compared to 2014. Factors Affecting Operating Costs Operating Expenses. Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general and administrative (“SG&A”) expenses. Our largest individual raw material expenditures include lumber and veneers, PVC resins and plasticizers. Natural gas is also a significant input cost. Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results. In 2015, the costs for raw materials, sourced products and energy positively impacted operating income by approximately $53 million, compared to 2014. During 2015, we incurred approximately $9 million of severance and other charges associated with cost reduction actions in EMEA and our decision to idle one of our Building Products plants in China in 2016. We continue to evaluate the efficiency of our manufacturing footprint and may take additional actions in support of our cost and standardization initiatives. The charges associated with any additional cost reduction initiatives could include severance and related termination benefits, fixed asset write-downs, asset impairments and accelerated depreciation and may be material to our financial statements. Management’s Discussion and Analysis of Financial Condition and Results of Operations See also “Results of Operations” for further discussion of other significant items affecting operating costs. Employees As of December 31, 2015, we had approximately 7,600 full-time and part-time employees worldwide, compared to approximately 7,400 employees as of December 31, 2014. The majority of the increase related to staff additions at our Alabuga, Russia mineral fiber ceiling plant, which began operating in 2015, along with higher staffing levels in our Americas flooring business. During 2015, we negotiated collective bargaining agreements covering approximately 500 employees at two U.S. plants. Collective bargaining agreements covering approximately 150 employees at two North American plants will expire during 2016. CRITICAL ACCOUNTING ESTIMATES In preparing our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”), we are required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an on-going basis, using relevant internal and external information. We believe that our estimates and assumptions are reasonable. However, actual results may differ from what was estimated and could have a significant impact on the financial statements. We have identified the following as our critical accounting estimates. We have discussed these critical accounting estimates with our Audit Committee. U.S. Pension Credit and Postretirement Benefit Costs - We maintain pension and postretirement plans throughout the world, with the most significant plans located in the U.S. Our defined benefit pension and postretirement benefit costs are developed from actuarial valuations. These valuations are calculated using a number of assumptions, which represent management’s best estimate of the future. The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets and the estimated inflation in health care costs. These assumptions are generally updated annually. The discount rate is used to determine retirement plan liabilities and to determine the interest cost component of net periodic pension and postretirement cost. Management utilizes the Aon Hewitt AA only above median yield curve, which is a hypothetical AA yield curve comprised of a series of annualized individual discount rates, as the primary basis for determining the discount rate. As of December 31, 2015 and 2014, we assumed discount rates of 4.40% and 4.05%, respectively, for the U.S. defined benefit pension plans. As of December 31, 2015, we assumed a discount rate of 4.25% compared with a discount rate of 3.90% as of December 31, 2014 for the U.S. postretirement plans. The effects of the change in discount rate will be amortized into earnings as described below. Absent any other changes, a one-quarter percentage point decrease in the discount rates for the U.S. pension and postretirement plans would decrease 2016 operating income by $6.1 million and a one-quarter percentage point increase in the discount rates would increase 2016 operating income by $5.8 million. We manage two U.S. defined benefit pension plans, a qualified funded plan and a nonqualified unfunded plan. For the qualified funded plan, the expected long-term return on plan assets represents a long-term view of the future estimated investment return on plan assets. This estimate is determined based on the target allocation of plan assets among asset classes and input from investment professionals on the expected performance of the asset classes over 10 to 30 years. Historical asset returns are monitored and considered when we develop our expected long-term return on plan assets. An incremental component is added for the expected return from active management based on historical information obtained from the plan’s investment consultants. These forecasted gross returns are reduced by estimated management Management’s Discussion and Analysis of Financial Condition and Results of Operations fees and expenses. Over the 10 year period ended December 31, 2015, the historical annualized return was approximately 5.8% compared to an average expected return of 7.4%. The actual loss on plan assets achieved for 2015 was 1.4%. The difference between the actual and expected rate of return on plan assets will be amortized into earnings as described below. The expected long-term return on plan assets used in determining our 2015 U.S. pension credit was 7.0%. We have assumed a return on plan assets during 2016 of 6.75%. The 2016 expected return on assets was calculated in a manner consistent with 2015. A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2016 operating income by approximately $4.7 million. Contributions to the unfunded plan were $3.6 million in 2015 and were made on a monthly basis to fund benefit payments. We estimate the 2016 contributions will be approximately $4.0 million. See Note 16 to the Consolidated Financial Statements for more information. The estimated inflation in health care costs represents a 5-10 year view of the expected inflation in our postretirement health care costs. We separately estimate expected health care cost increases for pre-65 retirees and post-65 retirees due to the influence of Medicare coverage at age 65, as illustrated below: The difference between the actual and expected health care costs is amortized into earnings as described below. As of December 31, 2015, health care cost increases are estimated to decrease ratably until 2024, after which they are estimated to be constant at 4.5%. A one percentage point increase or decrease in the assumed health care cost trend rate would not have a material impact on 2016 operating income. See Note 16 to the Consolidated Financial Statements for more information. Actual results that differ from our various pension and postretirement plan estimates are captured as actuarial gains/losses. When certain thresholds are met, the gains and losses are amortized into future earnings over the expected remaining service period of plan participants, which is approximately eight years for our U.S. pension plans and our U.S. postretirement plans. Changes in assumptions could have significant effects on earnings in future years. We recognized a decrease in net actuarial losses related to our U.S. pension benefit plans of $28.7 million in 2015 primarily due to changes in actuarial assumptions (most significantly a 35 basis point increase in the discount rate). The $28.7 million actuarial gain impacting our U.S. pension plans is reflected as a component of other comprehensive income in our Consolidated Statement of Earnings and Comprehensive Income along with actuarial gains and losses from our foreign pension plans and our U.S. postretirement benefit plans. Income Taxes - Our effective tax rate is primarily determined based on our pre-tax income and the statutory income tax rates in the jurisdictions in which we operate. The effective tax rate also reflects the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences are temporary, reversing over time, such as depreciation expense. These temporary differences create deferred income tax assets and liabilities. Deferred income tax assets are also recorded for net operating loss (“NOL”) and foreign tax credit (“FTC”) carryforwards. Deferred income tax assets and liabilities are recognized by applying enacted tax rates to temporary differences that exist as of the balance sheet date. We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized. The need to establish valuation allowances for deferred tax assets is assessed quarterly. Management’s Discussion and Analysis of Financial Condition and Results of Operations In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard, we give appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability and foreign source income (“FSI”), the duration of statutory carryforward periods, and our experience with operating loss and tax credit carryforward expirations. A history of cumulative losses is a significant piece of negative evidence used in our assessment. If a history of cumulative losses is incurred for a tax jurisdiction, forecasts of future profitability are not used as positive evidence related to the realization of the deferred tax assets in the assessment. Specifically with respect to the domestic FTC carryforward deferred tax asset of $27.1 million at December 31, 2015, we considered the following positive and negative evidence in assessing the need for a valuation allowance and concluded that a valuation allowance is not required: Positive Evidence • Our emergence from bankruptcy in 2006 created significant NOLs. The last portion of these NOLs was completely utilized during 2012. Starting in 2013, we had domestic taxable income which allowed us to begin utilizing the FTCs; • Under U.S. tax law, approximately $43.1 million of our domestic source income in future years can be characterized as FSI to enable the utilization of our FTCs. This amount primarily represents prior year intercompany dividends associated with the FTC carryforwards. These dividends created domestic taxable income that was reduced by the utilization of domestic NOLs; and • Forecasts of future profitability and FSI. Negative Evidence • Our history of FTC expirations as a result of the carryback and carryforward of the NOLs generated upon emergence from bankruptcy. All FTCs were fully utilized before the bankruptcy NOL carryback. The NOL carryback reduced the taxable income (a portion of which is considered FSI) to zero and thus the FTCs were carried forward along with the remaining portion of the NOL. The utilization of the remaining NOL carryforward reduced taxable income to zero, which caused the expiration of the FTCs; and • Our stated position to permanently reinvest unremitted earnings of our foreign subsidiaries. The ability to fully utilize the FTC carryforwards may be affected by the following factors: • FSI of $77.4 million is needed to fully utilize the FTC carryforward of $27.1 million before they expire in 2022. In addition to the $43.1 million of domestic source income that can be characterized as FSI in future years, $34.3 million of additional foreign source income is needed. • The main factor that could result in our inability to re-characterize domestic source income to foreign source income is a U.S. tax law change. • The main factors that could contribute to lower FSI are decreased export sales and increased allocable expenses. As of December 31, 2015, we have recorded valuation allowances totaling $69.1 million for various federal, state, and foreign deferred tax assets. While we have considered future taxable income in assessing the need for the valuation allowances based on our best available projections, if these estimates and assumptions change in the future or if actual results differ from our projections, we may be required to adjust our valuation allowances accordingly. Such adjustments could be material to our Consolidated Financial Statements. Management’s Discussion and Analysis of Financial Condition and Results of Operations As further described in Note 14 to the Consolidated Financial Statements, our Consolidated Balance Sheet as of December 31, 2015 includes net deferred income tax assets of $282.3 million. Included in this amount are deferred federal income tax assets for FTC carryforwards of $27.1 million, state NOL deferred income tax assets of $31.2 million, and foreign NOL deferred tax assets of $52.5 million. We have established valuation allowances in the amount of $69.1 million consisting of $13.8 million for state deferred tax assets, primarily operating loss carryovers, and $55.3 million for foreign deferred tax assets, primarily foreign operating loss carryovers. Inherent in determining our effective tax rate are judgments regarding business plans and expectations about future operations. These judgments include the amount and geographic mix of future taxable income, the amount of FSI, limitations on usage of NOL carryforwards, the impact of ongoing or potential tax audits, earnings repatriation plans, and other future tax consequences. We estimate we will need to generate future U.S. taxable income of approximately $971.1 million for state income tax purposes during the respective realization periods (ranging from 2016 to 2035) in order to fully realize the net deferred income tax assets. As previously disclosed in prior SEC filings, our ability to utilize deferred tax assets may be impacted by certain future events, such as changes in tax legislation and insufficient future taxable income prior to expiration of certain deferred tax assets. We recognize the tax benefits of an uncertain tax position if those benefits are more likely than not to be sustained based on existing tax law. Additionally, we establish a reserve for tax positions that are more likely than not to be sustained based on existing tax law, but uncertain in the ultimate benefit to be sustained upon examination by the relevant taxing authorities. Unrecognized tax benefits are subsequently recognized at the time the more likely than not recognition threshold is met, the tax matter is effectively settled or the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired, whichever is earlier. Inventories - Inventories are valued at the lower of cost or market, with cost for U.S. inventories determined principally on the LIFO (last-in, first-out) basis and cost for non-U.S. inventories valued on the FIFO (first-in, first-out) basis. We establish reserves for LIFO valuation adjustments and for inventory obsolescence, excess inventory and inventory expected to be sold below cost. Approximately 77% and 73% of our total inventory in 2015 and 2014, respectively, was valued on a LIFO basis. The calculation of LIFO reserves is affected by inflation and deflation in inventory components. In recent years, our Wood Flooring business has been most susceptible to LIFO valuation volatility due to the high volatility of lumber prices and long production cycles. LIFO reserves as of December 31, 2015 declined in comparison to December 31, 2014, primarily due to declines in lumber costs. Reserves for inventory obsolescence, excess inventory and inventory expected to be sold below cost are established when the estimated market value of inventory is below its cost. Market value is represented as the replacement cost or net realizable value of inventory. We continuously review our inventory values to determine if there are any indicators that costs exceed market values. Historically, significant indicators requiring increases to inventory valuation reserves have been the age of inventory, an anticipated decrease in demand, a shift in customer preferences and overall economic conditions. Our reserves for inventory obsolescence as of December 31, 2015 and 2014 were $3.2 million and $2.4 million, respectively. Management believes that our inventory reserves as of December 31, 2015 and 2014 are adequate, however, actual results could differ from assumptions used to value obsolete inventory, excess inventory or inventory expected to be sold below cost and additional reserves may be required. Impairments of Long-Lived Tangible and Intangible Assets - Our indefinite-lived intangibles are primarily trademarks and brand names, which are integral to our corporate identity and expected to contribute indefinitely to our corporate cash flows. Accordingly, they have been assigned an indefinite life. We conduct our annual impairment test for non-amortizable intangible assets during the fourth quarter, although we conduct interim impairment tests if events or circumstances indicate the asset might be Management’s Discussion and Analysis of Financial Condition and Results of Operations impaired. We conduct impairment tests for tangible assets and amortizable intangible assets when indicators of impairment exist, such as operating losses and/or negative cash flows. If an indication of impairment exists, we compare the carrying amount of the asset group to the estimated undiscounted future cash flows expected to be generated by the assets. The estimate of an asset group’s fair value is based on discounted future cash flows expected to be generated by the asset group, or based on management’s estimated exit price assuming the assets could be sold in an orderly transaction between market participants or estimated salvage value if no sale is assumed. If the fair value is less than the carrying value of the asset group, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group. The principal assumption utilized in our impairment tests for definite-lived intangible assets is operating profit adjusted for depreciation and amortization. The principal assumptions utilized in our impairment tests for indefinite-lived intangible assets include revenue growth rate, discount rate and royalty rate. Revenue growth rate and operating profit assumptions are derived from those utilized in our operating plan and strategic planning processes. The discount rate assumption is calculated based upon an estimated weighted average cost of equity which reflects the overall level of inherent risk and the rate of return a market participant would expect to achieve. Methodologies used for valuing our intangible assets did not change from prior periods. The cash flow estimates used in applying our impairment tests are based on management’s analysis of information available at the time of the impairment test. Actual cash flows lower than the estimate could lead to significant future impairments. If subsequent testing indicates that fair values have declined, the carrying values would be reduced and our future statements of income would be affected. During the fourth quarter of 2014, we recorded a non-cash impairment charge of $10.0 million to reduce the carrying amount of a Wood Flooring trademark to its estimated fair value based on the results of our annual impairment test. The fair value was negatively affected by lower expected sales and profits due to the competitive environment in the U.S. residential housing market. The remaining carrying value of the Wood Flooring trademarks at December 31, 2015 was $31.9 million. Continued competitive pressure beyond our expectations could lead to future material impairments of the Wood Flooring intangible assets. There were no impairment charges in 2015 or 2013 related to intangible assets. We tested the tangible assets within the following reporting units for impairment: Based upon the impairment testing in 2014, the carrying value of the tangible assets for each of these asset groups was determined to be recoverable (except as discussed below) because the related undiscounted cash flows and/or fair value exceeded the carrying value of assets. During the third quarter of 2014, we recorded an impairment charge of $11.9 million on the tangible assets of the European Resilient Flooring business as a result of disappointing operating results. This charge was reflected within Discontinued Operations due to DLW’s insolvency filing. See Note 4 to the Consolidated Financial Statements for further information. During the second quarter of 2014, we decided to close our resilient flooring plant in Thomastown, Australia and our engineered wood flooring plant in Kunshan, China. During 2014, we recorded $2.2 million in cost of goods sold for accelerated depreciation due to the closure of the resilient flooring plant in Australia. We sold this facility in January 2015. We also recorded $4.0 million in 2014 in cost of goods sold for accelerated depreciation due to the closure of the wood flooring plant in China. Management’s Discussion and Analysis of Financial Condition and Results of Operations During 2014, we also made the decision to dispose of certain idle equipment at five of our wood flooring manufacturing facilities and as a result we recorded a $4.4 million impairment charge in cost of goods sold. We cannot predict the occurrence of certain events that might lead to material impairment charges in the future. Such events may include, but are not limited to, the impact of economic environments, particularly related to the commercial and residential construction industries, material adverse changes in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. See Notes 3 and 10 to the Consolidated Financial Statements for further information. ACCOUNTING PRONOUNCEMENTS EFFECTIVE IN FUTURE PERIODS In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09 “Revenue from Contracts with Customers.” The guidance requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to a customer. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In August 2015, the FASB issued ASU 2015-14, “Revenue from Contracts with Customers: Deferral of the Effective Date” which defers the effective date for ASU 2014-09 by one year to January 1, 2018, however, public business entities would be permitted to adopt the standard as of the original effective date. We have not selected a transition method and are currently evaluating the impact this guidance will have on our financial condition, results of operations and cash flows. In June 2014, the FASB issued ASU 2014-12 “Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period” which is part of ASC 718: Compensation-Stock Compensation. The guidance requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition and should not be reflected in the estimate of the grant-date fair value of the award. The guidance is effective for annual periods beginning after December 15, 2015. The guidance can be applied prospectively for all awards granted or modified after the effective date or retrospectively to all awards with performance targets outstanding as of the beginning of the earliest annual period presented in the financial statements and to all new or modified awards thereafter. We do not expect a material impact on our financial condition, results of operations or cash flows from the adoption of this guidance. In April 2015, the FASB issued ASU 2015-03, “Simplifying the Presentation of Debt Issuance Costs.” This standard amends existing guidance to require the presentation of debt issuance costs in the balance sheet as a deduction from the carrying amount of the related debt liability instead of a deferred charge. The new guidance is effective for annual reporting periods beginning after December 15, 2015, but early adoption is permitted. In August 2015, the FASB issued ASU 2015-15, “Presentation and Subsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements,” which was issued to address the presentation and subsequent measurement of debt issuance costs related to line-of-credit arrangements. We are currently evaluating the impact the adoption of these standards will have on our financial condition and cash flows. In April 2015, the FASB issued ASU 2015-05, “Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement” which provides guidance to determine when a customer’s fees paid in a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If the arrangement does not include a software license, the customer should account for a cloud computing arrangement as a service contract. The new guidance is effective for annual reporting periods beginning after December 15, 2015, but early adoption is permitted. We are currently evaluating the impact the adoption of this standard would have on our financial condition, results of operations and cash flows. In July 2015, the FASB issued ASU 2015-11, “Simplifying the Measurement of Inventory” which requires inventory that is measured on a first-in, first-out or average cost basis to be measured at lower of cost and net realizable value, as opposed to the lower of cost or market. For inventory that is measured under the Management’s Discussion and Analysis of Financial Condition and Results of Operations last-in, first-out (“LIFO”) basis or the retail recovery method, there is no change to current measurement requirements. This new guidance is effective for annual reporting periods beginning after December 15, 2016, but early adoption is permitted. We are currently evaluating the impact the adoption of this standard would have on our financial condition, results of operations and cash flows. In November 2015, the FASB issued ASU 2015-17, “Balance Sheet Classification of Deferred Taxes” which requires entities with a classified balance sheet to present all deferred tax assets and liabilities as noncurrent. This new guidance is effective for annual reporting periods beginning after December 15, 2016. We are currently evaluating the impact the adoption of this standard would have on our financial condition and cash flows. In January 2016, the FASB issued ASU 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities” which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Most notably, this new guidance requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. This new guidance is effective for annual reporting periods beginning after December 15, 2017. We are currently evaluating the impact the adoption of this standard would have on our financial condition, results of operations and cash flows. RESULTS OF OPERATIONS Unless otherwise indicated, net sales in these results of operations are reported based upon the AWI location where the sale was made. Please refer to Notes 3 and 4 to the Consolidated Financial Statements for a reconciliation of segment operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations. 2015 COMPARED TO CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) The decrease in consolidated net sales was driven by the unfavorable impact of foreign exchange of approximately $95 million. Lower volumes of $33 million were offset by $33 million of favorable price and mix. The decrease in net sales in the Americas was driven by the unfavorable impact from foreign exchange of approximately $21 million and lower volumes, which were only partially offset by improvements in price and mix. The decrease in net sales in the EMEA region was driven by the unfavorable impact from foreign exchange of approximately $58 million and lower volumes which were only partially offset by improvements in price and mix. Excluding unfavorable foreign exchange impact of approximately $16 million, net sales in the Pacific Rim increased 4% as improvements in volumes and price were partially offset by unfavorable mix. Management’s Discussion and Analysis of Financial Condition and Results of Operations Cost of goods sold was 75.1% of net sales in 2015, compared to 76.8% in 2014. Compared to the prior year, the reduction was caused by lower input costs, primarily lumber, PVC resins and plasticizers, partially offset by higher manufacturing and U.S. pension costs. The comparison was also impacted by $9 million of severance and other charges associated with cost reduction actions in EMEA and the idling of a Building Products plant in China in 2015, and approximately $15 million of charges in 2014 associated with the closure of our Thomastown, Australia resilient flooring plant and the closure of our Kunshan, China engineered wood flooring plant. SG&A expenses in 2015 were $447.2 million, or 18.5% of net sales, compared to $398.5 million, or 15.8% of net sales, in 2014. The increase was primarily due to higher promotional spending in both flooring businesses and an increase in employee compensation and benefits, mostly notably higher incentive compensation accruals and U.S. pension costs. See Reportable Segment Results for additional information. Separation costs of $34.3 million were primarily related to outside professional services and employee compensation and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business. Equity earnings from our WAVE joint venture were $66.1 million in 2015, compared to $65.1 million in 2014. See Note 9 to the Consolidated Financial Statements for further information. Interest expense was $45.3 million in 2015, compared to $46.0 million in 2014. Other non-operating expenses were $23.5 million in 2015, compared to $10.5 million in 2014. The increase in 2015 was primarily due to foreign exchange rate losses on the translation of unhedged cross-currency intercompany loans denominated in Russian Rubles, related to the construction of our Russian mineral fiber ceiling plant that was completed in the first quarter of 2015. Where efficient, reliable and liquid markets exist we may utilize foreign currency forward exchange contracts to hedge exposures created by cross-currency intercompany loans and dividends. Our largest unhedged foreign currency exposures are in Chinese Renminbi and Russian Rubles. As of December 31, 2015, total unhedged foreign currency-denominated intercompany loan exposures in Chinese Renminbi and Russian Rubles were $161.6 million and $49.0 million, respectively. Income tax expense was $71.3 million and $83.2 million in 2015 and 2014, respectively. The effective tax rate for 2015 was 57.5% as compared to a rate of 44.9% for 2014. The effective tax rate for 2015 was higher than 2014 primarily due to lower pre-tax income causing a higher rate impact of unbenefitted foreign operating losses, non-deductible separation costs, a decrease in research and development tax credits as 2014 included the benefit of multiple years of such credits, and state net operating loss write-offs resulting from a change in ownership under Section 382 of the Internal Revenue Code. Total other comprehensive income (“OCI”) was $8.1 million for 2015 compared to a $123.9 million loss for 2014. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Amounts in 2015 and 2014 were driven primarily by changes in the exchange rate of the Euro, the Australian dollar and the British pound. Derivative gain/loss represents the mark to market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. The period changes are primarily due to the mark to market changes related to our natural gas hedges in both 2015 and 2014. Pension and postretirement adjustments represent actuarial gains and losses related to our defined-benefit pension and postretirement plans. The amounts in all periods primarily related to the U.S. pension plans. Management’s Discussion and Analysis of Financial Condition and Results of Operations REPORTABLE SEGMENT RESULTS Building Products (dollar amounts in millions) Excluding the unfavorable impact from foreign exchange of approximately $76 million, Building Products net sales increased 1%, resulting from $49 million of favorable price and mix which more than offset lower volumes of $35 million. Excluding the unfavorable impact from foreign exchange of approximately $9 million, net sales in the Americas increased 2% as favorable price and mix more than offset the impact of lower volumes. Excluding the unfavorable impact from foreign exchange of approximately $58 million, net sales in EMEA markets decreased 2% as lower volumes were only partially offset by improvements in price and mix. Excluding the unfavorable impact from foreign exchange of approximately $10 million, net sales in the Pacific Rim increased 2% as favorable mix and price more than offset lower volumes. Operating income was flat but gross margin improved driven by the benefits of positive price and mix of $28 million, lower manufacturing and input costs of $8 million and higher earnings from WAVE of $1 million, which offset the margin impact of lower volumes of $22 million and higher SG&A expenses of $10 million primarily to support go-to-market investments in the Americas. Operating income was also negatively impacted by cost reduction actions in international markets including $9 million of severance and other charges associated with cost reduction actions in EMEA and our decision to idle of one of our Building Products plants in China in 2016 compared to $1 million of severance to support cost reduction actions in EMEA during 2014. Resilient Flooring (dollar amounts in millions) Excluding the unfavorable impact from foreign exchange of approximately $14 million, Resilient Flooring net sales were up 2% driven by $30 million of higher volumes which were partially offset by unfavorable price and mix of $17 million. Excluding the unfavorable impact from foreign exchange of approximately $8 million, Americas net sales increased 1%. Higher volumes contributed 4% to this increase, driven by both the commercial and residential markets. The increase from volumes was partially offset by unfavorable price and mix, which each contributed a reduction to net sales of approximately 1%. Management’s Discussion and Analysis of Financial Condition and Results of Operations Excluding the unfavorable impact from foreign exchange of approximately $6 million, net sales in the Pacific Rim increased 7% as volume growth across the region was partially offset by unfavorable mix. Operating income declined primarily due to higher SG&A expenses of $31 million and unfavorable price and mix of $19 million partially offset by lower manufacturing and input costs of $18 million and the margin impact of higher volumes of $13 million. The increase in SG&A expenses was primarily due to ongoing promotional spending to support go-to-market initiatives in the Americas and higher employee compensation and benefits. The comparison was also impacted by approximately $6 million of charges in 2014 associated with the closure of our Thomastown, Australia resilient flooring plant and by a $2 million gain on the sale of the plant in 2015. Wood Flooring (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $4 million, Wood Flooring net sales declined by $28 million. Lower volumes contributed $28 million to the decline. Favorable mix was mostly offset by negative net pricing. The improvement in operating income was driven by a decline in lumber costs that resulted in a $37 million benefit, partially offset by the margin impact of lower volumes of $10 million, higher SG&A expenses to support go-to-market activities of $4 million and unfavorable price and mix of $2 million. The comparison was also impacted by $4 million of multilayered hardwood flooring import duties recorded in 2015. Additionally, 2014 results included approximately $9 million of severance, idle equipment and other charges associated with the closure of our Kunshan, China engineered wood flooring plant, $3 million of other idle equipment charges and a non-cash impairment charge of $10 million to reduce the carrying value of a Wood Flooring trademark to its estimated fair value. Unallocated Corporate Unallocated corporate expense of $138.8 million increased from $72.3 million in the prior year, primarily due to separation costs of $34 million recorded in 2015 and an increase in employee compensation and benefits, most notably higher U.S. pension costs of $25 million and a $4 million increase in environmental reserves related to our Macon, Georgia facility. FINANCIAL CONDITION AND LIQUIDITY Cash Flow Operating activities for 2015 provided $203.7 million of cash, compared to $208.8 million of cash provided in 2014. Lower cash earnings in 2015 were partially offset by favorable changes in working capital, primarily due to favorable timing of accounts payable and accrued expenses. Net cash used for investing activities was $101.5 million for 2015, compared to $149.3 million in 2014. This change was primarily due to decreased purchases of property, plant and equipment. Net cash used by financing activities was $32.3 million for 2015, compared to $3.3 million provided during 2014. Net cash used in 2015 was primarily driven by payments on long-term debt. Net cash provided in 2014 was driven by proceeds from exercised stock options and excess tax benefits from share-based awards, partially offset by payments of long-term debt. Liquidity Our liquidity needs for operations vary throughout the year. We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is generally lower during the first and fourth quarters of our fiscal year. We have a $1.3 billion senior credit facility which is composed of a $250 million revolving credit Management’s Discussion and Analysis of Financial Condition and Results of Operations facility (with a $150 million sublimit for letters of credit), a $550 million Term Loan A and a $475 million Term Loan B. This $1.3 billion senior credit facility is secured by U.S. personal property, the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first tier foreign subsidiaries. Under the senior credit facility we are subject to year-end leverage tests that may trigger mandatory prepayments. If our ratio of consolidated funded indebtedness minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) (“Consolidated Net Leverage Ratio”) is greater than 3.5 to 1.0, the prepayment amount would be based on a computation of 50% of consolidated annual excess cash flows, as defined by the credit agreement. These annual payments would be made in the first quarter of the following year. No payment will be required in 2016. The senior credit facility includes two financial covenants that require the ratio of consolidated EBITDA to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the Consolidated Net Leverage Ratio to be less than or equal to 3.75 to 1.0. As of December 31, 2015, we were in compliance with all covenants of the senior credit facility. The Revolving Credit and Term Loan A portions are currently priced at a spread of 2.50% over LIBOR and the Term Loan B portion is priced at 2.50% over LIBOR with a 1.00% LIBOR floor for its entire term. The Term Loan A and Term Loan B were both fully drawn and are currently priced on a variable interest rate basis. The following table summarizes our interest rate swaps (dollar amounts in millions): These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. The unpaid balances of Term Loan A, the Revolving Credit Facility and Term Loan B of the credit facility may be prepaid without penalty at the maturity of their respective interest reset periods. Any amounts prepaid on the Term Loan A or Term Loan B may not be re-borrowed. As of December 31, 2015, there was no outstanding balance on the Revolving Credit Facility. As of December 31, 2015 our outstanding long-term debt included two variable rate, tax-exempt industrial development bonds totaling $45.1 million that financed the construction of plants in prior years. These bonds have scheduled final maturities ranging from 2025 to 2041 and are remarketed by an agent on a regular basis at a market-clearing interest rate. Any portion of the bonds that are not successfully remarketed by the agent are required to be repurchased. These bonds are backed by letters of credit which will be drawn if a portion of the bond is not successfully remarketed. We have not had to repurchase any of the bonds. Prior to the planned separation of the flooring business, we intend on discharging a $10.0 million bond by providing the necessary funds to the trustee in anticipation of a planned redemption at the next interest payment date of April 1, 2016. As a result of our planned separation of the flooring business, we intend to refinance our existing credit facilities, and may modify certain interest rate hedges. We intend to use cash on hand as well as a planned $50.0 million cash dividend from AFI to reduce total debt outstanding. The new credit facility is expected to be for $1,050 million, including $200.0 million of an undrawn revolving credit facility. We anticipate concluding this transaction contemporaneously with our separation of the flooring business. Due to the significant decline in the value of the Russian Ruble, we received $30.0 million in cash in 2014 as a result of settling Russian Ruble forward contracts utilized to hedge the currency impact associated with intercompany loans to our Russian subsidiary. Our exposure to changes in the Ruble due to the intercompany loans is unhedged at December 31, 2015. Management’s Discussion and Analysis of Financial Condition and Results of Operations As of December 31, 2015, we had $244.8 million of cash and cash equivalents, $122.5 million in various foreign jurisdictions and $122.3 million in the U.S. On December 18, 2014, we amended and increased our $75 million Accounts Receivable Securitization Facility with the Bank of Nova Scotia, under which AWI and its subsidiary, Armstrong Hardwood Flooring Company, sell their U.S. receivables to Armstrong Receivables Company LLC (“ARC”), a Delaware entity that is consolidated in these financial statements. The facility reflects a seasonality clause changing to $100 million from March through September, and $90 million from October through February. The maturity date has been extended from March 2016 to December 2017. As of December 31, 2015, there was no outstanding balance on the accounts receivable securitization facility. In connection with the planned separation of AFI, we intend to amend this facility, resulting in lower purchase and letter of credit commitments under the program. On December 31, 2015, we had outstanding letters of credit totaling $68.2 million, of which $7.7 million was issued under the revolving credit facility, $60.3 million was issued under the securitization facility, and $0.2 million was issued by other banks of international subsidiaries. Letters of credit are issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. These lines of credit are uncommitted, and poor operating results or credit concerns at the related foreign subsidiaries could result in the lines being withdrawn by the lenders. We have historically been able to maintain and, as needed, replace credit facilities to support our non-U.S. operations. Since 2012, our Board of Directors has approved the construction of a mineral fiber ceiling plant in Russia (completed in the first quarter of 2015) and the expansion of our Lancaster, PA flooring plant to include the manufacture of LVT. Through December 31, 2015, we have incurred approximately $150 million related to these projects. We do not anticipate incurring any additional material spending related to these construction projects in 2016. We believe that cash on hand and cash generated from operations, together with lines of credit, availability under our securitization facility and the availability under our $250 million revolving credit facility, will be adequate to address our foreseeable liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations. Management’s Discussion and Analysis of Financial Condition and Results of Operations 2014 COMPARED TO 2013 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) The decrease in consolidated net sales was driven by the unfavorable impact of foreign exchange of approximately $19 million. Lower volumes of $100 million were more than offset by $106 million of favorable price and mix. The decrease in net sales in the Americas was driven by lower volumes, which were only partially offset by improvements in price and mix. The increase in net sales in the EMEA region was driven primarily by improvements in price, partially offset by the impact of unfavorable mix. Excluding unfavorable foreign exchange impact of approximately $6 million, net sales in the Pacific Rim increased 9% as improvements in volumes and price were partially offset by unfavorable mix. Cost of goods sold was 76.8% of net sales in 2014, compared to 76.5% in 2013. Compared to the prior year, lower manufacturing costs were more than offset by higher input costs. The comparison was impacted by approximately $15 million of charges in 2014 associated with the closure of our Thomastown, Australia resilient flooring plant and the closure of our Kunshan, China engineered wood flooring plant, and approximately $4 million of charges primarily associated with cost reduction actions in the Resilient Flooring business in Australia in 2013. SG&A expenses in 2014 were $398.5 million, or 15.8% of net sales, compared to $386.9 million, or 15.3% of net sales in 2013. The increase was primarily due to higher promotional spending in both flooring businesses. See Reportable Segment Results for additional information. Equity earnings from our WAVE joint venture were $65.1 million in 2014, compared to $59.4 million in 2013. Interest expense was $46.0 million in 2014, compared to $68.7 million in 2013. The decrease was due to the write-off of unamortized debt financing costs associated with the refinancing of our senior credit facility that occurred during the first quarter of 2013. Income tax expense was $83.2 million and $71.4 million in 2014 and 2013, respectively. The effective tax rate for 2014 was 44.9% as compared to a rate of 35.9% for 2013. The effective tax rate for 2014 was higher than 2013 primarily due to higher unbenefitted foreign operating losses, lower income in foreign subsidiaries with profits, and an increase in the state valuation allowance for NOLs. Management’s Discussion and Analysis of Financial Condition and Results of Operations REPORTABLE SEGMENT RESULTS Building Products (dollar amounts in millions) The improvement in Building Products net sales was driven by $46 million of favorable price and mix which more than offset the unfavorable impact of foreign exchange of approximately $10 million and lower volumes of $6 million. Net sales in the Americas increased driven by favorable mix and price which more than offset the impact of lower volumes. Net sales in EMEA markets increased driven by improvements in price which more than offset the impact of unfavorable mix. Net sales in the Pacific Rim increased as volume, mix and price all improved. Operating income increased slightly driven by the benefits of price and mix of $11 million and higher earnings from WAVE of $6 million, which offset the impact of lower volumes of $5 million, higher manufacturing and input costs of $7 million and higher SG&A expenses of $3 million. The increase in manufacturing costs was primarily associated with the construction of our plant in Russia. Resilient Flooring (dollar amounts in millions) The decline in Resilient Flooring net sales was driven by $24 million of lower volume and the unfavorable impact from foreign exchange of $6 million which more than offset favorable price and mix of $13 million. Net sales in the Americas decreased as improvements in mix were unable to offset commercial and residential volume declines. Net sales in the Pacific Rim increased as strong volume growth in China and India was partially offset by market driven sales declines in Australia. Operating income declined primarily due to the margin impact of lower volumes of $10 million and higher SG&A expenses of $8 million driven by higher promotional and marketing expense. These negative impacts were only partially offset by positive mix and price of $2 million and lower manufacturing and input costs of $8 million as strong productivity more than offset higher input costs. The comparison was also impacted by approximately $6 million of charges in 2014 associated with the closure of our Thomastown, Australia resilient flooring plant and $4 million of charges in 2013 associated with cost reduction actions in Australia. Management’s Discussion and Analysis of Financial Condition and Results of Operations Wood Flooring (dollar amounts in millions) The decrease in Wood Flooring net sales was driven primarily by lower volumes of $69 million which more than offset favorable price and mix of $47 million. Volume declines reflected sales lost to competition. The decline in operating income was driven by approximately $9 million of charges primarily associated with the closure of our Kunshan, China engineered wood flooring plant and a non-cash impairment charge of $10 million to reduce the carrying value of a Wood Flooring trademark to its estimated fair value. Gross profit improved driven by the benefit of price and mix of $55 million which more than offset the impact of lower volumes of $27 million, higher SG&A expenses of $3 million and higher manufacturing and input costs of $24 million, as improvements in productivity were more than offset by higher lumber costs. Unallocated Corporate Unallocated corporate expense of $72.3 million decreased from $73.3 million in the prior year, due to lower incentive compensation expense, partially offset by increased spending on outside professional services and higher foreign and domestic pension expenses. Cash Flow Operating activities for 2014 provided $208.8 million of cash, compared to $213.7 million of cash provided in 2013. The decrease was primarily due to changes in working capital, partially offset by higher cash earnings. The working capital change was primarily driven by accounts payable and accrued expenses due to timing of payments. Net cash used for investing activities was $149.3 million for 2014, compared to $145.8 million in 2013. This change was primarily due to increased purchases of property, plant and equipment, partially offset by higher distributions received from our WAVE joint venture. Net cash provided by financing activities was $3.3 million for 2014, compared to $263.7 million used during 2013. Net cash provided in 2014 was driven by proceeds from exercised stock options and excess tax benefits from share-based awards, partially offset by payments of long-term debt. Net cash used in 2013 included the $261.4 million repurchase of common stock, including associated fees. OFF-BALANCE SHEET ARRANGEMENTS No disclosures are required pursuant to Item 303(a)(4) of Regulation S-K. Management’s Discussion and Analysis of Financial Condition and Results of Operations CONTRACTUAL OBLIGATIONS As part of our normal operations, we enter into numerous contractual obligations that require specific payments during the term of the various agreements. The following table includes amounts ongoing under contractual obligations existing as of December 31, 2015. Only known payments that are dependent solely on the passage of time are included. Obligations under contracts that contain minimum payment amounts are shown at the minimum payment amount. Contracts that contain variable payment structures without minimum payments are excluded. Purchase orders that are entered into in the normal course of business are also excluded because they are generally cancelable and not legally binding. Amounts are presented below based upon the currently scheduled payment terms. Actual future payments may differ from the amounts presented below due to changes in payment terms or events affecting the payments. (1) For debt with variable interest rates and interest rate swaps, we projected future interest payments based on market-based interest rate swap curves. (2) Lease obligations include the minimum payments due under existing agreements with non-cancelable lease terms in excess of one year. (3) Unconditional purchase obligations include (a) purchase contracts whereby we must make guaranteed minimum payments of a specified amount regardless of how little material is actually purchased (“take or pay” contracts) and (b) service agreements. Unconditional purchase obligations exclude contracts entered into during the normal course of business that are non-cancelable and have fixed per unit fees, but where the monthly commitment varies based upon usage. Cellular phone contracts are an example. (4) Pension contributions include estimated contributions for our defined benefit pension plans. We are not presenting estimated payments in the table above beyond 2016 as funding can vary significantly from year to year based upon changes in the fair value of plan assets, funding regulations and actuarial assumptions. (5) Other obligations include payments under severance agreements. (6) Other obligations, does not include $150.6 million of liabilities under ASC 740 “Income Taxes.” Due to the uncertainty relating to these positions, we are unable to reasonably estimate the ultimate amount or timing of the settlement of these issues. See Note 14 to the Consolidated Financial Statements for more information. This table excludes obligations related to postretirement benefits (retiree health care and life insurance) since we voluntarily provide these benefits. The amount of benefit payments we made in 2015 was $17.4 million. See Note 16 to the Consolidated Financial Statements for additional information regarding future expected cash payments for postretirement benefits. We are party to supply agreements, some of which require the purchase of inventory remaining at the supplier upon termination of the agreement. The last such agreement will expire in 2018. Had these agreements terminated at December 31, 2015, we would have been obligated to purchase approximately $5.3 million of inventory. Historically, due to production planning, we have not had to purchase material amounts of product at the end of similar contracts. Accordingly, no liability has been recorded for these guarantees. We utilize lines of credit and other commercial commitments in order to ensure that adequate funds are available to meet operating requirements. Letters of credit are issued to third-party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of our failure to pay our Management’s Discussion and Analysis of Financial Condition and Results of Operations obligations to the beneficiary. This table summarizes the commitments we have available in the U.S. for use as of December 31, 2015. Letters of credit are currently arranged through our revolving credit facility or our securitization facility. In addition, our foreign subsidiaries had available lines of credit totaling $20.0 million of which $0.2 million was available only for letters of credit and guarantees. There were $0.2 million of letters of credit and guarantees issued under these credit lines as of December 31, 2015, leaving no additional letter of credit availability. There were no borrowings under these lines of credit as of December 31, 2015, leaving $19.8 million of unused lines of credit available for foreign borrowings. On December 31, 2015, we had a $250 million revolving credit facility with a $150 million sublimit for letters of credit, of which $7.7 million was outstanding. There were no borrowings under the revolving credit facility. Availability under this facility totaled $242.3 million as of December 31, 2015. We also have the $90 million securitization facility which as of December 31, 2015 had letters of credit outstanding of $60.3 million and no borrowings against it. Maximum capacity under this facility was $67.4 million (of which $7.1 million was available), subject to accounts receivable balances and other collateral adjustments. In connection with our disposition of certain assets through a variety of unrelated transactions, we have entered into contracts that included various indemnity provisions, some of which are customary for such transactions, while others hold the acquirer of the assets harmless with respect to liabilities relating to such matters as taxes, environmental and other litigation. Some of these provisions include exposure limits, but many do not. Due to the nature of the indemnities, it is not possible to estimate the potential maximum exposure under these contractual provisions. As of December 31, 2015, we had no liabilities recorded for which an indemnity claim had been received.

<s>[INST] This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forwardlooking statements and risk factors included in this Form 10K. Overview We are a leading global producer of flooring products and ceiling systems for use primarily in the construction and renovation of residential, commercial and institutional buildings. We design, manufacture and sell flooring products (primarily resilient and wood) and ceiling systems (primarily mineral fiber, fiberglass and metal) around the world. On February 23, 2015, we announced that our board of directors unanimously approved a plan to separate our Resilient Flooring and Wood Flooring segments from our Building Products (Ceilings) segment. The separation will be effected by allocating the assets and liabilities related primarily to the Resilient Flooring and Wood Flooring segments to Armstrong Flooring, Inc. (“AFI”) and then distributing the common stock of AFI to AWI’s shareholders. The separation and distribution will result in AWI and AFI becoming two independent, publiclytraded companies, with AFI owning and operating the Resilient Flooring and Wood Flooring segments and AWI continuing to own and operate the Building Products (Ceilings) segment. The effective date of the separation is expected to be near the end of the first quarter of 2016. On December 4, 2014, our Board of Directors approved the cessation of funding to our former DLW subsidiary, which was our former European Resilient Flooring business. This decision followed a comprehensive evaluation of the strategic alternatives for the business. As a result of this decision, DLW management concluded that its operations could not be financed and sustained without funding from us and filed for insolvency in Germany on December 11, 2014. See Note 4 to the Consolidated Financial Statements for more information. During 2015 we opened a mineral fiber ceiling plant in Russia. As of December 31, 2015, we operated 32 manufacturing plants in nine countries, including 20 plants located throughout the U.S. Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., operates 10 additional plants in five countries to produce suspension system (grid) products which we use in our ceiling systems. We report our financial results through the following segments: Building Products, Resilient Flooring, Wood Flooring, and Unallocated Corporate. See “Results of Operations” and “Reportable Segment Results” for additional financial information on our consolidated company and our segments. Factors Affecting Revenues For information on our segments’ 2015 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10K. Markets. We compete in building material markets around the world. The majority of our sales are in North America. We closely monitor publicly available macroeconomic trends that provide insight to commercial and residential market activity including Gross Domestic Product, the Architecture Billings Index and the Consumer Confidence Index. In addition, we noted several factors and trends within our markets that directly affected our business performance during 2015, including: Americas For Building Products, we experienced growth from new construction and a decline in renovation activity. However, we continue to see some regional softness in the U.S. commercial office markets and weakness in retail markets, particularly in Canada as devaluation of the Canadian Dollar impacted market growth. Our Resilient commercial flooring markets saw improvement in education demand but continuing weakness in healthcare, while retail markets showed a slight decline. Management’s Discussion and Analysis of Financial Condition and Results of Operations Residential markets continued to show improvement in both builder activity and renovation activity. However, due to market conditions, we experienced continued competitive pricing actions in our Wood and Resilient Flooring businesses. Europe, Middle East and Africa (“EMEA”) We experienced continued softness in commercial sectors, such as office, education and healthcare. Overall market softness was exacerbated by the decline in global oil prices which heavily impacted market growth opportunities in economies closely linked to oil, such as [/INST] Negative. </s>

ARMSTRONG WORLD INDUSTRIES INC

2017-02-27

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this Form 10-K. Overview We are a leading global producer of ceiling systems and, prior to April 1, 2016, flooring products for use primarily in the construction and renovation of residential, commercial and institutional buildings. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) and, prior to April 1, 2016, flooring products (primarily resilient and wood) around the world. On April 1, 2016, we completed our previously announced separation of Armstrong Flooring, Inc. (“AFI”) by allocating the assets and liabilities related primarily to the Resilient Flooring and Wood Flooring segments to AFI and then distributing the common stock of AFI to our shareholders at a ratio of one share of AFI common stock for every two shares of AWI common stock. Subsequent to the separation and distribution, AWI and AFI operate as two independent, publicly-traded companies, with AFI owning and operating the Resilient Flooring and Wood Flooring segments and AWI continuing to own and operate the Building Products (Ceilings) segment. AFI’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented. We are focused on driving sustainable shareholder value creation. Our strategic priorities are to accelerate profitable volume growth globally and to improve the returns in our international business. Our primary goal is to expand into new and grow in existing markets by selling a broader array of products and solutions into those markets. As of December 31, 2016, we had 15 manufacturing plants in eight countries, including six plants located throughout the U.S. During the fourth quarter of 2016 we idled one of our mineral fiber plants in China. Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc. in which we hold a 50% equity interest, operates 9 additional plants in five countries to produce suspension system (grid) products, which we use and sell in our ceiling systems. Reportable Segments Effective April 1, 2016 and in connection with our separation of AFI, our former Resilient Flooring and Wood Flooring segments have been excluded from our results of continuing operations. In addition, effective April 1, 2016, we disaggregated our former Building Products operating segment into the following three distinct geographical segments: Americas (including Canada); Europe, Middle East and Africa (including Russia) (“EMEA”); and Pacific Rim. Each of our geographical segments produce suspended fiber and metal ceilings for use in commercial and institutional settings in addition to sourcing complimentary ceiling products. Commercial ceiling materials and accessories are sold to resale distributors and to ceiling systems contractors. Residential ceiling products are sold in the Americas primarily to wholesalers and retailers (including large home centers). Each segment also includes our WAVE joint venture, which manufactures suspension system (grid) products that are invoiced by both us and WAVE. In each of our segments, WAVE primarily sells its suspension system products directly to customers, for which we provide sales and administrative support. To a lesser extent, however, in some markets, WAVE sells its suspension systems products to us for resale to customers. Our segment results reflect those sales transactions. In addition, effective April 1, 2016, we reclassified the majority of the assets and liabilities formally allocated to our Unallocated Corporate segment to our Americas segment for all periods presented. The assets and liabilities reclassified to our Americas segment most notably included the Armstrong trade name intangible asset, property, plant and equipment comprised primarily of Corporate campus facilities, the cash surrender value of life insurance supporting deferred compensation liabilities and income tax assets and liabilities and pension and postretirement assets and liabilities. Balance sheet items classified as Unallocated Corporate primarily include cash and cash equivalents and outstanding borrowings under our senior credit facilities. Management’s Discussion and Analysis of Financial Condition and Results of Operations Effective January 1, 2016, in anticipation of the April 1, 2016 AFI separation, the majority of our historical corporate support functions, representing costs of approximately $85 million for 2016 were incorporated into our Americas segment. As a result, Unallocated Corporate support expenses have decreased significantly during 2016 in comparison to 2015. For 2016, 2015 and 2014, Unallocated Corporate segment operating (loss) was comprised of the following (dollar amounts in millions): Factors Affecting Revenues For information on our segments’ 2016 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10-K. Markets. We compete in building material markets around the world, with the majority of our sales in the Americas. We closely monitor publicly available macroeconomic trends that provide insight into commercial and residential market activity, including Gross Domestic Product, office vacancy rates, the Architecture Billings Index, new commercial construction starts, state and local government spending, corporate profits and retail sales. In addition, we noted several factors and trends within our markets that directly affected our business performance during 2016, including: Americas We believe we experienced growth from new construction and, to a lesser extent, renovation and remodel activity, based on the mix of products sold. Both new construction and renovation activity were strong in the first half of 2016, with new construction activity continuing its momentum, albeit at a more moderate pace, throughout the second half of the year. EMEA We experienced continued softness in commercial sectors, such as office, education and healthcare. Market opportunities continue to be hindered by low global oil prices, particularly in economies closely linked to oil, such as Russia and the Middle East. While recent improvements in oil prices have begun to positively impact market opportunities in Russia, building activity in the Middle East continues to be negatively impacted by lower project funding. Pacific Rim Commercial office markets in China continued to experience challenging conditions, while India markets were impacted by tight project financing. Average Unit Value. We periodically modify prices in each of our business segments due to changes in costs for raw materials and energy, market conditions and the competitive environment. In certain cases, realized price increases are less than the announced price increases because of competitive reactions and changing market conditions. Additionally, we offer a wide assortment of products that are differentiated by style, design and performance attributes. Pricing and margins for products within the assortment vary. In addition, changes in the relative quantity of products purchased at different price points can impact year-to-year comparisons of net sales and operating income. We focus on improving sales dollars per unit sold, or average unit value (“AUV”), as a measure that accounts for the varying assortment of products and geographic mix impacting our revenues. We estimate that favorable AUV increased our total consolidated net sales for the full year of 2016 by approximately $24 million compared to 2015. In the first quarter of 2016, we implemented ceiling tile pricing increases in the Americas, EMEA and Pacific Rim. In the second quarter of 2016, we implemented price increases on grid products in the Americas. In the third quarter of 2016 we implemented price increases on ceilings tiles in the Americas and grid products in EMEA. We also announced price increases on ceiling tile and grid products in the Americas effective in the first quarter of 2017. We may implement additional pricing actions based on upon future movements in raw material prices or foreign currency valuations. Management’s Discussion and Analysis of Financial Condition and Results of Operations Factors Affecting Operating Costs Operating Expenses. Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general, and administrative (“SG&A”) expenses. Our largest individual raw material expenditures are for fiberglass, mineral wool, perlite, starch and waste paper. Natural gas and packaging materials are also significant input costs. Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results. In 2016, the costs for raw materials, sourced products and energy positively impacted operating income by approximately $9 million, compared to 2015. We continue to evaluate the efficiency of our manufacturing footprint and may take additional actions in support of our cost and standardization initiatives. The charges associated with any additional cost reduction initiatives could include severance and related termination benefits, fixed asset write-downs, asset impairments and accelerated depreciation and may be material to our financial statements. See also “Results of Operations” for further discussion of other significant items affecting operating costs. Employees As of December 31, 2016, we had approximately 3,700 full-time and part-time employees worldwide compared to approximately 3,800 (excluding AFI) as of December 31, 2015. Effective April 1, 2016, approximately 3,900 of our former employees were employed by AFI as a result of the separation. Collective bargaining agreements covering approximately 300 employees at two U.S. plants will expire during 2017. During the fourth quarter of 2016, we idled one of our plants in China. As a result, we expect a reduction of approximately 190 employees in China in the first quarter of 2017. We believe that our relations with our employees are satisfactory. CRITICAL ACCOUNTING ESTIMATES In preparing our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”), we are required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an on-going basis, using relevant internal and external information. We believe that our estimates and assumptions are reasonable. However, actual results may differ from what was estimated and could have a significant impact on the financial statements. We have identified the following as our critical accounting estimates. We have discussed these critical accounting estimates with our Audit Committee. U.S. Pension Credit and Postretirement Benefit Costs - We maintain pension and postretirement plans throughout the world, with the most significant plans located in the U.S. Our defined benefit pension and postretirement benefit costs are developed from actuarial valuations. These valuations are calculated using a number of assumptions, which represent management’s best estimate of the future. The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets and the estimated inflation in health care costs. These assumptions are generally updated annually. Effective December 31, 2016, we elected to measure the U.S. pension plans’ and U.S. postretirement plan’s benefit obligations by applying spot rates along the yield curve to the relevant projected cash flows, as we believe this provides a better measurement of these costs. This change in methodology requires management to utilize different discount rates to measure service cost and interest cost. We have accounted for this change in discount rate methodology as a change in accounting estimate and, accordingly have applied it on a prospective basis. This change did not affect the measurement of the total benefit obligation. Management’s Discussion and Analysis of Financial Condition and Results of Operations Management utilizes the Aon Hewitt AA only above median yield curve, which is a hypothetical AA yield curve comprised of a series of annualized individual discount rates, as the primary basis for determining discount rates. As of December 31, 2016 and 2015, we assumed discount rates of 4.12% and 4.40%, respectively, for the U.S. defined benefit pension plans. As of December 31, 2016 and 2015, we assumed a discount rates of 4.10% and 4.25%, respectively, for the U.S. postretirement plan. The effects of the change in discount rate will be amortized into earnings as described below. Absent any other changes, a one-quarter percentage point increase or decrease in the discount rates for the U.S. pension and postretirement plans would not have a material impact on 2017 operating income. We manage two U.S. defined benefit pension plans, a qualified funded plan and a nonqualified unfunded plan. For the qualified funded plan, the expected long-term return on plan assets represents a long-term view of the future estimated investment return on plan assets. This estimate is determined based on the target allocation of plan assets among asset classes and input from investment professionals on the expected performance of the asset classes over 10 to 30 years. Historical asset returns are monitored and considered when we develop our expected long-term return on plan assets. An incremental component is added for the expected return from active management based on historical information obtained from the plan’s investment consultants. These forecasted gross returns are reduced by estimated management fees and expenses. Over the 10 year period ended December 31, 2016, the historical annualized return was approximately 5.4% compared to an average expected return of 7.3%. The actual gain on plan assets achieved for 2016 was 9.2%. The difference between the actual and expected rate of return on plan assets will be amortized into earnings as described below. The expected long-term return on plan assets used in determining our 2016 U.S. pension cost was 6.75%. We have assumed a return on plan assets for 2017 of 6.50%. The 2017 expected return on assets was calculated in a manner consistent with 2016. A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2017 operating income by approximately $3.8 million. Contributions to the unfunded plan were $4.2 million in 2016 and were made on a monthly basis to fund benefit payments. We estimate the 2017 contributions will be approximately $3.9 million. See Note 16 to the Consolidated Financial Statements for more information. The estimated inflation in health care costs represents a 5-10 year view of the expected inflation in our postretirement health care costs. We separately estimate expected health care cost increases for pre-65 retirees and post-65 retirees due to the influence of Medicare coverage at age 65, as illustrated below: The difference between the actual and expected health care costs is amortized into earnings as described below. As of December 31, 2016, health care cost increases are estimated to decrease ratably until 2025, after which they are estimated to be constant at 4.5%. A one percentage point increase or decrease in the assumed health care cost trend rate would not have a material impact on 2017 operating income. See Note 16 to the Consolidated Financial Statements for more information. Actual results that differ from our various pension and postretirement plan estimates are captured as actuarial gains/losses. During 2016, as a result of certain thresholds being met, actuarial gains and losses were amortized into future earnings over the expected remaining service period of plan participants, which was approximately eight years for our U.S. pension plans and our U.S. postretirement plan. Beginning in 2017, actuarial gains and losses will be amortized over the remaining life expectancy of participants, which is estimated to be approximately 20 years for our U.S. pension plans and approximately 10 years for our U.S. postretirement plans. The 2017 change in amortization period for our U.S. pension plans results from active AFI participants leaving our plan, which correspondingly results in retirees representing a larger portion of our plan participants. Changes in assumptions could have significant effects on earnings in future years. Excluding the impact of the separation of AFI, we recognized a decrease in net actuarial losses related to our U.S. pension benefit plans of $81.8 million in 2016 primarily due to changes in actuarial assumptions (most significantly a 28 basis point decrease in the discount rate) and the amortization of net actuarial losses recorded as a component of 2016 net periodic pension cost. The $81.8 million actuarial gain impacting our U.S. pension plans is reflected as a component of other comprehensive income in our Consolidated Statement of Earnings and Comprehensive Income (Loss) along with actuarial gains and losses from our foreign pension plans and our U.S. postretirement benefit plan. Management’s Discussion and Analysis of Financial Condition and Results of Operations Income Taxes - Our effective tax rate is primarily determined based on our pre-tax income and the statutory income tax rates in the jurisdictions in which we operate. The effective tax rate also reflects the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences are temporary, reversing over time, such as depreciation expense. These temporary differences create deferred income tax assets and liabilities. Deferred income tax assets are also recorded for net operating loss (“NOL”) and foreign tax credit (“FTC”) carryforwards. Deferred income tax assets and liabilities are recognized by applying enacted tax rates to temporary differences that exist as of the balance sheet date. We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized. The need to establish valuation allowances for deferred tax assets is assessed quarterly. In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard, we give appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability and foreign source income (“FSI”), the duration of statutory carryforward periods, and our experience with operating loss and tax credit carryforward expirations. A history of cumulative losses is a significant piece of negative evidence used in our assessment. If a history of cumulative losses is incurred for a tax jurisdiction, forecasts of future profitability are not used as positive evidence related to the realization of the deferred tax assets in the assessment. Our domestic FTC carryforward deferred tax asset as of December 31, 2016 was $22.1 million on a gross basis ($19.3 million when netted with unrecognized tax benefits). As of December 31, 2016, our valuation allowance for our domestic FTC carryforward deferred tax asset was $0.8 million. We considered the following positive and negative evidence in assessing the need for a valuation allowance for our domestic FTC carryforward deferred tax asset: Positive Evidence • Under U.S. tax law, approximately $10.2 million of our domestic source income in future years can be characterized as FSI to enable the utilization of our FTCs. This amount primarily represents prior year intercompany dividends associated with the FTC carryforwards. These dividends created domestic taxable income that was reduced by the utilization of domestic NOLs; and • Forecasts of future profitability and FSI. Negative Evidence • Our stated position to permanently reinvest unremitted earnings of our foreign subsidiaries. The ability to fully utilize the FTC carryforwards may be affected by the following factors: • FSI of $63.1 million is needed to fully utilize the FTC carryforward of $22.1 million before they expire in 2022. In addition to the $10.2 million of domestic source income that can be characterized as FSI in future years, $52.9 million of additional foreign source income is needed. • The main factor that could result in our inability to re-characterize domestic source income to foreign source income is a U.S. tax law change. • The main factors that could contribute to lower FSI are decreased export sales and increased allocable expenses. As of December 31, 2016, we have recorded valuation allowances totaling $60.5 million for various federal, state, and foreign deferred tax assets. While we have considered future taxable income in assessing the need for the valuation allowances based on our best available projections, if these estimates and assumptions change in the future or if actual results differ from our projections, we may be required to adjust our valuation allowances accordingly. Such adjustments could be material to our Consolidated Financial Statements. As further described in Note 14 to the Consolidated Financial Statements, our Consolidated Balance Sheet as of December 31, 2016 includes net deferred income tax assets of $159.1 million. Included in this amount are deferred federal income tax assets for FTC carryforwards of $22.1 million, state NOL deferred income tax assets of $32.0 million, and foreign NOL deferred tax assets of $39.9 million. We have established valuation allowances in the amount of $60.5 million consisting of $0.8 million for federal deferred tax assets related to FTC carryovers, $16.5 million for state deferred tax assets, primarily operating loss carryovers, and $43.2 million for foreign deferred tax assets, primarily foreign operating loss carryovers. Management’s Discussion and Analysis of Financial Condition and Results of Operations Inherent in determining our effective tax rate are judgments regarding business plans and expectations about future operations. These judgments include the amount and geographic mix of future taxable income, the amount of FSI, limitations on usage of NOL carryforwards, the impact of ongoing or potential tax audits, earnings repatriation plans, and other future tax consequences. We estimate we will need to generate future U.S. taxable income of approximately $772.7 million for state income tax purposes during the respective realization periods (ranging from 2017 to 2036) in order to fully realize the net deferred income tax assets. As previously disclosed in prior SEC filings, our ability to utilize deferred tax assets may be impacted by certain future events, such as changes in tax legislation and insufficient future taxable income prior to expiration of certain deferred tax assets. We recognize the tax benefits of an uncertain tax position if those benefits are more likely than not to be sustained based on existing tax law. Additionally, we establish a reserve for tax positions that are more likely than not to be sustained based on existing tax law, but uncertain in the ultimate benefit to be sustained upon examination by the relevant taxing authorities. Unrecognized tax benefits are subsequently recognized at the time the more likely than not recognition threshold is met, the tax matter is effectively settled or the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired, whichever is earlier. Impairments of Long-Lived Tangible and Intangible Assets - Our indefinite-lived intangibles are primarily trademarks and brand names, which are integral to our corporate identity and expected to contribute indefinitely to our corporate cash flows. Accordingly, they have been assigned an indefinite life. We conduct our annual impairment test for non-amortizable intangible assets during the fourth quarter, although we conduct interim impairment tests if events or circumstances indicate the asset might be impaired. We conduct impairment tests for tangible assets and amortizable intangible assets when indicators of impairment exist, such as operating losses and/or negative cash flows. If an indication of impairment exists, we compare the carrying amount of the asset group to the estimated undiscounted future cash flows expected to be generated by the assets. The estimate of an asset group’s fair value is based on discounted future cash flows expected to be generated by the asset group, or based on management’s estimated exit price assuming the assets could be sold in an orderly transaction between market participants or estimated salvage value if no sale is assumed. If the fair value is less than the carrying value of the asset group, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group. The principal assumption utilized in our impairment tests for definite-lived intangible assets is operating profit adjusted for depreciation and amortization. The principal assumptions utilized in our impairment tests for indefinite-lived intangible assets include revenue growth rate, discount rate and royalty rate. Revenue growth rate and operating profit assumptions are derived from those utilized in our operating plan and strategic planning processes. The discount rate assumption is calculated based upon an estimated weighted average cost of equity which reflects the overall level of inherent risk and the rate of return a market participant would expect to achieve. The royalty rate assumption represents the estimated contribution of the intangible assets to the overall profits of the reporting unit. In 2016, indefinite-lived intangibles were tested for impairment based on our existing reporting units, which changed as a result of the separation of AFI and the subsequent change in our operating segments. No other methodologies used for valuing our intangible assets changed from prior periods. The cash flow estimates used in applying our impairment tests are based on management’s analysis of information available at the time of the impairment test. Actual cash flows lower than the estimate could lead to significant future impairments. If subsequent testing indicates that fair values have declined, the carrying values would be reduced and our future statements of income would be affected. There were no material impairment charges recorded in 2016, 2015 or 2014 related to intangible assets. We did not test tangible assets for impairment in 2016, 2015 or 2014 as no indicators of impairment existed. We cannot predict the occurrence of certain events that might lead to material impairment charges in the future. Such events may include, but are not limited to, the impact of economic environments, particularly related to the commercial and residential construction industries, material adverse changes in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. See Notes 3 and 10 to the Consolidated Financial Statements for further information. Environmental Liabilities - We are actively involved in the investigation, closure and/or remediation of existing or potential environmental contamination under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), and Management’s Discussion and Analysis of Financial Condition and Results of Operations state Superfund and similar type environmental laws at several domestically owned, formerly owned and non-owned locations allegedly resulting from past industrial activity. In a few cases, we are one of several potentially responsible parties and have agreed to jointly fund the required investigation, while preserving our defenses to the liability. We may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies. We provide for environmental remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Accruals are estimates based on the judgment of management related to ongoing proceedings. Estimates of our future liability at the environmental sites are based on evaluations of currently available facts regarding each individual site. In determining the probability of contribution, we consider the solvency of other parties, the site activities of other parties, whether liability is being disputed, the terms of any existing agreements and experience with similar matters, and the effect of our October 2006 Chapter 11 reorganization upon the validity of the claim. We evaluate the measurement of recorded liabilities each reporting period based on current facts and circumstances specific to each matter. The ultimate losses incurred upon final resolution may materially differ from the estimated liability recorded. Changes in estimates are recorded in earnings in the period in which such changes occur. We are unable to predict the extent to which any recoveries from other parties or coverage under insurance policies might cover our final share of costs for these sites. Our final share of investigation and remediation costs may exceed any such recoveries, and such amounts net of insurance recoveries may be material. ACCOUNTING PRONOUNCEMENTS EFFECTIVE IN FUTURE PERIODS See Note 2 to the Consolidated Financial Statements for further information. RESULTS OF OPERATIONS Unless otherwise indicated, net sales in these results of operations are reported based upon the AWI location where the sale was made. Please refer to Notes 3 and 4 to the Consolidated Financial Statements for a reconciliation of segment operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations. 2016 COMPARED TO 2015 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $22 million, consolidated net sales increased 2.0% due to favorable AUV of $24 million and higher volumes of $1 million. Cost of goods sold was 69.9% of net sales in 2016, compared to 69.4% in 2015. The comparison was impacted by $5 million of severance and other charges associated with the idling of a plant in China in 2016. SG&A expenses in 2016 were $225.2 million, or 18.2% of net sales, compared to $267.7 million, or 21.7% of net sales, in 2015. The decrease was primarily the result the impact of the separation and cost control measures, particularly in international markets to offset soft market demand. Separation costs of $34.5 million in 2016, compared to $34.3 million in 2015, were primarily related to outside professional services and employee compensation and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business. Equity earnings from our WAVE joint venture were $73.1 million in 2016, compared to $66.1 million in 2015. The increase was due to higher sales volumes, favorable AUV and lower manufacturing input costs, partially offset by higher SG&A expenses for go-to-market investments. See Note 9 to the Consolidated Financial Statements for further information. Management’s Discussion and Analysis of Financial Condition and Results of Operations Interest expense was $49.8 million in 2016, compared to $45.3 million in 2015. The increase in interest expense was due to $10.7 million of losses that were reclassified from accumulated other comprehensive income to interest expense during the first quarter of 2016 as a result of the settlement of $450.0 million of notional amount interest rate swaps which occurred in connection with the refinancing of our credit facilities, partially offset by lower costs due to a reduction in total debt outstanding and a lower interest rate spread and $2.4 million of gains that were reclassified from accumulated other comprehensive income to interest expense during the fourth quarter of 2016 in connection with our entering into $450.0 million of notional amount of basis rate swaps. See Note 15 to the Consolidated Financial Statements for details related to our debt refinancing and Note 18 to the Consolidated Financial Statements for details related to our interest rate swap transactions. Other non-operating income was $9.6 million in 2016 and $5.0 million in 2015. The changes in other non-operating income were primarily due to foreign exchange rate gains on the translation of unhedged cross-currency intercompany loans. Other non-operating expenses were $0.1 million in 2016, compared to $20.1 million in 2015. Expenses in 2015 were primarily due to foreign exchange rate losses on the translation of unhedged cross-currency intercompany loans denominated in Russian rubles, related to the construction of our Russian mineral fiber ceiling plant that was completed in the first quarter of 2015. During the fourth quarter of 2016, all Russian ruble denominated intercompany loans were settled with intercompany capital contributions. Where efficient, reliable and liquid markets exist we may utilize foreign currency forward exchange contracts to hedge exposures created by cross-currency intercompany loans and dividends. Our largest unhedged foreign currency exposures are in Chinese renminbi and Russian rubles. Income tax expense was $50.4 million and $53.5 million in 2016 and 2015, respectively. The effective tax rate for 2016 was 34.9% as compared to a rate of 66.8% for 2015. The effective tax rate for 2016 was lower than 2015 primarily due to income tax benefits recorded during the second half of 2016 resulting from the reversal of reserves for uncertain tax positions as a result of an expiration of the federal statute of limitations to review previously filed income tax returns and a benefit resulting from the write-off of the historical tax basis of one of our foreign subsidiaries. Total other comprehensive income (“OCI”) was $23.6 million for 2016 compared to $8.1 million for 2015. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Foreign currency losses in 2016 were driven primarily by changes in the exchange rate of the British pound, the Chinese renminbi, partially offset by gains in the Russian ruble. Derivative gain/loss represents the mark to market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. Derivative gains in 2016 were primarily due to the mark to market changes related to interest rate swaps and our natural gas hedges, partially offset by losses on our foreign currency hedges. Gains on interest rate hedges were partially offset by $8.3 million of net losses related to settlements of interest rates swaps in 2016. Pension and postretirement adjustments represent actuarial gains and losses related to our defined-benefit pension and postretirement plans with gains in 2016 primarily related to our U.S. pension plans. REPORTABLE SEGMENT RESULTS Americas (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $2 million, net sales in the Americas increased 4.3% due to higher volumes of $20 million and favorable AUV of $15 million. Operating income decreased as higher earnings from WAVE of $7 million, the favorable margin impact of higher volumes of $5 million, and the favorable margin impact of higher AUV of $5 million were more than offset by higher SG&A expenses of $54 million and higher manufacturing and input costs of $14 million. The increase in SG&A expenses in 2016 was primarily a result of the inclusion of costs formally assigned to our Corporate Unallocated segment, partially offset by a reduction in costs primarily due to the separation. The increase in manufacturing costs was impacted by investments in our manufacturing footprint to expand and enhance our capabilities to produce high end products. Management’s Discussion and Analysis of Financial Condition and Results of Operations EMEA (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $15 million, net sales in the EMEA markets decreased 4.0% due to lower volumes of $17 million which were only partially offset by favorable AUV of $6 million. The decline in volumes was driven by the Middle East and to a lesser extent the United Kingdom. Operating loss decreased driven by lower SG&A expenses of $9 million and lower manufacturing and input costs of $3 million, which was mostly offset by the margin impact of lower volumes of $6 million and the margin impact of unfavorable AUV of $4 million. The comparison was also impacted by $2 million of severance costs associated with cost reduction actions in 2015. Pacific Rim (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $4 million, net sales in the Pacific Rim increased 1.5% due to higher AUV of $4 million partially offset by lower volumes of $2 million. Sales volumes in Australia and China grew in comparison to the prior year while India sales softened. Operating loss decreased driven by the margin impact of favorable AUV of $3 million, lower manufacturing and input costs of $2 million and lower SG&A expense of $1 million. The comparison was also impacted by $5 million and $3 million of severance and other charges associated with the idling of a plant in China during 2016 and 2015, respectively. Unallocated Corporate Unallocated corporate expense of $38.8 million decreased from $124.3 million in the prior year. The decrease was due to the inclusion of most of the Corporate functions within the Americas segment as a result of the separation. FINANCIAL CONDITION AND LIQUIDITY Cash Flow The discussion that follows includes cash flows related to discontinued operations. Operating activities for 2016 provided $49.3 million of cash, compared to $203.7 million of cash provided in 2015. The decrease was primarily due to change in working capital, most notably a decrease accounts payable and accrued expenses related to the separation of AFI. The decrease due to the change in working capital was partially offset by higher cash earnings partially offset by a reduction in depreciation and amortization. Net cash used for investing activities was $17.0 million in 2016, compared to $101.5 million in 2015. The change in investing activities cash flows was primarily due to decreased purchases of property, plant and equipment, partially offset by higher dividends from our WAVE joint venture. Net cash used by financing activities was $128.9 million in 2016, compared to $32.3 million in 2015. The unfavorable use of cash was primarily the result of higher payments of debt and repurchase of outstanding common stock. Management’s Discussion and Analysis of Financial Condition and Results of Operations Liquidity Our liquidity needs for operations vary throughout the year. We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is generally lower during the first and fourth quarters of our fiscal year. On April 1, 2016, we refinanced our $1,275.0 million senior credit facility, utilizing a $50.0 million cash dividend from AFI and cash on hand to pay down a portion of the debt outstanding. The $1,050.0 million new credit facility is composed of a $200.0 million revolving credit facility (with a $150.0 million sublimit for letters of credit), a $600.0 million Term Loan A and a $250.0 million Term Loan B. The terms of the credit facility resulted in a lower interest rate spread for both the revolving credit facility and Term Loan A (2.00% vs. 2.50%) and a higher spread for Term Loan B (3.25% vs. 2.50%). In addition, we lowered the interest rate floor on the Term Loan B from 1.00% to 0.75%. We also extended the maturity of both the revolving credit facility and Term Loan A from March 2018 to April 2021 and of Term Loan B from November 2020 to April 2023. This $1,050.0 million senior credit facility is secured by U.S. personal property, the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first tier foreign subsidiaries. Finally, in April 2016, we established a $25.0 million letter of credit facility with the Bank of Nova Scotia, also known as our bi-lateral facility. As of December 31, 2016, total borrowing outstanding under our senior credit facility were $600.0 million under Term Loan A and $248.1 million under Term Loan B. There were no borrowings outstanding under the revolving credit facility or the bi-lateral facility. Under our refinanced senior credit facility we are subject to year-end leverage tests that may trigger mandatory prepayments. If our ratio of consolidated funded indebtedness minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) (“Consolidated Net Leverage Ratio”) is greater than 3.5 to 1.0, the prepayment amount would be based on a computation of 50% of Consolidated Excess Cash Flow, as defined by the credit agreement. These annual payments would be made in the first quarter of the following year. No payment will be required in 2017. The refinanced senior credit facility includes two financial covenants that require the ratio of consolidated EBITDA to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the Consolidated Net Leverage Ratio to be less than or equal to 3.75 to 1.0. As of December 31, 2016, we were in compliance with all covenants of the senior credit facility. The Term Loan A and Term Loan B were both fully drawn and are currently priced on a variable interest rate basis. The following table summarizes our interest rate swaps (dollar amounts in millions): These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. The unpaid balances of Term Loan A, the Revolving Credit Facility and Term Loan B may be prepaid without penalty at the maturity of their respective interest reset periods. Any amounts prepaid on the Term Loan A or Term Loan B may not be re-borrowed. In connection with the refinancing of our credit facilities in April 2016, $450.0 million of notional amount Term Loan B swaps with a trade date of March 27, 2012 were settled and $10.7 million of losses previously recorded as a component of accumulated other comprehensive income were reclassified to interest expense in 2016. As of December 31, 2015, we had a $250.0 million notional Term A swap with a trade date of April 16, 2013 and a maturity date of March 2018, in which we received 3-month LIBOR and paid a fixed rate over the hedged period. On April 1, 2016, we entered into an additional $200.0 million notional amount Term Loan A swap with a maturity date of March 2021, in which we also received 3-month LIBOR and paid a fixed rate over the hedged period, collectively resulting in $450.0 million notional Term Loan A interest rate swaps (the “Term Loan A Swaps”). During the fourth quarter of 2016, we elected to change the basis for interest payments due under our Term Loan A from 3-month LIBOR to 1-month LIBOR. In connection with the change in our underlying interest payments, in November 2016 we entered into $450.0 million forward-starting notional amount basis rate swaps to convert the floating rate risk under our Term Loan A Swaps from 3-month LIBOR to 1-month LIBOR and jointly designated the basis swaps with our Term Loan A Swaps in cash flow hedging Management’s Discussion and Analysis of Financial Condition and Results of Operations relationships. As a result of this transaction, $2.4 million of gains previously recorded as a component of accumulated other comprehensive income were reclassified as a reduction to interest expense during the fourth quarter of 2016. Since the basis rate swaps had a non-zero fair value upon designation as cash flow hedges, mark-to-market gains or losses on ineffective portions of these hedges will be recorded as a component of interest expense. Also on April 1, 2016, we entered into a $100.0 million notional Term Loan B swap in which we receive the greater of 3-month LIBOR or a 0.75% LIBOR Floor and pay a fixed rate over the hedged period. As of December 31, 2016 our outstanding long-term debt included a $35.0 million variable rate, tax-exempt industrial development bond that financed the construction of a plant in prior years. This bond has a scheduled final maturity of 2041 and is remarketed by an agent on a regular basis at a market-clearing interest rate. Any portion of the bond that is not successfully remarketed by the agent are required to be repurchased. This bond is backed by letters of credit which will be drawn if a portion of the bond is not successfully remarketed. We have not had to repurchase the bond. Our foreign subsidiaries had available lines of credit totaling $4.1 million as of December 31, 2016. These lines of credit are uncommitted, and poor operating results or credit concerns at the related foreign subsidiaries could result in the lines being withdrawn by the lenders. We have historically been able to maintain and, as needed, replace credit facilities to support our non-U.S. operations. As of December 31, 2016 we had no borrowings under these lines of credit. As of December 31, 2016, we had $141.9 million of cash and cash equivalents, $86.8 million in various foreign jurisdictions and $55.1 million in the U.S. In February 2017, we repriced the interest rate of our $248.1 million Term Loan B borrowing, resulting in a lower LIBOR spread (2.75% vs. 3.25%). The maturity date remained unchanged along with all other terms and conditions. In connection with the repricing we paid $0.6 million of bank, legal and other fees, the majority of which were capitalized. In March 2016, we amended and decreased our $100.0 million Accounts Receivable Securitization Facility with the Bank of Nova Scotia (the “funding entity”) to $40.0 million to reflect a lower anticipated receivables balance in connection with the separation of AFI, and we extended the maturity date from December 2017 to March 2019. Under our Accounts Receivable Securitization Facility we sell accounts receivables to Armstrong Receivables Company, LLC (“ARC”), a Delaware entity that is consolidated in these financial statements. ARC is a 100% wholly owned single member LLC special purpose entity created specifically for this transaction; therefore, any receivables sold to ARC are not available to the general creditors of AWI. ARC then sells an undivided interest in the purchased accounts receivables to the funding entity. This undivided interest acts as collateral for drawings on the facility. Any borrowings under this facility are obligations of ARC and not AWI. ARC contracts with and pays a servicing fee to AWI to manage, collect and service the purchased accounts receivables. All new receivables under the program are continuously purchased by ARC with the proceeds from collections of receivables previously purchased. As of December 31, 2016 we had no borrowings under this facility. We utilize lines of credit and other commercial commitments in order to ensure that adequate funds are available to meet operating requirements. Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. In addition, our foreign subsidiaries’ available lines of credit are available for letters of credit and guarantees. Letters of credit are issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table presents details related to our letters of credit (dollar amounts in millions): As of December 31, 2016, $4.0 million of letters of credits issued under our accounts receivable securitization facility in excess of our maximum limit were classified as restricted cash and reported as a component of Cash and cash equivalents on our Consolidated Balance Sheets. This restriction will lapse upon replacement of collateral with accounts receivables and/or upon a change in the letter of credit limit as a result of higher securitized accounts receivable balances. Management’s Discussion and Analysis of Financial Condition and Results of Operations We believe that cash on hand and cash generated from operations, together with lines of credit, availability under our securitization facility and the availability under our revolving credit facility, will be adequate to address our foreseeable liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations. 2015 COMPARED TO 2014 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $76 million, consolidated net sales for 2015 increased 1.0% due to favorable AUV of $48 million, partially offset by lower volumes of $35 million. Cost of goods sold was 69.4% of net sales in 2015, compared to 70.4% in 2014. Compared to the prior year, the reduction was caused by lower input costs, partially offset by higher manufacturing and U.S. pension costs. SG&A expenses in 2015 were $267.7 million, or 21.7% of net sales, compared to $250.1 million, or 19.3% of net sales in 2014. The increase was primarily due to an increase in go-to-market investments in the Americas and an increase in U.S. pension costs. See Reportable Segment Results for additional information. Separation costs of $34.3 million in 2015 were primarily related to outside professional services and employee retention and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business. Equity earnings from our WAVE joint venture were $66.1 million in 2015, compared to $65.1 million in 2014. Interest expense was $45.3 million in 2015, compared to $46.0 million in 2014. Income tax expense was $53.5 million and $69.3 million in 2015 and 2014, respectively. The effective tax rate for 2015 was 66.8% as compared to a rate of 46.7% for 2014. The effective tax rate for 2015 was higher than 2014 primarily due to lower pre-tax income causing a higher rate of unbenefited foreign operating losses, non-deductible separation costs, a decrease in research and development tax credits as 2014 included the benefit of multiple years of such credits and state net operating loss write-offs resulting from a change in ownership under Section 382 of the Internal Revenue Code. REPORTABLE SEGMENT RESULTS Americas (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $9 million, net sales in the Americas increased 2.0% due to favorable AUV of $26 million, partially offset by lower volumes of $10 million. Operating income increased primarily due to the margin impact of favorable AUV of $19 million, lower manufacturing and input costs of $10 million and higher earnings from WAVE of $2 million, partially offset by the margin impact of lower volumes of $11 million and higher SG&A expenses of $7 million. Management’s Discussion and Analysis of Financial Condition and Results of Operations EMEA (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $58 million, net sales in EMEA decreased 1.7% due to lower volumes of $21 million, partially offset by favorable AUV of $16 million. Operating loss increased primarily due to the margin impact of lower volumes of $10 million, an increase in manufacturing and input costs of $8 million, due primarily to start-up costs associated with our Russian mineral fiber plant and $2 million higher severance charges in 2015 for cost reduction actions. Partially offsetting these increases in operating loss was the margin impact of favorable AUV of $8 million and lower SG&A expense of $7 million. Pacific Rim (dollar amounts in millions) Excluding the unfavorable impact of foreign exchange of $10 million, net sales in the Pacific Rim increased 2.2% due to favorable AUV of $7 million, partially offset by lower volumes of $4 million. Operating loss increased primarily due to $5 million of severance and other charges in 2015 related to our decision to idle one of our plants in China. Unallocated Corporate Unallocated corporate expense of $124.3 million increased from $66.6 million in the prior year, due to separation costs of $34 million recorded in 2015 and higher U.S. pension costs of $17 million and a $4 million increase in environmental reserves related to our Macon, Georgia facility. Cash Flow The discussion that follows includes cash flows related to discontinued operations. Operating activities for 2015 provided $203.7 million of cash, compared to $208.8 million of cash provided in 2014. Lower cash earnings in 2015 were partially offset by favorable changes in working capital, primarily due to favorable timing of accounts payable and accrued expenses. Net cash used for investing activities was $101.5 million for 2015, compared to $149.3 million in 2014. This change was primarily due to decreased purchases of property, plant and equipment. Net cash used by financing activities was $32.3 million for 2015, compared to $3.3 million provided during 2014. Net cash used in 2015 was primarily driven by payments on long-term debt. Net cash provided in 2014 was driven by proceeds from exercised stock options and excess tax benefits from share-based awards, partially offset by payments of long-term debt. OFF-BALANCE SHEET ARRANGEMENTS No disclosures are required pursuant to Item 303(a)(4) of Regulation S-K. Management’s Discussion and Analysis of Financial Condition and Results of Operations CONTRACTUAL OBLIGATIONS As part of our normal operations, we enter into numerous contractual obligations that require specific payments during the term of the various agreements. The following table includes amounts ongoing under contractual obligations existing as of December 31, 2016. Only known payments that are dependent solely on the passage of time are included. Obligations under contracts that contain minimum payment amounts are shown at the minimum payment amount. Contracts that contain variable payment structures without minimum payments are excluded. Purchase orders that are entered into in the normal course of business are also excluded because they are generally cancelable and not legally binding. Amounts are presented below based upon the currently scheduled payment terms. Actual future payments may differ from the amounts presented below due to changes in payment terms or events affecting the payments. (1) Excludes $9.5 million of unamortized debt financing costs as of December 31, 2016. (2) For debt with variable interest rates and interest rate swaps, we projected future interest payments based on market-based interest rate swap curves. (3) Lease obligations include the minimum payments due under existing agreements with non-cancelable lease terms in excess of one year. (4) Unconditional purchase obligations include (a) purchase contracts whereby we must make guaranteed minimum payments of a specified amount regardless of how little material is actually purchased (“take or pay” contracts) and (b) service agreements. Unconditional purchase obligations exclude contracts entered into during the normal course of business that are non-cancelable and have fixed per unit fees, but where the monthly commitment varies based upon usage. Cellular phone contracts are an example. (5) Pension contributions include estimated contributions for our defined benefit pension plans. We are not presenting estimated payments in the table above beyond 2017 as funding can vary significantly from year to year based upon changes in the fair value of plan assets, funding regulations and actuarial assumptions. (6) Other obligations include payments under severance agreements. (7) Other obligations, does not include $86.9 million of liabilities under ASC 740 “Income Taxes.” Due to the uncertainty relating to these positions, we are unable to reasonably estimate the ultimate amount or timing of the settlement of these issues. See Note 14 to the Consolidated Financial Statements for more information. This table excludes obligations related to postretirement benefits (retiree health care and life insurance) since we voluntarily provide these benefits. The amount of benefit payments we made in 2016 was $8.3 million. See Note 16 to the Consolidated Financial Statements for additional information regarding future expected cash payments for postretirement benefits. We are party to supply agreements, some of which require the purchase of inventory remaining at the supplier upon termination of the agreement. Had these agreements terminated at December 31, 2016, we would have been obligated to purchase approximately $0.9 million of inventory. Historically, due to production planning, we have not had to purchase material amounts of product at the end of similar contracts. Accordingly, no liability has been recorded for these guarantees. Management’s Discussion and Analysis of Financial Condition and Results of Operations Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. In addition, our foreign subsidiaries’ available lines of credit are available for letters of credit and guarantees. Letters of credit are issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table summarizes the commitments we have available for use as of December 31, 2016. In connection with our disposition of certain assets through a variety of unrelated transactions, we have entered into contracts that included various indemnity provisions, some of which are customary for such transactions, while others hold the acquirer of the assets harmless with respect to liabilities relating to such matters as taxes, environmental and other litigation. Some of these provisions include exposure limits, but many do not. Due to the nature of the indemnities, it is not possible to estimate the potential maximum exposure under these contractual provisions. As of December 31, 2016, we had no liabilities recorded for which an indemnity claim had been received.

<s>[INST] Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forwardlooking statements and risk factors included in this Form 10K. Overview We are a leading global producer of ceiling systems and, prior to April 1, 2016, flooring products for use primarily in the construction and renovation of residential, commercial and institutional buildings. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) and, prior to April 1, 2016, flooring products (primarily resilient and wood) around the world. On April 1, 2016, we completed our previously announced separation of Armstrong Flooring, Inc. (“AFI”) by allocating the assets and liabilities related primarily to the Resilient Flooring and Wood Flooring segments to AFI and then distributing the common stock of AFI to our shareholders at a ratio of one share of AFI common stock for every two shares of AWI common stock. Subsequent to the separation and distribution, AWI and AFI operate as two independent, publiclytraded companies, with AFI owning and operating the Resilient Flooring and Wood Flooring segments and AWI continuing to own and operate the Building Products (Ceilings) segment. AFI’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented. We are focused on driving sustainable shareholder value creation. Our strategic priorities are to accelerate profitable volume growth globally and to improve the returns in our international business. Our primary goal is to expand into new and grow in existing markets by selling a broader array of products and solutions into those markets. As of December 31, 2016, we had 15 manufacturing plants in eight countries, including six plants located throughout the U.S. During the fourth quarter of 2016 we idled one of our mineral fiber plants in China. Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc. in which we hold a 50% equity interest, operates 9 additional plants in five countries to produce suspension system (grid) products, which we use and sell in our ceiling systems. Reportable Segments Effective April 1, 2016 and in connection with our separation of AFI, our former Resilient Flooring and Wood Flooring segments have been excluded from our results of continuing operations. In addition, effective April 1, 2016, we disaggregated our former Building Products operating segment into the following three distinct geographical segments: Americas (including Canada); Europe, Middle East and Africa (including Russia) (“EMEA”); and Pacific Rim. Each of our geographical segments produce suspended fiber and metal ceilings for use in commercial and institutional settings in addition to sourcing complimentary ceiling products. Commercial ceiling materials and accessories are sold to resale distributors and to ceiling systems contractors. Residential ceiling products are sold in the Americas primarily to wholesalers and retailers (including large home centers). Each segment also includes our WAVE joint venture, which manufactures suspension system (grid) products that are invoiced by both us and WAVE. In each of our segments, WAVE primarily sells its suspension system products directly to customers, for which we provide sales and administrative support. To a lesser extent, however, in some markets, WAVE sells its suspension systems products to us for resale to customers. Our segment results reflect those sales transactions. In addition, effective April 1, 2016, we reclassified the majority of the assets and liabilities formally allocated to our Unallocated Corporate segment to our Americas segment for all periods presented. The assets and liabilities reclassified to our Americas segment most notably included the Armstrong trade name intangible asset, property, plant and equipment comprised primarily of Corporate campus facilities, the cash surrender value of life insurance supporting deferred compensation liabilities and income tax assets and liabilities and pension and postretirement assets and liabilities. Balance sheet items classified as Unallocated [/INST] Positive. </s>

ARMSTRONG WORLD INDUSTRIES INC

2018-02-26

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this Form 10-K. Overview We are a global leader in the design, innovation and manufacture of commercial and residential ceiling, wall and suspension system solutions. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas. On November 17, 2017, we entered into a Share Purchase Agreement (the “Purchase Agreement”) with Knauf International GmbH (“Knauf”), to sell certain subsidiaries comprising our business in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., in which AWI holds a 50% interest. The total consideration to be paid by Knauf in connection with the sale is $330 million in cash, inclusive of amounts due to WAVE, subject to certain adjustments as provided in the Purchase Agreement, including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment. The transaction, which is subject to regulatory approvals and other customary conditions, is currently anticipated to close in mid-2018. EMEA and Pacific Rim segment historical financial results have been reflected in AWI’s Consolidated Financial Statements as discontinued operations for all periods presented. In January 2017, we acquired the business and assets of Tectum, Inc. (“Tectum”), based in Newark, Ohio. Tectum is a manufacturer of acoustical ceiling, wall and structural solutions for commercial building applications with two manufacturing facilities. Tectum’s operations from the date of acquisition, and its assets and liabilities as of December 31, 2017, have been included as a component of our Architectural Specialties segment. On April 1, 2016, we completed our separation of Armstrong Flooring, Inc. (“AFI”). AFI’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented. See Note 4 to the Consolidated Financial Statements for additional information related to our acquisitions and discontinued operations. As of December 31, 2017, we had 16 manufacturing plants in eight countries, including eight plants located throughout the U.S. During the fourth quarter of 2016 we idled one of our mineral fiber plants in China, reported as a component of our Unallocated Corporate segment as it will be retained by AWI after the sale of the Pacific Rim business. Upon closure of the sale of our EMEA and Pacific Rim businesses, we will have ten plants, including eight plants in the U.S. During the fourth quarter of 2017, we announced the closing of our St. Helens, Oregon mineral fiber manufacturing facility, expected to occur in the first half of 2018. WAVE operates 9 additional plants in five countries to produce suspension system (grid) products, which we use and sell in our ceiling systems. Upon closure of the sale of its corresponding EMEA and Pacific Rim businesses, WAVE will operate five plants in the U.S. Reportable Segments Effective December 31, 2017 and in connection with the anticipated sale of our EMEA and Pacific Rim businesses, our EMEA and Pacific Rim segments have been excluded from our results of continuing operations. As a result, effective December 31, 2017 and for all periods presented, our operating segments are as follows: Mineral Fiber, Architectural Specialties and Unallocated Corporate. Mineral Fiber - produces suspended mineral fiber and soft fiber ceiling systems for use in commercial and residential settings. Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal. Commercial ceiling products are sold to resale distributors and to ceiling systems contractors. Residential ceiling products are sold primarily to wholesalers and retailers (including large home centers). The Mineral Fiber segment also includes the results of WAVE, which manufactures suspension system (grid) products and ceiling component products that are invoiced by both us and WAVE. Segment results relating to WAVE consist primarily of equity earnings and reflect our 50% equity interest in the joint venture. Ceiling component products consist of ceiling perimeters and trim, in addition to grid products that support drywall ceiling systems. To a Management’s Discussion and Analysis of Financial Condition and Results of Operations lesser extent, however, in some markets, WAVE sells its suspension systems products to us for resale to customers. Mineral Fiber segment results reflect those sales transactions. Architectural Specialties - produces and sources ceilings and walls for use in commercial settings. Products are available in numerous materials, such as metal and wood, in addition to various colors, shapes and designs. Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal. We produce standard and customized products, with the majority of Architectural Specialties revenues derived from sourced products. Architectural Specialties products are sold to resale distributors and ceiling systems contractors. The majority of revenues are project driven, which can lead to more volatile sales patterns due to project scheduling. Unallocated Corporate - includes assets, liabilities, income and expenses that have not been allocated to our other business segments and consist of: cash and cash equivalents, the net funded status of our U.S. Retirement Income Plan (“RIP”), the estimated fair value of interest rate swap contracts, outstanding borrowings under our senior credit facilities and income tax balances. Effective December 31, 2017 and for all periods presented, our Unallocated Corporate segment also includes all assets, liabilities, income and expenses formerly reported in our EMEA and Pacific Rim segments that are not included in the pending sale to Knauf. Factors Affecting Revenues For information on our segments’ 2017 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10-K. Markets. We compete in building material markets in the Americas. We closely monitor publicly available macroeconomic trends that provide insight into commercial and residential market activity, including GDP, office vacancy rates, the Architecture Billings Index, new commercial construction starts, state and local government spending, corporate profits and retail sales. In addition, we noted several factors and trends within our markets that directly affected our business performance during 2017, including: Mineral Fiber We experienced lower renovation activity, partially offset by growth from new construction, leading to a slight overall decline in volume. Architectural Specialties We experienced strong growth due to new commercial construction activity and increased market penetration, partially driven by the acquisition of Tectum. Average Unit Value. We periodically modify sales prices of our products due to changes in costs for raw materials and energy, market conditions and the competitive environment. In certain cases, realized price increases are less than the announced price increases because of project pricing, competitive reactions and changing market conditions. Additionally, we offer a wide assortment of products that are differentiated by style, design and performance attributes. Pricing and margins for products within the assortment vary. In addition, changes in the relative quantity of products purchased at different price points can impact year-to-year comparisons of net sales and operating income. We focus on improving sales dollars per unit sold, or average unit value (“AUV”), as a measure that accounts for the varying assortment of products and geographic mix impacting our revenues. We estimate that favorable AUV increased our Mineral Fiber and total consolidated net sales for 2017 by approximately $29 million compared to 2016. Architectural Specialties revenues are generally earned based on individual contracts that include a mix of products, manufactured by us and sourced, that vary by project. As such, we do not track AUV performance for this segment, but rather attribute all changes in net sales to volume. In the first and fourth quarters of 2017, we implemented ceiling tile pricing increases. We also implemented a pricing increase on grid products in the third quarter of 2017. Finally, in the fourth quarter of 2017 we also announced price increases on certain architectural specialties products, ceiling tile and grid products effective in the first quarter of 2018. We may implement additional pricing actions based on numerous factors, most notably upon future movements in raw material prices. Management’s Discussion and Analysis of Financial Condition and Results of Operations Factors Affecting Operating Costs Operating Expenses. Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general, and administrative (“SG&A”) expenses. Our largest individual raw material expenditures are for fiberglass, perlite, starch, waste paper, pigments and clays. We manufacture most of the production needs for mineral wool at one of our manufacturing facilities. Natural gas and packaging materials are also significant input costs. Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results. In 2017, the costs for raw materials, sourced products and energy negatively impacted operating income by approximately $3 million, compared to 2016. During the fourth quarter of 2017, we announced the closing of our St. Helens, Oregon mineral fiber manufacturing facility, expected to occur in the first half of 2018. Production activity will move to existing facilities in the U.S. We will continue to evaluate the efficiency of our manufacturing footprint and may take additional actions in support of our cost and standardization initiatives. The charges associated with any additional cost reduction initiatives could include severance and related termination benefits, fixed asset write-downs, asset impairments and accelerated depreciation and may be material to our financial statements. See also “Results of Operations” for further discussion of other significant items affecting operating costs. Employees As of December 31, 2017, we had approximately 3,900 full-time and part-time employees worldwide compared to approximately 3,700 as of December 31, 2016. Excluding our EMEA and Pacific Rim businesses, we had approximately 2,200 employees as of December 31, 2017 compared to approximately 2,000 as of December 31, 2016. The increase in total worldwide employees as of December 31, 2017 in comparison to December 31, 2016 was primarily due to our addition of Tectum employees, partially offset by a reduction of employees related to the closure of one of our plants in China. Collective bargaining agreements covering approximately 460 employees at two U.S. plants will expire during 2018. We believe that our relations with our employees are satisfactory. CRITICAL ACCOUNTING ESTIMATES In preparing our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”), we are required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an on-going basis, using relevant internal and external information. We believe that our estimates and assumptions are reasonable. However, actual results may differ from what was estimated and could have a significant impact on the financial statements. We have identified the following as our critical accounting estimates. We have discussed these critical accounting estimates with our Audit Committee. U.S. Pension Credit and Postretirement Benefit Costs - We maintain pension and postretirement plans throughout the world, with the most significant plans located in the U.S. Our defined benefit pension and postretirement benefit costs are developed from actuarial valuations. These valuations are calculated using a number of assumptions, which represent management’s best estimate of the future. The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets and the estimated inflation in health care costs. These assumptions are generally updated annually. Management utilizes the Aon Hewitt AA only above median yield curve, which is a hypothetical AA yield curve comprised of a series of annualized individual discount rates, as the primary basis for determining discount rates. As of December 31, 2017 and 2016, we assumed discount rates of 3.63% and 4.12%, respectively, for the U.S. defined benefit pension plans. As of December 31, 2017 and 2016, we assumed a discount rates of 3.60% and 4.10%, respectively, for the U.S. postretirement plan. The effects of the change in discount rate will be amortized into earnings as described below. Absent any other changes, a one-quarter percentage point increase or decrease in the discount rates for the U.S. pension and postretirement plans would not have a material impact on 2018 operating income. Management’s Discussion and Analysis of Financial Condition and Results of Operations We manage two U.S. defined benefit pension plans, our RIP, which is a qualified funded plan, and a nonqualified unfunded plan. For the RIP, the expected long-term return on plan assets represents a long-term view of the future estimated investment return on plan assets. This estimate is determined based on the target allocation of plan assets among asset classes and input from investment professionals on the expected performance of the asset classes over 10 to 30 years. Historical asset returns are monitored and considered when we develop our expected long-term return on plan assets. An incremental component is added for the expected return from active management based on historical information obtained from the plan’s investment consultants. These forecasted gross returns are reduced by estimated management fees and expenses. Over the 10 year period ended December 31, 2017, the historical annualized return was approximately 5.5% compared to an average expected return of 7.1%. The actual gain on plan assets achieved for 2017 was 12.4%. The difference between the actual and expected rate of return on plan assets will be amortized into earnings as described below. The expected long-term return on plan assets used in determining our 2017 U.S. pension cost was 6.50%. We have assumed a return on plan assets for 2018 of 6.50%. The 2018 expected return on assets was calculated in a manner consistent with 2017. A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2018 operating income by approximately $3.7 million. Contributions to the unfunded plan were $3.9 million in 2017 and were made on a monthly basis to fund benefit payments. We estimate the 2018 contributions will be approximately $4.0 million. See Note 16 to the Consolidated Financial Statements for more information. The estimated inflation in health care costs represents a 5-10 year view of the expected inflation in our postretirement health care costs. We separately estimate expected health care cost increases for pre-65 retirees and post-65 retirees due to the influence of Medicare coverage at age 65, as illustrated below: The difference between the actual and expected health care costs is amortized into earnings as described below. As of December 31, 2017, health care cost increases are estimated to decrease ratably until 2026, after which they are estimated to be constant at 4.5%. A one percentage point increase or decrease in the assumed health care cost trend rate would not have a material impact on 2018 operating income. See Note 16 to the Consolidated Financial Statements for more information. Actual results that differ from our various pension and postretirement plan estimates are captured as actuarial gains/losses. When certain thresholds are met, the gains and losses are amortized into future earnings over the remaining life expectancy of participants. Changes in assumptions could have significant effects on earnings in future years. We recognized a decrease in net actuarial losses related to our U.S. pension benefit plans of $34.8 million in 2017 primarily due to a better than expected return on assets and a partial settlement of the RIP in 2017, partially offset by changes in actuarial assumptions (most significantly a 49 basis point decrease in the discount rate). The $34.8 million actuarial gain impacting our U.S. pension plans is reflected as a component of other comprehensive income in our Consolidated Statement of Earnings and Comprehensive Income along with actuarial gains and losses from our foreign pension plan and our U.S. postretirement benefit plan. Income Taxes - Our effective tax rate is primarily determined based on our pre-tax income and the statutory income tax rates in the jurisdictions in which we operate. The effective tax rate also reflects the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences are temporary, reversing over time, such as depreciation expense. These temporary differences create deferred income tax assets and liabilities. Deferred income tax assets are also recorded for net operating loss (“NOL”) and foreign tax credit (“FTC”) carryforwards. Deferred income tax assets and liabilities are recognized by applying enacted tax rates to temporary differences that exist as of the balance sheet date. We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized. The need to establish valuation allowances for deferred tax assets is assessed quarterly. In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard, we give appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts Management’s Discussion and Analysis of Financial Condition and Results of Operations of future profitability and foreign source income (“FSI”), the duration of statutory carryforward periods, and our experience with operating loss and tax credit carryforward expirations. A history of cumulative losses is a significant piece of negative evidence used in our assessment. If a history of cumulative losses is incurred for a tax jurisdiction, forecasts of future profitability are not used as positive evidence related to the realization of the deferred tax assets in the assessment. As of December 31, 2017, we have recorded valuation allowances totaling $47.4 million for various federal, state, and foreign deferred tax assets. While we have considered future taxable income in assessing the need for the valuation allowances based on our best available projections, if these estimates and assumptions change in the future or if actual results differ from our projections, we may be required to adjust our valuation allowances accordingly. Such adjustments could be material to our Consolidated Financial Statements. As further described in Note 14 to the Consolidated Financial Statements, our Consolidated Balance Sheet as of December 31, 2017 includes net deferred income tax assets of $96.8 million. Included in this amount are deferred federal income tax assets for FTC carryforwards of $15.7 million, and state NOL deferred income tax assets of $35.6 million. We have established valuation allowances in the amount of $47.4 million consisting of $10.3 million for federal deferred tax assets related to FTC carryovers, $17.7 million for differences between book and tax basis of undistributed foreign earnings, and $19.4 million for state deferred tax assets, primarily operating loss carryovers. Inherent in determining our effective tax rate are judgments regarding business plans and expectations about future operations. These judgments include the amount and geographic mix of future taxable income, the amount of FSI, limitations on usage of NOL carryforwards, the impact of ongoing or potential tax audits, and other future tax consequences. We estimate we will need to generate future U.S. taxable income of approximately $506.8 million for state income tax purposes during the respective realization periods (ranging from 2018 to 2036) in order to fully realize the net deferred income tax assets. As previously disclosed in prior SEC filings, our ability to utilize deferred tax assets may be impacted by certain future events, such as changes in tax legislation and insufficient future taxable income prior to expiration of certain deferred tax assets. We recognize the tax benefits of an uncertain tax position if those benefits are more likely than not to be sustained based on existing tax law. Additionally, we establish a reserve for tax positions that are more likely than not to be sustained based on existing tax law, but uncertain in the ultimate benefit to be sustained upon examination by the relevant taxing authorities. Unrecognized tax benefits are subsequently recognized at the time the more likely than not recognition threshold is met, the tax matter is effectively settled or the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired, whichever is earlier. Impairments of Long-Lived Tangible and Intangible Assets - Our indefinite-lived intangibles are primarily trademarks and brand names, which are integral to our corporate identity and expected to contribute indefinitely to our corporate cash flows. Accordingly, they have been assigned an indefinite life. We conduct our annual impairment test for non-amortizable intangible assets during the fourth quarter, although we conduct interim impairment tests if events or circumstances indicate the asset might be impaired. We conduct impairment tests for tangible assets and amortizable intangible assets when indicators of impairment exist, such as operating losses and/or negative cash flows. If an indication of impairment exists, we compare the carrying amount of the asset group to the estimated undiscounted future cash flows expected to be generated by the assets. If the undiscounted cash flows of an impaired asset are less than the carrying value, an estimate of an asset group’s fair value is based on discounted future cash flows expected to be generated by the asset group, or based on management’s estimated exit price assuming the assets could be sold in an orderly transaction between market participants or estimated salvage value if no sale is assumed. If the fair value is less than the carrying value of the asset group, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group. The principal assumption utilized in our impairment tests for definite-lived intangible assets is operating profit adjusted for depreciation and amortization. The principal assumptions utilized in our impairment tests for indefinite-lived intangible assets include revenue growth rate, discount rate and royalty rate. Revenue growth rate and operating profit assumptions are primarily derived from those utilized in our operating plan and strategic planning processes. The discount rate assumption is calculated based upon an estimated weighted average cost of equity which reflects the overall level of inherent risk and the rate of return a market participant would expect to achieve. The royalty rate assumption represents the estimated contribution of the intangible assets to the overall profits of the reporting unit. In 2017, indefinite-lived intangibles were tested for impairment based on our existing reporting units, which changed as a result of the announced future sale of our EMEA and Pacific Rim segments. No other methodologies used for valuing our intangible assets changed from prior periods. Management’s Discussion and Analysis of Financial Condition and Results of Operations The cash flow estimates used in applying our impairment tests are based on management’s analysis of information available at the time of the impairment test. Actual cash flows lower than the estimate could lead to significant future impairments. If subsequent testing indicates that fair values have declined, the carrying values would be reduced and our future statements of income would be affected. There were no material impairment charges recorded in 2017, 2016 or 2015 related to intangible assets. We did not test tangible assets within our continuing operations for impairment in 2017, 2016 or 2015 as no indicators of impairment existed. We cannot predict the occurrence of certain events that might lead to material impairment charges in the future. Such events may include, but are not limited to, the impact of economic environments, particularly related to the commercial and residential construction industries, material adverse changes in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. See Notes 3 and 10 to the Consolidated Financial Statements for further information. Environmental Liabilities - We are actively involved in the investigation, closure and/or remediation of existing or potential environmental contamination under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), and state Superfund and similar type environmental laws at several domestically owned, formerly owned and non-owned locations allegedly resulting from past industrial activity. In a few cases, we are one of several potentially responsible parties and have agreed to jointly fund the required investigation, while preserving our defenses to the liability. We may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies. We provide for environmental remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Accruals are estimates based on the judgment of management related to ongoing proceedings. Estimates of our future liability at the environmental sites are based on evaluations of currently available facts regarding each individual site. In determining the probability of contribution, we consider the solvency of other parties, the site activities of other parties, whether liability is being disputed, the terms of any existing agreements and experience with similar matters, and the effect of our October 2006 Chapter 11 reorganization upon the validity of the claim. We evaluate the measurement of recorded liabilities each reporting period based on current facts and circumstances specific to each matter. The ultimate losses incurred upon final resolution may materially differ from the estimated liability recorded. Changes in estimates are recorded in earnings in the period in which such changes occur. We are unable to predict the extent to which any recoveries from other parties or coverage under insurance policies might cover our final share of costs for these sites. Our final share of investigation and remediation costs may exceed any such recoveries, and such amounts net of insurance recoveries may be material. ACCOUNTING PRONOUNCEMENTS EFFECTIVE IN FUTURE PERIODS See Note 2 to the Consolidated Financial Statements for further information. RESULTS OF OPERATIONS Unless otherwise indicated, net sales in these results of operations are reported based upon the AWI location where the sale was made. Please refer to Notes 3 and 4 to the Consolidated Financial Statements for a reconciliation of segment operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations. 2017 COMPARED TO 2016 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Management’s Discussion and Analysis of Financial Condition and Results of Operations Consolidated net sales increased due to favorable AUV of $29 million and higher volumes of $27 million. Cost of goods sold was 63.8% of net sales in 2017, compared to 63.5% in 2016 due to higher manufacturing and input costs. The increase in cost of goods sold as a percentage of sales in comparison to 2016 was impacted by $10 million of accelerated depreciation charges due to management’s decision to permanently close a plant in China that will be retained by AWI after the sale of our Pacific Rim business and management’s decision to close our St. Helens, Oregon plant. Cost of goods sold for 2017 were also impacted by an increase in manufacturing and input costs and $3 million of severance and other charges associated with the announced closure of our St. Helens, Oregon plant. Partially offsetting these increases was a $10 million reduction in RIP expense and a $10 million reduction of cost of goods sold related to environmental insurance settlements recorded in 2017. SG&A expenses in 2017 were $135.7 million, or 15.2% of net sales, compared to $155.5 million, or 18.6% of net sales, in 2016. The decrease in SG&A expenses was impacted by a $7 million decrease in the RIP expense, a $6 million reduction in expenses resulting from an increase in certain selling, promotional and administrative processing service reimbursements from WAVE and a $5 million reduction related to environmental insurance settlements, net of charges. These decreases in SG&A expenses were partially offset by higher SG&A expenses as a result of the Tectum acquisition and $2 million of severance related to cost control measures in the U.S. Separation costs of $34.5 million in 2016 were primarily related to outside professional services and employee retention and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business. Equity earnings from our WAVE joint venture were $67.0 million in 2017, compared to $73.1 million in 2016. The decrease in WAVE earnings was primarily driven by an increase in selling and administrative processing charges from AWI and Worthington Industries, Inc. WAVE earnings were also negatively impacted by higher input costs, particularly steel. See Note 9 to the Consolidated Financial Statements for further information. Interest expense was $35.4 million in 2017, compared to $49.5 million in 2016. Interest expense in 2016 included higher debt financing costs as a result of the refinancing of our credit facilities in April 2016 and $8.3 million of net losses that were reclassified from accumulated other comprehensive income as a result of the settlement of interest rate swaps which occurred in April 2016 and in connection with our entering into $450.0 million of notional amount of basis rate swaps during the fourth quarter of 2016. Also contributing to the decrease in interest expense was a reduction in total debt outstanding and a lower interest rate spread in comparison to 2016. Other non-operating income was $2.4 million in 2017 and $11.2 million in 2016. The changes in other non-operating income were primarily due to foreign exchange rate gains on the translation of unhedged cross-currency intercompany loans in 2016. Income tax expense was $1.5 million and $51.3 million in 2017 and 2016, respectively. The effective tax rate for 2017 was 0.7% as compared to a rate of 34.1% for 2016. On December 22, 2017, the U.S. federal government enacted the Tax Cut and Jobs Act of 2017 (the “2017 Tax Act”), resulting in significant changes from previous tax law. Effective January 1, 2018, the 2017 Tax Act reduces the federal corporate income tax rate from 35% to 21%. As a result, we recorded a net $82.5 million income tax benefit in the fourth quarter of 2017. Excluding the impact of the 2017 Tax Act, income tax expense for 2017 increased in comparison to 2016 due to an increase in pre-tax income, a decrease in reversals of reserves for uncertain tax positions from the expiration of the federal statute of limitations and an increase to the valuation allowance on foreign tax credits due to the anticipated sale of our EMEA and Pacific Rim businesses. Total other comprehensive income (“OCI”) was $57.9 million for 2017 compared to $23.6 million for 2016. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Foreign currency translation adjustments in 2017 were driven primarily by changes in the exchange rates of the British pound, the Chinese renminbi, the Russian ruble and the Canadian dollar. Derivative gain/loss represents the mark to market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. Derivative gains in 2016 were impacted by $8.3 million of net losses related to settlements of interest rates swaps. Pension and postretirement adjustments represent actuarial gains and losses related to our defined benefit pension and postretirement plans and amortization of net losses on the U.S. pension plans. Increases in OCI in 2017 primarily related to our U.S. pension plans. Management’s Discussion and Analysis of Financial Condition and Results of Operations REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Net sales increased due to favorable AUV of $29 million, partially offset by lower volumes of $10 million. The favorable AUV was primarily due to improved mix from the sale of higher end ceiling tile products, while the decrease in volumes was primarily in lower end ceiling tile products. Operating income increased due to lower SG&A expenses of $20 million and the favorable margin impact of higher AUV of $12 million, partially offset by higher manufacturing and input costs of $13 million, lower earnings from WAVE of $6 million and the negative impact of lower volumes of $2 million. The reduction in SG&A expenses was impacted by $6 million of additional expense reimbursements from WAVE and $5 million of environmental insurance settlements, net of charges, both recorded in 2017. The increase in manufacturing costs was impacted by higher costs associated with planned enhancements to our manufacturing footprint to produce high end products and $7 million of severance and accelerated depreciation charges, primarily associated with the announced closure of our St. Helens manufacturing plant, partially offset by a $10 million reduction in costs related to environmental insurance settlements, net of charges, in 2017. Architectural Specialties (dollar amounts in millions) Net sales increased due to higher volumes, partially as a result of our acquisition of Tectum and increased new construction activity. Operating income increased due to the positive impact of higher volumes, partially offset by an increase in SG&A expenses due primarily to the acquisition of Tectum and investments in selling and design capabilities. Unallocated Corporate Unallocated Corporate expense of $5 million decreased from $54 million in the prior year, due to $35 million of charges incurred in connection with our separation of AFI in 2016 and a $17 million decrease in RIP expense. FINANCIAL CONDITION AND LIQUIDITY Cash Flow The discussion that follows includes cash flows related to discontinued operations. Operating activities for 2017 provided $170.4 million of cash, compared to $49.3 million of cash provided in 2016. The increase was primarily due to changes in working capital, most notably a decrease accounts payable and accrued expenses related to the separation of AFI. Net cash used for investing activities was $54.2 million in 2017, compared to $17.0 million in 2016. The change in investing activities cash flows was primarily due to the acquisition of Tectum and lower dividends from our WAVE joint venture, partially offset by decreased purchases of property, plant and equipment. Net cash used by financing activities was $102.7 million in 2017, compared to $128.9 million in 2016. The favorable change in use of cash was primarily the result of lower payments of debt, partially offset by higher repurchases of outstanding common stock. Management’s Discussion and Analysis of Financial Condition and Results of Operations Liquidity Our liquidity needs for operations vary throughout the year. We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is generally lower during the first and fourth quarters of our fiscal year. We have a $1,050.0 million senior credit facility which is comprised of a $200.0 million revolving credit facility (with a $150.0 million sublimit for letters of credit), a $600.0 million Term Loan A and a $250.0 million Term Loan B. The revolving credit facility and Term Loan A are currently priced at 2.00% over LIBOR and the Term Loan B portion is priced at 2.75% over LIBOR with a 0.75% floor. The senior credit facility also has a $25.0 million letter of credit facility, also known as our bi-lateral facility. The revolving credit facility and Term Loan A mature in March 2021 and Term Loan B matures in November 2023. This $1,050.0 million senior credit facility is secured by U.S. personal property, the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first tier foreign subsidiaries. As of December 31, 2017, total borrowings outstanding under our senior credit facility were $577.5 million under Term Loan A and $245.6 million under Term Loan B. There were no borrowings outstanding under the revolving credit facility. In February 2017, we repriced the interest rate of our Term Loan B borrowing, resulting in a lower LIBOR spread (2.75% vs. 3.25%). The maturity date remained unchanged along with all other terms and conditions. In connection with the repricing we paid $0.6 million of bank, legal and other fees, the majority of which were capitalized. Under our senior credit facility we are subject to year-end leverage tests that may trigger mandatory prepayments. If our ratio of consolidated funded indebtedness minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) (“Consolidated Net Leverage Ratio”) is greater than 3.5 to 1.0, the prepayment amount would be based on a computation of 50% of Consolidated Excess Cash Flow, as defined by the credit agreement. These annual payments would be made in the first quarter of the following year. No payment was made in 2017 or will be required in 2018. The senior credit facility includes two financial covenants that require the ratio of consolidated EBITDA to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the Consolidated Net Leverage Ratio to be less than or equal to 3.75 to 1.0. As of December 31, 2017, we were in compliance with all covenants of the senior credit facility. The Term Loan A and Term Loan B were both fully drawn and are currently priced on a variable interest rate basis. The following table summarizes our interest rate swaps (dollar amounts in millions): These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. The unpaid balances of Term Loan A, the Revolving Credit Facility and Term Loan B may be prepaid without penalty at the maturity of their respective interest reset periods. Any amounts prepaid on the Term Loan A or Term Loan B may not be re-borrowed. In connection with the refinancing of our credit facilities in April 2016, $450.0 million of notional amount Term Loan B swaps with a trade date of March 27, 2012 were settled and $10.7 million of losses previously recorded as a component of accumulated other comprehensive income were reclassified to interest expense in 2016. As of December 31, 2017, we had $450.0 million notional Term A swaps (the “Term Loan A Swaps”), in which we received 1-month LIBOR and paid a fixed rate over the hedged period. During the fourth quarter of 2016, we elected to change the basis for interest payments due under our Term Loan A Swaps from 3-month LIBOR to 1-month LIBOR. In connection with the change in our underlying interest payments, in November 2016 we entered into $450.0 million forward-starting notional amount basis rate swaps to convert the floating rate risk under our Term Loan A Swaps from 3-month LIBOR to 1-month LIBOR and jointly designated the basis swaps with our Term Loan A Swaps in cash flow hedging relationships. As a result of this transaction, $2.4 million of gains previously recorded as a component of accumulated other comprehensive income were reclassified as a reduction to interest expense during the fourth quarter of 2016. Since the basis rate Management’s Discussion and Analysis of Financial Condition and Results of Operations swaps had a non-zero fair value upon designation as cash flow hedges, mark-to-market gains or losses on ineffective portions of these hedges are recorded as a component of interest expense. As of December 31, 2017, we had a $100.0 million notional Term Loan B swap in which we receive the greater of 3-month LIBOR or a 0.75% LIBOR Floor and pay a fixed rate over the hedged period. As of December 31, 2017 our outstanding long-term debt included a $35.0 million variable rate, tax-exempt industrial development bond that financed the construction of a plant in prior years. This bond has a scheduled final maturity of 2041 and is remarketed by an agent on a regular basis at a market-clearing interest rate. Any portion of the bond that is not successfully remarketed by the agent is required to be repurchased. This bond is backed by letters of credit which will be drawn if a portion of the bond is not successfully remarketed. We have not had to repurchase the bond. As of December 31, 2017, we had $159.6 million of cash and cash equivalents, $81.0 million in the U.S and $78.6 million in various foreign jurisdictions. Upon completion of the sale of our EMEA and Pacific Rim businesses, it is our intention to repatriate a significant majority of the $78.6 million of cash held in various foreign jurisdictions; however our Purchase Agreement with Knauf allows AWI to transfer any cash balances held in our EMEA and Pacific Rim businesses to Knauf up to $10.0 million. See Note 4 to the Consolidated Financial Statements for additional information. We have a $40.0 million Accounts Receivable Securitization Facility (the “funding entity”) that matures in March 2019. Under our Accounts Receivable Securitization Facility we sell accounts receivables to Armstrong Receivables Company, LLC (“ARC”), a Delaware entity that is consolidated in these financial statements. ARC is a 100% wholly owned single member LLC special purpose entity created specifically for this transaction; therefore, any receivables sold to ARC are not available to the general creditors of AWI. ARC then sells an undivided interest in the purchased accounts receivables to the funding entity. This undivided interest acts as collateral for drawings on the facility. Any borrowings under this facility are obligations of ARC and not AWI. ARC contracts with and pays a servicing fee to AWI to manage, collect and service the purchased accounts receivables. All new receivables under the program are continuously purchased by ARC with the proceeds from collections of receivables previously purchased. As of December 31, 2017 we had no borrowings under this facility. We utilize lines of credit and other commercial commitments in order to ensure that adequate funds are available to meet operating requirements. Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table presents details related to our letters of credit (dollar amounts in millions): As of December 31, 2017 and 2016, $6.6 million and $4.0 million, respectively, of letters of credit issued under our accounts receivable securitization facility in excess of our maximum limit were classified as restricted cash and reported as a component of Cash and cash equivalents on our Consolidated Balance Sheets. This restriction will lapse upon replacement of collateral with accounts receivables and/or upon a change in the letter of credit limit as a result of higher securitized accounts receivable balances. We believe that cash on hand and cash generated from operations, together with lines of credit, availability under our revolving credit facility, will be adequate to address our foreseeable liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations. Management’s Discussion and Analysis of Financial Condition and Results of Operations 2016 COMPARED TO 2015 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Consolidated net sales for 2016 increased due to higher volumes of $20 million and favorable AUV of $15 million. Cost of goods sold was 63.5% of net sales in 2016, compared to 62.0% in 2015. Compared to the prior year, the increase was due to higher manufacturing and input costs. SG&A expenses in 2016 were $155.5 million, or 18.6% of net sales, compared to $180.8 million, or 22.5% of net sales in 2015. The decrease was the result of the AFI separation and a decrease in RIP expense. Separation costs of $34.5 million in 2016 and $34.3 million in 2015 were primarily related to outside professional services and employee retention and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business. Equity earnings from our WAVE joint venture were $73.1 million in 2016, compared to $66.1 million in 2015. The increase was due to higher sales volumes, favorable AUV and lower manufacturing input costs, partially offset by higher SG&A expenses for go-to-market investments. Interest expense was $49.5 million in 2016, compared to $44.6 million in 2015. The increase in interest expense was due to $10.7 million of losses that were reclassified from accumulated other comprehensive income to interest expense during 2016 as a result of the settlement of $450.0 million of notional amount interest rate swaps which occurred in connection with the refinancing of our credit facilities, partially offset by lower costs due to a reduction in total debt outstanding and a lower interest rate spread and $2.4 million of gains that were reclassified from accumulated other comprehensive income to interest expense during 2016 in connection with our entering into $450.0 million of notional amount of basis rate swaps. Other non-operating income was $11.2 million in 2016, compared to other non-operating expense of $17.8 million in 2015. The changes in other non-operating income were primarily due to foreign exchange rate gains on the translation of unhedged cross-currency intercompany loans. Expenses in 2015 were primarily due to foreign exchange rate losses on the translation of unhedged cross-currency intercompany loans denominated in Russian rubles, related to the construction of our Russian mineral fiber ceiling plant that was completed in the first quarter of 2015. During the fourth quarter of 2016, all Russian ruble denominated intercompany loans were settled with intercompany capital contributions. Income tax expense was $51.3 million and $36.7 million in 2016 and 2015, respectively. The effective tax rate for 2016 was 34.1% as compared to a rate of 38.8% for 2015. The effective tax rate for 2016 was lower than 2015 primarily due to income tax benefits recorded during the second half of 2016 resulting from the reversal of reserves for uncertain tax positions as a result of an expiration of the federal statute of limitations to review previously filed income tax returns. REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Net sales increased due to favorable AUV of $15 million, while volume was flat. Operating income decreased due to higher SG&A expenses of $50 million, the margin impact of lower volumes of $5 million and an increase manufacturing and input costs of $4 million, partially offset by the margin impact of favorable AUV of $8 million and higher Management’s Discussion and Analysis of Financial Condition and Results of Operations earnings from WAVE of $7 million. The increase in SG&A expenses in 2016 was primarily a result of the inclusion of costs formally assigned to our Unallocated Corporate segment prior to the separation of AFI, partially offset by a reduction in costs primarily due to the separation of AFI. Architectural Specialties (dollar amounts in millions) Net sales and operating income both increased due to higher volumes. The increase in operating income was partially offset by a $4 million increase in SG&A expenses, due to investments in selling and design capabilities. Unallocated Corporate Unallocated Corporate expense of $54.2 million decreased from $129.8 million in the prior year. The decrease was due to the inclusion of most of the Corporate functions within the Mineral Fiber and Architectural Specialties segments starting in 2016 as a result of the AFI separation. Cash Flow The discussion that follows includes cash flows related to discontinued operations. Operating activities for 2016 provided $49.3 million of cash, compared to $203.7 million of cash provided in 2015. The decrease was primarily due to change in working capital, most notably a decrease in accounts payable and accrued expenses related to the separation of AFI. The decrease due to the change in working capital was partially offset by higher cash earnings partially offset by a reduction in depreciation and amortization. Net cash used for investing activities was $17.0 million in 2016, compared to $101.5 million in 2015. The change in investing activities cash flows was primarily due to decreased purchases of property, plant and equipment, partially offset by higher dividends from our WAVE joint venture. Net cash used by financing activities was $128.9 million in 2016, compared to $32.3 million in 2015. The unfavorable use of cash was primarily the result of higher payments of debt and repurchase of outstanding common stock. OFF-BALANCE SHEET ARRANGEMENTS No disclosures are required pursuant to Item 303(a)(4) of Regulation S-K. Management’s Discussion and Analysis of Financial Condition and Results of Operations CONTRACTUAL OBLIGATIONS As part of our normal operations, we enter into numerous contractual obligations that require specific payments during the term of the various agreements. The following table includes amounts ongoing under contractual obligations existing as of December 31, 2017. Only known payments that are dependent solely on the passage of time are included. Obligations under contracts that contain minimum payment amounts are shown at the minimum payment amount. Contracts that contain variable payment structures without minimum payments are excluded. Purchase orders that are entered into in the normal course of business are also excluded because they are generally cancelable and not legally binding. Amounts are presented below based upon the currently scheduled payment terms. Actual future payments may differ from the amounts presented below due to changes in payment terms or events affecting the payments. (1) Excludes $7.9 million of unamortized debt financing costs as of December 31, 2017. (2) For debt with variable interest rates and interest rate swaps, we projected future interest payments based on market-based interest rate swap curves. (3) Lease obligations include the minimum payments due under existing agreements with non-cancelable lease terms in excess of one year. (4) Unconditional purchase obligations include (a) purchase contracts whereby we must make guaranteed minimum payments of a specified amount regardless of how little material is actually purchased (“take or pay” contracts) and (b) service agreements. Unconditional purchase obligations exclude contracts entered into during the normal course of business that are non-cancelable and have fixed per unit fees, but where the monthly commitment varies based upon usage. Cellular phone contracts are an example. (5) Pension contributions include estimated contributions for our defined benefit pension plans. We are not presenting estimated payments in the table above beyond 2018 as funding can vary significantly from year to year based upon changes in the fair value of plan assets, funding regulations and actuarial assumptions. (6) Other obligations include payments under severance agreements. (7) Other obligations excludes $53.4 million of unrecognized tax benefit liabilities under ASC 740 “Income Taxes.” Due to the uncertainty relating to these positions, we are unable to reasonably estimate the ultimate amount or timing of the settlement of these issues. Other obligations also excludes $10.3 million of one-time deemed repatriation tax liabilities on undistributed foreign earnings and profits, gross of foreign tax credit utilization, as a result of the enactment of the 2017 Tax Act as such amounts were recorded on a provisional basis and estimated based on information available as of December 31, 2017. See Note 14 to the Consolidated Financial Statements for more information. This table excludes obligations related to postretirement benefits (retiree health care and life insurance) since we voluntarily provide these benefits. The amount of benefit payments we made in 2017 was $10.3 million. See Note 16 to the Consolidated Financial Statements for additional information regarding future expected cash payments for postretirement benefits. We are party to supply agreements, some of which require the purchase of inventory remaining at the supplier upon termination of the agreement. Had these agreements terminated at December 31, 2017, we would have been obligated to purchase approximately $0.6 million of inventory. Historically, due to production planning, we have not had to purchase material amounts of product at the end of similar contracts. Accordingly, no liability has been recorded for these guarantees. Management’s Discussion and Analysis of Financial Condition and Results of Operations Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table summarizes the commitments we have available for use as of December 31, 2017. In connection with our disposition of certain assets through a variety of unrelated transactions, we have entered into contracts that included various indemnity provisions, some of which are customary for such transactions, while others hold the acquirer of the assets harmless with respect to liabilities relating to such matters as taxes, environmental and other litigation. Some of these provisions include exposure limits, but many do not. Due to the nature of the indemnities, it is not possible to estimate the potential maximum exposure under these contractual provisions. As of December 31, 2017, we had no liabilities recorded for which an indemnity claim had been received.

<s>[INST] Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forwardlooking statements and risk factors included in this Form 10K. Overview We are a global leader in the design, innovation and manufacture of commercial and residential ceiling, wall and suspension system solutions. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas. On November 17, 2017, we entered into a Share Purchase Agreement (the “Purchase Agreement”) with Knauf International GmbH (“Knauf”), to sell certain subsidiaries comprising our business in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc., in which AWI holds a 50% interest. The total consideration to be paid by Knauf in connection with the sale is $330 million in cash, inclusive of amounts due to WAVE, subject to certain adjustments as provided in the Purchase Agreement, including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment. The transaction, which is subject to regulatory approvals and other customary conditions, is currently anticipated to close in mid2018. EMEA and Pacific Rim segment historical financial results have been reflected in AWI’s Consolidated Financial Statements as discontinued operations for all periods presented. In January 2017, we acquired the business and assets of Tectum, Inc. (“Tectum”), based in Newark, Ohio. Tectum is a manufacturer of acoustical ceiling, wall and structural solutions for commercial building applications with two manufacturing facilities. Tectum’s operations from the date of acquisition, and its assets and liabilities as of December 31, 2017, have been included as a component of our Architectural Specialties segment. On April 1, 2016, we completed our separation of Armstrong Flooring, Inc. (“AFI”). AFI’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented. See Note 4 to the Consolidated Financial Statements for additional information related to our acquisitions and discontinued operations. As of December 31, 2017, we had 16 manufacturing plants in eight countries, including eight plants located throughout the U.S. During the fourth quarter of 2016 we idled one of our mineral fiber plants in China, reported as a component of our Unallocated Corporate segment as it will be retained by AWI after the sale of the Pacific Rim business. Upon closure of the sale of our EMEA and Pacific Rim businesses, we will have ten plants, including eight plants in the U.S. During the fourth quarter of 2017, we announced the closing of our St. Helens, Oregon mineral fiber manufacturing facility, expected to occur in the first half of 2018. WAVE operates 9 additional plants in five countries to produce suspension system (grid) products, which we use and sell in our ceiling systems. Upon closure of the sale of its corresponding EMEA and Pacific Rim businesses, WAVE will operate five plants in the U.S. Reportable Segments Effective December 31, 2017 and in connection with the anticipated sale of our EMEA and Pacific Rim businesses, our EMEA and Pacific Rim segments have been excluded from our results of continuing operations. As a result, effective December 31, 2017 and for all periods presented, our operating segments are as follows: Mineral Fiber, Architectural Specialties and Unallocated Corporate. Mineral Fiber produces suspended mineral fiber and soft fiber ceiling systems for use in commercial and residential settings. Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal. Commercial ceiling products are [/INST] Negative. </s>

ARMSTRONG WORLD INDUSTRIES INC

2019-02-25

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this Form 10-K. Overview We are a leading global producer of ceiling systems for use primarily in the construction and renovation of commercial, institutional and residential buildings. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas. In August 2018, we acquired the business and assets of Steel Ceilings, Inc. (“Steel Ceilings”), based in Johnstown, Ohio. Steel Ceilings is a manufacturer of aluminum and stainless metal ceilings that include architectural, radiant and security solutions with one manufacturing facility. Steel Ceilings’ operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In May 2018, we acquired the business and assets of Plasterform, Inc. (“Plasterform”), based in Mississauga, Ontario, Canada. Plasterform is a manufacturer of architectural cast ceilings, walls, facades, columns and moldings with one manufacturing facility. Plasterform’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. On November 17, 2017, we entered into a Share Purchase Agreement (the “Purchase Agreement”) with Knauf International GmbH (“Knauf”), to sell certain subsidiaries comprising our business in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc. (“Worthington”) in which AWI holds a 50% interest. The consideration paid by Knauf in connection with the sale is $330 million in cash, inclusive of amounts due to WAVE, subject to certain adjustments as provided in the Purchase Agreement, including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment. On July 18, 2018, we entered into an amendment to the Purchase Agreement, pursuant to which Knauf agreed to irrevocably and unconditionally pay AWI (i) $250 million on August 1, 2018, and (ii) $80 million on September 15, 2018, if, prior to such date, (A) any competition condition has not been satisfied or (B) the closing has not yet occurred. The amendment also provided for the reduction (from a maximum of $35 million to a maximum of $20 million) of potential adjustments to the purchase price consideration for the transaction based on the impact of remedies required to satisfy competition conditions. We received both the $250 million payment and the $80 million payment from Knauf in the third quarter of 2018. Following receipt of these payments, we remitted $70 million to WAVE in partial consideration of the purchase price payable in respect of the business and operations of WAVE under the transaction. WAVE subsequently paid each of AWI and Worthington a dividend of $35 million. We also recorded a $22.4 million payable to WAVE, which is reflected within Accounts Payable and Accrued Expenses. The total consideration payable by AWI to WAVE will be determined following closing in connection with the calculation of the adjustments contemplated by the Purchase Agreement. The transaction was notified for merger control clearance in the European Union (“EU”), Bosnia and Herzegovina, Macedonia, Montenegro, Russia and Serbia, and was cleared unconditionally in Montenegro (February 2018), Serbia (February 2018), Russia (March 2018), Macedonia (July 2018) and Bosnia and Herzegovina (August 2018). On December 7, 2018, the European Commission granted conditional clearance of the transaction, subject to certain commitments intended to address concerns regarding the overlap between the activities of AWI and Knauf, including the divestment by Knauf to a third party of certain mineral fiber and grid businesses and operations in Austria, Estonia, Germany, Ireland, Italy, Latvia, Lithuania, Portugal, Spain, Turkey and the UK. This includes our sales operations in each of the relevant countries, as well as our production facilities, and those of WAVE, located in Team Valley, UK. The terms of the sale of the divestment business by Knauf and the identity of the purchaser are subject to the approval of the European Commission. We continue to work closely with Knauf towards closing and expect the transaction to close by the end of the first half of 2019. The EMEA and Pacific Rim historical financial results have been reflected in AWI’s Consolidated Financial Statements as discontinued operations for all periods presented. In January 2017, we acquired the business and assets of Tectum, Inc. (“Tectum”), based in Newark, Ohio. Tectum is a manufacturer of acoustical ceiling, wall and structural solutions for commercial building applications with two manufacturing facilities. Tectum’s Management’s Discussion and Analysis of Financial Condition and Results of Operations operations from the date of acquisition, and its assets and liabilities as of December 31, 2018, have been included as a component of our Architectural Specialties segment. On April 1, 2016, we completed our separation of Armstrong Flooring, Inc. (“AFI”). AFI’s historical financial results have been reflected in AWI’s Consolidated Financial Statements as a discontinued operation for all periods presented. See Note 5 to the Consolidated Financial Statements for additional information related to our acquisitions and discontinued operations. As of December 31, 2018, we had 18 manufacturing plants in eight countries, including nine plants located throughout the U.S., which included our St. Helens, Oregon mineral fiber manufacturing facility, which closed in the second quarter of 2018. During the second quarter of 2018, as part of our acquisition of Plasterform, we acquired one plant located in Canada. During the third quarter of 2018, as part of our acquisition of Steel Ceilings, we acquired one plant located in Ohio. We have one idle mineral fiber plant in China, reported as a component of our Unallocated Corporate segment as it is not included in the pending sale to Knauf. Upon closure of the sale of our EMEA and Pacific Rim businesses to Knauf, we will have 12 plants, including nine plants in the U.S, two plants in Canada and the idle plant in China. WAVE operates nine additional plants in five countries to produce suspension system (grid) products, which we use and sell in our ceiling systems. Upon closure of the sale of its corresponding EMEA and Pacific Rim businesses, WAVE will operate five plants in the U.S. Reportable Segments In connection with the anticipated sale of our EMEA and Pacific Rim businesses, our EMEA and Pacific Rim segments have been excluded from our results of continuing operations. As a result, our operating segments are as follows: Mineral Fiber, Architectural Specialties and Unallocated Corporate. Mineral Fiber - produces suspended mineral fiber and soft fiber ceiling systems for use in commercial and residential settings. Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal. Commercial ceiling products are sold to resale distributors and to ceiling systems contractors. Residential ceiling products are sold primarily to wholesalers and retailers (including large home centers). The Mineral Fiber segment also includes the results of WAVE, which manufactures suspension system (grid) products and ceiling component products that are invoiced by both us and WAVE. Segment results relating to WAVE consist primarily of equity earnings and reflect our 50% equity interest in the joint venture. Ceiling component products consist of ceiling perimeters and trim, in addition to grid products that support drywall ceiling systems. To a lesser extent, however, in some markets, WAVE sells its suspension systems products to us for resale to customers. Mineral Fiber segment results reflect those sales transactions. Architectural Specialties - produces and sources ceilings and walls for use in commercial settings. Products are available in numerous materials, such as metal and wood, in addition to various colors, shapes and designs. Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal. We sell standard and customized products, with the majority of Architectural Specialties revenues derived from sourced products. Architectural Specialties products are sold to resale distributors and ceiling systems contractors. The majority of revenues are project driven, which can lead to more volatile sales patterns due to project scheduling. Unallocated Corporate - includes assets, liabilities, income and expenses that have not been allocated to our other business segments and consist of: cash and cash equivalents, the net funded status of our U.S. Retirement Income Plan (“RIP”), the estimated fair value of interest rate swap contracts, outstanding borrowings under our senior credit facilities and income tax balances. Our Unallocated Corporate segment also includes all assets, liabilities, income and expenses formerly reported in our EMEA and Pacific Rim segments that are not included in the pending sale to Knauf. Factors Affecting Revenues For information on our segments’ 2018 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10-K. Markets. We compete in building material markets in the Americas. We closely monitor publicly available macroeconomic trends that provide insight into commercial and residential market activity, including GDP, office vacancy rates, the Architecture Billings Index, new commercial construction starts, state and local government spending, corporate profits and retail sales. Management’s Discussion and Analysis of Financial Condition and Results of Operations In addition, we noted several factors and trends within our markets that directly affected our business performance during 2018. In our Mineral Fiber segment, we experienced increased volume activity due to growth in the distributor customer group. In our Architectural Specialties segment, we experienced strong growth primarily due to increased market penetration and due to the impact of recent acquisitions. Average Unit Value. We periodically modify sales prices of our products due to changes in costs for raw materials and energy, market conditions and the competitive environment. In certain cases, realized price increases are less than the announced price increases because of project pricing, competitive reactions and changing market conditions. Additionally, we offer a wide assortment of products that are differentiated by style, design and performance attributes. Pricing and margins for products within the assortment vary. In addition, changes in the relative quantity of products purchased at different price points can impact year-to-year comparisons of net sales and operating income. Within our Mineral Fiber segment, we focus on improving sales dollars per unit sold, or average unit value (“AUV”), as a measure that accounts for the varying assortment of products and geographic mix impacting our revenues. We estimate that favorable AUV increased our total consolidated net sales for 2018 by approximately $43 million compared to 2017. Architectural Specialties revenues are generally earned based on individual contracts that include a mix of products, manufactured by us and sourced, that vary by project. As such, we do not track AUV performance for this segment, but rather attribute all changes in sales to volume. In the first, second and third quarters of 2018, we implemented price increases on Mineral Fiber ceiling tile and certain grid and Architectural Specialties products. In the fourth quarter of 2018, we announced a price increase on Mineral Fiber grid products to be effective in the first quarter of 2019. We may implement additional pricing actions based on numerous factors, most notably upon future movements in raw material prices and sourced product costs. Factors Affecting Operating Costs Operating Expenses. Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general, and administrative (“SG&A”) expenses. Our largest individual raw material expenditures are for fiberglass, perlite, starch, waste paper, pigments and clays. We manufacture most of the production needs for mineral wool at one of our manufacturing facilities. Natural gas and packaging materials are also significant input costs. Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results. In 2018, the costs for raw materials, sourced products and energy negatively impacted operating income by approximately $7.0 million, compared to 2017. Employees As of December 31, 2018 we had approximately 4,000 full time and part time employees. As of December 31, 2017, we had approximately 3,900 full-time and part-time employees. Excluding our EMEA and Pacific Rim businesses, we had approximately 2,200 employees as of December 31, 2018 and December 31, 2017. CRITICAL ACCOUNTING ESTIMATES In preparing our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”), we are required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an on-going basis, using relevant internal and external information. We believe that our estimates and assumptions are reasonable. However, actual results may differ from what was estimated and could have a significant impact on the financial statements. We have identified the following as our critical accounting estimates. We have discussed these critical accounting estimates with our Audit Committee. U.S. Pension Credit and Postretirement Benefit Costs - We maintain pension and postretirement plans throughout the world, with the most significant plans located in the U.S. Our defined benefit pension and postretirement benefit costs are developed from actuarial valuations. These valuations are calculated using a number of assumptions, which represent management’s best estimate of the future. The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets and the estimated inflation in health care costs. These assumptions are generally updated annually. Management’s Discussion and Analysis of Financial Condition and Results of Operations Management utilizes the Aon Hewitt AA only above median yield curve, which is a hypothetical AA yield curve comprised of a series of annualized individual discount rates, as the primary basis for determining discount rates. As of December 31, 2018 and 2017, we assumed discount rates of 4.30% and 3.63%, respectively, for the U.S. defined benefit pension plans. As of December 31, 2018 and 2017, we assumed a discount rates of 4.32% and 3.60%, respectively, for the U.S. postretirement plan. The effects of the change in discount rate will be amortized into earnings as described below. Absent any other changes, a one-quarter percentage point increase or decrease in the discount rates for the U.S. pension and postretirement plans would not have a material impact on 2019 operating income. We manage two U.S. defined benefit pension plans, our RIP, which is a qualified funded plan, and a nonqualified unfunded plan. For the RIP, the expected long-term return on plan assets represents a long-term view of the future estimated investment return on plan assets. This estimate is determined based on the target allocation of plan assets among asset classes and input from investment professionals on the expected performance of the asset classes over 10 to 30 years. Historical asset returns are monitored and considered when we develop our expected long-term return on plan assets. An incremental component is added for the expected return from active management based on historical information obtained from the plan’s investment consultants. These forecasted gross returns are reduced by estimated management fees and expenses. Over the 10 year period ended December 31, 2018, the historical annualized return was approximately 7.9% compared to an average expected return of 6.8%. The actual loss on plan assets incurred for 2018 was 4.4% net of fees. The difference between the actual and expected rate of return on plan assets will be amortized into earnings as described below. The expected long-term return on plan assets used in determining our 2018 U.S. pension cost was 6.50%. We have assumed a return on plan assets for 2019 of 5.75%. The 2019 expected return on assets was calculated in a manner consistent with 2018. A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2019 operating income by approximately $3.5 million. Contributions to the unfunded plan were $3.9 million in 2018 and were made on a monthly basis to fund benefit payments. We estimate the 2019 contributions will be approximately $4.3 million. See Note 16 to the Consolidated Financial Statements for more information. The estimated inflation in health care costs represents a 5-10 year view of the expected inflation in our postretirement health care costs. We separately estimate expected health care cost increases for pre-65 retirees and post-65 retirees due to the influence of Medicare coverage at age 65, as illustrated below: The difference between the actual and expected health care costs is amortized into earnings as described below. As of December 31, 2018, health care cost increases are estimated to decrease ratably until 2026, after which they are estimated to be constant at 4.5%. A one percentage point increase or decrease in the assumed health care cost trend rate would not have a material impact on 2019 operating income. See Note 16 to the Consolidated Financial Statements for more information. Actual results that differ from our various pension and postretirement plan estimates are captured as actuarial gains/losses. When certain thresholds are met, the gains and losses are amortized into future earnings over the remaining life expectancy of participants. Changes in assumptions could have significant effects on earnings in future years. We recognized an increase in net actuarial losses related to our U.S. pension benefit plans of $57.1 million in 2018 primarily due to a worse than expected return on assets, partially offset by changes in actuarial assumptions (most significantly a 67 basis point increase in the discount rate). The $57.1 million actuarial loss impacting our U.S. pension plans is reflected as a component of other comprehensive income in our Consolidated Statement of Earnings and Comprehensive Income along with actuarial gains and losses from our foreign pension plan and our U.S. postretirement benefit plan. Management’s Discussion and Analysis of Financial Condition and Results of Operations Income Taxes - Our effective tax rate is primarily determined based on our pre-tax income, statutory income tax rates in the jurisdictions in which we operate, and the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences are temporary, reversing over time, such as depreciation expense. These temporary differences create deferred income tax assets and liabilities. Deferred income tax assets are also recorded for net operating losses (“NOL”) and foreign tax credit (“FTC”) carryforwards. Deferred income tax assets and liabilities are recognized by applying enacted tax rates to temporary differences that exist as of the balance sheet date. We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized. The need to establish valuation allowances for deferred tax assets is assessed quarterly. In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard, we give appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability and foreign source income (“FSI”), the duration of statutory carryforward periods, and our experience with operating loss and tax credit carryforward expirations. A history of cumulative losses is a significant piece of negative evidence used in our assessment. If a history of cumulative losses is incurred for a tax jurisdiction, forecasts of future profitability are not used as positive evidence related to the realization of the deferred tax assets in the assessment. As of December 31, 2018, we have recorded valuation allowances totaling $79.6 million for various federal, state, and foreign deferred tax assets. While we have considered future taxable income in assessing the need for the valuation allowances based on our best available projections, if these estimates and assumptions change in the future or if actual results differ from our projections, we may be required to adjust our valuation allowances accordingly. Such adjustments could be material to our Consolidated Financial Statements. As further described in Note 14 to the Consolidated Financial Statements, our Consolidated Balance Sheet as of December 31, 2018 includes net deferred income tax assets of $101.9 million. Included in this amount are deferred federal income tax assets for FTC carryforwards of $19.1 million, and state NOL deferred income tax assets of $58.7 million. We have established valuation allowances in the amount of $79.6 million consisting of $19.1 million for federal deferred tax assets related to FTC carryovers, $13.2 million for the outside basis difference between book and tax basis of our EMEA and Pacific Rim businesses, and $47.3 million for state deferred tax assets, primarily operating loss carryovers. The state deferred income tax asset and related state valuation allowance were each grossed up by $26.5 million in 2018, with no overall net change to the net deferred state income tax asset, to reflect gross Pennsylvania net operating loss deferred tax asset and valuation allowance amounts, pursuant to a change in that state’s net operating loss regulations. Inherent in determining our effective tax rate, are judgments regarding business plans and expectations about future operations. These judgments include the amount and geographic mix of future taxable income, the amount of FSI, limitations on usage of NOL carryforwards, the impact of ongoing or potential tax audits, and other future tax consequences. We estimate we will need to generate future U.S. taxable income of approximately $537.5 million for state income tax purposes during the respective realization periods (ranging from 2019 to 2036) in order to fully realize the net deferred income tax assets. As previously disclosed in prior SEC filings, our ability to utilize deferred tax assets may be impacted by certain future events, such as changes in tax legislation and insufficient future taxable income prior to expiration of certain deferred tax assets. We recognize the tax benefits of an uncertain tax position if those benefits are more likely than not to be sustained based on existing tax law. Additionally, we establish a reserve for tax positions that are more likely than not to be sustained based on existing tax law, but uncertain in the ultimate benefit to be sustained upon examination by the relevant taxing authorities. Unrecognized tax benefits are subsequently recognized at the time the more likely than not recognition threshold is met, the tax matter is effectively settled or the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired, whichever is earlier. Management’s Discussion and Analysis of Financial Condition and Results of Operations Impairments of Long-Lived Tangible, Intangible Assets and Goodwill - Our indefinite-lived intangibles are primarily trademarks and brand names, which are integral to our corporate identity and expected to contribute indefinitely to our corporate cash flows. Accordingly, they have been assigned an indefinite life. We conduct our annual impairment test for non-amortizable intangible assets during the fourth quarter, although we conduct interim impairment tests if events or circumstances indicate the asset might be impaired. We conduct impairment tests for tangible assets and amortizable intangible assets when indicators of impairment exist, such as operating losses and/or negative cash flows. In connection with the performance of an impairment test for indefinite-lived intangible assets and goodwill, we compare the carrying amount of the asset group (when testing indefinite-lived intangible assets) and reporting units (when testing goodwill) to the estimated undiscounted future cash flows expected to be generated by the assets. If the undiscounted cash flows of the asset group/reporting unit are less than the carrying value, an estimate of an asset group’s/reporting unit’s fair value is based on discounted future cash flows expected to be generated by the asset group/reporting unit, or based on management’s estimated exit price assuming the assets could be sold in an orderly transaction between market participants or estimated salvage value if no sale is assumed. If the fair value is less than the carrying value of the asset group/reporting unit, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group/reporting unit. The principal assumption utilized in our impairment tests for definite-lived intangible assets and goodwill is operating profit adjusted for depreciation and amortization. The principal assumptions utilized in our impairment tests for indefinite-lived intangible assets include revenue growth rate, discount rate and royalty rate. The principal assumptions utilized in our impairment tests for goodwill include after-tax cash flows growth rates and discount rate. Revenue growth rates, after-tax cash flows growth rates and operating profit assumptions are primarily derived from those utilized in our operating plan and strategic planning processes. The discount rate assumption is calculated based upon an estimated weighted average cost of capital which reflects the overall level of inherent risk and the rate of return a market participant would expect to achieve. The royalty rate assumption represents the estimated contribution of the intangible assets to the overall profits of the asset group. In 2018, indefinite-lived intangibles were tested for impairment based on our identified asset groups. The cash flow estimates used in applying our impairment tests are based on management’s analysis of information available at the time of the impairment test. Actual cash flows lower than the estimate could lead to significant future impairments. If subsequent testing indicates that fair values have declined, the carrying values would be reduced and our future statements of income would be affected. There were no material impairment charges recorded in 2018, 2017 or 2016 related to intangible assets. We did not test tangible assets within our continuing operations for impairment in 2018, 2017 or 2016 as no indicators of impairment existed. We cannot predict the occurrence of certain events that might lead to material impairment charges in the future. Such events may include, but are not limited to, the impact of economic environments, particularly related to the commercial and residential construction industries, material adverse changes in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. See Notes 3 and 11 to the Consolidated Financial Statements for further information. Environmental Liabilities - We are actively involved in the investigation, closure and/or remediation of existing or potential environmental contamination under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), and state Superfund and similar type environmental laws at several domestically owned, formerly owned and non-owned locations allegedly resulting from past industrial activity. In a few cases, we are one of several potentially responsible parties and have agreed to jointly fund the required investigation, while preserving our defenses to the liability. We may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies. We provide for environmental remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Accruals are estimates based on the judgment of management related to ongoing proceedings. Estimates of our future liability at the environmental sites are based on evaluations of currently available facts regarding each individual site. In determining the probability of contribution, we consider the solvency of other parties, the site activities of other parties, whether liability is being disputed, the terms of any existing agreements and experience with similar matters, and the effect of our October 2006 Chapter 11 reorganization upon the validity of the claim. We evaluate the measurement of recorded liabilities each reporting period based on current facts and circumstances specific to each matter. The ultimate losses incurred upon final resolution may materially differ from the estimated liability recorded. Changes in estimates are recorded in earnings in the period in which such changes occur. Management’s Discussion and Analysis of Financial Condition and Results of Operations We are unable to predict the extent to which any recoveries from other parties or coverage under insurance policies might cover our final share of costs for these sites. Our final share of investigation and remediation costs may exceed any such recoveries, and such amounts net of insurance recoveries may be material. ACCOUNTING PRONOUNCEMENTS EFFECTIVE IN FUTURE PERIODS See Note 2 to the Consolidated Financial Statements for further information. RESULTS OF OPERATIONS Unless otherwise indicated, net sales in these results of operations are reported based upon the AWI location where the sale was made. Please refer to Notes 3 and 5 to the Consolidated Financial Statements for a reconciliation of segment operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations. 2018 COMPARED TO 2017 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Consolidated net sales increased due to favorable AUV of $43 million and higher volumes of $39 million. Cost of goods sold was 65.8% of net sales in 2018, compared to 64.7% in 2017. The increase in cost of goods sold as a percentage of sales in comparison to 2017 was impacted by an increase in input costs and $14 million of higher accelerated depreciation and closure costs in 2018 related to management’s decision to permanently close the St. Helens, Oregon plant, partially offset by savings from the closure of the plant realized in the second half of 2018. Also impacting the increase in cost of goods sold as a percent of net sales was $10 million of environmental insurance settlements, net of charges, recorded in 2017 partially offset by $6 million of accelerated depreciation of machinery and equipment recorded in 2017 based on management’s decision to permanently close a previously idled plant in China. SG&A expenses in 2018 were $159.0 million, or 16.3% of net sales, compared to $138.6 million, or 15.5% of net sales, in 2017. The increase in SG&A expenses was primarily due to higher selling expenses due to an increase in net sales, an increase in legal fees and higher stock-based compensation expense. Also contributing to the increase in SG&A expenses was a $3 million reduction in environmental insurance settlements, net of expenses, in 2018 as compared to 2017. Equity earnings from our WAVE joint venture were $74.9 million in 2018, compared to $67.0 million in 2017. The increase in WAVE earnings was primarily driven by an increase in net sales as a result of positive AUV, partially offset by higher input costs, particularly steel and freight. See Note 10 to the Consolidated Financial Statements for further information. Interest expense was $39.2 million in 2018, compared to $35.4 million in 2017. The increase in interest expense in 2018 was due to increased floating interest rates. Also contributing in the increase of interest expense over 2017 was the expiration of a $250 interest rate swap on March 31, 2018. Other non-operating income was $32.5 million in 2018 and $13.7 million in 2017. The increase in other non-operating income was primarily related to higher pension and postretirement net periodic benefit credits, excluding service costs. In accordance with our adoption of Accounting Standards Update (“ASU”) 2017-07, all non-service cost components of net periodic pension and postretirement benefit costs were recorded as a component of non-operating income in both 2018 and 2017. Also contributing to the increase in other non-operating income, net was a $20 million partial settlement loss recorded in 2017 for our RIP. See Note 16 to the Consolidated Financial Statements for further information. Income tax expense was $53.1 million and $1.5 million in 2018 and 2017, respectively. The effective tax rate for 2018 was 21.9% as compared to a rate of 0.7% for 2017. On December 22, 2017, the U.S. federal government enacted the Tax Cut and Jobs Act of 2017 (the “2017 Tax Act”), resulting in significant changes from previous tax law. Effective January 1, 2018, the 2017 Tax Act reduces the federal corporate income tax rate from 35% to 21%. We applied the guidance in Staff Accounting Bulletin (“SAB”) 118 when Management’s Discussion and Analysis of Financial Condition and Results of Operations accounting for the enactment-date effects of the 2017 Tax Act in 2017 and throughout 2018. As a result, in the fourth quarter of 2017 we recorded a net $82.5 million income tax benefit. At December 31, 2018 we have now completed our accounting for the enactment-date income tax effects of the 2017 Tax Act. We increased our December 31, 2017 estimated tax benefit of $82.5 million to $83.7 million in 2018, primarily related to the mandatory repatriation of earnings feature of federal tax reform. Excluding the December 31, 2017 enactment-date impact of the 2017 Tax Act, income tax expense for 2018 decreased in comparison to 2017 due primarily to the reduced 21% federal income tax rate that took effect January 1, 2018. The 2017 Tax Act subjects a U.S. shareholder to tax on Global Intangible Low Tax Income (“GILTI”) earned by certain foreign subsidiaries. We have elected to account for GILTI as a current period expense when incurred, with the December 31, 2018 GILTI income tax expense being immaterial. Other than the items noted above, the remaining provisions of the 2017 Tax Act did not have a material effect on our financial condition, liquidity or results of operations. Total other comprehensive income (loss) (“OCI”) was a $59.4 million loss for 2018 compared to $57.9 million of income for 2017. The change was primarily due to foreign currency translation adjustments and pension and post retirement adjustments. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Foreign currency translation adjustments in 2018 were driven primarily by changes in the exchange rates of the Russian ruble and the British pound. Foreign currency translation adjustments in 2017 were driven primarily by changes in the exchange rates of the British pound, the Chinese renminbi, the Russian ruble and the Canadian dollar. Pension and postretirement adjustments represent actuarial gains and losses related to our defined benefit pension and postretirement plans and amortization of net losses on the U.S. pension plans. These losses in OCI in 2018 primarily related to our U.S. pension plans. Derivative gain/loss represents the mark to market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. See Note 24 to the Consolidated Financial Statements for further information. REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Net sales increased due to favorable AUV of $42 million and higher volumes of $3 million. The favorable AUV was due to improved price and positive mix from the sale of higher end ceiling tile products. Operating income decreased due to higher manufacturing and input costs of $26 million and higher SG&A expenses of $19 million, partially offset by the favorable margin impact of higher AUV of $27 million and higher equity earnings from WAVE of $8 million. The increase in manufacturing costs was impacted by increases in input costs and $10 million environmental insurance settlements, net of charges, recorded in 2017. Also impacting the increase in manufacturing costs was a $14 million increase in depreciation and closure costs attributable to our St. Helens manufacturing plant, partially offset by savings from the closure of the plant. The increase in SG&A expenses was primarily due to a $6 million increase in legal fees, a $6 million increase in selling expenses, a $3 million increase in stock-based compensation expense and a $3 million reduction in environmental insurance settlements, net of charges. Architectural Specialties (dollar amounts in millions) Net sales increased due to higher volumes from increased market penetration and new construction activity as well as the 2018 acquisitions of Plasterform and Steel Ceilings. Management’s Discussion and Analysis of Financial Condition and Results of Operations Operating income increased due to the positive impact of higher volumes, partially offset by an increase in manufacturing costs, due to investments in design capabilities and investments related to recent years’ acquisitions, and higher SG&A expenses due primarily to increased selling expenses as a result of increased net sales. Unallocated Corporate Unallocated Corporate expense of $9 million decreased from $17 million in the prior year primarily due to $6 million of accelerated depreciation charges for machinery and equipment recorded in 2017 due to management’s decision to permanently close a plant in China that will be retained by AWI after the sale of our Pacific Rim businesses and a $3 decrease in service costs associated with our RIP. FINANCIAL CONDITION AND LIQUIDITY Cash Flow The discussion that follows includes cash flows related to discontinued operations. Operating activities for 2018 provided $203.2 million of cash, compared to $170.4 million of cash provided in 2017. The increase was primarily due to a decrease in accounts receivable primarily related to proceeds received in 2018 for environmental insurance recoveries. Net cash provided by investing activities was $309.6 million for 2018, compared to a $54.2 million use of cash for 2017. The increase was primarily due to $330 million of proceeds received from Knauf related to the anticipated sale of our EMEA and Pacific Rim businesses, net of $70 million of payments to WAVE. Also contributing to the increase in investing cash flows was an increase of dividends from our WAVE joint venture. Net cash used by financing activities was $329.3 million in 2018, compared to $102.7 million in 2017. The decrease was primarily due to the higher repurchases of outstanding common stock, payments of dividends and an increase in credit facility payments, partially offset by proceeds from exercised employee stock awards. Liquidity Our liquidity needs for operations vary throughout the year. We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is generally lower during the first and fourth quarters of our fiscal year. We have a $1,050.0 million senior credit facility which is comprised of a $200.0 million revolving credit facility (with a $150.0 million sublimit for letters of credit), a $600.0 million Term Loan A and a $250.0 million Term Loan B. The revolving credit facility and Term Loan A are currently priced at 2.00% over LIBOR and the Term Loan B portion is priced at 2.75% over LIBOR with a 0.75% floor. The senior credit facility also has a $25.0 million letter of credit facility, also known as our bi-lateral facility. The revolving credit facility and Term Loan A mature in March 2021 and Term Loan B matures in November 2023. This $1,050.0 million senior credit facility is secured by U.S. personal property, the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first tier foreign subsidiaries. As of December 31, 2018, total borrowings outstanding under our senior credit facility were $547.5 million under Term Loan A and $243.1 million under Term Loan B. There were no borrowings outstanding under the revolving credit facility. Under our senior credit facility, we are subject to year-end leverage tests that may trigger mandatory prepayments. If our ratio of consolidated funded indebtedness minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million to consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) (“Consolidated Net Leverage Ratio”) is greater than 3.5 to 1.0, the prepayment amount would be based on a computation of 50% of Consolidated Excess Cash Flow, as defined by the credit agreement. These annual payments would be made in the first quarter of the following year. No payment was made in 2018 or will be required in 2019. The senior credit facility includes two financial covenants that require the ratio of consolidated EBITDA to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the Consolidated Net Leverage Ratio to be less than or equal to 3.75 to 1.0. As of December 31, 2018, we were in compliance with all covenants of the senior credit facility. Management’s Discussion and Analysis of Financial Condition and Results of Operations The Term Loan A and Term Loan B were both fully drawn and are currently priced on a variable interest rate basis. The following table summarizes our interest rate swaps (dollar amounts in millions): Under the terms of our April 2016 swap, we receive the greater of 3-month LIBOR or a 0.75% LIBOR Floor and pay a fixed rate over the hedged period. Under the terms of our November 2016 swap, we receive 3-month LIBOR and pay a fixed rate over the hedged period, in addition to a basis rate swap to convert the floating rate risk under our November 2016 Swap from 3-month LIBOR to 1-month LIBOR. As a result, we receive 1-month LIBOR and pay a fixed rate over the hedged period. We entered into two new swap positions effective November 28, 2018. Under the $200.0 million notional 2018 swap we pay a fixed rate over the hedged amount and receive 1-month LIBOR. This includes a 0% floor. Under the $100.0 million notional 2021 swap, we will pay a fixed rate monthly and receive 1-month LIBOR. This is inclusive of a 0% floor. These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. As of December 31, 2018, our outstanding long-term debt included a $35.0 million variable rate, tax-exempt industrial development bond that financed the construction of a plant in prior years. This bond has a scheduled final maturity of 2041 and is remarketed by an agent on a regular basis at a market-clearing interest rate. Any portion of the bond that is not successfully remarketed by the agent is required to be repurchased. This bond is backed by letters of credit which will be drawn if a portion of the bond is not successfully remarketed. We have not had to repurchase the bond. As of December 31, 2018, we had $325.7 million of cash and cash equivalents, $259.9 million in the U.S and $65.8 million in various foreign jurisdictions. Upon completion of the sale of our EMEA and Pacific Rim businesses, it is our intention to repatriate a significant majority of the cash held in various foreign jurisdictions; however our Purchase Agreement with Knauf allows AWI to transfer any cash balances held in our EMEA businesses to Knauf up to $10.0 million. See Note 1 to the Consolidated Financial Statements for additional information. As of December 31, 2018, we had a $40.0 million Accounts Receivable Securitization Facility with the Bank of Nova Scotia (the “funding entity”) that matures in March 2019. Under our Accounts Receivable Securitization Facility we sell accounts receivables to Armstrong Receivables Company, LLC (“ARC”), a Delaware entity that is consolidated in these financial statements. ARC is a 100% wholly owned single member LLC special purpose entity created specifically for this transaction; therefore, any receivables sold to ARC are not available to the general creditors of AWI. ARC then sells an undivided interest in the purchased accounts receivables to the funding entity. This undivided interest acts as collateral for drawings on the facility. Any borrowings under this facility are obligations of ARC and not AWI. ARC contracts with and pays a servicing fee to AWI to manage, collect and service the purchased accounts receivables. All new receivables under the program are continuously purchased by ARC with the proceeds from collections of receivables previously purchased. As of December 31, 2018, we had no borrowings under this facility. In February 2019, the facility was amended to resize the purchase limit from $40.0 million to $36.2 million and to extend the maturity to March 2020. We utilize lines of credit and other commercial commitments in order to ensure that adequate funds are available to meet operating requirements. Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table presents details related to our letters of credit (dollar amounts in millions): Management’s Discussion and Analysis of Financial Condition and Results of Operations As of December 31, 2018 and 2017, $6.0 million and $6.6 million, respectively, of letters of credit issued under our accounts receivable securitization facility in excess of our maximum limit were classified as restricted cash and reported as a component of Cash and cash equivalents on our Consolidated Balance Sheets. This restriction will lapse upon replacement of collateral with accounts receivables and/or upon a change in the letter of credit limit as a result of higher securitized accounts receivable balances. We believe that cash on hand and cash generated from operations, together with lines of credit, availability under our revolving credit facility, will be adequate to address our foreseeable liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations. 2017 COMPARED TO 2016 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Consolidated net sales increased due to favorable AUV of $29 million and higher volumes of $27 million. Cost of goods sold was 64.7% of net sales in 2017, compared to 63.3% in 2016 due to higher manufacturing and input costs. The increase in cost of goods sold as a percentage of sales in comparison to 2016 was impacted by $10 million of accelerated depreciation charges due to management’s decision to permanently close a plant in China that will be retained by AWI after the sale of our Pacific Rim business and management’s decision to close our St. Helens, Oregon plant. Cost of goods sold for 2017 were also impacted by an increase in manufacturing and input costs and $3 million of severance and other charges associated with the announced closure of our St. Helens, Oregon plant. Partially offsetting these increases was a $10 million reduction of cost of goods sold related to environmental insurance settlements recorded in 2017. SG&A expenses in 2017 were $138.6 million, or 15.5% of net sales, compared to $184.2 million, or 21.9% of net sales, in 2016. The decrease in SG&A expenses was impacted by a $6 million reduction in expenses resulting from an increase in certain selling, promotional and administrative processing service reimbursements from WAVE and a $5 million reduction related to environmental insurance settlements, net of charges. These decreases in SG&A expenses were partially offset by higher SG&A expenses as a result of the Tectum acquisition and $2 million of severance related to cost control measures in the U.S. Separation costs of $34.5 million in 2016 were primarily related to outside professional services and employee retention and severance accruals incurred in conjunction with our initiative to separate our flooring business from our ceilings business. Equity earnings from our WAVE joint venture were $67.0 million in 2017, compared to $73.1 million in 2016. The decrease in WAVE earnings was primarily driven by an increase in selling and administrative processing charges from AWI and Worthington Industries, Inc. WAVE earnings were also negatively impacted by higher input costs, particularly steel. See Note 9 to the Consolidated Financial Statements for further information. Interest expense was $35.4 million in 2017, compared to $49.5 million in 2016. Interest expense in 2016 included higher debt financing costs as a result of the refinancing of our credit facilities in April 2016 and $8.3 million of net losses that were reclassified from accumulated other comprehensive income as a result of the settlement of interest rate swaps which occurred in April 2016 and in connection with our entering into $450.0 million of notional amount of basis rate swaps during the fourth quarter of 2016. Also contributing to the decrease in interest expense was a reduction in total debt outstanding and a lower interest rate spread in comparison to 2016. Other non-operating income was $13.7 million in 2017 and $4.2 million in 2016. The changes in other non-operating income were primarily due to higher pension and postretirement net periodic benefit credits, excluding service costs. In accordance with our adoption of Accounting Standards Update (“ASU”) 2017-07, all non-service cost components of net periodic pension and postretirement benefit costs were recorded as a component of non-operating income in both 2017 and 2016. Also contributing to the change were the foreign exchange rate gains on the translation of unhedged cross-currency intercompany loans in 2016. Management’s Discussion and Analysis of Financial Condition and Results of Operations Income tax expense was $1.5 million and $51.3 million in 2017 and 2016, respectively. The effective tax rate for 2017 was 0.7% as compared to a rate of 34.1% for 2016. As a result of the 2017 Tax Act, we recorded a net $82.5 million income tax benefit in the fourth quarter of 2017. Excluding the impact of the 2017 Tax Act, income tax expense for 2017 increased in comparison to 2016 due to an increase in pre-tax income, a decrease in reversals of reserves for uncertain tax positions from the expiration of the federal statute of limitations and an increase to the valuation allowance on foreign tax credits due to the anticipated sale of our EMEA and Pacific Rim businesses. Total other comprehensive income (“OCI”) was $57.9 million for 2017 compared to $23.6 million for 2016. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Foreign currency translation adjustments in 2017 were driven primarily by changes in the exchange rates of the British pound, the Chinese renminbi, the Russian ruble and the Canadian dollar. Derivative gain/loss represents the mark to market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. Derivative gains in 2016 were impacted by $8.3 million of net losses related to settlements of interest rates swaps. Pension and postretirement adjustments represent actuarial gains and losses related to our defined benefit pension and postretirement plans and amortization of net losses on the U.S. pension plans. Increases in OCI in 2017 primarily related to our U.S. pension plans. REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Net sales increased due to favorable AUV of $29 million, partially offset by lower volumes of $10 million. The favorable AUV was primarily due to improved mix from the sale of higher end ceiling tile products, while the decrease in volumes was primarily in lower end ceiling tile products. Operating income increased due to lower SG&A expenses of $20 million and the favorable margin impact of higher AUV of $12 million, partially offset by higher manufacturing and input costs of $13 million, lower earnings from WAVE of $6 million and the negative impact of lower volumes of $2 million. The reduction in SG&A expenses was impacted by $6 million of additional expense reimbursements from WAVE and $5 million of environmental insurance settlements, net of charges, both recorded in 2017. The increase in manufacturing costs was impacted by higher costs associated with planned enhancements to our manufacturing footprint to produce high end products and $7 million of severance and accelerated depreciation charges, primarily associated with the announced closure of our St. Helens manufacturing plant, partially offset by a $10 million reduction in costs related to environmental insurance settlements, net of charges, in 2017. Architectural Specialties (dollar amounts in millions) Net sales increased due to higher volumes, partially as a result of our acquisition of Tectum and increased new construction activity. Operating income increased due to the positive impact of higher volumes, partially offset by an increase in SG&A expenses due primarily to the acquisition of Tectum and investments in selling and design capabilities. Unallocated Corporate Unallocated Corporate expense of $17 million decreased from $50 million in the prior year, primarily due to $35 million of charges incurred in connection with our separation of AFI in 2016. Management’s Discussion and Analysis of Financial Condition and Results of Operations Cash Flow The discussion that follows includes cash flows related to discontinued operations. Operating activities for 2017 provided $170.4 million of cash, compared to $49.3 million of cash provided in 2016. The increase was primarily due to changes in working capital, most notably a decrease accounts payable and accrued expenses related to the separation of AFI. Net cash used for investing activities was $54.2 million in 2017, compared to $17.0 million in 2016. The change in investing activities cash flows was primarily due to the acquisition of Tectum and lower dividends from our WAVE joint venture, partially offset by decreased purchases of property, plant and equipment. Net cash used by financing activities was $102.7 million in 2017, compared to $128.9 million in 2016. The favorable change in use of cash was primarily the result of lower payments of debt, partially offset by higher repurchases of outstanding common stock. OFF-BALANCE SHEET ARRANGEMENTS No disclosures are required pursuant to Item 303(a)(4) of Regulation S-K. CONTRACTUAL OBLIGATIONS As part of our normal operations, we enter into numerous contractual obligations that require specific payments during the term of the various agreements. The following table includes amounts ongoing under contractual obligations existing as of December 31, 2018. Only known payments that are dependent solely on the passage of time are included. Obligations under contracts that contain minimum payment amounts are shown at the minimum payment amount. Contracts that contain variable payment structures without minimum payments are excluded. Purchase orders that are entered into in the normal course of business are also excluded because they are generally cancelable and not legally binding. Amounts are presented below based upon the currently scheduled payment terms. Actual future payments may differ from the amounts presented below due to changes in payment terms or events affecting the payments. (1) Excludes $5.8 million of unamortized debt financing costs as of December 31, 2018. (2) For debt with variable interest rates and interest rate swaps, we projected future interest payments based on market-based interest rate swap curves. (3) Lease obligations include the minimum payments due under existing agreements with non-cancelable lease terms in excess of one year. (4) Unconditional purchase obligations include (a) purchase contracts whereby we must make guaranteed minimum payments of a specified amount regardless of how little material is actually purchased (“take or pay” contracts) and (b) service agreements. Unconditional purchase obligations exclude contracts entered into during the normal course of business that are non-cancelable and have fixed per unit fees, but where the monthly commitment varies based upon usage. Cellular phone contracts are an example. (5) Pension contributions include estimated contributions for our defined benefit pension plans. We are not presenting estimated payments in the table above beyond 2019 as funding can vary significantly from year to year based upon changes in the fair value of plan assets, funding regulations and actuarial assumptions. (6) Other obligations include payments under severance agreements. (7) Other obligations excludes $42.6 million of unrecognized tax benefit liabilities under ASC 740 “Income Taxes.” Due to the uncertainty relating to these positions, we are unable to reasonably estimate the ultimate amount or timing of the settlement of these issues. See Note 14 to the Consolidated Financial Statements for more information. Management’s Discussion and Analysis of Financial Condition and Results of Operations This table excludes obligations related to postretirement benefits (retiree health care and life insurance) since we voluntarily provide these benefits. The amount of benefit payments we made in 2018 was $11.2 million. See Note 16 to the Consolidated Financial Statements for additional information regarding future expected cash payments for postretirement benefits. We are party to supply agreements, some of which require the purchase of inventory remaining at the supplier upon termination of the agreement. Had these agreements terminated at December 31, 2018, we would have been obligated to purchase approximately $0.8 million of inventory. Historically, due to production planning, we have not had to purchase material amounts of product at the end of similar contracts. Accordingly, no liability has been recorded for these guarantees. Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. Our securitization facility is with the Bank of Nova Scotia and matures in March 2020. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table summarizes the commitments we have available for use as of December 31, 2018. In connection with our disposition of certain assets through a variety of unrelated transactions, we have entered into contracts that included various indemnity provisions, some of which are customary for such transactions, while others hold the acquirer of the assets harmless with respect to liabilities relating to such matters as taxes, environmental and other litigation. Some of these provisions include exposure limits, but many do not. Due to the nature of the indemnities, it is not possible to estimate the potential maximum exposure under these contractual provisions. As of December 31, 2018, we had no liabilities recorded for which an indemnity claim had been received.

<s>[INST] Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forwardlooking statements and risk factors included in this Form 10K. Overview We are a leading global producer of ceiling systems for use primarily in the construction and renovation of commercial, institutional and residential buildings. We design, manufacture and sell ceiling systems (primarily mineral fiber, fiberglass wool and metal) throughout the Americas. In August 2018, we acquired the business and assets of Steel Ceilings, Inc. (“Steel Ceilings”), based in Johnstown, Ohio. Steel Ceilings is a manufacturer of aluminum and stainless metal ceilings that include architectural, radiant and security solutions with one manufacturing facility. Steel Ceilings’ operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In May 2018, we acquired the business and assets of Plasterform, Inc. (“Plasterform”), based in Mississauga, Ontario, Canada. Plasterform is a manufacturer of architectural cast ceilings, walls, facades, columns and moldings with one manufacturing facility. Plasterform’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. On November 17, 2017, we entered into a Share Purchase Agreement (the “Purchase Agreement”) with Knauf International GmbH (“Knauf”), to sell certain subsidiaries comprising our business in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc. (“Worthington”) in which AWI holds a 50% interest. The consideration paid by Knauf in connection with the sale is $330 million in cash, inclusive of amounts due to WAVE, subject to certain adjustments as provided in the Purchase Agreement, including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment. On July 18, 2018, we entered into an amendment to the Purchase Agreement, pursuant to which Knauf agreed to irrevocably and unconditionally pay AWI (i) $250 million on August 1, 2018, and (ii) $80 million on September 15, 2018, if, prior to such date, (A) any competition condition has not been satisfied or (B) the closing has not yet occurred. The amendment also provided for the reduction (from a maximum of $35 million to a maximum of $20 million) of potential adjustments to the purchase price consideration for the transaction based on the impact of remedies required to satisfy competition conditions. We received both the $250 million payment and the $80 million payment from Knauf in the third quarter of 2018. Following receipt of these payments, we remitted $70 million to WAVE in partial consideration of the purchase price payable in respect of the business and operations of WAVE under the transaction. WAVE subsequently paid each of AWI and Worthington a dividend of $35 million. We also recorded a $22.4 million payable to WAVE, which is reflected within Accounts Payable and Accrued Expenses. The total consideration payable by AWI to WAVE will be determined following closing in connection with the calculation of the adjustments contemplated by the Purchase Agreement. The transaction was notified for merger control clearance in the European Union (“EU”), Bosnia and Herzegovina, Macedonia, Montenegro, Russia and Serbia, and was cleared unconditionally in Montenegro (February 2018), Serbia (February 2018), Russia (March 2018), Macedonia (July 2018) and Bosnia and Herzegovina (August 2018). On December 7, 2018, the European Commission granted conditional clearance of the [/INST] Positive. </s>

ARMSTRONG WORLD INDUSTRIES INC

2020-02-25

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forward-looking statements and risk factors included in this Form 10-K. Overview We are a leading producer of ceiling systems for use in the construction and renovation of commercial and residential buildings. We design, manufacture and sell ceiling and wall systems (primarily mineral fiber, fiberglass wool, metal, wood, wood fiber, glass-reinforced-gypsum and felt) throughout the Americas. Acquisitions In November 2019, we acquired the business and assets of MRK Industries, Inc. (“MRK”), based in Libertyville, Illinois. MRK is a manufacturer of specialty metal ceiling, wall and exterior solutions with one manufacturing facility. MRK’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In March 2019, we acquired the business and assets of Architectural Components Group, Inc. (“ACGI”), based in Marshfield, Missouri. ACGI is a manufacturer of custom wood ceilings and walls with one manufacturing facility. ACGI’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In August 2018, we acquired the business and assets of Steel Ceilings, Inc. (“Steel Ceilings”), based in Johnstown, Ohio. Steel Ceilings is a manufacturer of aluminum and stainless metal ceilings that include architectural, radiant and security solutions with one manufacturing facility. Steel Ceilings’ operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In May 2018, we acquired the business and assets of Plasterform, Inc. (“Plasterform”), based in Mississauga, Ontario, Canada. Plasterform is a manufacturer of architectural cast ceilings, walls, facades, columns and moldings with one manufacturing facility. Plasterform’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In January 2017, we acquired the business and assets of Tectum, Inc. (“Tectum”), based in Newark, Ohio. Tectum is a manufacturer of acoustical ceiling, wall and structural solutions for commercial building applications with two manufacturing facilities. Tectum’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. Discontinued Operations On September 30, 2019, we completed the previously announced sale of certain subsidiaries comprising our businesses and operations in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc. (“Worthington”) in which AWI holds a 50% interest (collectively, the “Sale”), to Knauf International GmbH (“Knauf”). The purchase price of $330.0 million was previously paid by Knauf to us during the third quarter of 2018 and is subject to certain post-closing adjustments for cash and debt as provided in the Share Purchase Agreement dated as of November 17, 2017, by and between us and Knauf (the “Purchase Agreement”), including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment. On July 18, 2018, we entered into an amendment to the Purchase Agreement, pursuant to which Knauf irrevocably and unconditionally paid AWI (i) $250.0 million of the purchase price on August 1, 2018, and (ii) $80.0 million of the purchase price on September 15, 2018, which payments were credited against the aggregate consideration payable at closing. The amendment also provided for the reduction (from a maximum of $35.0 million to a maximum of $20.0 million) of potential adjustments to the purchase price consideration for the transaction based on the impact of remedies required to satisfy competition conditions. Following receipt of these payments, we remitted $70.0 million to WAVE in partial consideration of the purchase price payable in respect of the businesses and operations of WAVE under the transaction. WAVE subsequently paid each of AWI and Worthington a dividend of $35.0 million. We have recorded a $25.9 million payable to WAVE for their remaining portion of the proceeds from Knauf, which is reflected within Accounts payable and accrued expenses in the Consolidated Balance Sheets as of December 31, 2019. The transaction and final gain or loss amounts are subject to finalization of customary working capital and other adjustments, as provided in the Purchase Agreement. For the year ended December 31, 2019, payments to Knauf included $61.0 million of adjustments to cash consideration, estimated working capital adjustments and remedies, offset by $13.1 million of additional cash in international WAVE entities. Management’s Discussion and Analysis of Financial Condition and Results of Operations On December 7, 2018, the European Commission granted conditional clearance of the transaction, subject to certain commitments intended to address concerns regarding the overlap between the activities of AWI and Knauf, including the divestment by Knauf to a third party of certain mineral fiber and grid businesses and operations in Austria, Estonia, Germany, Ireland, Italy, Latvia, Lithuania, Portugal, Spain, Turkey and the United Kingdom (“UK”). This included our sales operations in each of the relevant countries, as well as our production facilities, and those of WAVE, located in Team Valley, UK. On May 23, 2019, we entered into a Transition Services Agreement with Knauf for its benefit and the benefit of the buyer of the divestment business, pursuant to which we are providing certain transition technology, finance and information technology support services during the period between March 18, 2019 and September 30, 2020. On September 23, 2019, the European Commission approved the Sale, as well as the terms of the sale of the divestment business by Knauf and the identity of the purchaser. In connection with the closing of the Sale, we also entered into (i) an intellectual property License Agreement with Knauf for its benefit (and, under sublicense, to the buyer of the divestment business) under which they license certain patents, trademarks and know-how from us for use in certain licensed territories, and (ii) a Supply Agreement with Knauf under which the parties may continue to purchase certain products from each other following the closing of the Sale. WAVE also entered into similar agreements with Knauf for such purposes. The EMEA and Pacific Rim segment historical financial results through September 30, 2019 have been reflected in AWI’s Consolidated Statements of Earnings and Comprehensive Income as discontinued operations for all periods presented, while the assets and liabilities of discontinued operations have been removed from AWI’s Consolidated Balance Sheet as of December 31, 2019. See Notes 5 and 6 to the Consolidated Financial Statements for additional information related to our acquisitions and discontinued operations. Manufacturing Plants As of December 31, 2019, we had 14 manufacturing plants in three countries, with 11 plants located within the U.S, which included our St. Helens, Oregon mineral fiber manufacturing facility, which closed in the second quarter of 2018. During 2019, as part of our acquisitions of ACGI and MRK, we acquired two additional plants located in Missouri and Illinois, respectively. We have two plants in Canada and one idle mineral fiber plant in China. The idle plant in China is reported as a component of our Unallocated Corporate segment and is classified as an asset held for sale as of December 31, 2019, as we entered into a sale agreement for the property during the third quarter of 2019 with closing expected in the second quarter of 2020. WAVE operates five additional plants in the U.S. to produce suspension system (grid) products, which we use and sell in our ceiling systems. Reportable Segments Our operating segments are as follows: Mineral Fiber, Architectural Specialties and Unallocated Corporate. Mineral Fiber - produces suspended mineral fiber and soft fiber ceiling systems for use in commercial and residential settings. Products offer various performance attributes such as acoustical control, rated fire protection and aesthetic appeal. Commercial ceiling products are sold to resale distributors and to ceiling systems contractors. Residential ceiling products are sold primarily to wholesalers and retailers (including large home centers). The Mineral Fiber segment also includes the results of WAVE, which manufactures and sells suspension system (grid) products and ceiling component products that are invoiced by both AWI and WAVE. Segment results relating to WAVE consist primarily of equity earnings and reflect our 50% equity interest in the joint venture. Ceiling component products consist of ceiling perimeters and trim, in addition to grid products that support drywall ceiling systems. To a lesser extent, however, in some geographies and for some customers, WAVE sells its suspension systems products to AWI for resale to customers. Mineral Fiber segment results reflect those sales transactions. The Mineral Fiber segment also includes all assets and liabilities not specifically allocated to our Architectural Specialties or Unallocated Corporate segment, including all property and related depreciation associated with our Lancaster, PA headquarters. Operating results for the Mineral Fiber segment include a significant majority of allocated Corporate administrative expenses that represent a reasonable allocation of general services to support its operations. Architectural Specialties - produces and sources ceilings and walls for use in commercial settings. Products are available in numerous materials, such as metal and wood, in addition to various colors, shapes and designs. Products offer various performance attributes Management’s Discussion and Analysis of Financial Condition and Results of Operations such as acoustical control, rated fire protection and aesthetic appeal. We sell standard and customized products, with the majority of Architectural Specialties revenues derived from sourced products. Architectural Specialties products are sold primarily to resale distributors and ceiling systems contractors. The majority of revenues are project driven, which can lead to more volatile sales patterns due to project scheduling uncertainty. Operating results for the Architectural Specialties segment include a minor portion of allocated Corporate administrative expenses that represent a reasonable allocation of general services to support its operations. Unallocated Corporate - includes assets, liabilities, income and expenses that have not been allocated to our other business segments and consist of: cash and cash equivalents, the net funded status of our U.S. Retirement Income Plan (“RIP”), the estimated fair value of interest rate swap contracts, outstanding borrowings under our senior credit facility and income tax balances. Our Unallocated Corporate segment also includes all assets, liabilities, income and expenses formerly reported in our EMEA and Pacific Rim segments that were not included in the Sale. Factors Affecting Revenues For information on our segments’ 2019 net sales by geography, see Note 3 to the Consolidated Financial Statements included in this Form 10-K. Markets. We compete in the commercial and residential construction markets. We closely monitor publicly available macroeconomic trends that provide insight into commercial and residential market activity, including GDP, office vacancy rates, the Architecture Billings Index, new commercial construction starts, state and local government spending, corporate profits and retail sales. We noted several factors and trends within our markets that directly affected our business performance during 2019. In our Mineral Fiber segment, softer demand for lower end products exceeded increased demand for high end products. In our Architectural Specialties segment, we experienced strong growth due to the impact of the 2018 acquisitions of Plasterform and Steel Ceilings (collectively, the “2018 Acquisitions”) and the 2019 acquisitions of ACGI and MRK (collectively, the “2019 Acquisitions”). Our Architectural Specialties segment also experienced increased market penetration as a result of an expanded range of product offerings, and new construction activity. The following table presents the impact of the 2018 Acquisitions and the 2019 Acquisitions on our Architectural Specialties segment (dollar amounts in millions): Average Unit Value. We periodically modify sales prices of our products due to changes in costs for raw materials and energy, market conditions and the competitive environment. In certain cases, realized price increases are less than the announced price increases because of project pricing, competitive reactions and changing market conditions. We also offer a wide assortment of products that are differentiated by style, design and performance attributes. Pricing and margins for products within the assortment vary. In addition, changes in the relative quantity of products purchased at different price points can impact year-to-year comparisons of net sales and operating income. Within our Mineral Fiber segment, we focus on improving sales dollars per unit sold, or average unit value (“AUV”), as a measure that accounts for the varying assortment of products impacting our revenues. We estimate that favorable AUV increased our Mineral Fiber and total consolidated net sales for 2019 by approximately $44 million compared to 2018. Our Architectural Specialties segment generates revenues that are generally earned based on individual contracts that include a mix of products, both manufactured by us and sourced from third parties that vary by project. As such, we do not track AUV performance for this segment, but rather attribute all changes in sales to volume. In the first and third quarters of 2019, we implemented price increases on certain Mineral Fiber ceiling tile and Architectural Specialties products. In the fourth quarter of 2019, we announced a price increase on Mineral Fiber ceiling tile and grid products to be effective in the first quarter of 2020. We may implement future pricing actions based on numerous factors. Seasonality. Generally, our sales tend to be stronger in the second and the third quarters of our fiscal year due to more favorable weather conditions, customer business cycles and the timing of renovation and new construction. Management’s Discussion and Analysis of Financial Condition and Results of Operations Factors Affecting Operating Costs Operating Expenses. Our operating expenses are comprised of direct production costs (principally raw materials, labor and energy), manufacturing overhead costs, freight, costs to purchase sourced products and selling, general, and administrative (“SG&A”) expenses. Our largest individual raw material expenditures are for fiberglass, perlite, starch, waste paper, wood, wood fiber, aluminum, steel, pigments and clays. We manufacture most of the production needs for mineral wool at one of our manufacturing facilities. Natural gas and packaging materials are also significant input costs. Fluctuations in the prices of these inputs are generally beyond our control and have a direct impact on our financial results. In 2019, costs for raw materials and energy negatively impacted operating income by $1 million, compared to 2018. CRITICAL ACCOUNTING ESTIMATES In preparing our consolidated financial statements in accordance with U.S. generally accepted accounting principles (“GAAP”), we are required to make certain estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We evaluate our estimates and assumptions on an on-going basis, using relevant internal and external information. We believe that our estimates and assumptions are reasonable. However, actual results may differ from what was estimated and could have a significant impact on the financial statements. We have identified the following as our critical accounting estimates. We have discussed these critical accounting estimates with our Audit Committee. U.S. Pension Credit and Postretirement Benefit Costs - We maintain significant pension and postretirement plans in the U.S. Our defined benefit pension and postretirement benefit costs are developed from actuarial valuations. These valuations are calculated using a number of assumptions, which represent management’s best estimate of the future. The assumptions that have the most significant impact on reported results are the discount rate, the estimated long-term return on plan assets and the estimated inflation in health care costs. These assumptions are generally updated annually. Management utilizes the Aon Hewitt AA only above median yield curve, which is a hypothetical AA yield curve comprised of a series of annualized individual discount rates, as the primary basis for determining discount rates. As of December 31, 2019 and 2018, we assumed discount rates of 3.16% and 4.30%, respectively, for the U.S. defined benefit pension plans. As of December 31, 2019 and 2018, we assumed a discount rates of 3.14% and 4.31%, respectively, for the U.S. postretirement plan. The effects of the change in discount rate will be amortized into earnings as described below. Absent any other changes, a one-quarter percentage point increase or decrease in the discount rates for the U.S. pension and postretirement plans would not have a material impact on 2020 operating or non-operating income. We manage two U.S. defined benefit pension plans, our RIP, which is a qualified funded plan, and a nonqualified unfunded plan. For the RIP, the expected long-term return on plan assets represents a long-term view of the future estimated investment return on plan assets. This estimate is determined based on the target allocation of plan assets among asset classes and input from investment professionals on the expected performance of the asset classes over 10 to 30 years. Historical asset returns are monitored and considered when we develop our expected long-term return on plan assets. An incremental component is added for the expected return from active management based on historical information obtained from the plan’s investment consultants. These forecasted gross returns are reduced by estimated management fees and expenses. Over the 10-year period ended December 31, 2019, the historical annualized return was approximately 7.9% compared to an average expected return of 6.5%. The actual gain on plan assets incurred for 2019 was 16.6%, net of fees. The difference between the actual and expected rate of return on plan assets will be amortized into earnings as described below. The expected long-term return on plan assets used in determining our 2019 U.S. pension cost was 5.75%. We have assumed a return on plan assets for 2020 of 5.25%. The 2020 expected return on assets was calculated in a manner consistent with 2019. A one-quarter percentage point increase or decrease in this assumption would increase or decrease 2020 non-operating income by approximately $3.7 million. Contributions to the unfunded pension plan were $4.0 million in 2019 and were made on a monthly basis to fund benefit payments. We estimate the 2020 contributions will be approximately $3.9 million. See Note 18 to the Consolidated Financial Statements for more information. Management’s Discussion and Analysis of Financial Condition and Results of Operations The estimated inflation in health care costs represents a 5-10 year view of the expected inflation in our postretirement health care costs. We separately estimate expected health care cost increases for pre-65 retirees and post-65 retirees due to the influence of Medicare coverage at age 65, as illustrated below: The difference between the actual and expected health care costs is amortized into earnings as described below. As of December 31, 2019, health care cost increases are estimated to decrease ratably until 2026, after which they are estimated to be constant at 4.50%. A one percentage point increase or decrease in the assumed health care cost trend rate would not have a material impact on 2020 operating or non-operating income. See Note 18 to the Consolidated Financial Statements for more information. Actual results that differ from our various pension and postretirement plan estimates are captured as actuarial gains/losses. When certain thresholds are met, the gains and losses are amortized into future earnings over the remaining life expectancy of participants. Changes in assumptions could have significant effects on earnings in future years. Total net actuarial losses related to our U.S. pension benefit plans decreased by $36.6 million in 2019 primarily due to a better than expected return on assets, partially offset by changes in actuarial assumptions (most significantly a 114 basis point decrease in the discount rate). The $36.6 million actuarial gain impacting our U.S. pension plans is reflected as a component of other comprehensive income in our Consolidated Statement of Earnings and Comprehensive Income along with actuarial gains and losses from our foreign pension plan and our U.S. postretirement benefit plan. On February 20, 2020, we entered into a commitment agreement with a third-party insurance company to partially settle approximately $1.0 billion of retiree benefit obligations under our RIP. See Note 18 to the Consolidated Financial Statements for further information. Income Taxes - Our effective tax rate is primarily determined based on our pre-tax income, statutory income tax rates in the jurisdictions in which we operate, and the tax impacts of items treated differently for tax purposes than for financial reporting purposes. Some of these differences are permanent, such as expenses that are not deductible in our tax returns, and some differences are temporary, reversing over time, such as depreciation expense. These temporary differences create deferred income tax assets and liabilities. Deferred income tax assets are also recorded for net operating losses (“NOL”), capital loss carryforwards, and foreign tax credit (“FTC”) carryforwards. Deferred income tax assets and liabilities are recognized by applying enacted tax rates to temporary differences that exist as of the balance sheet date. We reduce the carrying amounts of deferred tax assets by a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized. The need to establish valuation allowances for deferred tax assets is assessed quarterly. In assessing the requirement for, and amount of, a valuation allowance in accordance with the more likely than not standard, we give appropriate consideration to all positive and negative evidence related to the realization of the deferred tax assets. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, capital gain income, and foreign source income (“FSI”), the duration of statutory carryforward periods, and our experience with operating loss and tax credit carryforward expirations. A history of cumulative losses is a significant piece of negative evidence used in our assessment. If a history of cumulative losses is incurred for a tax jurisdiction, forecasts of future profitability are not used as positive evidence related to the realization of the deferred tax assets in the assessment. As of December 31, 2019, we have recorded valuation allowances totaling $75.5 million for various federal and state deferred tax assets. While we have considered future taxable income in assessing the need for the valuation allowances based on our best available projections, if these estimates and assumptions change in the future or if actual results differ from our projections, we may be required to adjust our valuation allowances accordingly. Such adjustments could be material to our Consolidated Financial Statements. As further described in Note 16 to the Consolidated Financial Statements, our Consolidated Balance Sheet as of December 31, 2019 includes deferred income tax assets of $155.8 million. Included in this amount are deferred federal income tax assets for FTC carryforwards of $13.1 million, federal and state capital loss carryforwards of $16.0 million, and state NOL deferred income tax assets of $54.8 million. We have established valuation allowances in the amount of $75.5 million consisting of $13.1 million for federal deferred tax assets related to FTC carryovers, $46.4 million for state deferred tax assets, primarily operating loss carryovers, and $16.0 million for federal and state deferred tax assets related to capital loss carryovers. Inherent in determining our effective tax rate are Management’s Discussion and Analysis of Financial Condition and Results of Operations judgments regarding business plans and expectations about future operations. These judgments include the amount and geographic mix of future taxable income, the amount of FSI, limitations on usage of NOL carryforwards, the impact of ongoing or potential tax audits, and other future tax consequences. We estimate we will need to generate future U.S. taxable income of approximately $681.6 million for state income tax purposes during the respective realization periods (ranging from 2020 to 2039) in order to fully realize the net state NOL deferred income tax assets. Our ability to utilize deferred tax assets may be impacted by certain future events, such as changes in tax legislation and insufficient future taxable income prior to expiration of certain deferred tax assets. We recognize the tax benefits of an uncertain tax position if those benefits are more likely than not to be sustained based on existing tax law. Additionally, we establish a reserve for tax positions that are more likely than not to be sustained based on existing tax law, but uncertain in the ultimate benefit to be sustained upon examination by the relevant taxing authorities. Unrecognized tax benefits are subsequently recognized at the time the more likely than not recognition threshold is met, the tax matter is effectively settled or the statute of limitations for the relevant taxing authority to examine and challenge the tax position has expired, whichever is earlier. Impairments of Long-Lived Tangible, Intangible Assets and Goodwill - Our indefinite-lived assets include goodwill and other intangibles, primarily trademarks and brand names. Trademarks and brand names are integral to our corporate identity and expected to contribute indefinitely to our corporate cash flows. Accordingly, they have been assigned an indefinite life. We conduct our annual impairment tests for these indefinite-lived intangible assets and goodwill during the fourth quarter. These assets undergo more frequent tests if an indication of possible impairment exists. We conduct impairment tests for tangible assets and definite-lived intangible assets when indicators of impairment exist, such as operating losses and/or negative cash flows. In connection with the performance of an impairment test for tangible assets and definite-lived intangible assets, we compare the carrying amount of the asset group to the estimated undiscounted future cash flows expected to be generated by the assets. If the undiscounted cash flows of the asset group/reporting unit are less than the carrying value, an estimate of an asset group’s/reporting unit’s fair value is based on discounted future cash flows expected to be generated by the asset group/reporting unit, or based on management’s estimated exit price assuming the assets could be sold in an orderly transaction between market participants or estimated salvage value if no sale is assumed. If the fair value is less than the carrying value of the asset group/reporting unit, we record an impairment charge equal to the difference between the fair value and carrying value of the asset group/reporting unit. In connection with the performance of an impairment test for indefinite-lived intangible assets and goodwill, we compare the carrying amount of the asset (when testing indefinite-lived intangible assets) and reporting unit (when testing goodwill) to the estimated fair value. For indefinite-lived intangible assets, the estimated fair value is based on discounted future cash flows using the relief from royalty method. For goodwill, the estimated fair value is based on discounted future cash flows expected to be generated by the reporting unit. If the fair value is less than the carrying value of the asset/reporting unit, we record an impairment charge equal to the difference between the fair value and carrying value of the asset/reporting unit. The principal assumptions used in our impairment tests for definite-lived intangible assets is operating profit adjusted for depreciation and amortization and, if required to estimate the fair value, the discount rate. The principal assumptions used in our impairment tests for indefinite-lived intangible assets include revenue growth rate, discount rate and royalty rate. The principal assumptions utilized in our impairment tests for goodwill include after-tax cash flows growth rates and discount rate. Revenue growth rates, after-tax cash flows growth rates and operating profit assumptions are derived from those used in our operating plan and strategic planning processes. The discount rate assumption is calculated based upon an estimated weighted average cost of capital which reflects the overall level of inherent risk and the rate of return a market participant would expect to achieve. The royalty rate assumption represents the estimated contribution of the intangible assets to the overall profits of the related businesses. In 2019, indefinite-lived intangibles and goodwill were tested for impairment based on our identified asset groups/reporting units. There were no material impairment charges recorded in 2019, 2018 or 2017 related to intangible assets. We did not test tangible assets within our continuing operations for impairment in 2019, 2018 or 2017 as no indicators of impairment existed. The cash flow estimates used in applying our impairment tests are based on management’s analysis of information available at the time of the impairment test. Actual cash flows lower than the estimate could lead to significant future impairments. If subsequent testing indicates that fair values have declined, the carrying values would be reduced and our future statements of income would be affected. Management’s Discussion and Analysis of Financial Condition and Results of Operations We cannot predict the occurrence of certain events that might lead to material impairment charges in the future. Such events may include, but are not limited to, the impact of economic environments, particularly related to the commercial and residential construction industries, material adverse changes in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. See Notes 3 and 13 to the Consolidated Financial Statements for further information. Environmental Liabilities - We are actively involved in the investigation, closure and/or remediation of existing or potential environmental contamination under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), and state Superfund and similar type environmental laws at several domestically owned, formerly owned and non-owned locations allegedly resulting from past industrial activity. In a few cases, we are one of several potentially responsible parties and have agreed to jointly fund the required investigation, while preserving our defenses to the liability. We may also have rights of contribution or reimbursement from other parties or coverage under applicable insurance policies. We provide for environmental remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Accruals are estimates based on the judgment of management related to ongoing proceedings. Estimates of our future liability at the environmental sites are based on evaluations of currently available facts regarding each individual site. In determining the probability of contribution, we consider the solvency of other parties, the site activities of other parties, whether liability is being disputed, the terms of any existing agreements and experience with similar matters, and the effect of our October 2006 Chapter 11 reorganization upon the validity of the claim. We evaluate the measurement of recorded liabilities each reporting period based on current facts and circumstances specific to each matter. The ultimate losses incurred upon final resolution may materially differ from the estimated liability recorded. Changes in estimates are recorded in earnings in the period in which such changes occur. We are unable to predict the extent to which any recoveries from other parties or coverage under insurance policies might cover our final share of costs for these sites. Our final share of investigation and remediation costs may exceed any such recoveries, and such amounts net of insurance recoveries may be material. ACCOUNTING PRONOUNCEMENTS EFFECTIVE IN FUTURE PERIODS See Note 2 to the Consolidated Financial Statements for further information. RESULTS OF OPERATIONS This section of this Form 10-K generally discusses 2019 and 2018 items and year-to-year comparisons between 2019 and 2018. Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2018. Unless otherwise indicated, net sales in these results of operations are reported based upon the AWI location where the sale was made. Please refer to Notes 3 and 6 to the Consolidated Financial Statements for a reconciliation of segment operating income to consolidated earnings from continuing operations before income taxes and additional financial information related to discontinued operations. 2019 COMPARED TO 2018 CONSOLIDATED RESULTS FROM CONTINUING OPERATIONS (dollar amounts in millions) Consolidated net sales increased due to favorable AUV of $44 million and higher volumes of $19 million. Mineral Fiber net sales increased by $25 million and Architectural Specialties net sales increased by $38 million. Cost of goods sold was 61.9% of net sales in 2019, compared to 65.8% in 2018. The decrease in cost of goods sold as a percent of net sales in comparison to 2018 was driven primarily by a $27 million reduction in cost of goods sold due to savings from the closure of Management’s Discussion and Analysis of Financial Condition and Results of Operations our St. Helens manufacturing plant during the second quarter of 2018, combined with the absence of accelerated depreciation and related costs attributable to the closed facility, and increased price realization in excess of inflation. SG&A expenses in 2019 were $174.3 million, or 16.8% of net sales, compared to $159.0 million, or 16.3% of net sales, in 2018. The increase in SG&A expenses was primarily due to a $13 million increase in legal and professional fees, including expenses and attorney’s fees paid under our litigation settlement agreement with Roxul USA, Inc. (“Rockfon”). Also contributing to the increase in SG&A expenses was the impact of the 2018 Acquisitions and the 2019 Acquisitions. Partially offsetting the impact of these increases in SG&A expenses was $5 million of cost reimbursements, net of expenses, earned in 2019 under our Transition Services Agreement with Knauf and a $4 million reduction in share-based compensation expense. Equity earnings from our WAVE joint venture were $96.6 million in 2019, compared to $74.9 million in 2018. During 2019 and as a result of the Sale, we recorded a $21 million increase in WAVE equity earnings, representing our share of WAVE’s gain on sale of its discontinued European and Pacific Rim businesses, net of a $4 million write-off related to our WAVE fresh-start reporting for customer relationship and developed technology intangible assets. Excluding the impact of our portion of WAVE’s gain on the Sale and the write-off, WAVE equity earnings increased as a result of increases in AUV, partially offset by investments in manufacturing and lower volumes. Negatively impacting WAVE equity earnings for 2019 was a $1 million partial pension settlement charge. See Note 11 to the Consolidated Financial Statements for further information. Interest expense was $38.4 million in 2019, compared to $39.2 million in 2018. The decrease in interest expense in 2019 was driven primarily by lower interest rates and the refinancing of our credit facility on September 30, 2019. In connection with the refinancing, we wrote off $2.7 million of unamortized debt financing costs, included as a component of interest expense, related to our previous credit facility. Other non-operating income was $20.4 million in 2019, compared to $32.5 million in 2018. The decrease was primarily related to lower credits from non-service cost components associated with our RIP. See Note 18 to the Consolidated Financial Statements for further information. Income tax expense was $57.1 million in 2019, compared to $53.1 million in 2018. The effective tax rate for 2019 was 19.1% as compared to a rate of 21.9% for 2018. The effective tax rate was lower in 2019 as a result of our share of WAVE’s gain on sale of its EMEA and Pacific Rim businesses having no related income tax expense, in addition to a favorable impact of state deferred tax asset adjustments. Total other comprehensive income (loss) (“OCI”) was $83.4 million of income in 2019, compared to a $59.4 million loss for 2018. The change was driven by $83.8 million of Accumulated Other Comprehensive Income (“AOCI”) adjustments related primarily to foreign currency translation adjustments that were reclassified out of AOCI concurrent with the Sale. Foreign currency translation adjustments represent the change in the U.S. dollar value of assets and liabilities denominated in foreign currencies. Also impacting the change in OCI in both periods was pension and postretirement adjustments and derivative losses. Pension and postretirement adjustments represent the amortization of actuarial gains and losses related to our defined benefit pension and postretirement plans. Derivative gain/loss represents the mark-to-market value adjustments of our derivative assets and liabilities and the recognition of gains and losses previously deferred in OCI. REPORTABLE SEGMENT RESULTS Mineral Fiber (dollar amounts in millions) Net sales increased due to favorable AUV of $44 million, partially offset by lower volumes of $19 million. The favorable AUV was due to favorable price and improved mix from the sale of higher end ceiling tile products. Operating income increased due primarily to a $21 million increase in WAVE equity earnings relating to the Sale. Also contributing to the increase was $31 million of favorable AUV and a $27 million increase in operating income due to savings from the closure of our St. Helens manufacturing plant during the second quarter of 2018, combined with the absence of accelerated depreciation and related costs attributable to the closed facility. Partially offsetting the operating income increase was a $13 million increase in costs Management’s Discussion and Analysis of Financial Condition and Results of Operations associated with the Rockfon litigation settlement, a $12 million negative impact from lower volumes, $5 million of cost reimbursements, net of related expenses, earned in 2019 under our Transition Services Agreement with Knauf, and a $4 million reduction in share-based compensation expense. Architectural Specialties (dollar amounts in millions) Net sales increased due to the full year impact of the 2018 Acquisitions, and the 2019 Acquisitions (see table in Factors Affecting Revenue), in addition to higher volumes from increased market penetration as a result of an expanded range of product offerings, and new construction activity. Operating income increased due to the positive impact of higher sales volume, partially offset by additional investments in selling and design capacities and intangible asset amortization expense related to the 2018 Acquisitions and the 2019 Acquisitions. Unallocated Corporate Unallocated Corporate expense of $8 million decreased from $9 million in the prior year primarily due to lower service cost associated with our RIP. FINANCIAL CONDITION AND LIQUIDITY Cash Flow The discussion that follows includes cash flows related to discontinued operations, primarily operations sold in the Sale. Operating activities for 2019 provided $182.7 million of cash, compared to $203.2 million of cash provided in 2018. The decrease was primarily due to an increase in working capital, most notably a decrease in receipts of environmental insurance settlements, partially offset by higher cash earnings. Net cash used for investing activities was $89.1 million for 2019, compared to $309.6 million of cash provided in 2018. The decrease resulted primarily from $47.9 million of payments to Knauf as a result of the Sale combined with the absence of $330.0 million of proceeds received from Knauf in 2018 related to the sale of our EMEA and Pacific Rim businesses, partially offset by $70.0 million of payments to WAVE. Also contributing to the decrease was the cash paid for the acquisitions of ACGI and MRK, and a decrease in dividends from our WAVE joint venture. Net cash used for financing activities was $384.9 million in 2019, compared to $329.3 million in 2018. The unfavorable change in use of cash was primarily due to higher net debt payments as a result of our September 2019 debt refinancing, higher share tax withholdings from employee stock awards and the payment of dividends, partially offset by a lower repurchases of outstanding common stock. Liquidity Our liquidity needs for operations vary throughout the year. We retain lines of credit to facilitate our seasonal cash flow needs, since cash flow is generally lower during the first and fourth quarters of our fiscal year. As of June 30, 2019, total debt outstanding under our $1,050.0 million variable rate senior credit facility was $525.0 million under Term Loan A and $241.9 million under Term Loan B, with no borrowings outstanding under the revolving credit facility. On July 3, 2019, we used cash on hand to make a voluntary prepayment of $100.0 million of the debt outstanding under Term Loan B. Term Loan B was priced at 2.75% over the London Interbank Offered Rate (“LIBOR”). On September 30, 2019, we refinanced our $1,050.0 million variable rate senior credit facility, using cash on hand to pay down a portion of the debt outstanding, including the debt outstanding under Term Loan B. The $1,000.0 million amended senior credit facility is composed of a $500.0 million revolving credit facility (with a $150.0 million sublimit for letters of credit) and a $500.0 million Term Loan A. The terms of the amended credit facility resulted in a lower interest rate spread for both the revolving credit facility (2.00% to 1.50% over LIBOR) and Term Loan A (1.75% to 1.50% over LIBOR). We also extended the maturity of both the revolving credit facility and Term Loan A from April 2021 Management’s Discussion and Analysis of Financial Condition and Results of Operations to September 2024. The $1,000.0 million senior credit facility is secured by the capital stock of material U.S. subsidiaries and a pledge of 65% of the stock of our material first-tier foreign subsidiaries, primarily Canada. The unpaid balances of the revolving credit facility and Term Loan A may be prepaid without penalty at the maturity of their respective interest reset periods. Any principal amounts paid on the Term Loan A may not be re-borrowed. As of December 31, 2019, total borrowings outstanding under our senior credit facility were $115.0 million under the revolving credit facility and $500.0 million under Term Loan A. The refinanced senior credit facility includes two financial covenants that require the ratio of consolidated earnings before interest, taxes, depreciation and amortization (“EBITDA”) to consolidated cash interest expense minus cash consolidated interest income to be greater than or equal to 3.0 to 1.0 and requires the ratio of consolidated funded indebtedness, minus AWI and domestic subsidiary unrestricted cash and cash equivalents up to $100 million, to EBITDA to be less than or equal to 3.75 to 1.0. As of December 31, 2019, we were in compliance with all covenants of the senior credit facility. The Term Loan A is fully drawn and is currently priced on a variable interest rate basis. The following table summarizes our interest rate swaps (dollar amounts in millions): Under the terms of the November 2016 swap maturing in 2021, we receive 3-month LIBOR and pay a fixed rate over the hedged period, in addition to a basis rate swap to convert the floating rate risk under our November 2016 swap from 3-month LIBOR to 1-month LIBOR. As a result, we receive 1-month LIBOR and pay a fixed rate over the hedged period. Under the terms of the November 2018 swap maturing in 2023, we pay a fixed rate over the hedged amount and receive a 1-month LIBOR. This is inclusive of a 0% floor. Under the terms of the forward starting November 2018 swap maturing in 2025, we will pay a fixed rate monthly and receive 1-month LIBOR. This is inclusive of a 0% floor. These swaps are designated as cash flow hedges against changes in LIBOR for a portion of our variable rate debt. During the fourth quarter of 2019, we used proceeds from our revolving credit facility to pay off a $35.0 million variable rate, tax exempt industrial development bond that financed the construction of a plant in prior years. The bond was remarketed by an agent on a regular basis at a market-clearing interest rate. As of December 31, 2019, we had $45.3 million of cash and cash equivalents, $29.8 million in the U.S and $15.5 million in various foreign jurisdictions, primarily Canada. As of December 31, 2019, we had a $36.2 million Accounts Receivable Securitization Facility with the Bank of Nova Scotia (the “funding entity”) that matures in March 2020. Under this facility, we sell accounts receivables to Armstrong Receivables Company, LLC (“ARC”), a Delaware entity that is consolidated in these financial statements. ARC is a 100% wholly-owned single member limited liability company special purpose entity created specifically for this transaction; therefore, any receivables sold to ARC are not available to the general creditors of AWI. ARC then sells an undivided interest in the purchased accounts receivables to the funding entity. This undivided interest acts as collateral for drawings on the facility. Any borrowings under this facility are obligations of ARC and not AWI. ARC contracts with and pays a servicing fee to AWI to manage, collect and service the purchased accounts receivables. All new receivables under the program are continuously purchased by ARC with the proceeds from collections of receivables previously purchased. During the first quarter of 2020, we expect to amend the facility to reduce the purchase limit from $36.2 million to $30.0 million and to extend its maturity to March 2021. Management’s Discussion and Analysis of Financial Condition and Results of Operations We utilize lines of credit and other commercial commitments in order to ensure that adequate funds are available to meet operating requirements. Letters of credit are currently arranged through our revolving credit facility, our bi-lateral facility and our securitization facility. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table presents details related to our letters of credit (dollar amounts in millions): As of December 31, 2019, there was no restricted cash under our accounts receivable securitization facility for letters of credit issued in excess of our maximum limit. As of December 31, 2018, $6.0 million of letters of credit issued under our accounts receivable securitization facility in excess of our maximum limit was classified as restricted cash and reported as a component of Cash and cash equivalents on our Consolidated Balance Sheets. We believe that cash on hand and cash generated from operations, together with lines of credit, availability under our revolving credit facility, will be adequate to address our foreseeable liquidity needs based on current expectations of our business operations, capital expenditures and scheduled payments of debt obligations. OFF-BALANCE SHEET ARRANGEMENTS No disclosures are required pursuant to Item 303(a)(4) of Regulation S-K. CONTRACTUAL OBLIGATIONS As part of our normal operations, we enter into numerous contractual obligations that require specific payments during the term of the various agreements. The following table includes amounts ongoing under contractual obligations existing as of December 31, 2019. Only known payments that are dependent solely on the passage of time are included. Obligations under contracts that contain minimum payment amounts are shown at the minimum payment amount. Contracts that contain variable payment structures without minimum payments are excluded. Purchase orders that are entered into in the normal course of business are also excluded because they are generally cancelable and not legally binding. Amounts are presented below based upon the currently scheduled payment terms. Actual future payments may differ from the amounts presented below due to changes in payment terms or events affecting the payments. (1) Excludes $4.2 million of unamortized debt financing costs as of December 31, 2019. (2) For debt with variable interest rates and interest rate swaps, we projected future interest payments based on market-based interest rate swap curves. (3) Lease obligations include the undiscounted lease payments due under existing agreements with non-cancelable lease terms in excess of one year. Reasonably certain renewal periods are included and non-lease components are excluded. (4) Unconditional purchase obligations include (a) purchase contracts whereby we must make guaranteed minimum payments of a specified amount regardless of how little material is actually purchased (“take or pay” contracts) and (b) service agreements. Unconditional purchase obligations exclude contracts entered into during the normal course of business that are non-cancelable and have fixed per unit fees, but where the monthly commitment varies based upon usage. Cellular phone contracts are an example. Management’s Discussion and Analysis of Financial Condition and Results of Operations (5) Pension contributions include estimated contributions for our unfunded U.S. Retirement Benefit Equity Plan. We are not presenting estimated payments in the table above beyond 2024 as funding can vary from year to year based upon changes in funding regulations and actuarial assumptions. The table above excludes $34.7 million of unrecognized tax benefit liabilities under ASC 740 “Income Taxes.” Due to the uncertainty relating to these positions, we are unable to reasonably estimate the ultimate amount or timing of the settlement of these issues. See Note 16 to the Consolidated Financial Statements for more information. This table excludes obligations related to postretirement benefits (retiree health care and life insurance) since we voluntarily provide these benefits. The amount of benefit payments we made in 2019 was $9.4 million. See Note 18 to the Consolidated Financial Statements for additional information regarding future expected cash payments for postretirement benefits. Letters of credit are currently arranged through our bi-lateral facility. Letters of credit may be issued to third party suppliers, insurance and financial institutions and typically can only be drawn upon in the event of AWI’s failure to pay its obligations to the beneficiary. The following table summarizes the commitments we have available for use as of December 31, 2019. In connection with our disposition of certain assets through a variety of unrelated transactions, we have entered into contracts that included various indemnity provisions, some of which are customary for such transactions, while others hold the acquirer of the assets harmless with respect to liabilities relating to such matters as taxes, environmental and other litigation. Some of these provisions include exposure limits, but many do not. Due to the nature of the indemnities, it is not possible to estimate the potential maximum exposure under these contractual provisions. As of December 31, 2019, we had no liabilities recorded for which an indemnity claim had been received.

<s>[INST] Armstrong World Industries, Inc. (“AWI”) is a Pennsylvania corporation incorporated in 1891. This discussion should be read in conjunction with the financial statements, the accompanying notes, the cautionary note regarding forwardlooking statements and risk factors included in this Form 10K. Overview We are a leading producer of ceiling systems for use in the construction and renovation of commercial and residential buildings. We design, manufacture and sell ceiling and wall systems (primarily mineral fiber, fiberglass wool, metal, wood, wood fiber, glassreinforcedgypsum and felt) throughout the Americas. Acquisitions In November 2019, we acquired the business and assets of MRK Industries, Inc. (“MRK”), based in Libertyville, Illinois. MRK is a manufacturer of specialty metal ceiling, wall and exterior solutions with one manufacturing facility. MRK’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In March 2019, we acquired the business and assets of Architectural Components Group, Inc. (“ACGI”), based in Marshfield, Missouri. ACGI is a manufacturer of custom wood ceilings and walls with one manufacturing facility. ACGI’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In August 2018, we acquired the business and assets of Steel Ceilings, Inc. (“Steel Ceilings”), based in Johnstown, Ohio. Steel Ceilings is a manufacturer of aluminum and stainless metal ceilings that include architectural, radiant and security solutions with one manufacturing facility. Steel Ceilings’ operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In May 2018, we acquired the business and assets of Plasterform, Inc. (“Plasterform”), based in Mississauga, Ontario, Canada. Plasterform is a manufacturer of architectural cast ceilings, walls, facades, columns and moldings with one manufacturing facility. Plasterform’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. In January 2017, we acquired the business and assets of Tectum, Inc. (“Tectum”), based in Newark, Ohio. Tectum is a manufacturer of acoustical ceiling, wall and structural solutions for commercial building applications with two manufacturing facilities. Tectum’s operations, and its assets and liabilities, are included as a component of our Architectural Specialties segment. Discontinued Operations On September 30, 2019, we completed the previously announced sale of certain subsidiaries comprising our businesses and operations in Europe, the Middle East and Africa (including Russia) (“EMEA”) and the Pacific Rim, including the corresponding businesses and operations conducted by Worthington Armstrong Venture (“WAVE”), our joint venture with Worthington Industries, Inc. (“Worthington”) in which AWI holds a 50% interest (collectively, the “Sale”), to Knauf International GmbH (“Knauf”). The purchase price of $330.0 million was previously paid by Knauf to us during the third quarter of 2018 and is subject to certain postclosing adjustments for cash and debt as provided in the Share Purchase Agreement dated as of November 17, 2017, by and between us and Knauf (the “Purchase Agreement”), including adjustments based on the economic impact of any required regulatory remedies and a working capital adjustment. On July 18, 2018, we entered into an amendment to the Purchase Agreement, pursuant to which Knauf irrevocably and unconditionally paid AWI (i) $250.0 million of the purchase price on August 1, 2018, and (ii) $80.0 million of the purchase price on September 15, 2018, which payments were credited against the aggregate consideration payable at closing. The amendment also provided for the reduction (from a maximum of $35.0 million to a maximum of $ [/INST] Positive. </s>

HEALTHSOUTH CORP

2015-03-02

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business With the acquisition of Encompass discussed below, HealthSouth is one of the nation’s largest providers of post-acute healthcare services, offering both facility-based and home-based post-acute services in 33 states and Puerto Rico through its network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As of December 31, 2014, we operated 107 inpatient rehabilitation hospitals (including one hospital that operates as a joint venture which we account for using the equity method of accounting). While our national network of inpatient hospitals stretches across 29 states and Puerto Rico, our inpatient hospitals are concentrated in the eastern half of the United States and Texas. In addition to HealthSouth hospitals, we manage three inpatient rehabilitation units through management contracts. For additional information about our business, see Item 1, Business. Encompass Acquisition On December 31, 2014, we completed the previously announced acquisition of EHHI Holdings, Inc. (“EHHI”) and its Encompass Home Health and Hospice business (“Encompass”). Encompass is the nation’s fifth largest provider of Medicare-certified skilled home health services. In the acquisition, we acquired, for cash, all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to HealthSouth Home Health Holdings, Inc. (“Holdings”), a subsidiary of HealthSouth and now indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. These certain sellers were members of Encompass management, including April Anthony, the Chief Executive Officer of Encompass. These sellers contributed a portion of their shares of common stock of EHHI, valued at approximately $64.5 million, in exchange for shares of common stock of Holdings. As a result of that contribution, they hold approximately 16.7% of the outstanding common stock of Holdings, while HealthSouth owns the remainder. In addition, Ms. Anthony and certain other employees of Encompass entered into amended and restated employment agreements, each agreement having an initial term of three years. We funded the cash purchase price in the acquisition entirely with draws under the revolving and expanded term loan facilities of our credit agreement. The total cash consideration delivered at closing was $695.5 million. Encompass operates in 135 locations across 12 states and has approximately 4,900 employees making more than 2.1 million patient visits annually. For the year ended December 31, 2014, Encompass had total revenues of approximately $369 million, which are not included in the accompanying consolidated statement of operations. Encompass provides: • home health services - a comprehensive range of Medicare-certified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational and speech therapy, medical social work, and home health aide services. Encompass also provides specialized home care services in Texas and Kansas for pediatric patients with severe medical conditions. Encompass’ home health services have historically represented a substantial portion of its revenues. For the year ended December 31, 2014, these services represented approximately 94% of Encompass’ total revenues. • hospice services - primarily in-home services to terminally ill patients and their families to address the patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. For the year ended December 31, 2014, these services represented approximately 6% of Encompass’ total revenues. We believe Encompass will provide us with a high-quality, scalable asset that is capable of participating in the consolidation of the highly fragmented home health industry. Encompass has demonstrated an ability to acquire under-performing operations and incorporate them into its existing platform. As part of HealthSouth, we believe Encompass will be able to consider more numerous and significant home health acquisition opportunities given our strong cash flows from operations and our access to capital. We also believe this acquisition will further our long-term growth strategy of expanding into post-acute services that complement our core business of operating inpatient rehabilitation hospitals. Specifically, we believe the acquisition of Encompass will enhance our ability to provide a continuum of facility-based and home-based post-acute services to our patients and their families, which we believe will become increasingly important as coordinated care delivery models, such as accountable care organizations (“ACOs”) and bundled payment arrangements, become more prevalent. We intend to transition our existing 25 hospital-based home health operations to the Encompass platform in 2015. Home health and hospice will represent a separate operating segment for us going forward. See Item 1, Business, and Item 1A, Risk Factors, of this report, Note 2, Business Combinations, and Note 8, Long-term Debt, to the accompanying consolidated financial statements, and the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item. 2014 Overview Our 2014 strategy focused on the following priorities: • continuing to provide high-quality, cost-effective care to patients in our existing markets; • achieving organic growth at our existing hospitals; • expanding our services to more patients who require inpatient rehabilitative services by constructing and acquiring new hospitals in new markets; • continuing our shareholder value-enhancing strategies such as common stock dividends and repurchases of our common stock; and • positioning the Company for continued success in the evolving healthcare delivery system. This preparation includes continuing the installation of our electronic clinical information system which allows for interfaces with all major acute care electronic medical record systems and health information exchanges, participating in bundling projects and ACOs, and evaluating potential service line expansions via acquisitions. During 2014, discharge growth of 3.5% coupled with a 3.1% increase in net patient revenue per discharge generated 6.7% growth in net patient revenue from our hospitals compared to 2013. Discharge growth was comprised of 2.2% growth from new stores and a 1.3% increase in same-store discharges. Our quality and outcome measures, as reported through the Uniform Data System for Medical Rehabilitation (the “UDS”), remained well above the average for hospitals included in the UDS database, and they did so while we continued to increase our market share throughout 2014. Not only did our hospitals treat more patients and enhance outcomes, they did so in a highly cost-effective manner. See the “Results of Operations” section of this Item. Likewise, our growth efforts continued to yield positive results in 2014. Specifically, we: • acquired an additional 30% equity interest from UMass Memorial Health Care, our joint venture partner in Fairlawn Rehabilitation Hospital (“Fairlawn”) in Worcester, Massachusetts in June 2014. This transaction increased our ownership interest from 50% to 80% and resulted in a change in accounting for this hospital from the equity method of accounting to a consolidated entity; • began accepting patients at our newly built, 50-bed inpatient rehabilitation hospital in Altamonte Springs, Florida in October 2014; • created, in October 2014, a joint venture with Memorial Health to own and operate a 50-bed inpatient rehabilitation hospital in Savannah, Georgia. Initially, this hospital will operate in the current location of Memorial Health’s 50-bed Rehabilitation Institute on Memorial University Medical Center’s campus. The joint venture plans to build a new, 50-bed replacement inpatient rehabilitation hospital, which is expected to be completed in early 2016. We expect to begin operating the inpatient rehabilitation hospital at Memorial University Medical Center in the first half of 2015; • acquired Quillen Rehabilitation Hospital, a 26-bed inpatient rehabilitation hospital in Johnson City, Tennessee, in November 2014 through a joint venture with Mountain States Health Alliance; • began accepting patients at our newly built, 50-bed inpatient rehabilitation hospital in Newnan, Georgia in December 2014; • began accepting patients at our newly built, 34-bed inpatient rehabilitation hospital in Middletown, Delaware in December 2014; • continued our capacity expansions by adding 51 new beds to existing hospitals; and • continued development of the following de novo hospitals: *In August 2014, we acquired land and began the design and permitting process to build an inpatient rehabilitation hospital. We also continued our shareholder value-enhancing strategies in 2014. Namely, we: • increased our board-approved stock repurchase authorization from $200 million to $250 million in February 2014 and repurchased 1.3 million shares of our common stock in the open market for $43.1 million during the first and second quarters of 2014, leaving approximately $207 million remaining under this repurchase authorization and • paid approximately $66 million in cash dividends on our common stock and increased the quarterly cash dividend by 16.7% from $0.18 per share to $0.21 per share effective with the October 2014 dividend payment. While continuing our shareholder value-enhancing strategies, we also took additional steps to increase the strength and flexibility of our balance sheet. Specifically, we: • amended our credit agreement in September and December 2014 to, among other things, add $450 million of term loan facility capacity, permit unlimited restricted payments so long as the senior secured leverage ratio remains less than or equal to 1.75x, and extend the revolver maturity to September 2019; • redeemed the outstanding principal amount, or approximately $271 million in principal, of our 7.25% Senior Notes due 2018 in October 2014 using the net proceeds from an additional $175 million offering of our existing 5.75% Senior Notes due 2024, a $75 million draw under our term loan facilities, and cash on hand; • redeemed approximately $25 million of the outstanding principal amount of our existing 7.75% Senior Notes due 2022 in December 2014. This optional redemption represented 10% of the outstanding principal amount of the notes at a price of 103%, which resulted in a total cash outlay of approximately $26 million; and • purchased the real estate previously subject to a lease associated with our hospital in San Antonio, Texas. For additional information regarding these actions, see Note 8, Long-term Debt, to the accompanying consolidated financial statements and the “Liquidity and Capital Resources” section of this Item. Business Outlook We believe our business outlook remains positive for two primary reasons. First, demographic trends, such as population aging, should increase long-term demand for facility-based and home-based post-acute services. While we treat patients of all ages, most of our patients are 65 and older, and the number of Medicare enrollees is expected to grow approximately 3% per year for the foreseeable future. We believe the demand for facility-based and home-based post-acute services will continue to increase as the U.S. population ages and life expectancies increase. Second, we are an industry leader in this growing sector. As the nation’s largest owner and operator of inpatient rehabilitation hospitals, we believe we differentiate ourselves from our competitors based on our broad platform of clinical expertise, the quality of our clinical outcomes, the sustainability of best practices, our financial strength, and the application of rehabilitative technology. With the recent acquisition of Encompass, we are the fifth largest provider of Medicare-certified skilled home health services, and we look forward to combining our strengths as operators of inpatient rehabilitation hospitals with those of a proven home health and hospice provider that offers exceptional home-based patient care in a cost efficient manner. We have invested considerable resources into clinical and management systems and protocols that have allowed us to consistently produce high-quality outcomes for our patients while continuing to contain cost growth. Our proprietary hospital management reporting system aggregates data from each of our key business systems into a comprehensive reporting package used by the management teams in our hospitals, as well as executive management, and allows them to analyze data and trends and create custom reports on a timely basis. Our commitment to technology also includes the on-going implementation of our rehabilitation-specific electronic clinical information system. As of December 31, 2014, we had installed this system in 58 of our 107 hospitals. We believe this system will improve patient care and safety, enhance staff recruitment and retention, and set the stage for connectivity with other providers and health information exchanges. Encompass also utilizes information technology to enhance patient care and manage costs. Specifically, Encompass utilizes Homecare HomebaseSM, a comprehensive information platform that allows home health providers to process clinical, compliance, and marketing information as well as analyze data and trends for management purposes using custom reports on a timely basis. This allows Encompass to manage the entire patient work flow and provide valuable data for health systems, payors, and ACO partners. Encompass is currently party to one newly formed ACO serving 20,000 patients and is exploring several other participation opportunities. We believe these factors align with our strengths in, and focus on, post-acute services. In addition, we believe we can address the demand for facility-based and home-based post-acute services in markets where we currently do not have a presence by constructing or acquiring new hospitals and by acquiring home health and hospice agencies in that highly fragmented industry. Longer-term, the nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain and will likely remain so for some time, as the development of new delivery and payment systems will almost certainly require significant time and resources. Furthermore, many of the alternative approaches being explored may not work as intended. However, as outlined in the “Key Challenges-Changes to Our Operating Environment Resulting from Healthcare Reform” section below, our goal is to position the Company in a prudent manner to be responsive to industry shifts. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2019. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. Our balance sheet remains strong. We have significant availability under our revolving credit facility, and we continue to generate strong cash flows from operations. Importantly, we have flexibility with how we choose to invest our cash and return value to shareholders, including bed additions, de novos, acquisitions of inpatient rehabilitation hospitals, home health agencies, and hospice agencies, common stock dividends, repurchases of our common and preferred stock, and repayments of long-term debt. For these and other reasons, we believe we will be able to adapt to changes in reimbursement, sustain our business model, and grow through acquisition and consolidation opportunities as they arise. Key Challenges The healthcare industry is facing many well-publicized regulatory and reimbursement challenges. The industry is also facing uncertainty associated with the efforts, primarily arising from initiatives included in the 2010 Healthcare Reform Laws (as defined in Item 1, Business, “Regulatory and Reimbursement Challenges”) to identify and implement workable coordinated care delivery models. Successful healthcare providers are those who provide high-quality, cost-effective care and have the ability to adjust to changes in the regulatory and operating environments. We believe we have the necessary capabilities - scale, infrastructure, balance sheet, and management - to adapt to changes and continue to succeed in a highly regulated industry, and we have a proven track record of doing so. As we continue to execute our business plan, the following are some of the challenges we face: • Operating in a Highly Regulated Industry. We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These rules and regulations have affected, or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the costs of compliance, mandating new documentation standards, requiring additional licensure or certification of our hospitals, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and limiting our ability to enter new markets or add new beds to existing hospitals. Ensuring continuous compliance with extensive laws and regulations is an operating requirement for all healthcare providers. We have invested, and will continue to invest, substantial time, effort, and expense in implementing and maintaining training programs as well as internal controls and procedures designed to ensure regulatory compliance, and we are committed to continued adherence to these guidelines. More specifically, because Medicare comprises a significant portion of our Net operating revenues, it is important for us to remain compliant with the laws and regulations governing the Medicare program and related matters including anti-kickback and anti-fraud requirements. If we were unable to remain compliant with these regulations, our financial position, results of operations, and cash flows could be materially, adversely impacted. As discussed in Item 1, Business, “Sources of Revenues,” in connection with United States Centers for Medicare and Medicaid Services (“CMS”) approved and announced Recovery Audit Contractor (“RAC”) audits related to inpatient rehabilitation facilities (“IRFs”), we have received requests to review certain patient files for discharges occurring from 2010 to 2014. To date, the Medicare payments that are subject to these audit requests represent less than 1% of our Medicare patient discharges during those years, and not all of these patient file requests have resulted in payment denial determinations by the RACs. Because we have confidence in the medical judgment of both the referring and the admitting physicians who assess the treatment needs of their patients, we have appealed substantially all RAC denials arising from these audits. The contracts awarded to RACs by CMS were set to expire in February 2014, but they have been extended and modified pending finalization of new contracts. In late February 2014, CMS announced it would pause the operations of the current RACs until new contracts are awarded, meaning that hospitals would not receive any new requests from RACs until that time. Legal challenges to the contract award process have delayed finalizing the new contracts longer than expected, and as a result, CMS modified the existing RAC contracts to allow some RAC reviews to be restarted on a limited basis. Additionally, on December 30, 2014, CMS announced the beginning of a new contract for the RAC assigned to audit payments for home health and hospice services, which has subsequently been delayed by another challenge. Once the new contracts are in place, whether for IRFs or home health and hospice agencies, the associated RACs will be able to audit claims for dates of service during the time period covered by the pause in RAC operations. We cannot predict when the legal challenges to the new contracts will be resolved or when CMS will otherwise finalize the new RAC contracts. While we make provisions for these claims based on our historical experience and success rates in the claims adjudication process, which is the same process we follow for appealing denials of certain diagnosis codes by Medicare Administrative Contractors (“MACs”), we cannot provide assurance as to our future success in the resolution of these and future disputes, nor can we predict or estimate the scope or number of denials that ultimately may be received. Another challenge relates to reduced Medicare reimbursement, which is also discussed in Item 1A, Risk Factors. Unless the United States Congress acts to change or eliminate it, sequestration, which began affecting payments received after April 1, 2013, will continue to result in a 2% decrease to reimbursements otherwise due from Medicare, after taking into consideration other changes to reimbursement rates such as market basket updates. Additionally, concerns held by federal policymakers about the federal deficit, national debt levels, and reforming the sustainable growth rate formula used to pay physicians who treat Medicare beneficiaries (the so called “Doc Fix”) could result in enactment of further federal spending reductions, further entitlement reform legislation affecting the Medicare program, and/or further reductions to provider payments. Likewise, issues related to the federal budget or the unwillingness to raise the statutory cap on the federal government’s ability to issue debt, also referred to as the “debt ceiling,” may have a significant impact on the economy and indirectly on our results of operations and financial position. We cannot predict what alternative or additional deficit reduction initiatives, Medicare payment reductions, or post-acute care reforms, if any, will ultimately be enacted into law, or the timing or effect any such initiatives or reductions will have on us. If enacted, such initiatives or reductions would likely be challenging for all providers, would likely have the effect of limiting Medicare beneficiaries’ access to healthcare services, and could have an adverse impact on our financial position, results of operations, and cash flows. However, we believe our efficient cost structure coupled with the steps we have taken to reduce our debt and corresponding debt service obligations should allow us to absorb, adjust to, or mitigate any potential initiative or reimbursement reductions more easily than most other post-acute providers. See also Item 1, Business, “Sources of Revenues” and “Regulation,” and Item 1A, Risk Factors, to this report and Note 18, Contingencies and Other Commitments, “Governmental Inquiries and Investigations,” to the accompanying consolidated financial statements. • Changes to Our Operating Environment Resulting from Healthcare Reform. Our challenges related to healthcare reform are discussed in Item 1, Business, “Sources of Revenues,” and Item 1A, Risk Factors. Many provisions within the 2010 Healthcare Reform Laws have impacted, or could in the future impact, our business. Most notably for us are the reductions to our hospitals’ annual market basket updates, including productivity adjustments, mandated reductions to home health and hospice Medicare reimbursements, and future payment reforms such as ACOs and bundled payments. Given the complexity and the number of changes in the 2010 Healthcare Reform Laws, we cannot predict their ultimate impact. On July 31, 2014, CMS released its notice of final rulemaking for fiscal year 2015 (the “2015 Rule”) for IRFs under the prospective payment system (“IRF-PPS”). The 2015 Rule will implement a net 2.2% market basket increase effective for discharges between October 1, 2014 and September 30, 2015, calculated as follows: Market basket update 2.9% Healthcare reform reduction 20 basis points Productivity adjustment 50 basis points The 2015 Rule also includes other changes that impact our hospital-by-hospital base rate for Medicare reimbursement. Such changes include, but are not limited to, freezing the IRF-PPS facility-level rural adjustment factor, low-income patient factor, and teaching status adjustment factor and updating the outlier fixed loss threshold. Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the rule’s release and incorporates other adjustments included in the rule, we believe the 2015 Rule will result in a net increase to our Medicare payment rates of approximately 2.3% effective October 1, 2014, prior to the impact of sequestration. Additionally, the final rule introduces, beginning on October 1, 2015, a new data collection requirement that will capture the minutes and mode (individual, group, concurrent, or co-treatment) of therapy by specialty. CMS plans to use this data to potentially support future rule making in this area. Further, the final rule includes revisions to the list of codes used by CMS to presumptively test compliance with the 60% Rule. The post-amputation codes that CMS plans to eliminate represented approximately 0.5% of our 2013 Medicare discharges. CMS also will require reporting of two new quality measures, beginning January 1, 2015, and will conduct validation audits to ensure the completeness and accuracy of the quality data submitted. On October 30, 2014, CMS released the calendar year 2015 final rule for home health agencies under the prospective payment system (“HH-PPS”). CMS estimates the rule will cut Medicare payments to home health agencies by 0.3% in 2015. Specifically, while the rule provides for a market basket update of 2.6%, that update is offset by a 2.4% rebasing adjustment reduction (the second year of a four-year phase-in) and a productivity adjustment reduction of 50 basis points. We believe this final rule will result in a net decrease to Encompass’ Medicare payment rates of approximately 1.3% in calendar year 2015 before sequestration. The final rule also addresses a number of policy proposals. Notably, CMS is modifying the home health face-to-face encounter documentation requirements, including eliminating the narrative as part of the certification of eligibility and providing more flexibility in procedures for obtaining documentation supporting patient eligibility. CMS also discusses comments it received on a potential home health agency value-based purchasing model, under which CMS would test whether payment incentives would lead to higher quality of care for beneficiaries. CMS is considering testing such a model beginning in 2016. Additional details will be provided in future rulemaking. The healthcare industry in general is facing uncertainty associated with the efforts, primarily arising from initiatives included in the 2010 Healthcare Reform Laws, to identify and implement workable coordinated care delivery models. In a coordinated care delivery model, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the overall value of the services they provide to a patient rather than the number of services they provide. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new delivery model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are positioning the Company in preparation for whatever changes are ultimately made to the delivery system: • We have a track record of successful partnerships with acute care providers. Thirty-two of our hospitals already operate as joint ventures with acute care hospitals, and we continue to pursue joint ventures as one of our growth initiatives. These joint ventures create an immediate link to an acute care system and position us to quickly and efficiently integrate our services in a coordinated care model. • Our commitment to coordinated care is demonstrated and enhanced by the utilization of technology. Our hospital electronic clinical information system is capable of interfaces with all major acute care electronic medical record systems and health information exchanges making communication easier across the continuum of healthcare providers. Our home health and hospice clinical information system utilizes a leading home care technology that manages the entire patient work flow. Importantly, we have the ability to use data from both systems to develop clinical protocol best practices. • Our balance sheet is strong, and we have consistently strong free cash flows. We have no significant debt maturities prior to 2019, and we have significant liquidity under our revolving credit facility. In addition, we own the real estate associated with approximately 75% of our hospitals. • We have a proven track record of being a high-quality, cost-effective provider. The FIM® Gains (a tool based on an 18-point assessment used to measure functional independence from admission to discharge) at our inpatient rehabilitation hospitals consistently exceed industry results, and the re-hospitalization rates at our home health agencies are lower than the national average. In addition, we have the scale and operating leverage to generate a low cost per discharge/visit. • We are currently participating in several coordinated care delivery model initiatives and are exploring ACO participation in several others. We have 103 IRFs accepted into Phase 1 of Model 3 of the CMS Bundled Payments for Care Improvement (“BPCI”) initiative. In January 2015, we began the process to seek acceptance into Phase 2 of this initiative for five IRFs with an April 2015 start date. We have another opportunity, should we choose to pursue it, to submit additional IRFs into Phase 2 in March 2015 with a July 2015 start date. Encompass has 10 agencies participating in Phase 2 of Model 3 of the BPCI initiative. In addition, Encompass has partnered with Premier PHC™, an ACO serving 20,000 Medicare patients. Given the complexity and the number of changes in the 2010 Healthcare Reform Laws, we cannot predict their ultimate impact. In addition, the ultimate nature and timing of the transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. Additionally, in October 2014, the President signed into law the Improving Medicare Post-Acute Care Transformation Act of 2014 (the “IMPACT Act”). The IMPACT Act was developed on a bi-partisan basis by the House Ways and Means and Senate Finance Committees and incorporated feedback from healthcare providers and provider organizations that responded to the Committees’ solicitation of post-acute payment reform ideas and proposals. It directs the United States Department of Health and Human Services (“HHS”), in consultation with healthcare stakeholders, to implement standardized data collection processes for post-acute quality and outcome measures. Although the IMPACT Act does not specifically call for the development of a new post-acute payment system, we believe this act will lay the foundation for possible future post-acute payment policies that would be based on patients’ medical conditions and other clinical factors rather than the setting where the care is provided. It will create additional data reporting requirements for our hospitals and home health agencies, and we expect to fully comply with these requirements. The precise details of these new reporting requirements, including timing and content, will be developed and implemented by CMS through the regulatory process that we expect will take place over the next several years. While we cannot quantify the potential financial effects of the IMPACT Act on HealthSouth, we believe any post-acute payment system that is data-driven and focuses on the needs and underlying medical conditions of post-acute patients ultimately will be a net positive for providers who offer high-quality, cost-effective care. However, it will likely take years for the related quality measures to be established, quality data to be gathered, standardized patient assessment data to be assembled and disseminated, and potential payment policies to be developed, tested, and promulgated. As the nation’s largest owner and operator of inpatient rehabilitation hospitals and fifth largest provider of Medicare-certified skilled home health services, we will work with HHS, the Medicare Payment Advisory Commission, and other healthcare stakeholders on these initiatives. • Maintaining Strong Volume Growth. Various factors, including competition and increasing regulatory and administrative burdens, may impact our ability to maintain and grow our hospital, home health, and hospice volumes. In any particular market, we may encounter competition from local or national entities with longer operating histories or other competitive advantages, such as acute care hospitals who provide post-acute services similar to ours or other post-acute providers with relationships with referring acute care hospitals or physicians. Aggressive payment review practices by Medicare contractors, aggressive enforcement of regulatory policies by government agencies, and restrictive or burdensome rules, regulations or statutes governing admissions practices may lead us to not accept patients who would be appropriate for and would benefit from the services we provide. In addition, from time to time, we must get regulatory approval to expand our services and locations in states with certificate of need laws. This approval may be withheld or take longer than expected. In the case of new-store volume growth, the addition of hospitals, home health agencies, and hospice agencies to our portfolio also may be difficult and take longer than expected. • Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk Factors, for a discussion of competition for staffing, shortages of qualified personnel, and other factors that may increase our labor costs. Recruiting and retaining qualified personnel for our inpatient hospitals and home health and hospice agencies remain a high priority for us. We attempt to maintain a comprehensive compensation and benefits package that allows us to remain competitive in this challenging staffing environment while remaining consistent with our goal of being a high-quality, cost-effective provider of inpatient rehabilitative services. See also Item 1, Business, and Item 1A, Risk Factors. These key challenges notwithstanding, we have a strong business model, a strong balance sheet, and a proven track record of achieving strong financial and operational results. We are attempting to position the Company to respond to changes in the healthcare delivery system and believe we will be in a position to take advantage of any opportunities that arise as the industry moves to this new stage. We believe we are postured to continue to grow, adapt to external events, and create value for our shareholders in 2015 and beyond. Results of Operations As a result of the acquisition of Encompass on December 31, 2014, in the first quarter of 2015, management changed the way it manages and operates the consolidated reporting entity and modified the reports used by its chief operating decision maker to assess performance and allocate resources. These changes will require HealthSouth to revise its segment reporting from its historic presentation of only one reportable segment. Beginning in the first quarter of 2015, HealthSouth will manage its operations and disclose financial information using two reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. As part of this change in the first quarter of 2015, HealthSouth’s historic 25 hospital-based home health agencies will be reclassified and included in the home health and hospice segment. These 25 home health agencies represented approximately $29 million of HealthSouth’s consolidated Net operating revenues in 2014 and 2013. Because the Encompass acquisition took place on December 31, 2014, our consolidated results of operations and the discussion that follows in this section do not include the 2014 results of operations of Encompass. Pro forma information regarding the combined entity is included in Note 2, Business Combinations, to the accompanying consolidated financial statements. Payor Mix During 2014, 2013, and 2012, we derived consolidated Net operating revenues from the following payor sources: Our payor mix is weighted heavily towards Medicare. Our hospitals receive Medicare reimbursements under IRF-PPS. Under IRF-PPS, our hospitals receive fixed payment amounts per discharge based on certain rehabilitation impairment categories established by HHS. Under IRF-PPS, our hospitals retain the difference, if any, between the fixed payment from Medicare and their operating costs. Thus, our hospitals benefit from being cost-effective providers. For additional information regarding Medicare reimbursement, see the “Sources of Revenues” section of Item 1, Business. As part of the Balanced Budget Act of 1997, Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or “Medicare Advantage.” The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (Under Medicare Parts A and B) or enrollment in a health maintenance organization, preferred provider organization, point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Medicare Advantage revenues, included in the “managed care and other discount plans” category in the above table, represented approximately 8% of our total revenues during the years ended December 31, 2014, 2013, and 2012. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services. Net operating revenues also include other revenues generated from management and administrative fees and other nonpatient care services. These other revenues are included in “other income” in the above table. Under IRF-PPS, hospitals are reimbursed on a “per discharge” basis. Thus, the number of patient discharges is a key metric utilized by management to monitor and evaluate our performance. The number of outpatient visits is also tracked in order to measure the volume of outpatient activity each period. Our Results From 2012 through 2014, our consolidated results of operations were as follows: Provision for Doubtful Accounts and Operating Expenses as a % of Net Operating Revenues Additional information regarding our operating results for the years ended December 31, 2014, 2013, and 2012 is as follows: * Excludes approximately 400 full-time equivalents in each year who are considered part of corporate overhead with their salaries and benefits included in General and administrative expenses in our consolidated statements of operations. Full-time equivalents included in the above table represent HealthSouth employees who participate in or support the operations of our hospitals and exclude an estimate of full-time equivalents related to contract labor. We actively manage the productive portion of our Salaries and benefits utilizing certain metrics, including employees per occupied bed, or “EPOB.” This metric is determined by dividing the number of full-time equivalents, including an estimate of full-time equivalents from the utilization of contract labor, by the number of occupied beds during each period. The number of occupied beds is determined by multiplying the number of licensed beds by our occupancy percentage. In the discussion that follows, we use “same-store” comparisons to explain the changes in certain performance metrics and line items within our financial statements. We calculate same-store comparisons based on hospitals open throughout both the full current period and prior periods presented. These comparisons include the financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 2014 Compared to 2013 Net Operating Revenues Net patient revenue from our hospitals was 6.7% higher in 2014 than in 2013. This increase was attributable to a 3.5% increase in patient discharges and a 3.1% increase in net patient revenue per discharge. Discharge growth included a 1.3% increase in same-store discharges. Same-store discharges were negatively impacted by winter storms in the first quarter of 2014 (40 basis points) and the closure of 40 skilled nursing facility beds in June 2014 (20 basis points). Discharge growth from new stores primarily resulted from the consolidation of Fairlawn effective June 1, 2014, as discussed in Note 2, Business Combinations, to the accompanying consolidated financial statements. Net patient revenue per discharge in 2014 benefited from Medicare and managed care price adjustments and higher average acuity for the patients served. Net patient revenue per discharge was negatively impacted in the first quarter of 2014 by approximately $9 million for sequestration, which anniversaried on April 1, 2014. Net patient revenue per discharge in 2013 was negatively impacted by contractual allowances established in the fourth quarter of 2013 related to RAC audits (see the “2013 Compared to 2012 - Net Operating Revenues” section of this Item). Decreased outpatient volumes in 2014 compared to 2013 resulted from the closure of outpatient clinics and continued competition from physicians offering physical therapy services within their own offices. Provision for Doubtful Accounts For several years, under programs designated as “widespread probes,” certain of our MACs have conducted pre-payment claim reviews of our billings and denied payment for certain diagnosis codes based on medical necessity. We dispute, or “appeal,” most of these denials, but the resolution of these disputes can take in excess of two years, and we cannot provide assurance as to our ongoing and future success of these disputes. As such, we make provisions against these receivables in accordance with our accounting policy that necessarily considers historical collection trends of the receivables in this review process as part of our Provision for doubtful accounts. Therefore, as we experience increases or decreases in these denials, or if our actual collections of these denials differ from our estimated collections, we may experience volatility in our Provision for doubtful accounts. See also Item 1, Business, “Sources of Revenues-Medicare Reimbursement,” to this report. The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2014 compared to 2013 was primarily the result of these continued pre-payment reviews by MACs and substantial delays in the adjudication process at the administrative law judge hearing level. As these denials slowly work their way through the appeal process, we examine our success rate and adjust our historical collection percentage to estimate our Provision for doubtful accounts. In the fourth quarter of 2014, we revised our recovery estimates on pending MAC pre-payment claims from 58% to 63% using our historical collection percentage for all amounts denied. For claims we choose to take through all levels of appeal, up to and including administrative law judge hearings, we have historically experienced an approximate 72% success rate. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2014 compared to 2013 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2013 and 2014 development activities, and a 2.2% merit increase given to all eligible nonmanagement employees effective October 1, 2013. The net impact of reductions in self-insurance reserves, the negative impact of sequestration, and start-up costs associated with our de novo hospitals that opened in the fourth quarter of 2014 increased Salaries and benefits as a percent of Net operating revenues in 2014 compared to 2013. Excluding the impact of these three items, Salaries and benefits as a percent of Net operating revenues would have been approximately 40 basis points lower in 2014 than in 2013. Group medical and workers’ compensation reserves were reduced by approximately $8 million in 2014 as compared to approximately $15 million in 2013. We provided a 2.25% merit increase to our nonmanagement employees effective October 1, 2014. Hospital-related Expenses Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals. These expenses include such items as contract services, utilities, non-income related taxes, insurance, professional fees, and repairs and maintenance. Other operating expenses increased during 2014 compared to 2013 primarily as a result of increased patient volumes and approximately $7 million of lower reductions to self-insurance reserves for general and professional liability in 2014 than in 2013. As a percent of Net operating revenues, Other operating expenses for 2014 increased when compared to 2013 due primarily to these same lower reductions to self-insurance reserves. The increase in Other operating expenses as a percent of Net operating revenues for 2014 compared to 2013 also included the effects of sequestration experienced in the first quarter of 2014. Occupancy costs Occupancy costs include amounts paid for rent associated with leased hospitals and outpatient rehabilitation satellite clinics, including common area maintenance and similar charges. Occupancy costs decreased in total and as a percent of Net operating revenues in 2014 compared to 2013 due to our purchases of the real estate previously subject to operating leases at certain of our hospitals in the latter half of 2013 and first quarter of 2014. Supplies Supplies expense includes all costs associated with supplies used while providing patient care. Specifically, these costs include pharmaceuticals, food, needles, bandages, and other similar items. Supplies expense as a percent of Net operating revenues increased by 10 basis points during the 2014 compared to 2013 due primarily to the impact of sequestration on our Net operating revenues in the first quarter of 2014. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our corporate headquarters in Birmingham, Alabama. These expenses also include stock-based compensation expenses. In March 2008, we sold our corporate campus to Daniel Corporation (“Daniel”), a Birmingham, Alabama-based real estate company. The sale included a deferred purchase price component related to an incomplete 13-story building located on the property, often referred to as the Digital Hospital. Under the agreement, Daniel was obligated upon sale of its interest in the building to pay to us 40% of the net profit realized from the sale. In June 2013, Daniel sold the building to Trinity Medical Center. In the third quarter of 2013, we received $10.8 million in cash from Daniel in connection with the sale of the building. The gain associated with this transaction is being deferred and amortized over five years, which was the remaining life of our lease agreement with Daniel for the portion of the property we continue to occupy with our corporate office at the time of the transaction, as a component of General and administrative expenses. Approximately $2 million and $1 million of this gain was included in General and administrative expenses in 2014 and 2013, respectively. General and administrative expenses in 2014 included $9.3 million of transaction expenses related to our acquisition of Encompass. These one-time expenses were offset by decreased expenses associated with stock-based compensation and our Senior Management Bonus Program discussed in Note 14, Employee Benefit Plans, to the accompanying consolidated financial statements, as well as the amortization of the deferred gain on the Digital Hospital discussed above. General and administrative expenses were flat as a percent of Net operating revenues in 2014 compared to 2013 due primarily to our increasing revenue. Depreciation and Amortization Depreciation and amortization increased during 2014 compared to 2013 due to our increased capital expenditures and development activities throughout 2013 and 2014. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Government, Class Action, and Related Settlements The gain included in Government, class action, and related settlements in 2013 resulted from a noncash reduction in the estimated liability associated with the apportionment obligation to the plaintiffs in the January 2007 comprehensive settlement of the consolidated securities action, the collection of final judgments against former officers, and the recovery of assets from former officers, as discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2014 and 2013 related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt in 2014 resulted from the redemption of our 7.25% Senior Notes due 2018 and the redemption of 10% of the outstanding principal amount of our 7.75% Senior Notes due 2022 in the fourth quarter of 2014. The Loss on early extinguishment of debt in 2013 resulted from the redemption of 10% of the outstanding principal amount of our 7.25% Senior Notes due 2018 and our 7.75% Senior Notes due 2022 in November 2013. In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 at a price of 102% of the principal amount and used $250 million of the net proceeds to repay borrowings under our term loan facilities, with the remaining net proceeds used to repay borrowings under our revolving credit facility. As a result of this transaction, we expect to record an approximate $2 million Loss on early extinguishment of debt in the first quarter of 2015. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees during 2014 compared to 2013 primarily resulted from the noncash amortization of debt discounts and financing costs associated with the issuance of our 2.00% Convertible Senior Subordinated Notes due 2043 in November 2013. While our average borrowings increased in 2014 primarily as a result of issuing the convertible notes, our average cash interest rate decreased from 7.1% in 2013 to 6.2% in 2014. Cash paid for interest approximated $101 million and $99 million in 2014 and 2013, respectively. Average borrowings outstanding are expected to increase in 2015 primarily as a result of the acquisition of Encompass. In turn, interest expense is also expected to increase. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income for 2014 included a $27.2 million gain related to the acquisition of an additional 30% equity interest in Fairlawn. See Note 2, Business Combinations, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations for 2014 reflected continued revenue growth and increases in interest expense and depreciation and amortization. Pre-tax income was also impacted by three items having a net, favorable impact of $4.7 million. These items included the $27.2 million gain on the consolidation of Fairlawn offset by the $13.2 million Loss on early extinguishment of debt and $9.3 million of Encompass transaction expenses. Pre-tax income from continuing operations for 2013 included $23.5 million of gains related to Government, class action, and related settlements. Provision for Income Tax Expense Due to our federal and state net operating losses (“NOLs”), our cash income taxes approximated $16 million, net of refunds, in 2014. These payments resulted primarily from state income tax expense of subsidiaries which have separate state filing requirements, alternative minimum taxes, and federal income taxes for subsidiaries not included in our federal consolidated income tax return. In 2015, we estimate we will pay approximately $15 million to $20 million of cash income taxes, net of refunds. In 2014 and 2013, current income tax expense was $13.3 million and $6.3 million, respectively. Our effective income tax rate for 2014 was 28.6%. Our Provision for income tax expense in 2014 was less than the federal statutory rate of 35% primarily due to: (1) the impact of noncontrolling interests, (2) the nontaxable gain discussed in Note 2, Business Combinations, related to our acquisition of an additional 30% equity interest in Fairlawn, and (3) a decrease in our valuation allowance offset by (4) state and other income tax expense. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” for a discussion of the allocation of income or loss related to pass-through entities, which is referred to as the impact of noncontrolling interests in this discussion. As a result of the Fairlawn transaction, we released the deferred tax liability associated with the outside tax basis of our investment in Fairlawn because we now possess sufficient ownership to allow for the historical outside tax basis difference to be resolved through a tax-free transaction in the future. The decrease in our valuation allowance in 2014 related primarily to the expiration of state NOLs in certain jurisdictions, our current forecast of future earnings in each jurisdiction, and changes in certain state tax laws. In April 2013, we entered into closing agreements with the IRS that settled federal income tax matters related to the previous restatement of our 2000 and 2001 financial statements, as well as certain other tax matters, through December 31, 2008. As a result of these closing agreements, we increased our deferred tax assets, primarily our federal NOL, and recorded a net income tax benefit of approximately $115 million in the second quarter of 2013. This federal income tax benefit primarily resulted from an approximate $283 million increase to our federal NOL on a gross basis. Our effective income tax rate for 2013 was 3.2%. Our Provision for income tax expense in 2013 was less than the federal statutory rate of 35.0% primarily due to: (1) the IRS settlement discussed above, (2) the impact of noncontrolling interests, and (3) a decrease in our valuation allowance offset by (4) state and other income tax expense. The decrease in our valuation allowance in 2013 related primarily to our capital loss carryforwards, our then current forecast of future earnings in each jurisdiction, and changes in certain state tax laws. During the second quarter of 2013, we determined a valuation allowance related to our capital loss carryforwards was no longer required as sufficient positive evidence existed to substantiate their utilization. This evidence included our partial utilization of these assets as a result of realizing capital gains in 2013 and the identification of sufficient taxable capital gain income within the available capital loss carryforward period. In certain state jurisdictions, we do not expect to generate sufficient income to use all of the available NOLs prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable state tax jurisdiction, or if the timing of future tax deductions differs from our expectations. We recognize the financial statement effects of uncertain tax positions when it is more likely than not, based on the technical merits, a position will be sustained upon examination by and resolution with the taxing authorities. Total remaining gross unrecognized tax benefits were $0.9 million and $1.1 million as of December 31, 2014 and 2013, respectively. See Note 16, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests represents the share of net income or loss allocated to members or partners in our consolidated affiliates. Fluctuations in these amounts are primarily driven by the financial performance of the applicable hospital population each period. 2013 Compared to 2012 Net Operating Revenues Net patient revenue from our hospitals was 5.9% higher for the year ended December 31, 2013 than the year ended December 31, 2012. This increase was attributable to a 5.0% increase in patient discharges and a 0.9% increase in net patient revenue per discharge. Discharge growth included a 2.5% increase in same-store discharges. Same-store discharges were negatively impacted by the divestiture of 41 skilled nursing facility beds in the first quarter of 2013. Approximately 60 basis points of discharge growth from new stores resulted from the consolidation of St. Vincent Rehabilitation Hospital beginning in the third quarter of 2012, as discussed in Note 7, Investments in and Advances to Nonconsolidated Affiliates, to the accompanying consolidated financial statements. The increase in net patient revenue per discharge resulted from pricing adjustments, higher patient acuity, and a higher percentage of Medicare patients. Net patient revenue per discharge was negatively impacted in 2013 by sequestration (became effective for all discharges after April 1, 2013), the impact of post-payment claim reviews (as discussed below), and the ramping up of three new hospitals. New hospitals are required to treat a minimum of 30 patients for zero revenue as part of the Medicare certification process. As discussed in Item 1, Business, and the “Critical Accounting Estimates-Revenue Recognition” section of this Item, CMS has developed and instituted various Medicare audit programs under which CMS contracts with private companies to conduct claims and medical record audits. In connection with CMS approved and announced RAC audits related to IRFs, we received requests in 2013 to review certain patient files for discharges occurring from 2010 to 2013. While we make provisions for these claims based on our historical experience and success rates in the claims adjudication process, which is the same process we follow for appealing denials of certain diagnosis codes by MACs, we cannot provide assurance as to our future success in the resolution of these and future disputes, nor can we predict or estimate the scope or number of denials that ultimately may be received. During 2013, we reduced our Net operating revenues by approximately $8 million for post-payment claims that are part of this review process. Decreased outpatient volumes in 2013 compared to 2012 resulted from the closure of outpatient clinics and continued competition from physicians offering physical therapy services within their own offices. Outpatient and other revenues for 2013 included approximately $6 million more in state provider tax refunds than 2012. Provision for Doubtful Accounts The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2013 compared to 2012 was primarily the result of a decrease in pre-payment claims denials by MACs. Salaries and Benefits Salaries and benefits increased in 2013 compared to 2012 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2012 and 2013 development activities, and increased costs associated with medical plan benefits. Because merit increases were foregone in 2012, as discussed below, management determined the Company would absorb all of the increased costs associated with medical plan benefits to employees in 2013. These cost increases were offset by adjustments to our workers’ compensation accruals in 2013 due to favorable trends in claims and industry-wide loss development trends. As a result of these continued favorable trends, we also lowered the statistical confidence level used to determine our self-insurance reserves in 2013. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements. Salaries and benefits as a percent of Net operating revenues decreased in 2013 compared to 2012 due to our increasing revenue, the favorable adjustments to our workers’ compensation accruals discussed above, and the one-time, merit-based, year-end bonus paid in the fourth quarter of 2012 to all eligible nonmanagement employees in lieu of an annual merit increase. The fourth quarter of 2013 included a 2.2% merit increase whereas the fourth quarter of 2012 included an approximate $10 million bonus in lieu of a merit increase resulting in a year-over-year benefit of approximately $5.5 million in Salaries and benefits in 2013. The positive impact of all of the above items were offset by sequestration. Hospital-related Expenses Other Operating Expenses Other operating expenses increased during 2013 compared to 2012 primarily as a result of increased patient volumes, including new hospitals, and the ongoing implementation of our clinical information system. Other operating expenses associated with the ongoing implementation of our clinical information system were approximately $3 million higher in 2013 than in 2012. As a percent of Net operating revenues, Other operating expenses increased during 2013 compared to 2012 due to the effects of sequestration, the ramping up of operations at three new hospitals, and higher expenses associated with the ongoing implementation of our clinical information system offset by growth in our revenue and a reduction in general and professional liability reserves due to favorable trends in claims and industry-wide loss development trends. As a result of these continued favorable trends, we also lowered the statistical confidence level used to determine our self-insurance reserves in 2013. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements. Occupancy costs Occupancy costs decreased as a percent of Net operating revenues in 2013 compared to 2012 due to our purchases of the real estate previously subject to operating leases at certain of our hospitals in 2013 and 2012. Supplies Supplies expense decreased as a percent of Net operating revenues in 2013 compared to 2012 due to our supply chain efforts and continual focus on monitoring and actively managing pharmaceutical costs offset by sequestration. General and Administrative Expenses General and administrative expenses decreased as a percent of Net operating revenues in 2013 compared to 2012 due primarily to our increasing revenue. Depreciation and Amortization Depreciation and amortization increased during 2013 compared to 2012 due to our increased capital expenditures throughout 2012 and 2013. Government, Class Action, and Related Settlements As discussed above, the gain included in Government, class action, and related settlements in 2013 resulted from a noncash reduction in the estimated liability associated with the apportionment obligation to the plaintiffs in the January 2007 comprehensive settlement of the consolidated securities action, the collection of final judgments against former officers, and the recovery of assets from former officers. The gain included in Government, class action, and related settlements in 2012 resulted from the recovery of assets from former officers. See Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2013 and 2012 related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. These expenses in 2012 also included legal and consulting fees for the pursuit of our remaining income tax benefits as discussed in Note 16, Income Taxes, to the accompanying consolidated financial statements. Loss on Early Extinguishment of Debt As discussed above, the Loss on early extinguishment of debt in 2013 resulted from the redemption of 10% of the outstanding principal amount of our 7.25% Senior Notes due 2018 and our 7.75% Senior Notes due 2022 in November 2013. The Loss on early extinguishment of debt in 2012 resulted from the amendment to our credit agreement in August 2012 and the redemption of 10% of the outstanding principal amount of our 7.25% Senior Notes due 2018 and our 7.75% Senior Notes due 2022 in October 2012. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees during 2013 compared to 2012 resulted from an increase in our average borrowings outstanding offset by a decrease in our average cash interest rate. Average borrowings outstanding increased during 2013 compared to 2012 primarily as a result of our issuance of $275 million aggregate principal amount of 5.75% Senior Notes due 2024 in September 2012. Our average cash interest rate approximated 7.1% and 7.2% during 2013 and 2012, respectively. The decrease in our average cash interest rate primarily resulted from the August 2012 amendment to our credit agreement that lowered the interest rate spread on our revolving credit facility by 50 basis points. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income is primarily comprised of interest income and gains and losses on sales of investments. In 2012, Other income included a $4.9 million gain as a result of our consolidation of St. Vincent Rehabilitation Hospital and the remeasurement of our previously held equity interest at fair value. See Note 7, Investments in and Advances to Nonconsolidated Affiliates, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense The increase in our pre-tax income from continuing operations in 2013 compared to 2012 resulted from increased Net operating revenues and continued disciplined expense management. Pre-tax income in 2013 and 2012 included gains of $23.5 million and $3.5 million, respectively, related to Government, class action, and related settlements, as discussed above. Pre-tax income for 2012 also included a $4.9 million gain on the consolidation of St. Vincent Rehabilitation Hospital, as discussed above. Provision for Income Tax Expense As discussed above, our effective income tax rate for 2013 was 3.2%, which was less than the federal statutory rate of 35.0% primarily due to: (1) the IRS settlement discussed above, (2) the impact of noncontrolling interests, and (3) a decrease in our valuation allowance offset by (4) state and other income tax expense. Our effective income tax rate for 2012 was 31.9%. Our Provision for income tax expense in 2012 was less than the federal statutory rate of 35.0% primarily due to: (1) the impact of noncontrolling interests and (2) a decrease in the valuation allowance offset by (3) state and other income tax expense. Total remaining gross unrecognized tax benefits were $1.1 million and $78.0 million as of December 31, 2013 and 2012, respectively. The amount of gross unrecognized tax benefits changed during 2013 primarily due to the settlement with the IRS discussed above. See Note 16, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests represents the share of net income or loss allocated to members or partners in our consolidated affiliates. Fluctuations in these amounts are primarily driven by the financial performance of the applicable hospital population each period. Approximately $4 million of the increase in noncontrolling interests in 2013 compared to 2012 was due to changes at two of our existing hospitals. During 2013, we entered into an agreement to convert our 100% owned hospital in Jonesboro, Arkansas into a joint venture with St. Bernards Healthcare. In addition, our share of profits from our joint venture hospital in Memphis, Tennessee decreased in 2013 from 70% to 50% pursuant to the terms of that partnership agreement entered into in 1993. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. While we believe the current economic climate may help to moderate wage increases in the near term, there can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing pharmaceutical costs has enabled to us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions were not material to our operations in 2014, 2013, or 2012, and therefore, are not presented as a separate discussion within this Item. Encompass internally developed, and is now a licensee of, Homecare HomebaseSM, a comprehensive information platform that allows home health providers to process clinical, compliance, and marketing information as well as analyze data and trends for management purposes using custom reports. This software is licensed to Encompass by Homecare Homebase, LP. April Anthony, Chief Executive Officer of Encompass, is an investor and an officer of Homecare Homebase. Going forward, we expect to pay Homecare Homebase for software licenses and maintenance. Results of Discontinued Operations In connection with the 2007 sale of our surgery centers division (now known as Surgical Care Affiliates, or “SCA”) to ASC Acquisition LLC, an affiliate of TPG Partners V, L.P. (“TPG”), a private investment partnership, we received an option, subject to terms and conditions set forth below, to purchase up to a 5% equity interest in SCA. The price of the option is equal to the original issuance price of the units subscribed for by TPG and certain other co-investors in connection with the acquisition plus a 15% premium, compounded annually. The option has a term of ten years and is exercisable upon certain liquidity events, including a public offering of SCA’s shares of common stock that results in 30% or more of SCA’s common stock being listed or traded on a national securities exchange. On November 4, 2013, SCA announced the closing of its initial public offering, which was not a qualifying liquidity event. During the second quarter of 2014, we entered into an amendment to the option agreement that requires us to settle the option net of our exercise price. The addition of this new feature resulted in the option becoming a derivative that must be recorded as an asset or liability on our consolidated balance sheet and marked to market each period. As of December 31, 2014, the fair value of this option was $9.9 million and is included in Other long-term assets in our consolidated balance sheet. Income from discontinued operations, net of tax for 2014 included a $9.9 million net gain resulting from the initial recording of this option as a derivative and its fair value adjustments during 2014. If the option becomes exercisable, we believe it will have a strike price below the price of the asset being purchased. Income from discontinued operations, net of tax, in 2012 primarily resulted from gains associated with the sale of the real estate of Dallas Medical Center and an investment we had in a cancer treatment center that was part of our former diagnostic division. For additional information regarding discontinued operations, see Note 15, Assets and Liabilities in and Results of Discontinued Operations, to the accompanying consolidated financial statements. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Pursuing and achieving those objectives allows us to support the execution of our operating and strategic plans and weather temporary disruptions in the capital markets and general business environment. Maintaining adequate liquidity is a function of our unrestricted Cash and cash equivalents and our available borrowing capacity. Maintaining flexibility in our capital structure is a function of, among other things, the amount of debt maturities in any given year, the options for debt prepayments without onerous penalties, and limiting restrictive terms and maintenance covenants in our debt agreements. Consistent with these objectives, in September 2014, we issued an additional $175 million of our 5.75% Senior Notes due 2024 at a price of 103.625% of the principal amount. In September and December 2014, we amended our existing credit agreement to, among other things: • add $450 million of term loan capacity to our existing $600 million revolving credit facility; • permit unlimited restricted payments so long as the senior secured leverage ratio remains less than or equal to 1.75x (previously 1.50x); • increase the amount of permitted capital expenditures in a given year from $250 million to $300 million; and • set the maturity date for both the revolving credit and term loan facilities to September 2019, which represented a 15-month extension for our existing revolving credit facility. In October 2014, we used the net proceeds from the September offering of senior notes, a $75 million draw under our term loan facility, and cash on hand to redeem the outstanding principal amount of our 7.25% Senior Notes due 2018. Pursuant to the terms of the 7.25% Senior Notes due 2018, this redemption was made at a price of 103.625%, which resulted in a total cash outlay of approximately $281 million to retire the approximately $271 million in principal. Additionally, in December 2014, we redeemed approximately $25 million of the outstanding principal amount of our existing 7.75% Senior Notes due 2022. Pursuant to the terms of these senior notes, this optional redemption represented 10% of the outstanding principal amount of the notes at a price of 103%, which resulted in a total cash outlay of approximately $26 million. As a result of these redemptions, we recorded an approximate $13 million Loss on early extinguishment of debt in the fourth quarter of 2014. In December 2014, we drew $375 million under our expanded term loan facilities and $325 million under our revolving credit facility to fund the acquisition of Encompass. In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 at a price of 102% of the principal amount and used $250 million of the net proceeds to repay borrowings under our term loan facilities, with the remaining net proceeds used to repay borrowings under our revolving credit facility. As a result of this transaction, we expect to record an approximate $2 million Loss on early extinguishment of debt in the first quarter of 2015. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2019. Our balance sheet remains strong, and we have significant availability under our credit agreement. We continue to generate strong cash flows from operations, and we have significant flexibility with how we choose to invest our cash and return capital to shareholders. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Current Liquidity As of December 31, 2014, we had $66.7 million in Cash and cash equivalents. This amount excludes $45.6 million in Restricted cash and $50.5 million of restricted marketable securities ($45.9 million of restricted marketable securities are included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 3, Cash and Marketable Securities, to the accompanying consolidated financial statements. In addition to Cash and cash equivalents, as of December 31, 2014, we had approximately $243 million available to us under our revolving credit facility. Our credit agreement governs the substantial majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to $75 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As of December 31, 2014, the maximum leverage ratio requirement per our credit agreement was 4.25x and the minimum interest coverage ratio requirement was 2.75x, and we were in compliance with these covenants. Based on Adjusted EBITDA for 2014 and the interest rate in effect under our credit agreement during the three-month period ended December 31, 2014, if we had drawn on the first day and maintained the maximum amount of outstanding draws under our revolving credit facility for the entire year, we would still be in compliance with the maximum leverage ratio and minimum interest coverage ratio requirements. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2019, and our bonds all mature in 2020 and beyond. See the “Contractual Obligations” section below for information related to our contractual obligations as of December 31, 2014. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common and preferred stock and common stock dividends, including the potential growth of the quarterly cash dividend on our common stock, recognizing that these actions may increase our leverage ratio. See also the “Authorizations for Returning Capital to Stakeholders” section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years ended December 31, 2014, 2013, and 2012 (in millions): 2014 Compared to 2013 Operating activities. The decrease in Net cash provided by operating activities from 2013 to 2014 primarily resulted from growth in accounts receivable due to additional claims denials predominantly by one Medicare Administrative Contractor and continued delays at the administrative law judge hearing level. See Item 1, Business, “Sources of Revenues-Medicare Reimbursement-Inpatient Rehabilitation.” Investing activities. The increase in Net cash used in investing activities during 2014 compared to 2013 primarily resulted from the acquisition of Encompass. The total cash consideration delivered at closing was $695.5 million. Financing activities. Net cash provided by financing activities in 2014 primarily resulted from draws under the revolving and expanded term loan facilities of our credit agreement to fund the acquisition of Encompass. Excluding the Encompass-related borrowings, Net cash used in financing activities would have decreased in 2014 primarily due to repurchases of our common stock as part of a tender offer in the first quarter of 2013 offset by an increase in common stock cash dividends in 2014. See Note 2, Business Combinations, Note 8, Long-term Debt, and Note 17, Earnings per Common Share, to the accompanying consolidated financial statements. 2013 Compared to 2012 Operating activities. Net cash provided by operating activities increased from 2012 to 2013 due primarily to increased Net operating revenues and continued disciplined expense management. Investing activities. The increase in Net cash used in investing activities during 2013 compared to 2012 primarily resulted from increased capital expenditures and the acquisition of Walton Rehabilitation Hospital. The increase in our capital expenditures in 2013 primarily resulted from the purchase of the real estate previously subject to leases associated with four of our hospitals. Net cash used in investing activities during 2013 also included the receipt of $10.8 million related to the sale of the Digital Hospital. See Note 2, Business Combinations, and Note 5, Property and Equipment, to the accompanying consolidated financial statements. Financing activities. The increase in Net cash used in financing activities during 2013 compared to 2012 primarily resulted from repurchases of our common stock as part of the tender offer completed in the first quarter of 2013. As discussed in Note 17, Earnings per Common Share, to the accompanying consolidated financial statements, we repurchased approximately 9.1 million shares of our common stock for $234.1 million, including fees and expenses related to the tender offer. Contractual Obligations Our consolidated contractual obligations as of December 31, 2014 are as follows (in millions): (a) Included in long-term debt are amounts owed on our bonds payable and other notes payable. These borrowings are further explained in Note 8, Long-term Debt, to the accompanying consolidated financial statements. (b) In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 at a price of 102% of the principal amount. We used $250 million of the net proceeds from this additional offering of senior notes to repay borrowings under our term loan facilities. The remaining net proceeds were used to repay borrowings under our revolving credit facility. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. (c) Interest on our fixed rate debt is presented using the stated interest rate. Interest expense on our variable rate debt is estimated using the rate in effect as of December 31, 2014. Interest related to capital lease obligations is excluded from this line. Future minimum payments, which are accounted for as interest, related to sale/leaseback transactions involving real estate accounted for as financings are included in this line (see Note 5, Property and Equipment, and Note 8, Long-term Debt, to the accompanying consolidated financial statements). Amounts exclude amortization of debt discounts, amortization of loan fees, or fees for lines of credit that would be included in interest expense in our consolidated statements of operations. (d) Amounts include interest portion of future minimum capital lease payments. (e) We lease approximately 15% of our hospitals as well as other property and equipment under operating leases in the normal course of business. Some of our hospital leases contain escalation clauses based on changes in the Consumer Price Index while others have fixed escalation terms. The minimum lease payments do not include contingent rental expense. Some lease agreements provide us with the option to renew the lease or purchase the leased property. Our future operating lease obligations would change if we exercised these renewal options and if we entered into additional operating lease agreements. For more information, see Note 5, Property and Equipment, to the accompanying consolidated financial statements. (f) Future operating lease obligations and purchase obligations are not recognized in our consolidated balance sheet. (g) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on HealthSouth and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. Our purchase obligations primarily relate to software licensing and support. (h) Because their future cash outflows are uncertain, the following noncurrent liabilities are excluded from the table above: general liability, professional liability, and workers’ compensation risks, noncurrent amounts related to third-party billing audits, and deferred income taxes. Also, as of December 31, 2014, we had $0.9 million of total gross unrecognized tax benefits. For more information, see Note 9, Self-Insured Risks, Note 16, Income Taxes, and Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. (i) The table above does not include Redeemable noncontrolling interests of $84.7 million because of the uncertainty surrounding the timing and amounts of any related cash outflows. See Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year ended December 31, 2014, we made capital expenditures of approximately $188 million for property and equipment and capitalized software. These expenditures included approximately $17 million for the purchase of the real estate previously subject to a lease associated with our hospital in San Antonio, Texas and approximately $12 million of hospital and technology equipment that was received in 2013 but not paid for until 2014. These expenditures in 2014 are exclusive of approximately $695 million in net cash related to our acquisition activities in 2014, including the acquisition of Encompass, as discussed in Note 2, Business Combinations, to the accompanying consolidated financial statements. During 2015, we expect to spend approximately $190 million to $240 million for capital expenditures. This estimated range for capital expenditures is exclusive of hospital acquisitions, but it includes an estimated range of $30 million to $40 million for new home health and hospice agencies. Approximately $90 million to $100 million of this budgeted amount is considered nondiscretionary expenditures, which we may refer to in other filings as “maintenance” expenditures. Actual amounts spent will be dependent upon the timing of construction projects and acquisition opportunities for our home health and hospice business. Authorizations for Returning Capital to Stakeholders On October 15, 2013, we paid the first cash dividend, $0.18 per share, on our common stock, and we paid the same per share dividend quarterly through July 15, 2014. On July 17, 2014, our board of directors approved an increase in our quarterly dividend to $0.21 per share, which was paid on October 15, 2014 to stockholders of record on October 1, 2014. On October 21, 2014, our board of directors declared a cash dividend of $0.21 per share, payable on January 15, 2015 to stockholders of record on January 2, 2015. We expect quarterly dividends to be paid in January, April, July, and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates as well as the per share amounts, will be at the discretion of our board of directors after consideration of various factors, including our capital position and alternative uses of funds. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our credit agreement. The payment of cash dividends on our common stock triggers antidilution adjustments, except in instances when such adjustments are deemed de minimis, under our convertible notes and our convertible perpetual preferred stock. See Note 8, Long-term Debt, Note 10, Convertible Perpetual Preferred Stock, and Note 17, Earnings per Common Share, to the accompanying consolidated financial statements. On February 14, 2014, our board of directors approved an increase in our existing common stock repurchase authorization from $200 million to $250 million. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. During 2014, we repurchased 1.3 million shares of our common stock in the open market for $43.1 million under this repurchase authorization using cash on hand. Future repurchases under this authorization generally are expected to be funded using a combination of cash on hand and availability under our $600 million revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 8, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement - our interest coverage ratio and our leverage ratio - could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might be on terms less favorable to us than those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. In general terms, the credit agreement definition of Adjusted EBITDA, therein referred to as “Adjusted Consolidated EBITDA,” allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to $10 million in a year may be cash expenditures), (2) any losses from discontinued operations and closed locations, (3) costs and expenses, including legal fees and expert witness fees, incurred with respect to litigation associated with stockholder derivative litigation, including the matters related to Ernst & Young LLP and Richard Scrushy discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements, and (4) share-based compensation expense. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent increasing consolidated Net income. Under the credit agreement, the Adjusted EBITDA calculation does not include net income attributable to noncontrolling interests and includes (1) gain or loss on disposal of assets, (2) professional fees unrelated to the stockholder derivative litigation, and (3) unusual or nonrecurring cash expenditures in excess of $10 million. These items may not be indicative of our ongoing performance, so the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Our Adjusted EBITDA for the years ended December 31, 2014, 2013, and 2012 was as follows (in millions): Reconciliation of Net Income to Adjusted EBITDA Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA Growth in Adjusted EBITDA from 2013 to 2014 was due primarily to continued revenue growth, as well as an approximate $6 million contribution to Adjusted EBITDA from the increase in ownership and consolidation of Fairlawn. The comparison to last year was negatively impacted by approximately $14 million attributable to lower reductions in our self-insurance reserves in 2014 than in 2013, as discussed in the “Results of Operations” section of this Item. Adjusted EBITDA in 2014 also included approximately $8 million for the negative impact of sequestration in the first quarter of 2014 and approximately $4 million in higher net start-up costs, year over year, for new hospitals. Growth in Adjusted EBITDA from 2012 to 2013 was due primarily to revenue growth and disciplined expense management. Adjusted EBITDA for 2013 benefited from $6.7 million of adjustments to self-insurance reserves resulting from our change in assumptions related to our statistical confidence level, as discussed in Note 9, Self-Insured Risks, to the accompanying consolidated financial statements. Sequestration negatively impacted Adjusted EBITDA by approximately $25 million during 2013. Off-Balance Sheet Arrangements In accordance with the definition under SEC rules, the following qualify as off-balance sheet arrangements: • any obligation under certain guarantees or contracts; • a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that serves as credit, liquidity, or market risk support to that entity for such assets; • any obligation under certain derivative instruments; and • any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the registrant, or engages in leasing, hedging, or research and development services with the registrant. As of December 31, 2014, we do not have any material off-balance sheet arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2014, we are not involved in any unconsolidated SPE transactions. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates, and judgments to ensure our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, as they require our most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the audit committee of our board of directors. See also Note 2, Business Combinations, to the accompanying consolidated financial statements. Revenue Recognition We recognize net patient service revenue in the reporting period in which we perform the service based on our current billing rates (i.e., gross charges) less actual adjustments and estimated discounts for contractual allowances (principally for patients covered by Medicare, Medicaid, and managed care and other health plans). See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues,” to the accompanying consolidated financial statements for a complete discussion of our revenue recognition policies. Our patient accounting system calculates contractual allowances on a patient-by-patient basis based on the rates in effect for each primary third-party payor. Other factors that are considered and could further influence the level of our reserves include the patient’s total length of stay for in-house patients, each patient’s discharge destination, the proportion of patients with secondary insurance coverage and the level of reimbursement under that secondary coverage, and the amount of charges that will be disallowed by payors. Such additional factors are assumed to remain consistent with the experience for patients discharged in similar time periods for the same payor classes, and additional reserves are provided to account for these factors. Management continually reviews the contractual estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. In addition, laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. In addition, CMS has developed and instituted various Medicare audit programs under which CMS contracts with private companies to conduct claims and medical record audits. In connection with CMS approved and announced RAC audits related to IRFs, we received requests in 2013 and 2014 to review certain patient files for discharges occurring from 2010 to 2014. To date, the Medicare payments that are subject to these audit requests represent less than 1% of our Medicare patient discharges during those years, and not all of these patient file requests have resulted in payment denial determinations by the RACs. While we make provisions for these claims based on our historical experience and success rates in the claims adjudication process, which is the same process we follow for appealing denials of certain diagnosis codes by MACs, we cannot provide assurance as to our future success in the resolution of these and future disputes, nor can we predict or estimate the scope or number of denials that ultimately may be received. During 2014 and 2013, we reduced our Net operating revenues by approximately $0.4 million and $8 million, respectively, for post-payment claims that are part of this review process. Due to complexities involved in determining amounts ultimately due under reimbursement arrangements with third-party payors, which are often subject to interpretation and review, we may receive reimbursement for healthcare services authorized and provided that is different from our estimates, and such differences could be material. However, we continually review the amounts actually collected in subsequent periods in order to determine the amounts by which our estimates differed. Historically, such differences have not been material from either a quantitative or qualitative perspective. Allowance for Doubtful Accounts The collection of outstanding receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. We provide for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. See Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” and Note 4, Accounts Receivable, to the accompanying consolidated financial statements for a complete discussion of our policies related to the allowance for doubtful accounts. We estimate our allowance for doubtful accounts based on the aging of our accounts receivable, our historical collection experience for each type of payor, and other relevant factors so that the remaining receivables, net of allowances, are reflected at their estimated net realizable values. Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. Our collection risks include patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding. In addition, reimbursement claims made by health care providers are subject to audit from time to time by governmental payors and their agents. For several years, under programs designated as “widespread probes,” certain of our MACs have conducted pre-payment claim reviews of our billing and denied payment for certain diagnosis codes based on medical necessity. We dispute, or “appeal,” most of these denials, and we collect approximately 63% of all amounts denied. For claims we choose to take through all levels of appeal, up to and including administrative law judge hearings, we have historically experienced an approximate 72% success rate. Because we do not write off receivables until all collection efforts have been exhausted, we do not write-off receivables related to denied claims while they are in this review process. The resolution of these disputes can take in excess of two years. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. As of December 31, 2014 and 2013, $62.2 million and $22.5 million, or 15.4% and 7.5%, respectively, of our patient accounts receivable represented denials by MACs that were in the pre-payment medical necessity review process. During the years ended December 31, 2014, 2013, and 2012, we wrote off $1.4 million, $2.2 million, and $2.3 million, respectively, of previously denied claims while we collected $7.1 million, $1.7 million, and $4.3 million, respectively, of previously denied claims. The table below shows a summary of our net accounts receivable balances as of December 31, 2014 and 2013. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” to the accompanying consolidated financial statements. Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers’ compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers’ compensation risks are insured through a wholly owned insurance subsidiary. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost of reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers’ compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: • historical claims experience; • trending of loss development factors; • trends in the frequency and severity of claims; • coverage limits of third-party insurance; • demographic information; • statistical confidence levels; • medical cost inflation; • payroll dollars; and • hospital patient census. The time period to resolve claims can vary depending upon the jurisdiction, the nature, and the form of resolution of the claims. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): Over the past few years, we have experienced volatility in our estimates of prior year claim reserves due primarily to favorable trends in claims and industry-wide loss development trends. We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements for additional information. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management’s estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as of October 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our single reporting unit. We assess qualitative factors in our single reporting unit to determine whether it is necessary to perform the first step of the two-step quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not our reporting unit’s fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must proceed to Step 1, we would determine the fair value of our reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of our reporting unit determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting unit. The income approach includes the use of our reporting unit’s projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management’s best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company’s stock price. See Note 1, Summary of Significant Accounting Policies, “Goodwill and Other Intangibles,” and Note 6, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of our reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets; • Industry and market considerations and changes in healthcare regulations, including reimbursement and compliance requirements under the Medicare and Medicaid programs; • Cost factors, such as an increase in labor, supply, or other costs; • Overall financial performance, such as negative or declining cash flows or a decline in actual or forecasted revenue or earnings; • Other relevant company-specific events, such as material changes in management or key personnel or outstanding litigation; • Material events, such as a change in the composition or carrying amount of our reporting unit’s net assets, including acquisitions and dispositions; and • Consideration of the relationship of our market capitalization to our book value, as well as a sustained decrease in our share price. In the fourth quarter of 2014, we performed our annual evaluation of goodwill and determined no adjustment to impair goodwill was necessary. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our reporting unit is not at risk for any impairment charges. As discussed in the “Results of Operations” section of this Item and Note 2, Business Combinations, to the accompanying consolidated financial statements, we will revise our segment reporting in the first quarter of 2015 to report two reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. As a result, beginning in 2015, we will also conduct our annual impairment review of goodwill using these two reporting units. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” and Note 16, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year ended December 31, 2014, we decreased our valuation allowance by $7.7 million. As of December 31, 2014, we had a remaining valuation allowance of $23.0 million which related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the deferred tax assets before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management’s estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as of December 31, 2014 will be realized, no such assurances can be provided. If management’s expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, “Litigation Reserves,” and Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding ForwardLooking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business With the acquisition of Encompass discussed below, HealthSouth is one of the nation’s largest providers of postacute healthcare services, offering both facilitybased and homebased postacute services in 33 states and Puerto Rico through its network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As of December 31, 2014, we operated 107 inpatient rehabilitation hospitals (including one hospital that operates as a joint venture which we account for using the equity method of accounting). While our national network of inpatient hospitals stretches across 29 states and Puerto Rico, our inpatient hospitals are concentrated in the eastern half of the United States and Texas. In addition to HealthSouth hospitals, we manage three inpatient rehabilitation units through management contracts. For additional information about our business, see Item 1, Business. Encompass Acquisition On December 31, 2014, we completed the previously announced acquisition of EHHI Holdings, Inc. (“EHHI”) and its Encompass Home Health and Hospice business (“Encompass”). Encompass is the nation’s fifth largest provider of Medicarecertified skilled home health services. In the acquisition, we acquired, for cash, all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to HealthSouth Home Health Holdings, Inc. (“Holdings”), a subsidiary of HealthSouth and now indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. These certain sellers were members of Encompass management, including April Anthony, the Chief Executive Officer of Encompass. These sellers contributed a portion of their shares of common stock of EHHI, valued at approximately $64.5 million, in exchange for shares of common stock of Holdings. As a result of that contribution, they hold approximately 16.7% of the outstanding common stock of Holdings, while HealthSouth owns the remainder. In addition, Ms. Anthony and certain other employees of Encompass entered into amended and restated employment agreements, each agreement having an initial term of three years. We funded the cash purchase price in the acquisition entirely with draws under the revolving and expanded term loan facilities of our credit agreement. The total cash consideration delivered at closing was $695.5 million. Encompass operates in 135 locations across 12 states and has approximately 4,900 employees making more than 2.1 million patient visits annually. For the year ended December 31, 2014, Encompass had total revenues of approximately $369 million, which are not included in the accompanying consolidated statement of operations. Encompass provides: home health services a comprehensive range of Medicarecertified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational and speech therapy, medical social work, and home health aide services. Encompass also provides specialized home care services in Texas and Kansas for pediatric patients with severe medical conditions. Encompass’ home health services have historically represented a substantial portion of its revenues. For the year ended December 31, 2014, these services represented approximately 94% of Encompass’ total revenues. hospice services primarily inhome services to terminally ill patients and their families to address the patients’ physical needs, including pain control and symptom management, and to provide emotional and [/INST] Negative. </s>

HEALTHSOUTH CORP

2016-02-25

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business We are one of the nation’s largest providers of post-acute healthcare services, offering both facility-based and home-based post-acute services in 34 states and Puerto Rico through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As discussed in this Item, “Segment Results of Operations,” we manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. On December 31, 2014, we completed the acquisition of EHHI Holdings, Inc. (“EHHI”) and its Encompass Home Health and Hospice business (“Encompass”), which at the time consisted of 135 home health and hospice locations in 12 states. In the acquisition, we acquired, for cash, all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to HealthSouth Home Health Holdings, Inc. (“Holdings”), a subsidiary of HealthSouth and now indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. These certain sellers were members of Encompass management, including April Anthony, the Chief Executive Officer of Encompass. These sellers contributed a portion of their shares of common stock of EHHI in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. We funded the cash purchase price in the acquisition entirely with draws under the revolving and expanded term loan facilities of our credit agreement. The total cash consideration delivered at closing was $695.5 million. We view Encompass as a partnership that brings together the talent and home care experience of the existing Encompass team with all of the resources and post-acute care experience of HealthSouth. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. While our national network of inpatient hospitals stretches across 29 states and Puerto Rico, we are concentrated in the eastern half of the United States and Texas. As of December 31, 2015, we operate 121 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture which we account for using the equity method of accounting. In addition to HealthSouth hospitals, we manage three inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 84% of our Net operating revenues for the year ended December 31, 2015. Home Health and Hospice Encompass is the nation’s fourth largest provider of Medicare-certified skilled home health services. As of December 31, 2015, Encompass provides home health and hospice services in 213 locations across 23 states. In addition, two of these home health locations operate as joint ventures which we account for using the equity method of accounting. Encompass home health services include a comprehensive range of Medicare-certified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. Encompass also provides specialized home care services in Texas and Kansas for pediatric patients with severe medical conditions. Encompass hospice services primarily include in-home services to terminally ill patients and their families to address patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. The Encompass home health and hospice segment represented approximately 16% of our Net operating revenues for the year ended December 31, 2015. During 2015, we transitioned substantially all of HealthSouth’s legacy hospital-based home health locations to Encompass. As of December 31, 2015, 23 of HealthSouth’s legacy 25 agencies had been integrated into Encompass, with 12 of those locations relocated or merged into existing Encompass locations. In addition, Encompass operates one of HealthSouth’s integrated agencies as two locations. We expect to be fully integrated by the end of 2016. See Item 1, Business, and Item 1A, Risk Factors, of this report, Note 2, Business Combinations, Note 8, Long-term Debt, and Note 18, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item. 2015 Overview Our 2015 strategy focused on the following priorities: • continuing to provide high-quality, cost-effective care to patients in our existing markets; • achieving organic growth at our existing hospitals, home health agencies, and hospice agencies; • expanding our services to more patients who require post-acute healthcare services by constructing and acquiring new hospitals in new markets and acquiring home health and hospice agencies in new markets; • continuing our shareholder value-enhancing strategies such as common stock dividends and repurchases of our common stock; and • positioning the Company for continued success in the evolving healthcare delivery system. This preparation includes continuing the installation of our electronic clinical information system in our hospitals which allows for interfaces with all major acute care electronic medical record systems and health information exchanges and participating in bundling projects and Accountable Care Organizations (“ACOs”). During 2015, Net operating revenues increased by 31.5% over 2014 due primarily to strong volume growth in both of our operating segments and included the effect of our acquisitions of Encompass, Reliant, and CareSouth (see Note 2, Business Combinations, to the accompanying consolidated financial statements). Within our inpatient rehabilitation segment, discharge growth of 10.9% coupled with a 1.1% increase in net patient revenue per discharge in 2015 generated 11.6% growth in revenue from our hospitals compared to 2014. Discharge growth included a 3.2% increase in same-store discharges. Our inpatient rehabilitation quality and outcome measures, as reported through the Uniform Data System for Medical Rehabilitation (the “UDS”), remained well above the average for hospitals included in the UDS database. The results of operations for our home health and hospice segment in 2014 included only the results of HealthSouth’s legacy hospital-based home health agencies. Thus, year-over-year growth in all operating results and performance metrics resulted from our acquisition of Encompass. The quality of patient care star rating for our home health agencies continued to be well above the national average, as reported by the United States Centers for Medicare and Medicaid Services (“CMS”). In addition, 30-day readmission rates at our home health agencies continued to be well below the national average, as reported by Avalere Health and the Association for Home Health Quality. We experienced much success with our growth efforts in 2015. Specifically, in October 2015, we completed the previously announced acquisition of the operations of Reliant Hospital Partners, LLC and affiliated entities (“Reliant”). Reliant operated a portfolio of 11 inpatient rehabilitation hospitals in Texas, Massachusetts, and Ohio with a total of 902 beds. All of the Reliant hospitals are leased, and seven of the leases are treated as capital leases for accounting purposes. We assumed all of these lease obligations. The amount of the capital lease obligation initially recognized on our balance sheet was approximately $210 million. At closing, one Reliant hospital entity had a remaining minority limited partner interest of 0.5%. The cash purchase price was reduced by the estimated fair value of this interest. We funded the cash purchase price in the Reliant acquisition with proceeds from our August and September 2015 senior notes issuances (as discussed below) and borrowings under our senior secured credit facility. The total cash consideration delivered at closing was approximately $730 million. We believe this acquisition complements our existing networks in the highly competitive Houston, Dallas-Fort Worth, and Austin markets while providing entry into new markets in Abilene, Texas; Dayton, Ohio; and the greater Boston metropolitan areas. In 2014, Reliant’s operations generated revenues of approximately $249 million. The acquisition of the operations of Reliant were immediately accretive, excluding transaction costs, to our earnings per share. In addition to completing the Reliant acquisition to expand our portfolio of inpatient rehabilitation hospitals, we: • began operating the inpatient rehabilitation hospital at Memorial University Medical Center in Savannah, Georgia with our joint venture partner, Memorial Health, on April 1, 2015. The joint venture will build a new, 50-bed replacement inpatient rehabilitation hospital, which is expected to be completed in the first half of 2016; • acquired Cardinal Hill Rehabilitation Hospital (“Cardinal Hill”), comprised of 158 licensed inpatient rehabilitation beds and 74 licensed skilled nursing beds, in Lexington, Kentucky on May 1, 2015; • entered into an agreement, in May 2015, with West Tennessee Healthcare to form a joint venture to own and operate a 48-bed inpatient rehabilitation hospital in Jackson, Tennessee. The agreement calls for the relocation of the existing inpatient rehabilitation unit at Jackson-Madison County General Hospital to a free-standing hospital to be built by the joint venture, as well as joint ownership of our existing Cane Creek Rehabilitation Hospital in Martin, Tennessee. Under the agreement, HealthSouth assumed management of the existing rehabilitation unit on January 1, 2016. Construction of the new inpatient rehabilitation hospital will begin in 2016, once the required state regulatory approvals are obtained; • entered into an agreement, in June 2015, with Mount Carmel Health System to begin construction of a new inpatient rehabilitation hospital in Westerville, Ohio. Construction of the 60-bed joint venture hospital is expected to be completed by the first quarter of 2017; • formed a joint venture, in June 2015, with St. John Health System to own and operate a 40-bed inpatient rehabilitation hospital in Broken Arrow, Oklahoma. In the first quarter of 2016, the joint venture plans to begin construction of the new 40-bed, free-standing hospital, with construction expected to be completed in the first quarter of 2017; • entered into an agreement, in June 2015, with CHI St. Vincent Hot Springs, a Catholic Health Initiatives’ hospital, to jointly build, own, and operate a 40-bed inpatient rehabilitation hospital in Hot Springs, Arkansas. Initially, the joint venture will own and operate the 20-bed inpatient rehabilitation unit currently located on the campus of CHI St. Vincent Hot Springs. The joint venture’s operation of this unit began in February 2016, and the unit was expanded to 27 beds. Additionally, the joint venture began construction of the new hospital in the fourth quarter of 2015, with construction expected to be completed in the third quarter of 2016; • entered into an agreement, in November 2015, with St. Joseph Health System, a Catholic Health Initiatives’ hospital, to jointly own and operate a 49-bed inpatient rehabilitation hospital in Bryan, Texas. The joint venture’s operation of this hospital is expected to begin in the second half of 2016 once the required state regulatory approvals are obtained; • began accepting patients at our newly built, 40-bed inpatient rehabilitation hospital in Franklin, Tennessee in December 2015; and • continued development of the following de novo hospitals: Location # of Beds Actual / Expected Construction Start Date Expected Operational Date Modesto, California Q1 2015 Q2 2016 Murrieta, California* Q2 2017 Q4 2018 *In August 2014, we acquired land and began the design and permitting process to build an inpatient rehabilitation hospital. We also continued our growth efforts in our home health and hospice segment. In November 2015, Encompass completed its previously announced acquisition of the home health agency operations of CareSouth Health System, Inc. (“CareSouth”) for a cash purchase price of approximately $170 million. CareSouth operated a portfolio of 44 home health locations and 3 hospice locations in 7 states (35 of these locations are in CON states) and generated revenues of approximately $104 million in 2014. In addition, two of these home health locations operate as joint ventures which we account for using the equity method of accounting. We funded the cash purchase price in the acquisition with our term loan facility capacity and cash on hand. The CareSouth acquisition enables HealthSouth to leverage the operating platform of Encompass across home health locations in the new markets of Alabama, Georgia, North Carolina, South Carolina, and Tennessee. CareSouth also improves Encompass’ market share position in the key states of Florida and Virginia. Upon completion of this transaction, Encompass became the fourth largest home health provider in Virginia and the eighth largest home health provider in Florida. These new home health locations overlap (within a 30-mile radius) with 14 of HealthSouth’s existing inpatient rehabilitation hospitals. The addition of these assets allow HealthSouth to better serve the post-acute needs of patients in those markets by offering both facility-based and home-based post-acute services. Post the Reliant and CareSouth acquisitions, we have Encompass home health locations in 71 of HealthSouth’s 121 IRF markets, or 59% overlap. In addition to completing the CareSouth acquisition, in 2015, we opened four home health locations and two hospice locations and acquired ten home health locations and two hospice locations. The acquired locations included: • Integrity Home Health Care, Inc. - two locations in the Las Vegas, Nevada area (March 2015); • Harvey Home Health Services, Inc. - one location in Houston, Texas (April 2015); • Heritage Home Health, LLC - one location in Texarkana, Arkansas (May 2015); • Cardinal Hill - one location in Lexington, Kentucky (May 2015); • Alliance Home Health - two locations in the Fayetteville, Arkansas area (June 2015); • Southern Utah Home Health, Inc. - two home health locations and two hospice locations in southern Utah (July 2015); and • Orthopedic Rehab Specialist, LLC - one location in Ocala, Florida (July 2015). To support our growth efforts, we took the following steps to increase the capacity and flexibility of our balance sheet. • In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 at a price of 102% of the principal amount and used $250 million of the net proceeds to repay borrowings under our term loan facilities, with the remaining net proceeds used to repay borrowings under our revolving credit facility. • In March 2015, we issued $300 million of 5.125% Senior Notes due 2023 at a price of 100% of the principal amount and, in April 2015, used the net proceeds from the issuance along with cash on hand to redeem all the outstanding principal of our 8.125% Senior Notes due 2020. • In June 2015, we amended our credit agreement to (1) provide that the leverage ratio financial covenant be calculated on a pro forma basis to include the effects of investments, acquisitions, mergers, and other operational changes and (2) increase the amount of specifically permitted capital lease obligations from $200 million to $350 million. • In July 2015, we amended our credit agreement to (1) add $500 million of new term loan facilities to our existing $600 million revolving credit facility and $195 million of outstanding term loans, (2) change the maximum leverage ratio in the financial covenants applicable for the period July 2015 through June 2017 from 4.25x to 4.50x and to 4.25x from then until maturity, and (3) extend the maturity date for all borrowings to July 2020. Under the terms of the amendment, our issuance of additional senior notes in August 2015 and September 2015, as discussed below, reduced our availability under the new term loan facilities to $250 million. • In August 2015, we issued an additional $350 million of our 5.75% Senior Notes due 2024 at a price of 100.50% of the principal amount and used the net proceeds from the issuance to reduce borrowings under our revolving credit facility and, in October 2015, to fund a portion of the Reliant acquisition. • In September 2015, we issued $350 million of 5.75% Senior Notes due 2025 at a price of 100% of the principal amount and, in October 2015, used the net proceeds from the issuance to fund a portion of the Reliant acquisition. • In November 2015, we redeemed $50 million of the outstanding principal amount of our existing 7.75% Senior Notes due 2022 using borrowings under our senior secured credit facility. Pursuant to the terms of these notes, this optional redemption was made at a price of 103.875%, which resulted in a total cash outlay of approximately $52 million. For additional information regarding these actions, see Note 8, Long-term Debt, to the accompanying consolidated financial statements and the “Liquidity and Capital Resources” section of this Item. Business Outlook We believe our business outlook remains positive for two primary reasons. First, demographic trends, such as population aging, should increase long-term demand for facility-based and home-based post-acute services. While we treat patients of all ages, most of our patients are 65 and older, and the number of Medicare enrollees is expected to grow approximately 3% per year for the foreseeable future. We believe the demand for facility-based and home-based post-acute services will continue to increase as the U.S. population ages and life expectancies increase. Second, we are an industry leader in the growing post-acute sector. As the nation’s largest owner and operator of inpatient rehabilitation hospitals, we believe we differentiate ourselves from our competitors based on our broad platform of clinical expertise, the quality of our clinical outcomes, the sustainability of best practices, and the application of rehabilitative technology. As the fourth largest provider of Medicare-certified skilled home health services, we believe we differentiate ourselves from our competitors by virtue of our scale and density in the markets we serve, the application of a highly integrated technology platform, our ability to manage a variety of care pathways, and a proven track record of consummating and integrating acquisitions. We have invested considerable resources into clinical and management systems and protocols that have allowed us to consistently produce high-quality outcomes for our patients while continuing to contain cost growth. Our proprietary hospital management reporting system aggregates data from each of our key business systems into a comprehensive reporting package used by the management teams in our hospitals, as well as executive management, and allows them to analyze data and trends and create custom reports on a timely basis. Our commitment to technology also includes the on-going implementation of our rehabilitation-specific electronic clinical information system. As of December 31, 2015, we had installed this system in 83 of our 121 hospitals. We believe this system will improve patient care and safety, enhance staff recruitment and retention, and set the stage for connectivity with other providers and health information exchanges. Our home health and hospice segment also uses information technology to enhance patient care and manage the business by utilizing Homecare HomebaseSM, a comprehensive information platform that allows home health providers to process clinical, compliance, and marketing information as well as analyze data and trends for management purposes using custom reports on a timely basis. This allows our home health segment to manage the entire patient work flow and provide valuable data for health systems, payors, and ACO partners. We are currently the home health provider to one ACO serving approximately 20,000 patients and are exploring several other participation opportunities. We believe these factors align with our strengths in, and focus on, post-acute services. In addition, we believe we can address the demand for facility-based and home-based post-acute services in markets where we currently do not have a presence by constructing or acquiring new hospitals and by acquiring home health and hospice agencies in that highly fragmented industry. Longer-term, the nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain and will likely remain so for some time, as the development of new delivery and payment systems will almost certainly require significant time and resources. Furthermore, many of the alternative approaches being explored may not work as intended. However, as outlined in the “Key Challenges-Changes to Our Operating Environment Resulting from Healthcare Reform” section below, our goal is to position the Company in a prudent manner to be responsive to industry shifts. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2020. Our balance sheet remains strong and includes a substantial portfolio of owned real estate. We have significant availability under our revolving credit facility, and we continue to generate strong cash flows from operations. Importantly, we have flexibility with how we choose to deploy our cash and create value for shareholders, including repayments of long-term debt, repurchases of our common stock, bed additions, de novos, acquisitions of inpatient rehabilitation hospitals, home health agencies, and hospice agencies, and common stock dividends. While our financial leverage increased as a result of the Encompass, Reliant and CareSouth transactions, we anticipate in the longer term reducing our financial leverage based on growth of Adjusted EBITDA and an allocation of a portion of our free cash flow to debt reduction. For these and other reasons, we believe we will be able to adapt to changes in reimbursement, sustain our business model, and grow through acquisition and consolidation opportunities as they arise. Key Challenges The healthcare industry is facing many well-publicized regulatory and reimbursement challenges. The industry is also facing uncertainty associated with the efforts, primarily arising from initiatives included in the 2010 Healthcare Reform Laws (as defined in Item 1, Business, “Regulatory and Reimbursement Challenges”) to identify and implement workable coordinated care delivery models. Successful healthcare providers are those who provide high-quality, cost-effective care and have the ability to adjust to changes in the regulatory and operating environments. We believe we have the necessary capabilities - scale, infrastructure, balance sheet, and management - to adapt to changes and continue to succeed in a highly regulated industry, and we have a proven track record of doing so. As we continue to execute our business plan, the following are some of the challenges we face. • Operating in a Highly Regulated Industry. We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These rules and regulations have affected, or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the costs of compliance, mandating new documentation standards, requiring additional licensure or certification, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and limiting our ability to enter new markets or add new capacity to existing hospitals and agencies. Ensuring continuous compliance with extensive laws and regulations is an operating requirement for all healthcare providers. We have invested, and will continue to invest, substantial time, effort, and expense in implementing and maintaining training programs as well as internal controls and procedures designed to ensure regulatory compliance, and we are committed to continued adherence to these guidelines. More specifically, because Medicare comprises a significant portion of our Net operating revenues, it is particularly important for us to remain compliant with the laws and regulations governing the Medicare program and related matters including anti-kickback and anti-fraud requirements. If we were unable to remain compliant with these regulations, our financial position, results of operations, and cash flows could be materially, adversely impacted. Concerns held by federal policymakers about the federal deficit and national debt levels could result in enactment of further federal spending reductions, further entitlement reform legislation affecting the Medicare program, or both, in 2016 and beyond. Additionally, many legislators in the United States House of Representatives and the United States Senate continue to express the policy objective of modifying or repealing the Patient Protection and Affordable Care Act (as subsequently amended, the “2010 Healthcare Reform Laws”). At this time, it is unclear what, if any, of the Medicare-related changes may ultimately be enacted and signed into law by the President, but it is possible that any reductions in Medicare spending will have a material impact on reimbursements for healthcare providers generally and post-acute providers specifically. We cannot predict what, if any, changes in Medicare spending or modifications to the 2010 Healthcare Reform Laws will result from future budget and other legislative initiatives. On April 16, 2015, the President signed into law the Medicare Access and CHIP (Children’s Health Insurance Program) Reauthorization Act, which repealed the statutory mechanism providing for annual automatic adjustments to the Medicare physician fee schedule using a sustainable growth rate formula that has historically resulted in annual deep cuts to physician reimbursement rates, a consequence of which has been the so-called “doc fixes” passed by Congress annually since 2002 to override those automatic adjustments. The primary impact of this act on post-acute care providers is a mandated market basket update of +1.0% in 2018 for rehabilitation hospitals as well as home health and hospice agencies. Another challenge relates to reduced Medicare reimbursement, which is also discussed in Item 1A, Risk Factors. Unless the United States Congress acts to change or eliminate it, sequestration, which began affecting payments received after April 1, 2013, will continue to result in a 2% decrease to reimbursements otherwise due from Medicare, after taking into consideration other changes to reimbursement rates such as market basket updates. Additionally, concerns held by federal policymakers about the federal deficit and national debt levels could result in enactment of further federal spending reductions, further entitlement reform legislation affecting the Medicare program, and/or further reductions to provider payments. Likewise, issues related to the federal budget or the unwillingness to raise the statutory cap on the federal government’s ability to issue debt, also referred to as the “debt ceiling,” may have a significant impact on the economy and indirectly on our results of operations and financial position. We cannot predict what alternative or additional deficit reduction initiatives, Medicare payment reductions, or post-acute care reforms, if any, will ultimately be enacted into law, or the timing or effect any such initiatives or reductions will have on us. If enacted, such initiatives or reductions would likely be challenging for all providers, would likely have the effect of limiting Medicare beneficiaries’ access to healthcare services, and could have an adverse impact on our financial position, results of operations, and cash flows. However, we believe our efficient cost structure should allow us to absorb, adjust to, or mitigate any potential initiative or reimbursement reductions more easily than most other post-acute providers. On July 31, 2015, CMS released its notice of final rulemaking for fiscal year 2016 (the “2016 Rule”) for inpatient rehabilitation facilities (“IRFs”) under the prospective payment system (“IRF-PPS”). The final rule will implement a net 1.7% market basket increase effective for discharges between October 1, 2015 and September 30, 2016, calculated as follows: Market basket update 2.4% Healthcare reform reduction 20 basis points Productivity adjustment 50 basis points The final rule also includes other changes that impact our hospital-by-hospital base rate for Medicare reimbursement. Such changes include, but are not limited to, revisions to the wage index values, changes to designations between rural and urban facilities, and updates to the outlier fixed-loss threshold. The final rule also continues the freeze of the update to the IRF-PPS facility-level rural adjustment factor, low-income patient factor, and teaching status adjustment factors. Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the final rule’s release and incorporates other adjustments included in the final rule, we believe the 2016 Rule will result in a net increase to our Medicare payment rates of approximately 1.6% effective October 1, 2015, prior to the impact of sequestration. Additionally, the final rule contains changes that could affect us in future years. For example, pursuant to the Improving Medicare Post-Acute Care Transformation Act of 2014 (the “IMPACT Act”), CMS adopted six additional quality reporting measures, the reporting of which beginning on October 1, 2016 will require additional time and expense and could affect reimbursement beginning October 1, 2017. CMS also adopted an IRF-specific market basket that could, in a given year, result in a higher or lower pricing update than the current market basket methodologies. Reimbursement claims made by healthcare providers, including inpatient rehabilitation hospitals as well as home health and hospice agencies, are subject to audit from time to time by governmental payors and their agents, such as the Medicare Administrative Contractors (“MACs”), fiscal intermediaries and carriers, as well as the OIG, CMS, and state Medicaid programs. Under programs designated as “widespread probes,” certain of our MACs have conducted pre-payment claim reviews of our billings and denied payment for certain diagnosis codes. A substantial majority of the denials we have encountered in these probes derive from one MAC. In connection with recent probes, this MAC has made determinations regarding medical necessity which represent its uniquely restrictive interpretations of the CMS coverage rules. We have discussed our objections to those interpretations with both the MAC and CMS. We cannot predict what, if any, changes will result from those discussions. If the MAC continues to deny a significant number of claims for certain diagnosis codes, we may experience increases in the Provision for doubtful accounts, decreases in cash flow as a result of increasing accounts receivable, and/or a shift in the patients and conditions we treat, any of which could have an adverse effect on our financial position, results of operations, and liquidity. On November 16, 2015, CMS issued its final rule establishing the Comprehensive Care for Joint Replacement (“CJR”) payment model. This mandatory model holds acute care hospitals accountable for the quality of care they deliver to Medicare fee-for-service beneficiaries for lower extremity joint replacements (i.e., knees and hips) from surgery through recovery. Through the five-year payment model, healthcare providers in 67 geographic areas would continue to be paid under existing Medicare payment systems. However, the hospital where the joint replacement takes place would be held accountable for the quality and costs of care for the entire episode of care - from the time of the surgery through 90 days after discharge. Depending on the quality and cost performance during the entire episode, the hospital may receive an additional payment or be required to repay Medicare for a portion of the episode costs. As a result, the acute care hospitals would be incented to work with physicians and post-acute care providers to ensure beneficiaries receive the coordinated care they need in an efficient manner. We believe its impact would be positive for HealthSouth as it should favor high-quality, low-cost providers like us who have made significant commitments to information systems that enable and enhance connectivity. We also believe the rule further validates our movement into home health via the acquisition of Encompass. Currently, lower extremity joint replacement patients represent less than 8% of our total annual discharges due to our required compliance with the 60% rule. Given the 67 geographic areas included in the CJR proposal, our patients potentially subject to this model represent less than 2% of our annual Medicare discharges. The lower extremity joint replacement patients we do treat are generally higher acuity and bilateral or possess significant comorbidities. In these cases and in any risk-bearing bundling initiative, quality of outcomes is critical to achieving targeted financial results. On October 29, 2015, CMS released its notice of final rulemaking for calendar year 2016 for home health agencies under the prospective payment system (“HH-PPS”). Specifically, while the final rule provides for a market basket update of 2.3%, that update is offset by a 2.4% rebasing adjustment reduction (the third year of a four-year phase-in), a productivity adjustment reduction of 40 basis points, and a case-mix coding intensity reduction of 90 basis points. We believe the final rule will result in a net decrease to Encompass’ Medicare payment rates of approximately 1.7% effective for episodes ending in calendar year 2016, before sequestration. Additionally, the HH-PPS provides that quality reporting requirements must be satisfied in order for agencies to avoid a 2% reduction in their annual HH-PPS payment update percentage. All home health agencies must submit both admission and discharge outcome and assessment information sets, or “OASIS assessments,” for a minimum of 70% of all patients with episodes of care occurring during the reporting period starting July 1, 2015. In the 2016 final rule, CMS increased the minimum reporting threshold to 80% for episodes occurring between July 1, 2016 and June 30, 2017, and to 90% for episodes occurring from July 1, 2017 and thereafter. We do not expect, based on our agencies’ current OASIS submission rates, to experience a material impact. In addition, the final home health rule establishes a Home Health Value-Based Purchasing model in nine states that will include five performance years beginning January 1, 2016 and test whether incentives for better care can improve outcomes in the delivery of home health services. The model would apply a reduction or increase to current Medicare-certified home health agency payments, depending on quality performance, made to agencies in those nine states. Payment adjustments would be applied on an annual basis, beginning at 3% and increasing to 8% in later years of the initiative. See also Item 1, Business, “Sources of Revenues” and “Regulation,” and Item 1A, Risk Factors, to this report and Note 17, Contingencies and Other Commitments, “Governmental Inquiries and Investigations,” to the accompanying consolidated financial statements. • Changes to Our Operating Environment Resulting from Healthcare Reform. Our challenges related to healthcare reform are discussed in Item 1, Business, “Sources of Revenues,” and Item 1A, Risk Factors. Many provisions within the 2010 Healthcare Reform Laws have impacted, or could in the future impact, our business. Most notably for us are the reductions to our hospitals’ annual market basket updates, including productivity adjustments, mandated reductions to home health and hospice Medicare reimbursements, and future payment reforms such as ACOs and bundled payments. The healthcare industry in general is facing uncertainty associated with the efforts, primarily arising from initiatives included in the 2010 Healthcare Reform Laws, to identify and implement workable coordinated care delivery models. In a coordinated care delivery model, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the overall value of the services they provide to a patient rather than the number of services they provide. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new delivery model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are positioning the Company in preparation for whatever changes are ultimately made to the delivery system: • We have a track record of successful partnerships with acute care providers. Thirty-three of our hospitals already operate as joint ventures with acute care hospitals, and we continue to pursue joint ventures as one of our growth initiatives. These joint ventures create an immediate link to an acute care system and position us to quickly and efficiently integrate our services in a coordinated care model. • Our commitment to coordinated care is demonstrated and enhanced by the utilization of technology. Our hospital electronic clinical information system is capable of interfaces with all major acute care electronic medical record systems and health information exchanges making communication easier across the continuum of healthcare providers. Our home health and hospice clinical information system utilizes a leading home care technology that manages the entire patient work flow. Importantly, we have the ability to use data from both systems to develop clinical protocol best practices. • Our balance sheet is strong, and we have consistently strong free cash flows. We have no significant debt maturities prior to 2020, and we have significant liquidity under our revolving credit facility. In addition, we own the real estate associated with approximately 68% of our hospitals. • We have a proven track record of being a high-quality, cost-effective provider. The FIM® Gains (a tool based on an 18-point assessment used to measure functional independence from admission to discharge) at our inpatient rehabilitation hospitals consistently exceed industry results, and the 30-day readmission rates at our home health agencies are lower than the national average. In addition, we have the scale and operating leverage to generate a low cost per discharge/visit. • We are currently participating in several coordinated care delivery model initiatives and are exploring ACO participation in several others. Eight of our IRFs began participating in Phase 2, the “at-risk” phase, of Model 3 of CMS’ Bundled Payments for Care Improvement (“BPCI”) initiative in 2015. We also have several IRFs that have signed participation agreements with acute care providers participating in Model 2 of the BPCI initiative. Ten of our home health agencies began participating in Phase 2 of Model 3 of the BPCI initiative in April 2014. In July 2015, 42 additional home health agencies began participating in Phase 2 of Model 3 of this initiative. In addition, we have partnered as the home health provider with Premier PHC™, an ACO serving approximately 20,000 Medicare patients. Given the complexity and the number of changes in the 2010 Healthcare Reform Laws, we cannot predict their ultimate impact. In addition, the ultimate nature and timing of the transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. Additionally, in October 2014, the President signed into law the IMPACT Act. The IMPACT Act was developed on a bi-partisan basis by the House Ways and Means and Senate Finance Committees and incorporated feedback from healthcare providers and provider organizations that responded to the Committees’ solicitation of post-acute payment reform ideas and proposals. It directs the United States Department of Health and Human Services (“HHS”), in consultation with healthcare stakeholders, to implement standardized data collection processes for post-acute quality and outcome measures. Although the IMPACT Act does not specifically call for the development of a new post-acute payment system, we believe this act will lay the foundation for possible future post-acute payment policies that would be based on patients’ medical conditions and other clinical factors rather than the setting where the care is provided. It will create additional data reporting requirements for our hospitals and home health agencies, and we expect to fully comply with these requirements. The precise details of these new reporting requirements, including timing and content, will be developed and implemented by CMS through the regulatory process that we expect will take place over the next several years. While we cannot quantify the potential financial effects of the IMPACT Act on HealthSouth, we believe any post-acute payment system that is data-driven and focuses on the needs and underlying medical conditions of post-acute patients ultimately will be a net positive for providers who offer high-quality, cost-effective care. However, it will likely take years for the related quality measures to be established, quality data to be gathered, standardized patient assessment data to be assembled and disseminated, and potential payment policies to be developed, tested, and promulgated. As the nation’s largest owner and operator of inpatient rehabilitation hospitals and fourth largest provider of Medicare-certified skilled home health services, we will work with HHS, the Medicare Payment Advisory Commission, and other healthcare stakeholders on these initiatives. • Maintaining Strong Volume Growth. Various factors, including competition and increasing regulatory and administrative burdens, may impact our ability to maintain and grow our hospital, home health, and hospice volumes. In any particular market, we may encounter competition from local or national entities with longer operating histories or other competitive advantages, such as acute care hospitals who provide post-acute services similar to ours or other post-acute providers with relationships with referring acute care hospitals or physicians. Aggressive payment review practices by Medicare contractors, aggressive enforcement of regulatory policies by government agencies, and restrictive or burdensome rules, regulations or statutes governing admissions practices may lead us to not accept patients who would be appropriate for and would benefit from the services we provide. In addition, from time to time, we must get regulatory approval to expand our services and locations in states with certificate of need laws. This approval may be withheld or take longer than expected. In the case of new-store volume growth, the addition of hospitals, home health agencies, and hospice agencies to our portfolio also may be difficult and take longer than expected. • Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk Factors, for a discussion of competition for staffing, shortages of qualified personnel, and other factors that may increase our labor costs. Recruiting and retaining qualified personnel for our inpatient hospitals and home health and hospice agencies remain a high priority for us. We attempt to maintain a comprehensive compensation and benefits package that allows us to remain competitive in this challenging staffing environment while remaining consistent with our goal of being a high-quality, cost-effective provider of inpatient rehabilitative services. See also Item 1, Business, and Item 1A, Risk Factors. These key challenges notwithstanding, we have a strong business model, a strong balance sheet, and a proven track record of achieving strong financial and operational results. We are attempting to position the Company to respond to changes in the healthcare delivery system and believe we will be in a position to take advantage of any opportunities that arise as the industry moves to this new stage. We believe we are positioned to continue to grow, adapt to external events, and create value for our shareholders in 2016 and beyond. Results of Operations Payor Mix During 2015, 2014, and 2013, we derived consolidated Net operating revenues from the following payor sources: Our payor mix is weighted heavily towards Medicare. We receive Medicare reimbursements under the inpatient rehabilitation facility prospective payment system (the “IRF-PPS”), the home health prospective payment system (“HH-PPS”) and the hospice prospective payment system (the “Hospice-PPS”). For additional information regarding Medicare reimbursement, see the “Sources of Revenues” section of Item 1, Business. As part of the Balanced Budget Act of 1997, Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or “Medicare Advantage.” The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (under Medicare Parts A and B) or enrollment in a health maintenance organization, preferred provider organization, point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Medicare Advantage revenues, included in the “managed care and other discount plans” category in the above table, represented approximately 8% of our total patient revenues during the years ended December 31, 2015, 2014, and 2013. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services and home health and hospice services. Net operating revenues also include other revenues generated from management and administrative fees and other nonpatient care services. These other revenues are included in “other income” in the above table. Our Results From 2013 through 2015, our consolidated results of operations were as follows: Provision for Doubtful Accounts and Operating Expenses as a % of Net Operating Revenues In the discussion that follows, we use “same-store” comparisons to explain the changes in certain performance metrics and line items within our financial statements. We calculate same-store comparisons based on hospitals open throughout both the full current period and prior periods presented. These comparisons include the financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 2015 Compared to 2014 Net Operating Revenues Our consolidated Net operating revenues increased by $757.0 million, or 31.5%, in 2015 compared to 2014. This increase primarily resulted from strong volume growth in both of our operating segments and included the effect of our acquisitions of Encompass, Reliant, and CareSouth. See additional discussion in the “Segment Results of Operations” section of this Item. Provision for Doubtful Accounts For several years, under programs designated as “widespread probes,” certain of our MACs have conducted pre-payment claim reviews of our billings and denied payment for certain diagnosis codes based on medical necessity. We dispute, or “appeal,” most of these denials, but the resolution of these disputes can take in excess of three years, and we cannot provide assurance as to our ongoing and future success of these disputes. As such, we make provisions against these receivables in accordance with our accounting policy that necessarily considers historical collection trends of the receivables in this review process as part of our Provision for doubtful accounts. Therefore, as we experience increases or decreases in these denials, or if our actual collections of these denials differ from our estimated collections, we may experience volatility in our Provision for doubtful accounts. See also Item 1, Business, “Sources of Revenues-Medicare Reimbursement,” to this report. The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2015 compared to 2014 primarily resulted from an increase in pre-payment claims denials by MACs, and continued substantial delays (exceeding three years) in the adjudication process at the administrative law judge hearing level. As these denials slowly work their way through the appeal process, we examine our success rate and adjust our historical collection percentage to estimate our Provision for doubtful accounts. In 2015, we revised our recovery estimates on pending MAC pre-payment claims from 63% to 71% using our historical collection percentage for all amounts denied. For claims we choose to take through all levels of appeal, up to and including administrative law judge hearings, we have historically experienced an approximate 70% success rate. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2015 compared to 2014 primarily due to increased patient volumes, a 2.25% merit increase given to all eligible nonmanagement hospital employees effective October 1, 2014, and an increase in group medical costs in our inpatient rehabilitation segment. Increased patient volumes included an increase in the number of full-time equivalents as a result of our hospital development activities and the acquisitions of Encompass, Reliant, and CareSouth. Full-time equivalents also increased due to hospital staffing additions to ensure compliance with new Medicare quality reporting requirements and the creation of a new medical services department. Salaries and benefits as a percent of Net operating revenues increased by 450 basis points during 2015 compared to 2014 primarily as a result of the acquisition of Encompass, the pricing impact of proportionally higher discharge growth from payors where our reimbursement is lower (as discussed in this Item, “Segment Results of Operations-Inpatient Rehabilitation-Net Operating Revenues”), an increase in group medical costs in our inpatient rehabilitation segment, start-up costs associated with our de novo hospitals that opened in the fourth quarter of 2014, and the additional staff associated with Medicare quality reporting and the medical services department. In addition, 2015 also included the pricing impact of updated Supplemental Security Income (“SSI”) ratios (as discussed in this Item, “Segment Results of Operations-Inpatient Rehabilitation-Net Operating Revenues”). We provided a 2.5% merit increase to our nonmanagement hospital employees effective October 1, 2015. Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals. These expenses include such items as contract services, utilities, non-income related taxes, insurance, professional fees, and repairs and maintenance. Other operating expenses increased during 2015 compared to 2014 primarily due to the acquisition of Encompass, increased patient volumes at our hospitals, and the ongoing implementation of our clinical information system. As a percent of Net operating revenues, Other operating expenses decreased during 2015 compared to 2014 due to increased revenues, primarily as a result of the acquisition of Encompass. Occupancy costs Occupancy costs include amounts paid for rent associated with leased hospitals, outpatient rehabilitation satellite clinics, and home health and hospice agencies, including common area maintenance and similar charges. Occupancy costs remained flat as a percent of Net operating revenues in 2015 compared to 2014 due to our increasing revenue, primarily as a result of the acquisition of Encompass. We expect Occupancy costs to increase going forward as a result of our acquisition of Reliant. Supplies Supplies expense includes all costs associated with supplies used while providing patient care. Specifically, these costs include pharmaceuticals, food, needles, bandages, and other similar items. Supplies expense decreased as a percent of Net operating revenues in 2015 compared to 2014 primarily due to our increasing revenue, primarily as a result of the acquisition of Encompass. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our corporate headquarters in Birmingham, Alabama. These expenses also include stock-based compensation expenses and transaction costs associated with our acquisitions of Reliant and CareSouth in 2015 and Encompass in 2014. General and administrative expenses increased in 2015 compared to 2014 due primarily to increased expenses associated with stock-based compensation, discussed in Note 14, Employee Benefit Plans, to the accompanying consolidated financial statements, and higher transaction costs. General and administrative expenses decreased as a percent of Net operating revenues in 2015 compared to 2014 primarily due to our increasing revenue, primarily as a result of the acquisition of Encompass. Depreciation and Amortization Depreciation and amortization increased during 2015 compared to 2014 due to our acquisitions and capital expenditures throughout 2014 and 2015. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Government, Class Action, and Related Settlements The loss included in Government, Class Action, and Related Settlements in 2015 resulted from a settlement discussed in Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2015 and 2014 related primarily to legal and consulting fees for continued litigation and support matters. Loss on Early Extinguishment of Debt In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 at a price of 102% of the principal amount and used $250 million of the net proceeds to repay borrowings under our term loan facilities, with the remaining net proceeds used to repay borrowings under our revolving credit facility. As a result of the term loan prepayment, we recorded a $1.2 million Loss on early extinguishment of debt in the first quarter of 2015. In April 2015, we used the net proceeds from the offering of 5.125% Senior Notes due 2023 along with cash on hand to execute the redemption of our 8.125% Senior Notes due 2020. As a result of this redemption, we recorded an $18.8 million Loss on early extinguishment of debt in the second quarter of 2015. In November 2015, we used borrowings under our senior secured credit facility to execute the redemption of $50 million of the outstanding principal amount of our existing 7.75% Senior Notes due 2022. As a result of this redemption, we recorded an $2.4 million Loss on early extinguishment of debt in the fourth quarter of 2015. The Loss on early extinguishment of debt in 2014 resulted from the redemption of our 7.25% Senior Notes due 2018 and the redemption of 10% of the outstanding principal amount of our 7.75% Senior Notes due 2022 in the fourth quarter of 2014. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees in 2015 compared to 2014 resulted from an increase in average borrowings offset by a lower average cash interest rate. Average borrowings increased due to our use of debt to fund the acquisitions of Encompass, Reliant, and CareSouth. Our average cash interest rate decreased from 6.3% in 2014 to 5.3% in 2015 due to the redemption of our 7.25% Senior Notes due 2018 in October 2014, the redemption of approximately $25 million of our 7.75% Senior Notes due 2022 in December 2014, and the redemption of our 8.125% Senior Notes due 2020 in April 2015. Cash paid for interest approximated $121 million and $101 million in 2015 and 2014, respectively. Average borrowings outstanding increased in 2015 primarily as a result of the acquisitions of Encompass, Reliant, and CareSouth. In turn, interest expense is expected to increase in 2016. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income for 2015 included a $1.2 million realized gain from the sale of all the common stock of Surgical Care Affiliates (“SCA”), our former surgery centers division and a $2.0 million gain related to the increase in fair value of our option to purchase up to a 5% equity interest in SCA from April 1, 2015 (the date it became exercisable) to April 13, 2015 (the date we exercised the option). See Note 12, Fair Value Measurements, to the accompanying consolidated financial statements. Other income for 2014 included a $27.2 million gain related to the acquisition of an additional 30% equity interest in Fairlawn. See Note 2, Business Combinations, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2015 increased compared to 2014 due to increased Net operating revenues primarily as a result of the acquisitions of Encompass, Reliant, and CareSouth. Our pre-tax income from continuing operations for 2014 included the $27.2 million gain on the consolidation of Fairlawn. Provision for Income Tax Expense Due to our federal and state net operating losses (“NOLs”), our cash income taxes approximated $9.4 million, net of refunds, in 2015. These payments resulted primarily from state income tax expense of subsidiaries which have separate state filing requirements, alternative minimum taxes, and federal income taxes for subsidiaries not included in our federal consolidated income tax return. In 2016, we estimate we will pay approximately $20 million to $40 million of cash income taxes, net of refunds. In 2015 and 2014, current income tax expense was $14.8 million and $13.3 million, respectively. Our effective income tax rate for 2015 was 35.9%. Our Provision for income tax expense in 2015 was greater than the federal statutory rate of 35% primarily due to: (1) state and other income tax expense and (2) an increase in our valuation allowance offset by (3) the impact of noncontrolling interests. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” for a discussion of the allocation of income or loss related to pass-through entities, which is referred to as the impact of noncontrolling interests in this discussion. The increase in our valuation allowance in 2015 related primarily to changes to our state apportionment percentages resulting from the acquisitions of Encompass, Reliant, and CareSouth and changes to our current forecast of earnings in each jurisdiction. Our effective income tax rate for 2014 was 28.6%. Our Provision for income tax expense in 2014 was less than the federal statutory rate of 35% primarily due to: (1) the impact of noncontrolling interests, (2) the nontaxable gain discussed in Note 2, Business Combinations, related to our acquisition of an additional 30% equity interest in Fairlawn, and (3) a decrease in our valuation allowance offset by (4) state and other income tax expense. As a result of the Fairlawn transaction, we released the deferred tax liability associated with the outside tax basis of our investment in Fairlawn because we now possess sufficient ownership to allow for the historical outside tax basis difference to be resolved through a tax-free transaction in the future. The decrease in our valuation allowance in 2014 related primarily to the expiration of state NOLs in certain jurisdictions, our current forecast of future earnings in each jurisdiction, and changes in certain state tax laws. In certain state jurisdictions, we do not expect to generate sufficient income to use all of the available NOLs prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable state tax jurisdiction, or if the timing of future tax deductions differs from our expectations. We recognize the financial statement effects of uncertain tax positions when it is more likely than not, based on the technical merits, a position will be sustained upon examination by and resolution with the taxing authorities. Total remaining gross unrecognized tax benefits were $2.9 million and $0.9 million as of December 31, 2015 and 2014, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests represents the share of net income or loss allocated to members or partners in our consolidated affiliates. The increase in Net Income Attributable to Noncontrolling Interests in 2015 compared to 2014 primarily resulted from our acquisition of Encompass on December 31, 2014. 2014 Compared to 2013 Net Operating Revenues Net patient revenue from our hospitals was 6.7% higher in 2014 than in 2013. This increase was attributable to a 3.5% increase in patient discharges and a 3.1% increase in net patient revenue per discharge. Discharge growth included a 1.3% increase in same-store discharges. Same-store discharges were negatively impacted by winter storms in the first quarter of 2014 (40 basis points) and the closure of 40 skilled nursing facility beds in June 2014 (20 basis points). Discharge growth from new stores primarily resulted from the consolidation of Fairlawn effective June 1, 2014, as discussed in Note 2, Business Combinations, to the accompanying consolidated financial statements. Net patient revenue per discharge in 2014 benefited from Medicare and managed care price adjustments and higher average acuity for the patients served. Net patient revenue per discharge was negatively impacted in the first quarter of 2014 by approximately $9 million for sequestration, which anniversaried on April 1, 2014. Net patient revenue per discharge in 2013 was negatively impacted by contractual allowances established in the fourth quarter of 2013 related to RAC audits. Decreased outpatient volumes in 2014 compared to 2013 resulted from the closure of outpatient clinics and continued competition from physicians offering physical therapy services within their own offices. Provision for Doubtful Accounts The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2014 compared to 2013 was primarily the result of continued pre-payment reviews by MACs and substantial delays in the adjudication process at the administrative law judge hearing level. Salaries and Benefits Salaries and benefits increased in 2014 compared to 2013 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2013 and 2014 development activities, and a 2.2% merit increase given to all eligible nonmanagement employees effective October 1, 2013. The net impact of reductions in self-insurance reserves, the negative impact of sequestration, and start-up costs associated with our de novo hospitals that opened in the fourth quarter of 2014 increased Salaries and benefits as a percent of Net operating revenues in 2014 compared to 2013. Excluding the impact of these three items, Salaries and benefits as a percent of Net operating revenues would have been approximately 40 basis points lower in 2014 than in 2013. Group medical and workers’ compensation reserves were reduced by approximately $8 million in 2014 as compared to approximately $15 million in 2013. We provided a 2.25% merit increase to our nonmanagement employees effective October 1, 2014. Other Operating Expenses Other operating expenses increased during 2014 compared to 2013 primarily as a result of increased patient volumes and approximately $7 million of lower reductions to self-insurance reserves for general and professional liability in 2014 than in 2013. As a percent of Net operating revenues, Other operating expenses for 2014 increased when compared to 2013 due primarily to these same lower reductions to self-insurance reserves. The increase in Other operating expenses as a percent of Net operating revenues for 2014 compared to 2013 also included the effects of sequestration experienced in the first quarter of 2014. Occupancy costs Occupancy costs decreased in total and as a percent of Net operating revenues in 2014 compared to 2013 due to our purchases of the real estate previously subject to operating leases at certain of our hospitals in the latter half of 2013 and first quarter of 2014. Supplies Supplies expense as a percent of Net operating revenues increased by 10 basis points during the 2014 compared to 2013 due primarily to the impact of sequestration on our Net operating revenues in the first quarter of 2014. General and Administrative Expenses In March 2008, we sold our corporate campus to Daniel Corporation (“Daniel”), a Birmingham, Alabama-based real estate company. The sale included a deferred purchase price component related to an incomplete 13-story building located on the property, often referred to as the Digital Hospital. Under the agreement, Daniel was obligated upon sale of its interest in the building to pay to us 40% of the net profit realized from the sale. In June 2013, Daniel sold the building to Trinity Medical Center. In the third quarter of 2013, we received $10.8 million in cash from Daniel in connection with the sale of the building. The gain associated with this transaction is being deferred and amortized over five years, which was the remaining life of our lease agreement with Daniel for the portion of the property we continue to occupy with our corporate office at the time of the transaction, as a component of General and administrative expenses. Approximately $2 million and $1 million of this gain was included in General and administrative expenses in 2014 and 2013, respectively. General and administrative expenses in 2014 included $9.3 million of transaction expenses related to our acquisition of Encompass. These one-time expenses were offset by decreased expenses associated with stock-based compensation and our Senior Management Bonus Program discussed in Note 14, Employee Benefit Plans, to the accompanying consolidated financial statements, as well as the amortization of the deferred gain on the Digital Hospital discussed above. General and administrative expenses were flat as a percent of Net operating revenues in 2014 compared to 2013 due primarily to our increasing revenue. Depreciation and Amortization Depreciation and amortization increased during 2014 compared to 2013 due to our increased capital expenditures and development activities throughout 2013 and 2014. Government, Class Action, and Related Settlements The gain included in Government, class action, and related settlements in 2013 resulted from a noncash reduction in the estimated liability associated with the apportionment obligation to the plaintiffs in the January 2007 comprehensive settlement of the consolidated securities action, the collection of final judgments against former officers, and the recovery of assets from former officers. See Note 18, Contingencies and Other Commitments, to the consolidated financial statements accompanying the 2014 Form 10-K. Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2014 and 2013 related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt in 2014 resulted from the redemption of our 7.25% Senior Notes due 2018 and the redemption of 10% of the outstanding principal amount of our 7.75% Senior Notes due 2022 in the fourth quarter of 2014. The Loss on early extinguishment of debt in 2013 resulted from the redemption of 10% of the outstanding principal amount of our 7.25% Senior Notes due 2018 and our 7.75% Senior Notes due 2022 in November 2013. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees during 2014 compared to 2013 primarily resulted from the noncash amortization of debt discounts and financing costs associated with the issuance of our 2.00% Convertible Senior Subordinated Notes due 2043 in November 2013. While our average borrowings increased in 2014 primarily as a result of issuing the convertible notes, our average cash interest rate decreased from 7.1% in 2013 to 6.2% in 2014. Cash paid for interest approximated $101 million and $99 million in 2014 and 2013, respectively. Other Income Other income for 2014 included a $27.2 million gain related to the acquisition of an additional 30% equity interest in Fairlawn. See Note 2, Business Combinations, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations for 2014 reflected continued revenue growth and increases in interest expense and depreciation and amortization. Pre-tax income was also impacted by three items having a net, favorable impact of $4.7 million. These items included the $27.2 million gain on the consolidation of Fairlawn offset by the $13.2 million Loss on early extinguishment of debt and $9.3 million of Encompass transaction expenses. Pre-tax income from continuing operations for 2013 included $23.5 million of gains related to Government, class action, and related settlements. Provision for Income Tax Expense As discussed above, our effective income tax rate for 2014 was 28.6%, which was less than the federal statutory rate of 35.0% primarily due to: (1) the impact of noncontrolling interests, (2) the nontaxable gain discussed in Note 2, Business Combinations, related to our acquisition of an additional 30% equity interest in Fairlawn, and (3) a decrease in our valuation allowance offset by (4) state and other income tax expense. Our effective income tax rate for 2013 was 3.2%, which was less than the federal statutory rate of 35.0% primarily due to: (1) the IRS settlement discussed in Note 15, Income Taxes, to the accompanying consolidated financial statements, (2) the impact of noncontrolling interests, and (3) a decrease in our valuation allowance offset by (4) state and other income tax expense. Total remaining gross unrecognized tax benefits were $0.9 million and $1.1 million as of December 31, 2014 and 2013, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. There can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing pharmaceutical costs has enabled us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions were not material to our operations in 2015, 2014, or 2013, and therefore, are not presented as a separate discussion within this Item. Segment Results of Operations Our internal financial reporting and management structure is focused on the major types of services provided by HealthSouth. Beginning in the first quarter of 2015, we manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. Prior period information has been adjusted to conform to the current period presentation. Specifically, HealthSouth’s legacy 25 hospital-based home health agencies have been reclassified from our inpatient rehabilitation segment to our home health and hospice segment for all periods presented. For additional information regarding our business segments, including a detailed description of the services we provide, financial data for each segment, and a reconciliation of total segment Adjusted EBITDA to income from continuing operations before income tax expense, see Note 18, Segment Reporting, to the accompanying consolidated financial statements. Inpatient Rehabilitation During the years ended December 31, 2015, 2014 and 2013, our inpatient rehabilitation segment derived its Net operating revenues from the following payor sources: Additional information regarding our inpatient rehabilitation segment’s operating results for the years ended December 31, 2015, 2014 and 2013, is as follows: * Excludes approximately 400 full-time equivalents in each period who are considered part of corporate overhead with their salaries and benefits included in General and administrative expenses in our consolidated statements of operations. Full-time equivalents included in the above table represent HealthSouth employees who participate in or support the operations of our hospitals and exclude an estimate of full-time equivalents related to contract labor. We actively manage the productive portion of our Salaries and benefits utilizing certain metrics, including employees per occupied bed, or “EPOB.” This metric is determined by dividing the number of full-time equivalents, including an estimate of full-time equivalents from the utilization of contract labor, by the number of occupied beds during each period. The number of occupied beds is determined by multiplying the number of licensed beds by our occupancy percentage. Net Operating Revenues Net patient revenue from our hospitals was 12.1% higher for 2015 compared to 2014. This increase included a 10.9% increase in patient discharges and a 1.1% increase in net patient revenue per discharge. Discharge growth included a 3.2% increase in same-store discharges. Discharge growth from new stores resulted from three de novo hospitals that opened in the fourth quarter of 2014 (Altamonte Springs, Florida; Newnan, Georgia; and Middletown, Delaware) and one de novo hospital that opened in December 2015 (Franklin, Tennessee), our acquisitions of Reliant (October 2015), Quillen Rehabilitation Hospital (“Quillen”) in Johnson City, Tennessee (November 2014) and Cardinal Hill in Lexington, Kentucky (May 2015), and our joint venture with Memorial Health in Savannah, Georgia (April 2015). While we experienced pricing growth from Medicare and managed care payors, the pricing adjustments were negatively impacted by proportionally higher discharge growth in Medicaid and managed care payors where our reimbursement is lower. In addition, our net patient revenue per discharge was negatively impacted in 2015 by approximately $5 million for updated SSI ratios published by CMS for fiscal year 2013. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding Reliant, Cardinal Hill, Quillen, Fairlawn, and our joint venture with Memorial Health. Adjusted EBITDA The increase in Adjusted EBITDA in 2015 compared to 2014 primarily resulted from revenue growth from both same stores and new stores, as discussed above. Adjusted EBITDA in 2015 was also impacted by (1) an increase in salaries and benefits as a percent of revenue due to increases in group medical costs, an increase in our licensed skills mix, and an increase in volume-related “premium” pay, (2) increased bad debt expense from continued pre-payment claims denials predominately by one of our MACs, (3) SSI ratio adjustments, as discussed above (4) a settlement of an employee sexual harassment matter that was not covered by insurance, and (5) incremental investments in our operating platform, including a contractual increase in costs associated with the ongoing implementation of our electronic clinical information system, the addition of staff at our hospitals to ensure compliance with new CMS quality reporting requirements, the creation of a new medical services department, and costs associated with our participation in CMS’ Model 3 bundling pilot initiative. Increases in group medical costs resulted from an increase in the number and size of large claims (claims greater than $100,000) and an increase in the cost and use of specialty pharmaceuticals. Home Health and Hospice During the years ended December 31, 2015, 2014 and 2013, our home health and hospice segment derived its Net operating revenues from the following payor sources: Additional information regarding our home health and hospice segment’s operating results for the years ended December 31, 2015, 2014 and 2013, is as follows: The increase in Net operating revenues and Adjusted EBITDA during 2015 compared to 2014 was due to our acquisition of Encompass on December 31, 2014 (see Note 2, Business Combinations, to the accompanying consolidated financial statements). Because of this acquisition, certain variances in the above table are considered to be not meaningful figures and are labeled as “NMF.” Results of Discontinued Operations For information regarding discontinued operations, see Note 12, Fair Value Measurements, to the accompanying consolidated financial statements. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Pursuing and achieving those objectives allows us to support the execution of our operating and strategic plans and weather temporary disruptions in the capital markets and general business environment. Maintaining adequate liquidity is a function of our unrestricted Cash and cash equivalents and our available borrowing capacity. Maintaining flexibility in our capital structure is a function of, among other things, the amount of debt maturities in any given year, the options for debt prepayments without onerous penalties, and limiting restrictive terms and maintenance covenants in our debt agreements. Consistent with these objectives, in December 2014, we drew $375 million under our expanded term loan facilities and $325 million under our revolving credit facility to fund the acquisition of Encompass. In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 (the “2024 Notes”) at a price of 102% of the principal amount and used $250 million of the net proceeds to repay borrowings under our term loan facilities, with the remaining net proceeds used to repay borrowings under our revolving credit facility. As a result of this transaction, we recorded a $1.2 million Loss on early extinguishment of debt in the first quarter of 2015. In March 2015, we issued $300 million of 5.125% Senior Notes due 2023 (the “2023 Notes”) at a price of 100.0% of the principal amount, which resulted in approximately $295 million in net proceeds from the public offering. On April 10, 2015, we used the net proceeds from the 2023 Notes offering along with cash on hand to redeem all of our 8.125% Senior Notes due 2020 (the “2020 Notes”). Pursuant to the terms of the 2020 Notes, this redemption was made at a price of 104.063%, which resulted in a total cash outlay of approximately $302 million to retire the $290 million in principal. As a result of this redemption, we recorded an $18.8 million Loss on early extinguishment of debt in the second quarter of 2015. In order to facilitate the funding of our development pipeline, including the acquisition of Reliant, in June 2015, we amended our existing credit agreement to (1) provide that the leverage ratio financial covenant be calculated on a pro forma basis to include the effects of investments, acquisitions, mergers, and other operational changes and (2) increase the amount of specifically permitted capital lease obligations from $200 million to $350 million. In July 2015, we further amended our credit agreement to (1) add $500 million of new term loan facilities to our existing $600 million revolving credit facility and $195 million of outstanding term loans, (2) change the maximum leverage ratio in the financial covenants applicable for the period July 2015 through June 2017 from 4.25x to 4.50x and to 4.25x from then until maturity, and (3) extend the maturity date for all borrowings to July 2020. Under the terms of the amendment, the amount available to us under the new term loan facilities would be reduced in the event we incurred additional capital markets indebtedness. Based on our issuance of additional senior notes in August 2015 and September 2015, as discussed below, our availability under the new term loan facilities was reduced to $250 million. In September, we borrowed $125 million of the new term loan facilities, the proceeds of which were used to fund a portion of the Reliant acquisition. We utilized the remaining $125 million of term loan facility capacity, as well as cash on hand, to finance the CareSouth acquisition. See Note 2, Business Combinations, to the accompanying consolidated financial statements and the “Executive Overview-2015 Overview” section of this Item. In August 2015, we issued an additional $350 million of our 2024 Notes at a price of 100.5% of the principal amount, which resulted in approximately $351 million in net proceeds from the private offering. We used the net proceeds to reduce borrowings under our revolving credit facility and fund a portion of the Reliant acquisition. In September 2015, we issued $350 million of 5.75% Senior Notes due 2025 (the “2025 Notes”) at a price of 100.0% of the principal amount, which resulted in approximately $344 million in net proceeds from the private offering. We used the net proceeds from this borrowing to fund a portion of the Reliant acquisition. See Note 2, Business Combinations, to the accompanying consolidated financial statements and the “Executive Overview-2015 Overview” section of this Item. In November 2015, we used cash on hand and borrowings under our senior secured credit facility to redeem $50 million of the outstanding principal amount of our existing 7.75% Senior Notes due 2022 (the “2022 Notes”). Pursuant to the terms of the 2022 Notes, this optional redemption was made at a price of 103.875%, which resulted in a total cash outlay of approximately $52 million. As a result of this redemption, we recorded a $2.4 million Loss on early extinguishment of debt in the fourth quarter of 2015. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. On February 23, 2016, we gave notice of, and made an irrevocable commitment for, the redemption of $50 million of the outstanding principal amount of our existing 2022 Notes. Pursuant to the terms of the 2022 Notes, this optional redemption will be at a price of 103.875%, which will result in a total cash outlay of approximately $52 million when the transaction closes, which is expected to be on March 24, 2016. We plan to use cash on hand and capacity under our revolving credit facility to fund the redemption. As a result of this redemption, we expect to record an approximate $2 million loss on early extinguishment of debt in the first quarter of 2016. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. On April 22, 2015, we delivered notice of the exercise of our rights to force conversion of all outstanding shares of our Convertible perpetual preferred stock (par value of $0.10 per share and liquidation preference of $1,000 per share) pursuant to the underlying certificate of designations. The effective date of the conversion was April 23, 2015. On that date, each share of preferred stock automatically converted into 33.9905 shares of our common stock (par value of $0.01 per share). We completed the forced conversion by issuing and delivering in the aggregate 3,271,415 shares of our common stock to the registered holders of the 96,245 shares of the preferred stock outstanding and paying cash in lieu of fractional shares due to those holders. The conversion increased the number of basic shares outstanding by 3,271,415 and did not change the diluted share count. On an annual basis, the conversion of the preferred stock to common stock is expected to result in a net positive cash impact of $3.2 million for the difference between preferred dividends and common dividends on these shares, based on the current common dividend level of $0.23 per share. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2020. Our balance sheet remains strong, and we have significant availability under our credit agreement. We continue to generate strong cash flows from operations, and we have significant flexibility with how we choose to invest our cash and return capital to shareholders. While our financial leverage increased as a result of the Encompass, Reliant and CareSouth transactions, we anticipate in the longer term reducing our financial leverage based on growth of Adjusted EBITDA and an allocation of a portion of our free cash flow to debt reduction. See Note 8, Long-term Debt, to the accompanying consolidated financial statements. Current Liquidity As of December 31, 2015, we had $61.6 million in Cash and cash equivalents. This amount excludes $45.9 million in Restricted cash and $56.2 million of restricted marketable securities ($40.1 million of restricted marketable securities are included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 3, Cash and Marketable Securities, to the accompanying consolidated financial statements. In addition to Cash and cash equivalents, as of December 31, 2015, we had approximately $436 million available to us under our revolving credit facility. Our credit agreement governs the substantial majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to $75 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. In calculating the leverage ratio under our credit agreement, we are permitted to use pro forma Adjusted EBITDA, the calculation of which includes historical income statement items and pro forma adjustments resulting from (1) the dispositions and repayments or incurrence of debt and (2) the investments, acquisitions, mergers, amalgamations, consolidations and operational changes from acquisitions to the extent such items or effects are not yet reflected in our trailing four-quarter financial statements. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As of December 31, 2015, the maximum leverage ratio requirement per our credit agreement was 4.50x and the minimum interest coverage ratio requirement was 3.0x, and we were in compliance with these covenants. Based on Adjusted EBITDA for 2015 and the interest rate in effect under our credit agreement during the three-month period ended December 31, 2015, if we had drawn on the first day and maintained the maximum amount of outstanding draws under our revolving credit facility for the entire year, we would still be in compliance with the maximum leverage ratio and minimum interest coverage ratio requirements. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2020, and our bonds all mature in 2022 and beyond. See the “Contractual Obligations” section below for information related to our contractual obligations as of December 31, 2015. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common stock and distribution of common stock dividends, including the potential growth of the quarterly cash dividend on our common stock, recognizing that these actions may increase our leverage ratio. See also the “Authorizations for Returning Capital to Stakeholders” section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years ended December 31, 2015, 2014, and 2013 (in millions): 2015 Compared to 2014 Operating activities. The increase in Net cash provided by operating activities during 2015 compared to 2014 primarily resulted from revenue growth. Cash flows provided by operating activities in 2015 were also impacted by increased cash interest expense and higher working capital. Higher working capital resulted from growth in accounts receivable due to additional claims denials and continued delays at the administrative law judge hearing level. Investing activities. The increase in Net cash used in investing activities during 2015 compared to 2014 resulted primarily from the acquisitions of Reliant and CareSouth described in Note 2, Business Combinations, to the accompanying consolidated financial statements. Financing activities. The increase in Net cash provided by financing activities during 2015 compared to 2014 primarily resulted from the public offering of the 2023 Notes, the additional offering of the 2024 Notes, and the private offering of the 2025 Notes to fund the acquisitions of Reliant and CareSouth as discussed above and in Note 8, Long-term Debt, to the accompanying consolidated financial statements. 2014 Compared to 2013 Operating activities. The decrease in Net cash provided by operating activities from 2013 to 2014 primarily resulted from growth in accounts receivable due to additional claims denials predominantly by one Medicare Administrative Contractor and continued delays at the administrative law judge hearing level. See Item 1, Business, “Sources of Revenues-Medicare Reimbursement-Inpatient Rehabilitation.” Investing activities. The increase in Net cash used in investing activities during 2014 compared to 2013 primarily resulted from the acquisition of Encompass. The total cash consideration delivered at closing was $695.5 million. Financing activities. Net cash provided by financing activities in 2014 primarily resulted from draws under the revolving and expanded term loan facilities of our credit agreement to fund the acquisition of Encompass. Excluding the Encompass-related borrowings, Net cash used in financing activities would have decreased in 2014 primarily due to repurchases of our common stock as part of a tender offer in the first quarter of 2013 offset by an increase in common stock cash dividends in 2014. See Note 2, Business Combinations, Note 8, Long-term Debt, and Note 16, Earnings per Common Share, to the accompanying consolidated financial statements. Contractual Obligations Our consolidated contractual obligations as of December 31, 2015 are as follows (in millions): (a) Included in long-term debt are amounts owed on our bonds payable and other notes payable. These borrowings are further explained in Note 8, Long-term Debt, to the accompanying consolidated financial statements. (b) Interest on our fixed rate debt is presented using the stated interest rate. Interest expense on our variable rate debt is estimated using the rate in effect as of December 31, 2015. Interest related to capital lease obligations is excluded from this line. Future minimum payments, which are accounted for as interest, related to sale/leaseback transactions involving real estate accounted for as financings are included in this line (see Note 5, Property and Equipment, and Note 8, Long-term Debt, to the accompanying consolidated financial statements). Amounts exclude amortization of debt discounts, amortization of loan fees, or fees for lines of credit that would be included in interest expense in our consolidated statements of operations. (c) Amounts include interest portion of future minimum capital lease payments. (d) Our inpatient rehabilitation segment leases approximately 32% of its hospitals as well as other property and equipment under operating leases in the normal course of business. Our home health and hospice segment leases relatively small office spaces in the localities it serves, space for its corporate office, and other equipment under operating leases in the normal course of business. Some of our hospital leases contain escalation clauses based on changes in the Consumer Price Index while others have fixed escalation terms. The minimum lease payments do not include contingent rental expense. Some lease agreements provide us with the option to renew the lease or purchase the leased property. Our future operating lease obligations would change if we exercised these renewal options and if we entered into additional operating lease agreements. For more information, see Note 5, Property and Equipment, to the accompanying consolidated financial statements. (e) Future operating lease obligations and purchase obligations are not recognized in our consolidated balance sheet. (f) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on HealthSouth and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. Our purchase obligations primarily relate to software licensing and support. (g) Because their future cash outflows are uncertain, the following noncurrent liabilities are excluded from the table above: general liability, professional liability, and workers’ compensation risks, noncurrent amounts related to third-party billing audits, and deferred income taxes. Also, as of December 31, 2015, we had $2.9 million of total gross unrecognized tax benefits. For more information, see Note 9, Self-Insured Risks, Note 15, Income Taxes, and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements. (h) The table above does not include Redeemable noncontrolling interests of $121.1 million because of the uncertainty surrounding the timing and amounts of any related cash outflows. See Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year ended December 31, 2015, we made capital expenditures of approximately $157 million for property and equipment and capitalized software. These expenditures in 2015 are exclusive of approximately $985 million in net cash related to our acquisition activity. During 2016, we expect to spend approximately $185 million to $230 million for capital expenditures. Approximately $95 million to $110 million of this budgeted amount is considered nondiscretionary expenditures, which we may refer to in other filings as “maintenance” expenditures. Actual amounts spent will be dependent upon the timing of construction projects and acquisition opportunities for our home health and hospice business. Authorizations for Returning Capital to Stakeholders In October 2014, February 2015, and May 2015, our board of directors declared a cash dividend of $0.21 per share that was paid in January 2015, April 2015, and July 2015, respectively. On July 16, 2015, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.23 per share, payable on October 15, 2015 to stockholders of record on October 1, 2015. On October 23, 2015, our board of directors declared a cash dividend of $0.23 per share, payable on January 15, 2016 to stockholders of record on January 2, 2016. We expect quarterly dividends to be paid in January, April, July, and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates as well as the per share amounts, will be at the discretion of our board of directors after consideration of various factors, including our capital position and alternative uses of funds. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our credit agreement. The payment of cash dividends on our common stock triggers antidilution adjustments, except in instances when such adjustments are deemed de minimis, under our convertible notes and our previous convertible perpetual preferred stock. See Note 8, Long-term Debt, Note 10, Convertible Perpetual Preferred Stock, and Note 16, Earnings per Common Share, to the accompanying consolidated financial statements. On February 14, 2014, our board of directors approved an increase in our existing common stock repurchase authorization from $200 million to $250 million. As of December 31, 2015, approximately $160 million remained under this authorization. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. During 2015, we repurchased 1.3 million shares of our common stock in the open market for $45.3 million under this repurchase authorization using cash on hand. Future repurchases under this authorization generally are expected to be funded using a combination of cash on hand and availability under our $600 million revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 8, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement - our interest coverage ratio and our leverage ratio - could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might be on terms less favorable to us than those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. In general terms, the credit agreement definition of Adjusted EBITDA, therein referred to as “Adjusted Consolidated EBITDA,” allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to $10 million in a year may be cash expenditures), (2) any losses from discontinued operations and closed locations, (3) costs and expenses, including legal fees and expert witness fees, incurred with respect to litigation associated with stockholder derivative litigation, and (4) share-based compensation expense. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent increasing consolidated Net income. Under the credit agreement, the Adjusted EBITDA calculation does not include net income attributable to noncontrolling interests and includes (1) gain or loss on disposal of assets, (2) professional fees unrelated to the stockholder derivative litigation, (3) unusual or nonrecurring cash expenditures in excess of $10 million, and (4) pro forma adjustments resulting from debt transactions and development activities. These items may not be indicative of our ongoing performance, so the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Our Adjusted EBITDA for the years ended December 31, 2015, 2014, and 2013 was as follows (in millions): Reconciliation of Net Income to Adjusted EBITDA Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA Growth in Adjusted EBITDA from 2015 to 2014 resulted primarily from the acquisition of Encompass on December 31, 2014. As discussed above in the “Segment Results of Operations” section of this Item, increased Net operating revenues in our inpatient rehabilitation segment were impacted by (1) an increase in salaries and benefits as a percent of revenue due to increases in group medical costs, an increase in our licensed skills mix, and an increase in volume-related “premium” pay, (2) increased bad debt expense from continued pre-payment claims denials predominately by one of our MACs, (3) SSI ratio adjustments, and (4) incremental investments in our operating platform. Growth in Adjusted EBITDA from 2013 to 2014 was due primarily to continued revenue growth, as well as an approximate $6 million contribution to Adjusted EBITDA from the increase in ownership and consolidation of Fairlawn. The comparison to last year was negatively impacted by approximately $14 million attributable to lower reductions in our self-insurance reserves in 2014 than in 2013, as discussed in the “Results of Operations” section of this Item. Adjusted EBITDA in 2014 also included approximately $8 million for the negative impact of sequestration in the first quarter of 2014 and approximately $4 million in higher net start-up costs, year over year, for new hospitals. Off-Balance Sheet Arrangements In accordance with the definition under SEC rules, the following qualify as off-balance sheet arrangements: • any obligation under certain guarantees or contracts; • a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that serves as credit, liquidity, or market risk support to that entity for such assets; • any obligation under certain derivative instruments; and • any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the registrant, or engages in leasing, hedging, or research and development services with the registrant. As of December 31, 2015, we do not have any material off-balance sheet arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2015, we are not involved in any unconsolidated SPE transactions. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates, and judgments to ensure our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, as they require our most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the audit committee of our board of directors. See also Note 2, Business Combinations, to the accompanying consolidated financial statements. Revenue Recognition We recognize net patient service revenue in the reporting period in which we perform the service based on our current billing rates (i.e., gross charges) less actual adjustments and estimated discounts for contractual allowances (principally for patients covered by Medicare, Medicaid, and managed care and other health plans). See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues,” to the accompanying consolidated financial statements for a complete discussion of our revenue recognition policies. Our accounting systems calculate contractual allowances on a patient-by-patient basis based on the rates in effect for each primary third-party payor. Other factors that are considered and could further influence the level of our reserves include the patient’s total length of stay for in-house patients, each patient’s discharge destination, the proportion of patients with secondary insurance coverage and the level of reimbursement under that secondary coverage, and the amount of charges that will be disallowed by payors. Such additional factors are assumed to remain consistent with the experience for patients discharged in similar time periods for the same payor classes, and additional reserves are provided to account for these factors. Management continually reviews the contractual estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. In addition, laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. In addition, CMS has developed and instituted various Medicare audit programs under which CMS contracts with private companies to conduct claims and medical record audits. In connection with CMS approved and announced RAC audits related to IRFs, we received requests in 2013 and 2014 to review certain patient files for discharges occurring from 2010 to 2014. To date, the Medicare payments that are subject to these audit requests represent less than 1% of our Medicare patient discharges during those years, and not all of these patient file requests have resulted in payment denial determinations by the RACs. While we make provisions for these claims based on our historical experience and success rates in the claims adjudication process, which is the same process we follow for appealing denials of certain diagnosis codes by MACs, we cannot provide assurance as to our future success in the resolution of these and future disputes, nor can we predict or estimate the scope or number of denials that ultimately may be received. During 2015 and 2014, we adjusted our Net operating revenues by approximately ($0.6) million and $0.4 million, respectively, for post-payment claims that are part of this review process. Due to complexities involved in determining amounts ultimately due under reimbursement arrangements with third-party payors, which are often subject to interpretation and review, we may receive reimbursement for healthcare services authorized and provided that is different from our estimates, and such differences could be material. However, we continually review the amounts actually collected in subsequent periods in order to determine the amounts by which our estimates differed. Historically, such differences have not been material from either a quantitative or qualitative perspective. Allowance for Doubtful Accounts The collection of outstanding receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. We provide for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. See Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” and Note 4, Accounts Receivable, to the accompanying consolidated financial statements for a complete discussion of our policies related to the allowance for doubtful accounts. We estimate our allowance for doubtful accounts based on the aging of our accounts receivable, our historical collection experience for each type of payor, and other relevant factors so that the remaining receivables, net of allowances, are reflected at their estimated net realizable values. Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. Our collection risks include patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding. In addition, reimbursement claims made by health care providers are subject to audit from time to time by governmental payors and their agents. For several years, under programs designated as “widespread probes,” certain of our MACs have conducted pre-payment claim reviews of our billing and denied payment for certain diagnosis codes based on medical necessity. We dispute, or “appeal,” most of these denials, and we collect approximately 71% of all amounts denied. For claims we choose to take through all levels of appeal, up to and including administrative law judge hearings, we have historically experienced an approximate 70% success rate. Because we do not write off receivables until all collection efforts have been exhausted, we do not write-off receivables related to denied claims while they are in this review process. The resolution of these disputes can take in excess of three years. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. As of December 31, 2015 and 2014, $126.1 million and $62.2 million, or 22.1% and 15.4%, respectively, of our patient accounts receivable represented denials by MACs that were in the pre-payment medical necessity review process. During the years ended December 31, 2015, 2014, and 2013, we wrote off $2.6 million, $1.4 million, and $2.2 million, respectively, of previously denied claims while we collected $7.4 million, $7.1 million, and $1.7 million, respectively, of previously denied claims. The table below shows a summary of our net accounts receivable balances as of December 31, 2015 and 2014. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” to the accompanying consolidated financial statements. *Due to a methodology change, we have adjusted the 2014 amounts, which only impacts the aging categories and not total Accounts receivable, net. Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers’ compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers’ compensation risks are insured through a wholly owned insurance subsidiary. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost of reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers’ compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: • historical claims experience; • trending of loss development factors; • trends in the frequency and severity of claims; • coverage limits of third-party insurance; • demographic information; • statistical confidence levels; • medical cost inflation; • payroll dollars; and • hospital patient census. The time period to resolve claims can vary depending upon the jurisdiction, the nature, and the form of resolution of the claims. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): In the years leading up to 2013, we experienced volatility in our estimates of prior year claim reserves due primarily to favorable trends in claims and industry-wide loss development trends. We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. See Note 9, Self-Insured Risks, to the accompanying consolidated financial statements for additional information. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management’s estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as of October 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our inpatient rehabilitation and home health and hospice reporting units. We assess qualitative factors in each reporting unit to determine whether it is necessary to perform the first step of the two-step quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not a reporting unit’s fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must proceed to Step 1, we would determine the fair value of the applicable reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of the reporting units determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting units. The income approach includes the use of each reporting unit’s projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management’s best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company’s stock price. See Note 1, Summary of Significant Accounting Policies, “Goodwill and Other Intangibles,” and Note 6, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets; • Industry and market considerations and changes in healthcare regulations, including reimbursement and compliance requirements under the Medicare and Medicaid programs; • Cost factors, such as an increase in labor, supply, or other costs; • Overall financial performance, such as negative or declining cash flows or a decline in actual or forecasted revenue or earnings; • Other relevant company-specific events, such as material changes in management or key personnel or outstanding litigation; • Material events, such as a change in the composition or carrying amount of each reporting unit’s net assets, including acquisitions and dispositions; and • Consideration of the relationship of our market capitalization to our book value, as well as a sustained decrease in our share price. In the fourth quarter of 2015, we performed our annual evaluation of goodwill and determined no adjustment to impair goodwill was necessary. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our inpatient rehabilitation and home health and hospice reporting units are not at risk for any impairment charges. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” and Note 15, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year ended December 31, 2015, we increased our valuation allowance by $4.6 million. As of December 31, 2015, we had a remaining valuation allowance of $27.6 million which primarily related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the NOLs before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management’s estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as of December 31, 2015 will be realized, no such assurances can be provided. If management’s expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, “Litigation Reserves,” and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding ForwardLooking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business We are one of the nation’s largest providers of postacute healthcare services, offering both facilitybased and homebased postacute services in 34 states and Puerto Rico through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As discussed in this Item, “Segment Results of Operations,” we manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. On December 31, 2014, we completed the acquisition of EHHI Holdings, Inc. (“EHHI”) and its Encompass Home Health and Hospice business (“Encompass”), which at the time consisted of 135 home health and hospice locations in 12 states. In the acquisition, we acquired, for cash, all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to HealthSouth Home Health Holdings, Inc. (“Holdings”), a subsidiary of HealthSouth and now indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. These certain sellers were members of Encompass management, including April Anthony, the Chief Executive Officer of Encompass. These sellers contributed a portion of their shares of common stock of EHHI in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. We funded the cash purchase price in the acquisition entirely with draws under the revolving and expanded term loan facilities of our credit agreement. The total cash consideration delivered at closing was $695.5 million. We view Encompass as a partnership that brings together the talent and home care experience of the existing Encompass team with all of the resources and postacute care experience of HealthSouth. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. While our national network of inpatient hospitals stretches across 29 states and Puerto Rico, we are concentrated in the eastern half of the United States and Texas. As of December 31, 2015, we operate 121 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture which we account for using the equity method of accounting. In addition to HealthSouth hospitals, we manage three inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 84% of our Net operating revenues for the year ended December 31, 2015. Home Health and Hospice Encompass is the nation’s fourth largest provider of Medicarecertified skilled home health services. As of December 31, 2015, Encompass provides home health and hospice services in 213 locations across 23 states. In addition, two of these home health locations operate as joint ventures which we account for using the equity method of accounting. Encompass home health services include a comprehensive range of Medicarecertified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. Encompass also provides specialized home care services in Texas and Kansas for pediatric patients [/INST] Negative. </s>

HEALTHSOUTH CORP

2017-02-22

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business We are one of the nation’s largest providers of post-acute healthcare services, offering both facility-based and home-based post-acute services in 35 states and Puerto Rico through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As discussed in this Item, “Segment Results of Operations,” we manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 30 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2016, we operate 123 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture which we account for using the equity method of accounting. In addition to HealthSouth hospitals, we manage five inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 81% of our Net operating revenues for the year ended December 31, 2016. Home Health and Hospice Our home health and hospice business is the nation’s fourth largest provider of Medicare-certified skilled home health services in terms of revenues. We acquired EHHI Holdings, Inc. (“EHHI”) and its Encompass Home Health and Hospice business (“Encompass”) on December 31, 2014 and have since transitioned our previously existing HealthSouth home health operations to the Encompass platform and trade name. In the acquisition, we acquired, for cash, all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to HealthSouth Home Health Holdings, Inc. (“Holdings”), a subsidiary of HealthSouth and now indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. These certain sellers were members of Encompass management, including April Anthony, the chief executive officer of Encompass. These sellers contributed a portion of their shares of common stock of EHHI in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. We funded the cash purchase price in the acquisition entirely with draws under the revolving and expanded term loan facilities of our credit agreement. The total cash consideration delivered at closing was $695.5 million. As of December 31, 2016, Encompass provides home health and hospice services in 223 locations across 25 states, with concentrations in the Southeast, Oklahoma, and Texas. In addition, two of these home health locations operate as joint ventures which we account for using the equity method of accounting. Our home health and hospice segment represented approximately 19% of our Net operating revenues for the year ended December 31, 2016. See Item 1, Business, and Item 1A, Risk Factors, of this report, Note 2, Business Combinations, Note 9, Long-term Debt, and Note 18, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” and “Liquidity and Capital Resources” sections of this Item. 2016 Overview Our 2016 strategy focused on the following priorities: • continuing to provide high-quality, cost-effective care to patients in our existing markets; • achieving organic growth at our existing hospitals, home health agencies, and hospice agencies; • expanding our services to more patients who require post-acute healthcare services by constructing and acquiring hospitals in new markets and acquiring home health and hospice agencies in new markets; • continuing our shareholder distributions via common stock dividends and repurchases of our common stock; and • positioning the Company for success in the evolving healthcare delivery system. This preparation includes continuing the installation of our electronic clinical information system (“ACE-IT”) in our hospitals which allows for interfaces with all major acute care electronic medical record systems and health information exchanges and participating in bundling projects and Accountable Care Organizations (“ACOs”). During 2016, Net operating revenues increased by 17.2% over 2015 due primarily to our acquisitions of the operations of Reliant Hospital Partners, LLC and affiliated entities (“Reliant”) on October 1, 2015 and CareSouth Health System, Inc. (“CareSouth”) on November 2, 2015 (see Note 2, Business Combinations, to the accompanying consolidated financial statements). Within our inpatient rehabilitation segment, discharge growth of 10.8% coupled with a 2.9% increase in net patient revenue per discharge in 2016 generated 13.9% growth in net patient revenue from our hospitals compared to 2015. Discharge growth included a 1.7% increase in same-store discharges. Within our home health and hospice segment, home health admission growth of 43.6% coupled with the impact of a 1.3% decrease in revenue per episode in 2016 generated 34.6% growth in home health and hospice revenue compared to 2015. Home health admission growth included a 13.7% increase in same-store admissions. In 2016, we further positioned ourselves for the healthcare industry’s movement to integrated delivery payment models, value-based purchasing, and post-acute site neutrality. We deployed and coordinated clinical protocols and discharge planning between our hospitals and home health agencies. We increased the clinical collaboration rate between our hospitals and our home health agencies. Within our inpatient rehabilitation segment, we initiated development of a predictive model to identify patients at risk for acute care transfer. We implemented a multidisciplinary medication reconciliation process using ACE-IT. Our hospitals and agencies also participated in bundling and ACO alternative payment models in various markets, and we developed a form of collaborator agreement to facilitate entering into arrangements with acute care hospitals participating in bundled payment projects. Many of our quality and outcome measures remained above both inpatient rehabilitation and home health industry averages, as reported through the Uniform Data System for Medical Rehabilitation (the “UDS”), the United States Centers for Medicare and Medicaid Services (“CMS”), and Avalere Health and the Alliance for Home Health Quality and Innovation. Not only did we treat more patients and enhance outcomes, we did so in a cost-effective manner. Likewise, our growth efforts continued to yield positive results in 2016. In our inpatient rehabilitation hospital segment, we: • began operating the 27-bed inpatient rehabilitation hospital at CHI St. Vincent Hot Springs, a Catholic Health Initiatives’ hospital, in Hot Springs, Arkansas with our joint venture partner, St. Vincent Community Health Services, Inc, in February 2016. The joint venture completed construction of a 40-bed hospital and transferred its operations on July 1, 2016; • entered into an agreement, in July 2016, with Novant Health, Inc. to file a certificate of need (“CON”) application to build a new 68-bed inpatient rehabilitation hospital in Winston-Salem, North Carolina. We were awarded a CON in November 2016 and expect construction of the new hospital to commence in the summer of 2017. The rehabilitation unit currently located at the Novant Health Rehabilitation Center in Winston-Salem will be relocated to the newly constructed hospital that is expected to be completed in the fourth quarter of 2018; • entered into an agreement, in July 2016, with BJC HealthCare to file a CON application to build a 35-bed inpatient rehabilitation hospital on the third floor of BJC's Barnes-Jewish St. Peters Hospital located in St. Peters, Missouri. We were awarded a CON in September 2016 and construction of the new hospital commenced in October 2016. Construction is expected to be completed in the summer of 2017. The hospital will serve as a satellite location of the Rehabilitation Institute of St. Louis, an existing inpatient rehabilitation hospital we operate jointly with BJC HealthCare; • began operating the 22-bed inpatient rehabilitation hospital at the Bernsen Rehabilitation Center at St. John, in Broken Arrow, Oklahoma with our joint venture partner, St. John Health System, in August 2016. The joint venture began construction of a 40-bed hospital in August 2016. We expect construction to be completed and operations to be transferred in the third quarter of 2017; • began operating the new 49-bed inpatient rehabilitation hospital at CHI St. Joseph Health Rehabilitation Hospital in Bryan, Texas with our joint venture partner, St. Joseph’s Health System, in August 2016; • entered into an agreement, in August 2016, with Tidelands Health to jointly own and operate the existing 29-bed inpatient rehabilitation hospital currently located on the campus of Tidelands Waccamaw Community Hospital in Murrells Inlet, South Carolina. The joint venture’s operation of this hospital is expected to begin in 2018 and is subject to customary closing conditions, including regulatory approvals. In addition, the joint venture will build, own, and operate a second, 46-bed inpatient rehabilitation hospital in Little River, South Carolina. Construction of the new hospital is expected to begin in 2017, subject to CON approval; • began accepting patients at our new, 50-bed inpatient rehabilitation hospital in Modesto, California in October 2016; • formed a joint venture, in December 2016, with Memorial Hospital at Gulfport to own and operate a 33-bed inpatient rehabilitation hospital in Gulfport, Mississippi. The joint venture's operation of the hospital is expected to begin in the second quarter of 2017, and is subject to customary closing conditions, including regulatory approvals; • continued construction of our 60-bed joint venture hospital with Mount Carmel Health System in Westerville, Ohio. The joint venture's operation of the hospital is expected to begin in the second quarter of 2017; • continued construction of our 48-bed joint venture hospital with West Tennessee Healthcare in Jackson, Tennessee. The joint venture's operation of the hospital is expected to begin in the third quarter of 2017; • continued our capacity expansions by adding 83 new beds to existing hospitals; and • continued development of the following de novo hospitals: (1) In March 2016, we secured land and began the design and permitting process. (2) In June 2016, we were awarded a CON, acquired land, and began the design and permitting process. (3) In August 2016, we were awarded a CON, acquired land, and began the zoning, design, and permitting process. (4) In August 2014, we acquired land and began the design and permitting process. We also continued our growth efforts in our home health and hospice segment. During 2016, we: • acquired, in May 2016, Home Health Agency of Georgia, LLC., a home health and hospice provider with two home health locations and two hospice locations in the Greater Atlanta area; • began accepting patients at our new home health locations in Lee’s Summit, Missouri in February 2016 and New Port Richey, Florida in May 2016; • acquired, in July 2016, Advantage Health Inc., a home health provider with one location in Yuma, Arizona; • acquired, in September 2016, three hospice agencies from Sotto International, Inc. located in Texarkana, Arkansas, Magnolia, Arkansas, and Texarkana, Texas; • began accepting patients at our new hospice location in Lee’s Summit, Missouri in July 2016; • acquired, in October 2016, two home health agencies from Summit Home Health Care, Inc. located in Cheyenne, Wyoming and Laramie, Wyoming; • acquired, in October 2016, LightHouse Health Care, Inc., a home health provider with one location in Springfield, Virginia; • acquired, in November 2016, Gulf City Home Care, Inc., a home health provider with one location in Sarasota, Florida; • acquired, in November 2016, Honor Hospice, LLC, a hospice provider with one location in Wheat Ridge, Colorado; and • began accepting patients at our new home health location in Georgetown, Texas and our new hospice location in Nashville, Tennessee in November 2016. To support our growth efforts, we continued taking steps to further increase the strength and flexibility of our balance sheet. Specifically, we redeemed the outstanding principal balance of $176 million of the 7.75% Senior Notes due 2022 in March, May, and September of 2016. For additional information regarding these actions, see Note 9, Long-term Debt, to the accompanying consolidated financial statements and the “Liquidity and Capital Resources” section of this Item. We also continued our shareholder distributions by repurchasing 1.7 million shares of our common stock in the open market for approximately $64 million during 2016. In addition, we continued paying a quarterly cash dividend of $0.23 per share on our common stock in the first three quarters of 2016. On July 21, 2016, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.24 per share that was paid on October 17, 2016, and we paid the same per share quarterly dividend on January 17, 2017. See the “Liquidity and Capital Resources” section of this Item. Business Outlook We believe our business outlook remains positive for two primary reasons. First, demographic trends, such as population aging, should increase long-term demand for facility-based and home-based post-acute services. While we treat patients of all ages, most of our patients are 65 and older, and the number of Medicare enrollees is expected to grow approximately 3% per year for the foreseeable future. We believe the demand for facility-based and home-based post-acute services will continue to increase as the U.S. population ages and life expectancies increase. Second, we are an industry leader in the growing post-acute sector. As the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals, we believe we differentiate ourselves from our competitors based on our broad platform of clinical expertise, the quality of our clinical outcomes, the sustainability of best practices, and the application of rehabilitative technology. As the fourth largest provider of Medicare-certified skilled home health services in terms of revenues, we believe we differentiate ourselves from our competitors by virtue of our scale and density in the markets we serve, the application of a highly integrated technology platform, our ability to manage a variety of care pathways, and a proven track record of consummating and integrating acquisitions. We have invested considerable resources into clinical and management systems and protocols that have allowed us to consistently produce high-quality outcomes for our patients while continuing to contain cost growth. Our proprietary hospital management reporting system aggregates data from each of our key business systems into a comprehensive reporting package used by the management teams in our hospitals, as well as executive management, and allows them to analyze data and trends and create custom reports on a timely basis. Our commitment to technology also includes the on-going implementation of ACE-IT. As of December 31, 2016, we had installed this system in 101 of our 123 hospitals, and we expect to complete installation in substantially all of our existing hospitals by the end of 2017. We believe this system will improve patient care and safety, enhance staff recruitment and retention, and set the stage for connectivity with other providers and health information exchanges. Our home health and hospice segment also uses information technology to enhance patient care and manage the business by utilizing Homecare HomebaseSM, a comprehensive information platform that allows home health providers to process clinical, compliance, and marketing information as well as analyze data and trends for management purposes using custom reports on a timely basis. This allows our home health segment to manage the entire patient work flow and provide valuable data for health systems, payors, and ACO partners. We are currently the home health provider to one ACO serving approximately 22,000 patients and are exploring several other participation opportunities. We believe these factors align with our strengths in, and focus on, post-acute services. In addition, we believe we can address the demand for facility-based and home-based post-acute services in markets where we currently do not have a presence by constructing or acquiring new hospitals and by acquiring home health and hospice agencies in that highly fragmented industry. Longer-term, the nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain and will likely remain so for some time, as the development of new delivery and payment systems will almost certainly require significant time and resources. Furthermore, many of the alternative approaches being explored may not work as intended. However, as outlined in the “Key Challenges-Changes to Our Operating Environment Resulting from Healthcare Reform” section below, our goal is to position the Company in a prudent manner to be responsive to industry shifts. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2020. Our balance sheet remains strong and includes a substantial portfolio of owned real estate. We have significant availability under our revolving credit facility, and we continue to generate strong cash flows from operations. Importantly, we have flexibility with how we choose to deploy our cash and create value for shareholders, including bed expansions at existing inpatient rehabilitation hospital and de novos, acquisition and de novo construction of inpatient rehabilitation hospitals, home health agencies, and hospice agencies, repayments of long-term debt, common stock dividends, and repurchases of our common stock. While our financial leverage increased as a result of the acquisions in Note 2, Business Combinations, to the accompanying consolidated financial statements, we anticipate in the longer term reducing our financial leverage based on growth of Adjusted EBITDA and an allocation of a portion of our free cash flow to debt reduction. For these and other reasons, we believe we will be able to adapt to changes in reimbursement, sustain our business model, and grow through acquisition and consolidation opportunities as they arise. Key Challenges The healthcare industry is facing many well-publicized regulatory and reimbursement challenges. The industry is also facing uncertainty associated with the efforts, primarily arising from initiatives included in the 2010 Healthcare Reform Laws (as defined in Item 1, Business, “Regulatory and Reimbursement Challenges”) to identify and implement workable coordinated care and integrated delivery payment models. Successful healthcare providers are those who provide high-quality, cost-effective care and have the ability to adjust to changes in the regulatory and operating environments. We believe we have the necessary capabilities - scale, infrastructure, balance sheet, and management - to adapt to changes and continue to succeed in a highly regulated industry, and we have a proven track record of doing so. As we continue to execute our business plan, the following are some of the challenges we face. • Operating in a Highly Regulated Industry. We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These rules and regulations have affected, or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the costs of compliance, mandating new documentation standards, requiring additional licensure or certification, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and limiting our ability to enter new markets or add new capacity to existing hospitals and agencies. Ensuring continuous compliance with extensive laws and regulations is an operating requirement for all healthcare providers. We have invested, and will continue to invest, substantial time, effort, and expense in implementing and maintaining training programs as well as internal controls and procedures designed to ensure regulatory compliance, and we are committed to continued adherence to these guidelines. More specifically, because Medicare comprises a significant portion of our Net operating revenues, it is particularly important for us to remain compliant with the laws and regulations governing the Medicare program and related matters including anti-kickback and anti-fraud requirements. If we were unable to remain compliant with these regulations, our financial position, results of operations, and cash flows could be materially, adversely impacted. Concerns held by federal policymakers about the federal deficit and national debt levels could result in enactment of further federal spending reductions, further entitlement reform legislation affecting the Medicare program, or both, in 2017 and beyond. Additionally, many legislators in the United States House of Representatives and the United States Senate continue to express the policy objective of modifying or repealing the 2010 Healthcare Reform Laws. The election of President Donald Trump, along with Republican majorities in the United States Senate and House of Representatives, increase the likelihood of changes to or repeal of provisions of the 2010 Healthcare Reform Laws through both legislative and regulatory action. At this time, it is unclear what, if any, of the Medicare-related changes may ultimately be enacted and signed into law by the President, but it is possible that any reductions in Medicare spending will have a material impact on reimbursements for healthcare providers generally and post-acute providers specifically. We cannot predict what, if any, changes in Medicare spending or modifications to the healthcare laws and regulations will result from future budget and other legislative initiatives. On April 16, 2015, President Obama signed into law the Medicare Access and CHIP (Children’s Health Insurance Program) Reauthorization Act, which repealed the statutory mechanism providing for annual automatic adjustments to the Medicare physician fee schedule using a sustainable growth rate formula that had historically resulted in annual deep cuts to physician reimbursement rates, a consequence of which has been the so-called “doc fixes” passed by Congress annually since 2002 to override those automatic adjustments. The primary impact of this act on post-acute care providers is a mandated market basket update of +1.0% in 2018 for rehabilitation hospitals as well as home health and hospice agencies. Another challenge relates to reduced Medicare reimbursement, which is also discussed in Item 1A, Risk Factors. Unless the United States Congress acts to change or eliminate it, sequestration, which began affecting payments received after April 1, 2013, will continue to result in a 2% decrease to reimbursements otherwise due from Medicare, after taking into consideration other changes to reimbursement rates such as market basket updates. The Medicare Payment Advisory Commission (“MedPAC”) is an independent agency that advises Congress on issues affecting Medicare and makes payment policy recommendations to Congress and CMS for a variety of Medicare payment systems including, among others, the inpatient rehabilitation facility prospective payment system (the “IRF-PPS”), the home health prospective payment system (the “HH-PPS”) and the hospice prospective payment system (the “Hospice-PPS”). Congress and CMS are not obligated to adopt MedPAC recommendations, and, based on outcomes in previous years, there can be no assurance those recommendations will be adopted. However, MedPAC’s recommendations have, and may in the future, become the basis for subsequent legislative or regulatory action. In March 2016, MedPAC released recommendations to eliminate the market basket update for each of the IRF-PPS, the HH-PPS, and the Hospice-PPS for 2017. In another recommendation affecting IRFs, MedPAC suggested increasing the IRF-PPS outlier payment pool. The final rule for the IRF-PPS discussed below did not follow MedPAC’s recommendations to eliminate the market basket update or to increase the outlier pool. In a June 2016 report mandated by the IMPACT Act, MedPAC set out its evaluation of a unified payment system for all post-acute care (“PAC-PPS”) in lieu of separate systems for IRFs, skilled nursing facilities, long-term acute care hospitals, and home health agencies. MedPAC found a PAC-PPS to be feasible and desireable but also suggested many existing regulatory requirements, including the IRF 60% rule (as defined in Item 1A, Risk Factors) and the requirement for a minimum of three hours of therapy per day, should be waived as part of implementing a PAC-PPS. MedPAC also suggested that ultimately Medicare should move from fee-for-service reimbursement to more integrated delivery payment models. In December 2016, MedPAC recommended a 5% reduction in both inpatient rehabilitation and home health reimbursement for 2018 and a two-year rebasing of home health reimbursement rates beginning in 2019. MedPAC also reiterated an increase to the outlier payment pool to be funded by reductions to base Medicare payments rates under the IRF-PPS. This proposal would adversely affect us as we have a relatively low percentage of outlier payments compared to other inpatient rehabilitation providers. On July 29, 2016, CMS released its notice of final rulemaking for fiscal year 2017 for IRFs under the IRF-PPS (the “2017 IRF Rule”). The final rule will implement a net 1.65% market basket increase effective for discharges between October 1, 2016 and September 30, 2017, calculated as follows: Market basket update 2.7% Healthcare reform reduction 75 basis points Productivity adjustment 30 basis points The final rule also includes other changes that impact our hospital-by-hospital base rate for Medicare reimbursement. Such changes include, but are not limited to, revisions to the wage index values, changes to designations between rural and urban facilities, and updates to the outlier fixed loss threshold. The final rule also continues the freeze to the update to the IRF-PPS facility-level rural adjustment factor, low-income patient factor, and teaching status adjustment factors. Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the final rule’s release and incorporates other adjustments included in the final rule, we believe the 2017 IRF Rule will result in a net increase to our Medicare payment rates of approximately 1.9% effective October 1, 2016, prior to the impact of sequestration. Additionally, the 2017 IRF Rule contains changes that could affect us in future years. For example, CMS adopted five additional quality reporting measures, the reporting of which may require additional time and expense and could affect reimbursement beginning October 1, 2017. Reimbursement claims made by healthcare providers, including inpatient rehabilitation hospitals as well as home health and hospice agencies, are subject to audit from time to time by governmental payors and their agents, such as the Medicare Administrative Contractors (“MACs”), fiscal intermediaries and carriers, as well as the Office of Inspector General, CMS, and state Medicaid programs. Under programs designated as “widespread probes,” certain of our MACs have conducted pre-payment claim reviews of our billings and denied payment for certain diagnosis codes. We dispute, or “appeal,” most of these denials, and for claims we choose to take to administrative law judge hearings, we have historically experienced an approximate 70% success rate. The appeals process established by CMS has encountered significant delays in recent years. The resolution of these disputes can take in excess of three years. Currently, we have appeals being heard that have been pending for up to five years. The majority of the denials we have encountered in these probes derive from one MAC. In connection with recent probes, this MAC has made determinations regarding medical necessity which represent its uniquely restrictive interpretations of the CMS coverage rules. We continue to discuss our objections to those interpretations with both the MAC and CMS. We cannot predict what, if any, changes will result from those discussions. If the MAC continues to deny a significant number of claims for certain diagnosis codes, we may experience increases in the Provision for doubtful accounts, decreases in cash flow as a result of increasing accounts receivable, and/or a shift in the patients and conditions we treat, any of which could have an adverse effect on our financial position, results of operations, and liquidity. In December 2016, the presiding federal district court judge in the lawsuit ordered HHS to reduce the backlog of appeals by 30% by the end of 2017, by 60% by the end of 2018, by 90% by the end of 2019, and completely by the end of 2020. HHS has appealed the federal district court decision. On January 17, 2017, CMS published a rule implementing procedural and administrative changes to the appeals process, but it is unclear what, if any, impact these changes will have on the backlog. This new rule may be subject to legal challenge by healthcare providers as well. We cannot predict what, if any, further action CMS will take to reduce the backlog. On November 16, 2015, CMS published its final rule establishing the Comprehensive Care for Joint Replacement (“CJR”) bundled payment model. This mandatory model holds acute care hospitals accountable for the quality of care they deliver to Medicare fee-for-service beneficiaries for lower extremity joint replacements (i.e., knees and hips) from surgery through recovery. During the CJR model’s five-year term, which began on April 1, 2016, healthcare providers in 67 geographic areas (“MSAs”) will continue to be paid under existing Medicare payment systems. However, the hospital where the joint replacement takes place will be held accountable for the quality and costs of care for the entire episode of care - from the time of the original admission through 90 days after discharge. Depending on the quality and cost performance during the entire episode, the hospital may receive an additional payment or be required to repay Medicare for a portion of the episode costs. Under this model, hospitals had no repayment responsibility, or downside financial risk, for 2016. However, they do have downside risk beginning in 2017. As a result, CMS believes acute care hospitals would be incented to work with physicians and post-acute care providers to ensure beneficiaries receive the coordinated care they need in an efficient manner. Acute care hospitals participating in the CJR model may enter into risk-sharing financial arrangements with post-acute providers, including IRFs and home health agencies. We believe its impact will be positive for HealthSouth as it should favor high-quality, low-cost providers like us who have made significant commitments to information systems that enable and enhance connectivity. We also believe the rule further validates our movement into home health via the acquisition of Encompass. Currently, lower extremity joint replacement patients represent less than 8% of our total annual discharges due to our required compliance with the 60% rule. Given the 67 MSAs included in the CJR model, our patients potentially subject to this model represent approximately 2.1% of our annual Medicare discharges. The lower extremity joint replacement patients we do treat are generally higher acuity and possess significant comorbidities. In these cases and in any risk-bearing bundling initiative, quality of outcomes is critical to achieving targeted financial results. On January 3, 2017, CMS published its final rule providing for the creation and testing of three new episode payment models (“EPMs”) as well as modification of the CJR model. The three new Medicare EPMs are: (1) acute myocardial infarction model, (2) coronary artery bypass graft (“CABG”) model, and (3) surgical hip/femur fracture treatment excluding lower extremity joint replacement (“SHFFT”) model. Most relevant to us are the mandatory CABG and SHFFT models which are set to begin July 1, 2017 and continue through the end of 2021. Under these models, as with the CJR model, acute care hospitals are financially accountable for the quality and cost of an episode of care, which is intended to incentivize increased coordination of care among hospitals, physicians, and post-acute care providers. The SHFFT model covers the same 67 MSAs as the CJR model (HealthSouth is located in 36 of these MSAs), and the CABG model covers 98 MSAs (HealthSouth is located in 40 of these MSAs). Our patients potentially subject to the CABG model represent approximately 0.7% of our annual Medicare discharges. Our patients potentially subject to the SHFFT model represent approximately 1.2% of our annual Medicare discharges incremental to the above CJR program. On October 31, 2016, CMS released its notice of final rulemaking for calendar year 2017 for home health agencies under the HH-PPS (the “2017 HH Rule”). Specifically, while the final rule provides for a market basket update of 2.8%, that update is offset by a 2.3% rebasing adjustment reduction (the last year of a four-year phase-in), a productivity adjustment reduction of 30 basis points, an outlier fixed dollar loss adjustment of 0.1%, and a coding intensity reduction of 0.9% (the second year of a three-year phase-in). We believe the 2017 HH Rule will result in a net decrease to Encompass’ Medicare payment rates of approximately 3.6% effective for episodes ending in calendar year 2017. The net decrease to Encompass’ Medicare payment rates is primarily due to a 0.9% case mix re-weighting and 2.0% for the change in the outlier calculation methodology. The 2017 HH Rule had an approximate $1.5 million negative impact on revenues in the fourth quarter of 2016 applicable to episodes that began in 2016 and ended in 2017. Additionally, the 2017 HH Rule requires us to report four new quality measures, the reporting of which will require additional time and expense and could affect reimbursement beginning in 2018. On June 8, 2016, CMS implemented a new pre-claim review demonstration of home health services in five states for a period of three years. Encompass operates in three of these states (Florida, Texas, and Massachusetts). In the pre-claim review demonstration project, CMS proposes to have Medicare contractors collect additional information from home health providers submitting claims in order to determine proper payment or if there is a suspicion of fraud. The project began in Illinois on August 3, 2016. Because of difficulties encountered in administering the project, the start date in Florida was delayed to April 1, 2017. The start dates for the other states have not been announced. Approximately 48% of Encompass’ Medicare claims are submitted by agencies in these three states (primarily Texas and Florida). This pre-claim demonstration project will require us to incur additional administrative and staffing costs and may impact the timeliness of claims payment given that fiscal intermediaries in Illinois have had difficulty processing pre-claim reviews on a timely basis. Accordingly, if the roll out project is not delayed or canceled, we may experience temporary increases in the Provision for doubtful accounts and decreases in cash flow or we may incur costs associated with patient care, the Medicare claim for which is subsequently denied, each of which could have an adverse effect on our financial position, results of operations, and liquidity. See also Item 1, Business, “Sources of Revenues” and “Regulation,” and Item 1A, Risk Factors, to this report and Note 17, Contingencies and Other Commitments, “Governmental Inquiries and Investigations,” to the accompanying consolidated financial statements. • Changes to Our Operating Environment Resulting from Healthcare Reform. Our challenges related to healthcare reform are discussed in Item 1, Business, “Sources of Revenues,” and Item 1A, Risk Factors. Many provisions within the 2010 Healthcare Reform Laws have impacted, or could in the future impact, our business. Most notably for us are the reductions to our hospitals’ annual market basket updates, including productivity adjustments, mandated reductions to home health and hospice Medicare reimbursements, and future payment reforms such as ACOs and bundled payments. While the change in administrations has added to regulatory uncertainty, the healthcare industry in general has been facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models. In these models, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the overall value and quality of the services they provide to a patient rather than the number of services they provide. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new delivery model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are positioning the Company in preparation for whatever changes are ultimately made to the delivery system. • We have a track record of successful partnerships with acute care providers. Thirty-seven of our hospitals already operate as joint ventures with acute care hospitals, and we continue to pursue joint ventures as one of our growth initiatives. These joint ventures create an immediate link to an acute care system and position us to quickly and efficiently integrate our services in a coordinated care model. • Our commitment to coordinated care is demonstrated and enhanced by the utilization of technology. Our hospital electronic clinical information system is capable of interfaces with all major acute care electronic medical record systems and health information exchanges making communication easier across the continuum of healthcare providers. Our home health and hospice clinical information system utilizes a leading home care technology that manages the entire patient work flow. Importantly, we have the ability to use data from both systems to develop clinical protocol best practices. • Our balance sheet is strong, and we have consistently strong free cash flows. We have no significant debt maturities prior to 2020, and we have significant liquidity under our revolving credit facility. In addition, we own the real estate associated with approximately 69% of our hospitals. • We have a proven track record of being a high-quality, cost-effective provider. The FIM® Gains (a tool based on an 18-point assessment used to measure functional independence from admission to discharge) at our inpatient rehabilitation hospitals consistently exceed industry results, and the 30-day readmission rates at our home health agencies are lower than the national average. In addition, we have the scale and operating leverage to generate a low cost per discharge/visit. • The combination of home health and hospice with our existing inpatient rehabilitative healthcare services provides us with an increased opportunity to succeed in value-based purchasing programs and to participate in more coordinated care and integrated delivery payment models, such as ACOs and bundled payment arrangements. We believe enhanced clinical collaboration between our hospitals and home health agencies offers an excellent means to deliver the quality of care and the cost effectiveness that these new models require to be successful. Since partnering with Encompass, we have focused, and will continue to focus, on increasing this collaboration. We are currently participating in several coordinated care delivery model initiatives and are exploring ACO participation in several others. Eight of our IRFs began participating in Phase 2, the “at-risk” phase, of Model 3 of CMS’ Bundled Payments for Care Improvement (“BPCI”) initiative in 2015. We also have several IRFs that have signed participation agreements with acute care providers participating in Model 2 of the BPCI initiative. Ten of our home health agencies began participating in Phase 2 of Model 3 of the BPCI initiative in 2014. As of December 31, 2016, 38 home health agencies participate in Phase 2. In addition, we have partnered as the home health provider with Premier PHC™, an ACO serving approximately 22,000 Medicare patients. Given the complexity and the number of changes in the 2010 Healthcare Reform Laws and other pending regulatory initiatives, we cannot predict their ultimate impact. Furthermore, the election of President Donald Trump, along with Republican majorities in the United States Senate and House of Representatives, increase the likelihood of changes to or repeal of provisions of the 2010 Healthcare Reform Laws through both legislative and regulatory action. Therefore, the ultimate nature and timing of the transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. Additionally, in October 2014, President Obama signed into law the IMPACT Act. The IMPACT Act was developed on a bi-partisan basis by the House Ways and Means and Senate Finance Committees and incorporated feedback from healthcare providers and provider organizations that responded to the Committees’ solicitation of post-acute payment reform ideas and proposals. It directs the United States Department of Health and Human Services (“HHS”), in consultation with healthcare stakeholders, to implement standardized data collection processes for post-acute quality and outcome measures. Although the IMPACT Act does not specifically call for the development of a new post-acute payment system, we believe this act will lay the foundation for possible future post-acute payment policies that would be based on patients’ medical conditions and other clinical factors rather than the setting where the care is provided, also referred to as “site neutral” reimbursement. It will also create additional data reporting requirements for our hospitals and home health agencies, and we expect to fully comply with these requirements. The precise details of these new reporting requirements, including timing and content, will be developed and implemented by CMS through the regulatory process that we expect will take place over the next several years. While we cannot quantify the potential financial effects of the IMPACT Act on HealthSouth, we believe any post-acute payment system that is data-driven and focuses on the needs and underlying medical conditions of post-acute patients ultimately will be a net positive for providers who offer high-quality, cost-effective care. However, it will likely take years for the related quality measures to be established, quality data to be gathered, standardized patient assessment data to be assembled and disseminated, and potential payment policies to be developed, tested, and promulgated. As the nation’s largest owner and operator of inpatient rehabilitation hospitals and fourth largest provider of Medicare-certified skilled home health services, we will work with HHS, MedPAC, and other healthcare stakeholders on these initiatives. • Maintaining Strong Volume Growth. Various factors, including competition and increasing regulatory and administrative burdens, may impact our ability to maintain and grow our hospital, home health, and hospice volumes. In any particular market, we may encounter competition from local or national entities with longer operating histories or other competitive advantages, such as acute care hospitals who provide post-acute services similar to ours or other post-acute providers with relationships with referring acute care hospitals or physicians. Aggressive payment review practices by Medicare contractors, aggressive enforcement of regulatory policies by government agencies, and restrictive or burdensome rules, regulations or statutes governing admissions practices may lead us to not accept patients who would be appropriate for and would benefit from the services we provide. In addition, from time to time, we must get regulatory approval to expand our services and locations in states with certificate of need laws. This approval may be withheld or take longer than expected. In the case of new-store volume growth, the addition of hospitals, home health agencies, and hospice agencies to our portfolio also may be difficult and take longer than expected. • Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk Factors, for a discussion of competition for staffing, shortages of qualified personnel, and other factors that may increase our labor costs. Recruiting and retaining qualified personnel for our inpatient hospitals and home health and hospice agencies remain a high priority for us. We attempt to maintain a comprehensive compensation and benefits package that allows us to remain competitive in this challenging staffing environment while remaining consistent with our goal of being a high-quality, cost-effective provider of inpatient rehabilitative services. See also Item 1, Business, and Item 1A, Risk Factors. These key challenges notwithstanding, we believe we have a strong business model, a strong balance sheet, and a proven track record of achieving strong financial and operational results. We are attempting to position the Company to respond to changes in the healthcare delivery system and believe we will be in a position to take advantage of any opportunities that arise as the industry moves to this new stage. We believe we are positioned to continue to grow, adapt to external events, and create value for our shareholders in 2017 and beyond. Results of Operations Payor Mix During 2016, 2015, and 2014, we derived consolidated Net operating revenues from the following payor sources: Our payor mix is weighted heavily towards Medicare. We receive Medicare reimbursements under the IRF-PPS, the HH-PPS, and the Hospice-PPS. For additional information regarding Medicare reimbursement, see the “Sources of Revenues” section of Item 1, Business. As part of the Balanced Budget Act of 1997, Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or “Medicare Advantage.” The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (under Medicare Parts A and B) or enrollment in a health maintenance organization, preferred provider organization, point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services and home health and hospice services. Net operating revenues also include other revenues generated from management and administrative fees and other nonpatient care services. These other revenues are included in “other income” in the above table. Our Results From 2014 through 2016, our consolidated results of operations were as follows: Provision for Doubtful Accounts and Operating Expenses as a % of Net Operating Revenues In the discussion that follows, we use “same-store” comparisons to explain the changes in certain performance metrics and line items within our financial statements. We calculate same-store comparisons based on hospitals open throughout both the full current period and prior periods presented. These comparisons include the financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 2016 Compared to 2015 Net Operating Revenues Our consolidated Net operating revenues increased in 2016 compared to 2015 primarily from strong volume growth in both of our operating segments and included the effect of our acquisitions of Reliant on October 1, 2015 and CareSouth on November 2, 2015. See additional discussion in the “Segment Results of Operations” section of this Item. Provision for Doubtful Accounts The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2016 compared to 2015 was primarily due to aging-based reserves resulting from continued administrative payment delays at our largest MAC. For additional information, see Item 1, Business, “Sources of Revenues-Medicare Reimbursement,” of this report. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2016 compared to 2015 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2015 development activities, the acquisitions of Reliant and CareSouth, a salary increase given to all eligible nonmanagement hospital employees effective in October of each year, and an increase in benefit costs. Salaries and benefits as a percent of Net operating revenues increased during 2016 compared to 2015 primarily as a result of salary and benefit cost increases, Medicare home health reimbursement rate cuts, and the ramping up of new hospitals in Franklin, Tennessee, Hot Springs, Arkansas, Bryan, Texas, Broken Arrow, Oklahoma, and Modesto, California. We provided a 2.75% salary increase to our nonmanagement hospital employees effective October 1, 2016. Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals and home health and hospice agencies. These expenses include such items as contract services, utilities, non-income related taxes, insurance, professional fees, and repairs and maintenance. Other operating expenses increased during 2016 compared to 2015 primarily due to the acquisitions of Reliant and CareSouth and increased patient volumes at our hospitals offset by a $3.3 million gain from the divestiture of our home health pediatric services in November 2016. See Note 18, Segment Reporting, to the accompanying consolidated financial statements. Other operating expenses during 2015 included the settlement of an employee sexual harassment matter that was not covered by insurance. As a percent of Net operating revenues, Other operating expenses decreased during 2016 compared to 2015 due to our increasing revenues, primarily as a result of the acquisitions of Reliant and CareSouth, and to the aforementioned divestiture and settlement. Occupancy costs Occupancy costs include amounts paid for rent associated with leased hospitals, outpatient rehabilitation satellite clinics, and home health and hospice agencies, including common area maintenance and similar charges. Occupancy costs increased during 2016 compared to 2015 in terms of dollars and as a percent of Net operating revenues due to the acquisition of Reliant, which leased all of its hospitals. Supplies Supplies expense includes all costs associated with supplies used while providing patient care. Specifically, these costs include pharmaceuticals, food, needles, bandages, and other similar items. Supplies increased during 2016 compared to 2015 due primarily to increased patient volumes. Supplies decreased as a percent of Net operating revenues during 2016 compared to 2015 primarily due to supply chain efficiencies including the continued transition of brand name drugs to generic. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our home office in Birmingham, Alabama. These expenses also include stock-based compensation expenses and transaction costs associated with our acquisitions of Reliant and CareSouth in 2015. General and administrative expenses increased in 2016 compared to 2015 due primarily to increased corporate full-time equivalents, benefit costs, and stock compensation expenses offset by transaction costs related to the acquisitions of Reliant and CareSouth. General and administrative expenses decreased as a percent of Net operating revenues in 2016 compared to 2015 primarily due to our increasing revenues, primarily as a result of the acquisitions of Reliant and CareSouth. Depreciation and Amortization Depreciation and amortization increased during 2016 compared to 2015 due to our acquisitions and capital expenditures throughout 2015 and 2016. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Government, Class Action, and Related Settlements The loss included in Government, Class Action, and Related Settlements in 2015 resulted from a settlement discussed in Note 17, Contingencies and Other Commitments, to the consolidated financial statements accompanying our Annual Report on Form 10-K for the year ended December 31, 2015 (the “2015 Form 10-K”). Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2016 and 2015 related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements, and Note 17, Contingencies and Other Commitments, to the consolidated financial statements accompanying the 2015 Form 10-K. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt during 2016 resulted from the redemptions of our 7.75% Senior Notes due 2022 in March, May, and September of 2016. In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 at a price of 102% of the principal amount and used $250 million of the net proceeds to repay borrowings under our term loan facilities, with the remaining net proceeds used to repay borrowings under our revolving credit facility. As a result of the term loan prepayment, we recorded a $1.2 million Loss on early extinguishment of debt in the first quarter of 2015. In April 2015, we used the net proceeds from the offering of 5.125% Senior Notes due 2023 along with cash on hand to execute the redemption of our 8.125% Senior Notes due 2020. As a result of this redemption, we recorded an $18.8 million Loss on early extinguishment of debt in the second quarter of 2015. In November 2015, we used borrowings under our senior secured credit facility to execute the redemption of $50 million of the outstanding principal amount of our existing 7.75% Senior Notes due 2022. As a result of this redemption, we recorded an $2.4 million Loss on early extinguishment of debt in the fourth quarter of 2015. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees in 2016 compared to 2015 resulted from an increase in average borrowings due to our use of debt to fund the acquisitions of Reliant and CareSouth. Our average cash interest rate remained relatively flat during 2016 compared to 2015. Cash paid for interest approximated $164 million and $121 million in 2016 and 2015, respectively. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income for 2015 included a $1.2 million realized gain from the sale of all the common stock of Surgical Care Affiliates (“SCA”), our former surgery centers division and a $2.0 million gain related to the increase in fair value of our option to purchase up to a 5% equity interest in SCA from April 1, 2015 (the date it became exercisable) to April 13, 2015 (the date we exercised the option). See Note 12, Fair Value Measurements, to the consolidated financial statements accompanying the 2015 Form 10-K. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2016 increased compared to 2015 due to increased Net operating revenues primarily as a result of the acquisitions of Reliant and CareSouth. Provision for Income Tax Expense Due to our federal and state net operating losses (“NOLs”), our cash income taxes approximated $31.9 million, net of refunds, in 2016. These payments resulted from state income tax expense of subsidiaries which have separate state filing requirements and federal income taxes based upon alternative minimum taxes, tax planning opportunities, the utilization of the remaining federal NOL balance, and the availability of other federal tax credits. In 2017, we estimate we will pay approximately $120 million to $175 million of cash income taxes, net of refunds. In 2016 and 2015, current income tax expense was $31.0 million and $14.8 million, respectively. Our effective income tax rate for 2016 was 34.0%. The Provision for income tax expense in 2016 was less than the federal statutory rate primarily due to: (1) the impact of noncontrolling interests offset by (2) state and other income tax expense. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” for a discussion of the allocation of income or loss related to pass-through entities, which is referred to as the impact of noncontrolling interests in this discussion. Our effective income tax rate for 2015 was 35.9%. Our Provision for income tax expense in 2015 was greater than the federal statutory rate of 35% primarily due to: (1) state and other income tax expense and (2) an increase in our valuation allowance offset by (3) the impact of noncontrolling interests. The increase in our valuation allowance in 2015 related primarily to changes to our state apportionment percentages resulting from the acquisitions of Encompass, Reliant, and CareSouth and changes to our current forecast of earnings in each jurisdiction. During the third quarter of 2016, we filed an automatic tax accounting method change related to the deductibility of bad debts pursuant to the non-accrual experience method which resulted in a tax benefit of approximately $7 million. This change did not have a material impact on our effective tax rate. We also filed a non-automatic tax accounting method change related to billings denied under pre-payment claims reviews conducted by certain of our MACs. If our request for the non-automatic tax accounting change is accepted as filed, we estimate realization of additional tax benefits of approximately $53 million through December 31, 2016. Approximately $44 million of this amount represents pre-payment claims denials received in years prior to and including the year ended December 31, 2015. This change, if approved, is not expected to have a material impact on our effective tax rate, but will impact the payment of cash income taxes in 2017. In certain state jurisdictions, we do not expect to generate sufficient income to use all of the available NOLs prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable state tax jurisdiction, or if the timing of future tax deductions differs from our expectations. We recognize the financial statement effects of uncertain tax positions when it is more likely than not, based on the technical merits, a position will be sustained upon examination by and resolution with the taxing authorities. Total remaining gross unrecognized tax benefits were $2.8 million and $2.9 million as of December 31, 2016 and 2015, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. 2015 Compared to 2014 Net Operating Revenues Our consolidated Net operating revenues increased in 2015 compared to 2014 primarily from strong volume growth in both of our operating segments and included the effect of our acquisitions of Encompass, Reliant, and CareSouth. See additional discussion in the “Segment Results of Operations” section of this Item. Provision for Doubtful Accounts The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2015 compared to 2014 primarily resulted from an increase in pre-payment claims denials by MACs, and continued substantial delays (exceeding three years) in the adjudication process at the administrative law judge hearing level. Salaries and Benefits Salaries and benefits increased in 2015 compared to 2014 primarily due to increased patient volumes, a 2.25% salary increase given to all eligible nonmanagement hospital employees effective October 1, 2014, and an increase in benefit costs. Increased patient volumes included an increase in the number of full-time equivalents as a result of our hospital development activities and the acquisitions of Encompass, Reliant, and CareSouth. Full-time equivalents also increased due to hospital staffing additions to ensure compliance with new Medicare quality reporting requirements and the creation of a new medical services department. Salaries and benefits as a percent of Net operating revenues increased during 2015 compared to 2014 primarily as a result of the acquisition of Encompass, the pricing impact of proportionally higher discharge growth from payors where our reimbursement is lower (as discussed in this Item, “Segment Results of Operations-Inpatient Rehabilitation-Net Operating Revenues”), an increase in benefit costs, ramp-up costs associated with our de novo hospitals that opened in the fourth quarter of 2014, and the additional staff associated with Medicare quality reporting and the medical services department. In addition, 2015 also included the pricing impact of updated Supplemental Security Income (“SSI”) ratios (as discussed in this Item, “Segment Results of Operations-Inpatient Rehabilitation-Net Operating Revenues”). We provided a 2.5% merit increase to our nonmanagement hospital employees effective October 1, 2015. Other Operating Expenses Other operating expenses increased during 2015 compared to 2014 primarily due to the acquisition of Encompass, increased patient volumes at our hospitals, and the ongoing implementation of our clinical information system. As a percent of Net operating revenues, Other operating expenses decreased during 2015 compared to 2014 due to increased revenues, primarily as a result of the acquisition of Encompass. Occupancy costs Occupancy costs remained flat as a percent of Net operating revenues in 2015 compared to 2014 due to our increasing revenue, primarily as a result of the acquisition of Encompass. Supplies Supplies expense decreased as a percent of Net operating revenues in 2015 compared to 2014 primarily due to our increasing revenue, primarily as a result of the acquisition of Encompass. General and Administrative Expenses General and administrative expenses increased in 2015 compared to 2014 due primarily to increased expenses associated with stock-based compensation and higher transaction costs. General and administrative expenses decreased as a percent of Net operating revenues in 2015 compared to 2014 primarily due to our increasing revenue, primarily as a result of the acquisition of Encompass. Depreciation and Amortization Depreciation and amortization increased during 2015 compared to 2014 due to our acquisitions and capital expenditures throughout 2014 and 2015. Government, Class Action, and Related Settlements The loss included in Government, Class Action, and Related Settlements in 2015 resulted from a settlement discussed in Note 17, Contingencies and Other Commitments, to the consolidated financial statements accompanying the 2015 Form 10-K. Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2015 and 2014 related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 17, Contingencies and Other Commitments, to the consolidated financial statements accompanying the 2015 Form 10-K. Loss on Early Extinguishment of Debt In January 2015, we issued an additional $400 million of our 5.75% Senior Notes due 2024 at a price of 102% of the principal amount and used $250 million of the net proceeds to repay borrowings under our term loan facilities, with the remaining net proceeds used to repay borrowings under our revolving credit facility. As a result of the term loan prepayment, we recorded a $1.2 million Loss on early extinguishment of debt in the first quarter of 2015. In April 2015, we used the net proceeds from the offering of 5.125% Senior Notes due 2023 along with cash on hand to execute the redemption of our 8.125% Senior Notes due 2020. As a result of this redemption, we recorded an $18.8 million Loss on early extinguishment of debt in the second quarter of 2015. In November 2015, we used borrowings under our senior secured credit facility to execute the redemption of $50 million of the outstanding principal amount of our existing 7.75% Senior Notes due 2022. As a result of this redemption, we recorded an $2.4 million Loss on early extinguishment of debt in the fourth quarter of 2015. The Loss on early extinguishment of debt in 2014 resulted from the redemption of our 7.25% Senior Notes due 2018 and the redemption of 10% of the outstanding principal amount of our 7.75% Senior Notes due 2022 in the fourth quarter of 2014. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees in 2015 compared to 2014 resulted from an increase in average borrowings offset by a lower average cash interest rate. Average borrowings increased due to our use of debt to fund the acquisitions of Encompass, Reliant, and CareSouth. Our average cash interest rate decreased from 6.3% in 2014 to 5.3% in 2015 due to the redemption of our 7.25% Senior Notes due 2018 in October 2014, the redemption of approximately $25 million of our 7.75% Senior Notes due 2022 in December 2014, and the redemption of our 8.125% Senior Notes due 2020 in April 2015. Cash paid for interest approximated $121 million and $101 million in 2015 and 2014, respectively. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income for 2015 included a $1.2 million realized gain from the sale of all the common stock of SCA, our former surgery centers division and a $2.0 million gain related to the increase in fair value of our option to purchase up to a 5% equity interest in SCA from April 1, 2015 (the date it became exercisable) to April 13, 2015 (the date we exercised the option). See Note 12, Fair Value Measurements, to the accompanying consolidated financial statements. Other income for 2014 included a $27.2 million gain related to the acquisition of an additional 30% equity interest in Fairlawn. See Note 2, Business Combinations, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2015 increased compared to 2014 due to increased Net operating revenues primarily as a result of the acquisitions of Encompass, Reliant, and CareSouth. Our pre-tax income from continuing operations for 2014 included the $27.2 million gain on the consolidation of Fairlawn. Provision for Income Tax Expense As discussed above, our effective income tax rate for 2015 was 35.9%. Our Provision for income tax expense in 2015 was greater than the federal statutory rate of 35% primarily due to: (1) state and other income tax expense and (2) an increase in our valuation allowance offset by (3) the impact of noncontrolling interests. Our effective income tax rate for 2014 was 28.6%. Our Provision for income tax expense in 2014 was less than the federal statutory rate of 35% primarily due to: (1) the impact of noncontrolling interests, (2) the nontaxable gain discussed in Note 2, Business Combinations, related to our acquisition of an additional 30% equity interest in Fairlawn, and (3) a decrease in our valuation allowance offset by (4) state and other income tax expense. As a result of the Fairlawn transaction, we released the deferred tax liability associated with the outside tax basis of our investment in Fairlawn because we possessed sufficient ownership to allow for the historical outside tax basis difference to be resolved through a tax-free transaction in the future. The decrease in our valuation allowance in 2014 related primarily to the expiration of state NOLs in certain jurisdictions, our current forecast of future earnings in each jurisdiction, and changes in certain state tax laws. Total remaining gross unrecognized tax benefits were $2.9 million and $0.9 million as of December 31, 2015 and 2014, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests The increase in Net Income Attributable to Noncontrolling Interests in 2015 compared to 2014 primarily resulted from our acquisition of Encompass on December 31, 2014. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. There can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing pharmaceutical costs has enabled us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions were not material to our operations in 2016, 2015, or 2014, and therefore, are not presented as a separate discussion within this Item. Segment Results of Operations Our internal financial reporting and management structure is focused on the major types of services provided by HealthSouth. Beginning in the first quarter of 2015, we manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information regarding our business segments, including a detailed description of the services we provide, financial data for each segment, and a reconciliation of total segment Adjusted EBITDA to income from continuing operations before income tax expense, see Note 18, Segment Reporting, to the accompanying consolidated financial statements. Inpatient Rehabilitation During the years ended December 31, 2016, 2015 and 2014, our inpatient rehabilitation segment derived its Net operating revenues from the following payor sources: Additional information regarding our inpatient rehabilitation segment’s operating results for the years ended December 31, 2016, 2015 and 2014, is as follows: * Excludes approximately 420 full-time equivalents in 2016 and approximately 400 in 2015 and 2014 who are considered part of corporate overhead with their salaries and benefits included in General and administrative expenses in our consolidated statements of operations. Full-time equivalents included in the above table represent HealthSouth employees who participate in or support the operations of our hospitals and exclude an estimate of full-time equivalents related to contract labor. We actively manage the productive portion of our Salaries and benefits utilizing certain metrics, including employees per occupied bed, or “EPOB.” This metric is determined by dividing the number of full-time equivalents, including an estimate of full-time equivalents from the utilization of contract labor, by the number of occupied beds during each period. The number of occupied beds is determined by multiplying the number of licensed beds by our occupancy percentage. 2016 Compared to 2015 Net Operating Revenues Net operating revenues were 13.9% higher for 2016 compared to 2015. This increase included a 10.8% increase in patient discharges and a 2.9% increase in net patient revenue per discharge. Discharge growth included a 1.7% increase in same-store discharges. Discharge growth from new stores resulted from our joint ventures in Hot Springs, Arkansas (February 2016), Bryan, Texas (August 2016), and Broken Arrow, Oklahoma (August 2016), our wholly owned hospitals that opened in Franklin, Tennessee (December 2015) and Modesto California (October 2016), and our acquisitions of Reliant (October 2015) and Cardinal Hill in Lexington, Kentucky (May 2015). Growth in net patient revenue per discharge resulted primarily from patient mix (higher percentage of stroke patients and the integration of the Reliant hospitals) and an approximate $4 million Indirect Medical Education (“IME”) adjustment associated with the former Reliant hospital in Woburn, Massachusetts. Medicare provides that hospitals with residents in an approved graduate medical education program receive an additional payment for a Medicare discharge to reflect higher patient care costs of teaching hospitals relative to non-teaching hospitals. Our revenues in 2016 were positively impacted by this adjustment to our third-party payor estimates for 2014, 2015, and the year-to-date period through July 2016. In addition, net patient revenue per discharge growth in 2016 benefited from an approximate $5 million SSI adjustment that negatively impacted revenue in 2015. CMS periodically retroactively updates SSI ratios that are used to determine adjustments to Medicare payment rates for low-income patients. In the second quarter of 2015, CMS updated the ratios for fiscal year 2013, which resulted in adjustments to our third-party payor estimates for 2013, 2014, and year-to-date period through July 2015. Outpatient revenues increased during 2016 compared to 2015 due to the acquisition of Reliant. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our joint ventures and acquisitions discussed above. Adjusted EBITDA The increase in Adjusted EBITDA in 2016 compared to 2015 primarily resulted from revenue growth, as discussed above. All operating expenses as a percent of net operating revenues benefited in 2016 by the aforementioned IME adjustment. Salaries and benefits in 2016 included a year-over-year decline in group medical costs. Other operating expenses decreased as a percent of revenue due primarily to the 2015 settlement discussed below. Occupancy costs increased as a percent of net operating revenues due to the acquisition of Reliant. Supplies expense decreased as a percent of revenue due to continued supply chain efficiencies including the continued transition of brand name drugs to generic. Bad debt expense as a percent of net operating revenues increased from 1.7% in 2015 to 1.9% in 2016 due to aging-based reserves resulting from continued administrative payment delays at the Company's largest MAC. 2015 Compared to 2014 Net Operating Revenues Net operating revenues were 11.6% higher for 2015 compared to 2014. This increase included a 10.9% increase in patient discharges and a 1.1% increase in net patient revenue per discharge. Discharge growth included a 3.2% increase in same-store discharges. Discharge growth from new stores resulted from three de novo hospitals that opened in the fourth quarter of 2014 (Altamonte Springs, Florida; Newnan, Georgia; and Middletown, Delaware) and one de novo hospital that opened in December 2015 (Franklin, Tennessee), our acquisitions of Reliant (October 2015), Quillen Rehabilitation Hospital (“Quillen”) in Johnson City, Tennessee (November 2014) and Cardinal Hill in Lexington, Kentucky (May 2015), and our joint venture with Memorial Health in Savannah, Georgia (April 2015). While we experienced pricing growth from Medicare and managed care payors, the pricing adjustments were negatively impacted by proportionally higher discharge growth in Medicaid and managed care payors where our reimbursement is lower. In addition, our net patient revenue per discharge was negatively impacted in 2015 by approximately $5 million for updated SSI ratios published by CMS for fiscal year 2013. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our acquisitions and joint ventures discussed above. Adjusted EBITDA The increase in Adjusted EBITDA in 2015 compared to 2014 primarily resulted from revenue growth, as discussed above. Adjusted EBITDA in 2015 was also impacted by (1) an increase in salaries and benefits as a percent of revenue due to increases in group medical costs, an increase in our licensed skills mix, and an increase in volume-related “premium” pay, (2) increased bad debt expense from continued pre-payment claims denials predominately by one of our MACs, (3) SSI ratio adjustments, as discussed above (4) a settlement of an employee sexual harassment matter that was not covered by insurance, and (5) incremental investments in our operating platform, including a contractual increase in costs associated with the ongoing implementation of our electronic clinical information system, the addition of staff at our hospitals to ensure compliance with new CMS quality reporting requirements, the creation of a new medical services department, and costs associated with our participation in CMS’ Model 3 bundling pilot initiative. Increases in group medical costs resulted from an increase in the number and size of large claims (claims greater than $100,000) and an increase in the cost and use of specialty pharmaceuticals. Home Health and Hospice During the years ended December 31, 2016, 2015 and 2014, our home health and hospice segment derived its Net operating revenues from the following payor sources: Additional information regarding our home health and hospice segment’s operating results for the years ended December 31, 2016, 2015 and 2014, is as follows: 2016 Compared to 2015 Net Operating Revenues Home health and hospice revenue was 34.6% higher during 2016 compared to 2015. This increase included a 43.6% increase in home health admissions and was impacted by a 1.3% decrease in average revenue per episode. Home health admission growth included a 13.7% increase in same-store admissions. Home health admission growth from new stores resulted primarily from the acquisition of CareSouth in November 2015. Average revenue per episode was impacted by the Medicare home health reimbursement rate cuts that became effective January 1, 2016 and lower revenue per episode at CareSouth due to patient mix. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report regarding CareSouth and Encompass' other acquisitions throughout 2015. Adjusted EBITDA The increase in Adjusted EBITDA during 2016 compared to 2015 primarily resulted from revenue growth. Adjusted EBITDA for the segment during 2016 was impacted by Medicare reimbursment rate cuts, higher cost per visit (driven by an increased percentage of therapy patients), salary and benefit costs increases, a $3.3 million gain from the divestiture of our home health pediatric assets, and expenses related to the integration of CareSouth. 2015 Compared to 2014 The increase in Net operating revenues and Adjusted EBITDA during 2015 compared to 2014 was due to our acquisition of Encompass on December 31, 2014 (see Note 2, Business Combinations, to the accompanying consolidated financial statements). Because of this acquisition, certain variances in the above table are considered to be not meaningful figures and are labeled as “NMF.” Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Pursuing and achieving those objectives allows us to support the execution of our operating and strategic plans and weather temporary disruptions in the capital markets and general business environment. Maintaining adequate liquidity is a function of our unrestricted Cash and cash equivalents and our available borrowing capacity. Maintaining flexibility in our capital structure is a function of, among other things, the amount of debt maturities in any given year, the options for debt prepayments without onerous penalties, and limiting restrictive terms and maintenance covenants in our debt agreements. Consistent with these objectives, in both March and May of 2016, we redeemed $50.0 million of the outstanding principal amount of the 7.75% Senior Notes due 2022 using cash on hand and capacity under our revolving credit facility. Pursuant to the terms of these notes, we completed these optional redemptions at a price of 103.875%, which resulted in a total cash outlay of approximately $104 million. As a result of these redemptions, we recorded a $2.4 million Loss on early extinguishment of debt in both the first and second quarter of 2016. In September 2016, we redeemed the remaining outstanding principal balance of $76.0 million of the 7.75% Senior Notes due 2022 using cash on hand and capacity under our revolving credit facility. Pursuant to the terms of these notes, this optional redemption was made at a price of 102.583%, which resulted in a total cash outlay of approximately $78 million. As a result of this redemption, we recorded a $2.6 million Loss on early extinguishment of debt in the third quarter of 2016. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2020. Our balance sheet remains strong, and we have significant availability under our credit agreement. We continue to generate strong cash flows from operations, and we have significant flexibility with how we choose to invest our cash and return capital to shareholders. While our financial leverage increased as a result of the Reliant and CareSouth transactions, we anticipate in the longer term reducing our financial leverage based on growth of Adjusted EBITDA and an allocation of a portion of our free cash flow to debt reduction. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Current Liquidity As of December 31, 2016, we had $40.5 million in Cash and cash equivalents. This amount excludes $60.9 million in Restricted cash and $57.7 million of restricted marketable securities ($33.5 million of restricted marketable securities are included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 4, Cash and Marketable Securities, to the accompanying consolidated financial statements. In addition to Cash and cash equivalents, as of December 31, 2016, we had approximately $415 million available to us under our revolving credit facility. Our credit agreement governs the substantial majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to $75 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. In calculating the leverage ratio under our credit agreement, we are permitted to use pro forma Adjusted EBITDA, the calculation of which includes historical income statement items and pro forma adjustments resulting from (1) the dispositions and repayments or incurrence of debt and (2) the investments, acquisitions, mergers, amalgamations, consolidations and operational changes from acquisitions to the extent such items or effects are not yet reflected in our trailing four-quarter financial statements. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As of December 31, 2016, the maximum leverage ratio requirement per our credit agreement was 4.50x and the minimum interest coverage ratio requirement was 3.0x, and we were in compliance with these covenants. Based on Adjusted EBITDA for 2016 and the interest rate in effect under our credit agreement during the three-month period ended December 31, 2016, if we had drawn on the first day and maintained the maximum amount of outstanding draws under our revolving credit facility for the entire year, we would still be in compliance with the maximum leverage ratio and minimum interest coverage ratio requirements. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2020, and our bonds all mature in 2023 and beyond. See the “Contractual Obligations” section below for information related to our contractual obligations as of December 31, 2016. As part of the Encompass acquisition, we acquired all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to Holdings, a subsidiary of HealthSouth and a indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. These certain sellers were members of Encompass management. These sellers contributed a portion of their shares of common stock of EHHI in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. At any time after December 31, 2017, each management investor will have the right (but not the obligation) to have his or her shares of Holdings stock repurchased by HealthSouth for a cash purchase price per share equal to the fair value. The fair value is determined using the product of the trailing 12-month specified performance measure for Holdings and a specified median market price multiple based on a basket of public home health companies. Specifically, up to one-third of each management investor’s shares of Holdings stock may be sold prior to December 31, 2018; two-thirds of each management investor’s shares of Holdings stock may be sold prior to December 31, 2019; and all of each management investor’s shares of Holdings stock may be sold thereafter. At any time after December 31, 2019, HealthSouth will have the right (but not the obligation) to repurchase all or any portion of the shares of Holdings stock owned by one or more management investors for a cash purchase price per share equal to the fair value. As of December 31, 2016, the value of those outstanding shares of Holdings was approximately $116 million. See Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common stock and distribution of common stock dividends, including the potential growth of the quarterly cash dividend on our common stock, recognizing that these actions may increase our leverage ratio. See also the “Authorizations for Returning Capital to Stakeholders” section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years ended December 31, 2016, 2015, and 2014 (in millions): 2016 Compared to 2015 Operating activities. The increase in Net cash provided by operating activities during 2016 compared to 2015 primarily resulted from revenue growth, as described above, and changes to payroll-related liabilities. Investing activities. The decrease in Net cash used in investing activities during 2016 compared to 2015 resulted primarily from the decrease in cash used in the acquisition of businesses offset by the proceeds received from the divestiture of our home health pediatric assets in 2016. Cash outflows were significantly higher in 2015 due to the acquisitions of Reliant and CareSouth described in Note 2, Business Combinations, to the accompanying consolidated financial statements. Financing activities. The decrease in Net cash provided by financing activities during 2016 compared to 2015 primarily resulted from the 2015 debt transactions, including the public offering of the 2023 Notes, the additional offering of the 2024 Notes, and the private offering of the 2025 Notes to fund the acquisitions of Reliant and CareSouth as discussed and defined in Note 9, Long-term Debt, to the accompanying consolidated financial statements. 2015 Compared to 2014 Operating activities. The increase in Net cash provided by operating activities during 2015 compared to 2014 primarily resulted from revenue growth. Cash flows provided by operating activities in 2015 were also impacted by increased cash interest expense and higher working capital. Higher working capital resulted from growth in accounts receivable due to additional claims denials and continued delays at the administrative law judge hearing level. Investing activities. The increase in Net cash used in investing activities during 2015 compared to 2014 resulted primarily from the acquisitions of Reliant and CareSouth described in Note 2, Business Combinations, to the accompanying consolidated financial statements. Financing activities. The increase in Net cash provided by financing activities during 2015 compared to 2014 primarily resulted from the public offering of the 2023 Notes, the additional offering of the 2024 Notes, and the private offering of the 2025 Notes to fund the acquisitions of Reliant and CareSouth as discussed in Note 9, Long-term Debt, to the accompanying consolidated financial statements. Contractual Obligations Our consolidated contractual obligations as of December 31, 2016 are as follows (in millions): (a) Included in long-term debt are amounts owed on our bonds payable and other notes payable. These borrowings are further explained in Note 9, Long-term Debt, to the accompanying consolidated financial statements. (b) Interest on our fixed rate debt is presented using the stated interest rate. Interest expense on our variable rate debt is estimated using the rate in effect as of December 31, 2016. Interest related to capital lease obligations is excluded from this line. Future minimum payments, which are accounted for as interest, related to sale/leaseback transactions involving real estate accounted for as financings are included in this line (see Note 6, Property and Equipment, and Note 9, Long-term Debt, to the accompanying consolidated financial statements). Amounts exclude amortization of debt discounts, amortization of loan fees, or fees for lines of credit that would be included in interest expense in our consolidated statements of operations. (c) Amounts include interest portion of future minimum capital lease payments. (d) Our inpatient rehabilitation segment leases approximately 16% of its hospitals as well as other property and equipment under operating leases in the normal course of business. Our home health and hospice segment leases relatively small office spaces in the localities it serves, space for its corporate office, and other equipment under operating leases in the normal course of business. Some of our hospital leases contain escalation clauses based on changes in the Consumer Price Index while others have fixed escalation terms. The minimum lease payments do not include contingent rental expense. Some lease agreements provide us with the option to renew the lease or purchase the leased property. Our future operating lease obligations would change if we exercised these renewal options and if we entered into additional operating lease agreements. For more information, see Note 6, Property and Equipment, to the accompanying consolidated financial statements. (e) Future operating lease obligations and purchase obligations are not recognized in our consolidated balance sheet. (f) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on HealthSouth and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. Our purchase obligations primarily relate to software licensing and support. (g) Because their future cash outflows are uncertain, the following noncurrent liabilities are excluded from the table above: general liability, professional liability, and workers’ compensation risks, noncurrent amounts related to third-party billing audits, Encompass’ stock appreciation rights, and deferred income taxes. Also, as of December 31, 2016, we had $2.8 million of total gross unrecognized tax benefits. For more information, see Note 10, Self-Insured Risks, Note 13, Share-Based Payments, Note 15, Income Taxes, and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements. (h) The table above does not include Redeemable noncontrolling interests of $138.3 million because of the uncertainty surrounding the timing and amounts of any related cash outflows. See Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year ended December 31, 2016, we made capital expenditures of approximately $203 million for property and equipment and capitalized software. These expenditures in 2016 are exclusive of approximately $48 million in net cash related to our acquisition activity. During 2017, we expect to spend approximately $305 million to $415 million for capital expenditures. Approximately $130 million to $150 million of this budgeted amount is considered nondiscretionary expenditures, which we may refer to in other filings as “maintenance” expenditures. The expected increase in 2017 is due to growth in the Company, an enhanced hospital maintenance program, and leasehold improvements and furnishings associated with the build-out of our new home office location. Actual amounts spent will be dependent upon the timing of construction projects and acquisition opportunities for our home health and hospice business. Authorizations for Returning Capital to Stakeholders In October 2015, February 2016, and May 2016, our board of directors declared cash dividends of $0.23 per share that were paid in January 2016, April 2016, and July 2016, respectively. On July 21, 2016, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.24 per share, payable on October 17, 2016 to stockholders of record on October 3, 2016. On October 20, 2016, our board of directors declared a cash dividend of $0.24 per share, payable on January 17, 2017 to stockholders of record on January 3, 2017. We expect quarterly dividends to be paid in January, April, July, and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates as well as the per share amounts, will be at the discretion of our board of directors after consideration of various factors, including our capital position and alternative uses of funds. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our credit agreement. The payment of cash dividends on our common stock triggers antidilution adjustments, except in instances when such adjustments are deemed de minimis, under our convertible notes. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. On February 14, 2014, our board of directors approved an increase in our existing common stock repurchase authorization from $200 million to $250 million. As of December 31, 2016, approximately $96 million remained under this authorization. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. During 2016, we repurchased 1.7 million shares of our common stock in the open market for $64.1 million under this repurchase authorization using cash on hand. Future repurchases under this authorization generally are expected to be funded using a combination of cash on hand and availability under our $600 million revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 9, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement - our interest coverage ratio and our leverage ratio - could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might be on terms less favorable to us than those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. In general terms, the credit agreement definition of Adjusted EBITDA, therein referred to as “Adjusted Consolidated EBITDA,” allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to $10 million in a year may be cash expenditures), (2) any losses from discontinued operations and closed locations, (3) costs and expenses, including legal fees and expert witness fees, incurred with respect to litigation associated with stockholder derivative litigation, and (4) share-based compensation expense. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent increasing consolidated Net income. The calculation of Adjusted EBITDA under the credit agreement does not require us to deduct net income attributable to noncontrolling interests or gains on disposal of assets and development activities. It also does not allow us to add back professional fees unrelated to the stockholder derivative litigation, losses on disposal of assets, unusual or nonrecurring cash expenditures in excess of $10 million, and charges resulting from debt transactions and development activities. These items and amounts, in addition to the items falling within the credit agreement’s “unusual or nonrecurring” classification, may occur in future periods, but can vary significantly from period to period and may not directly relate to our ongoing operations. Accordingly, these items may not be indicative of our ongoing performance, so the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Our Adjusted EBITDA for the years ended December 31, 2016, 2015, and 2014 was as follows (in millions): Reconciliation of Net Income to Adjusted EBITDA Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA Growth in Adjusted EBTIDA from 2015 to 2016 resulted primarily from revenue growth in both operating segments due to the acquisitions of Reliant and CareSouth. Growth in Adjusted EBITDA from 2014 to 2015 resulted primarily from revenue growth due to the acquisition of Encompass. For additional information see the “Results of Operations” and “Segment Results of Operations” sections of this Item. Off-Balance Sheet Arrangements In accordance with the definition under SEC rules, the following qualify as off-balance sheet arrangements: • any obligation under certain guarantees or contracts; • a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that serves as credit, liquidity, or market risk support to that entity for such assets; • any obligation under certain derivative instruments; and • any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the registrant, or engages in leasing, hedging, or research and development services with the registrant. As of December 31, 2016, we do not have any material off-balance sheet arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2016, we are not involved in any unconsolidated SPE transactions. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates, and judgments to ensure our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, as they require our most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the audit committee of our board of directors. Revenue Recognition We recognize net patient revenue in the reporting period in which we perform the service based on our current billing rates (i.e., gross charges) less actual adjustments and estimated discounts for contractual allowances (principally for patients covered by Medicare, Medicare Advantage, Medicaid, and other third-party payors. See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues,” to the accompanying consolidated financial statements for a complete discussion of our revenue recognition policies. Our patient accounting systems calculate contractual allowances on a patient-by-patient basis based on the rates in effect for each primary third-party payor. Certain other factors that are considered and could influence the level of our reserves are assumed to remain consistent with the experience for patients discharged in similar time periods for the same payor classes, and additional reserves are provided to account for these factors. Management continually reviews the contractual estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. In addition, laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Due to complexities involved in determining amounts ultimately due under reimbursement arrangements with third-party payors, which are often subject to interpretation and review, we may receive reimbursement for healthcare services authorized and provided that is different from our estimates, and such differences could be material. However, we continually review the amounts actually collected in subsequent periods in order to determine the amounts by which our estimates differed. Historically, such differences have not been material from either a quantitative or qualitative perspective. Allowance for Doubtful Accounts The collection of outstanding receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. We provide for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. See Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” and Note 5, Accounts Receivable, to the accompanying consolidated financial statements for a complete discussion of our policies related to the allowance for doubtful accounts. We estimate our allowance for doubtful accounts based on the aging of our accounts receivable, our historical collection experience for each type of payor, and other relevant factors so that the remaining receivables, net of allowances, are reflected at their estimated net realizable values. Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. Our collection risks include patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding and pre-payment claim reviews by our respective MACs. In addition, reimbursement claims made by health care providers are subject to audit from time to time by governmental payors and their agents. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. See Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” to the accompanying consolidated financial statements. As of December 31, 2016 and 2015, $172.0 million and $126.1 million, or 26.0% and 22.1%, respectively, of our patient accounts receivable represented denials by MACs that were in the pre-payment medical necessity review process. During the years ended December 31, 2016, 2015, and 2014, we wrote off $3.5 million, $2.6 million, and $1.4 million, respectively, of previously denied claims while we collected $9.2 million, $7.4 million, and $7.1 million, respectively, of previously denied claims. The table below shows a summary of our net accounts receivable balances as of December 31, 2016 and 2015. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” to the accompanying consolidated financial statements. Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers’ compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers’ compensation risks are insured through a wholly owned insurance subsidiary. See Note 10, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost of reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers’ compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are certain of the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: • historical claims experience; • trending of loss development factors; • trends in the frequency and severity of claims; • coverage limits of third-party insurance; • demographic information; • statistical confidence levels; • medical cost inflation; • payroll dollars; and • hospital patient census. The time period to resolve claims can vary depending upon the jurisdiction, the nature, and the form of resolution of the claims. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. See Note 10, Self-Insured Risks, to the accompanying consolidated financial statements for additional information. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management’s estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as of October 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our inpatient rehabilitation and home health and hospice reporting units. We assess qualitative factors in each reporting unit to determine whether it is necessary to perform the first step of the two-step quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not a reporting unit’s fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must proceed to Step 1, we would determine the fair value of the applicable reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of the reporting units determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting units. The income approach includes the use of each reporting unit’s projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management’s best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company’s stock price. See Note 1, Summary of Significant Accounting Policies, “Goodwill and Other Intangibles,” and Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets; • Industry and market considerations and changes in healthcare regulations, including reimbursement and compliance requirements under the Medicare and Medicaid programs; • Cost factors, such as an increase in labor, supply, or other costs; • Overall financial performance, such as negative or declining cash flows or a decline in actual or forecasted revenue or earnings; • Other relevant company-specific events, such as material changes in management or key personnel or outstanding litigation; • Material events, such as a change in the composition or carrying amount of each reporting unit’s net assets, including acquisitions and dispositions; and • Consideration of the relationship of our market capitalization to our book value, as well as a sustained decrease in our share price. In the fourth quarter of 2016, we performed our annual evaluation of goodwill and determined no adjustment to impair goodwill was necessary. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our inpatient rehabilitation and home health and hospice reporting units are not at risk for any impairment charges. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” and Note 15, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year ended December 31, 2016, we increased our valuation allowance by $0.3 million. As of December 31, 2016, we had a remaining valuation allowance of $27.9 million which primarily related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the NOLs before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management’s estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as of December 31, 2016 will be realized, no such assurances can be provided. If management’s expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, “Litigation Reserves,” and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding ForwardLooking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business We are one of the nation’s largest providers of postacute healthcare services, offering both facilitybased and homebased postacute services in 35 states and Puerto Rico through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As discussed in this Item, “Segment Results of Operations,” we manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 30 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2016, we operate 123 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture which we account for using the equity method of accounting. In addition to HealthSouth hospitals, we manage five inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 81% of our Net operating revenues for the year ended December 31, 2016. Home Health and Hospice Our home health and hospice business is the nation’s fourth largest provider of Medicarecertified skilled home health services in terms of revenues. We acquired EHHI Holdings, Inc. (“EHHI”) and its Encompass Home Health and Hospice business (“Encompass”) on December 31, 2014 and have since transitioned our previously existing HealthSouth home health operations to the Encompass platform and trade name. In the acquisition, we acquired, for cash, all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to HealthSouth Home Health Holdings, Inc. (“Holdings”), a subsidiary of HealthSouth and now indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. These certain sellers were members of Encompass management, including April Anthony, the chief executive officer of Encompass. These sellers contributed a portion of their shares of common stock of EHHI in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. We funded the cash purchase price in the acquisition entirely with draws under the revolving and expanded term loan facilities of our credit agreement. The total cash consideration delivered at closing was $695.5 million. As of December 31, 2016, Encompass provides home health and hospice services in 223 locations across 25 states, with concentrations in the Southeast, Oklahoma, and Texas. In addition, two of these home health locations operate as joint ventures which we account for using the equity method of accounting. Our home health and hospice segment represented approximately 19% of our Net operating revenues for the year ended December 31, 2016. See Item 1, Business, and Item 1A, Risk Factors, of this report, Note 2, Business Combinations, Note 9, Longterm Debt, and Note 18, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” and “Liquidity and [/INST] Negative. </s>

Encompass Health Corp

2018-02-28

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business We are the nation’s leading owner and operator of inpatient rehabilitation hospitals and a leader in home-based care, offering services in 36 states and Puerto Rico. As discussed in this Item, “Segment Results of Operations,” we manage our operations in two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. On July 10, 2017, we announced the plan to rebrand and change our name from HealthSouth Corporation to Encompass Health Corporation. On October 20, 2017, our board of directors approved an amended and restated certificate of incorporation in order to change the name effective as of January 1, 2018. Along with the corporate name change, the NYSE ticker symbol for our common stock changed from “HLS” to “EHC.” Our operations in both business segments will transition to the Encompass Health branding on a rolling basis. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 31 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2017, we operate 127 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture which we account for using the equity method of accounting. In addition to our hospitals, we manage four inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 80% of our Net operating revenues for the year ended December 31, 2017. Home Health and Hospice Our home health and hospice business is the nation’s fourth largest provider of Medicare-certified skilled home health services in terms of revenues. Our home health services include a comprehensive range of Medicare-certified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. We also provide hospice services to terminally ill patients and their families that address patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. As of December 31, 2017, we provide home health and hospice services in 237 locations across 28 states, with concentrations in the Southeast and Texas. In addition, two of these home health locations operate as joint ventures which we account for using the equity method of accounting. Our home health and hospice segment represented approximately 20% of our Net operating revenues for the year ended December 31, 2017. See also Item 1, Business, and Item 1A, Risk Factors, of this report, Note 18, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” section of this Item. 2017 Overview In 2017, we focused on the following strategic priorities: • providing high-quality, cost-effective care to patients in our existing markets; • achieving organic growth at our existing inpatient rehabilitation hospitals, home health agencies, and hospice agencies; • expanding our services to more patients who require post-acute healthcare services by constructing and acquiring hospitals in new markets and acquiring home health and hospice agencies in new markets; • making shareholder distributions via common stock dividends and repurchases of our common stock; and • positioning the Company for success in the evolving healthcare delivery system. During 2017, Net operating revenues increased by 7.1% over 2016 due primarily to pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. Within our inpatient rehabilitation segment, discharge growth of 4.0% coupled with a 2.0% increase in net patient revenue per discharge in 2017 generated 5.5% growth in Net operating revenues compared to 2016. Discharge growth included a 1.8% increase in same-store discharges. Within our home health and hospice segment, home health admission growth of 17.0% coupled with the impact of a 1.1% decrease in revenue per episode in 2017 generated 14.2% growth in home health and hospice revenue compared to 2016. Home health admission growth included a 11.4% increase in same-store admissions. Many of our quality and outcome measures remained above both inpatient rehabilitation and home health industry averages. Not only did we treat more patients and enhance outcomes, we did so in a cost-effective manner. See the “Results of Operations” section of this Item. Our growth efforts continued to yield positive results in 2017. In our inpatient rehabilitation segment, we: • began operating the 33-bed inpatient rehabilitation hospital in Gulfport, Mississippi with our joint venture partner, Memorial Hospital at Gulfport, in April 2017; • began operating a new 60-bed inpatient rehabilitation hospital in Westerville, Ohio with our joint venture partner, Mount Carmel Health System, in April 2017; • began operating a new 48-bed inpatient rehabilitation hospital in Jackson, Tennessee and our existing 40-bed inpatient rehabilitation hospital in Martin, Tennessee with our joint venture partner, West Tennessee Healthcare, in July 2017; • entered into an agreement with University Medical Center Health System in September 2017 to own and operate a new 40-bed inpatient rehabilitation hospital in Lubbock, Texas. We expect construction of the new hospital to commence in the second quarter of 2018. The joint venture hospital is expected to begin operating in the second quarter of 2019 subject to customary closing conditions, including regulatory approvals; • began accepting patients at our new, 40-bed inpatient rehabilitation hospital in Pearland, Texas in October 2017; • continued planning the operation of our 29-bed joint venture hospital with Tidelands Health in Murrells Inlet, South Carolina. The hospital is expected to begin operating in the fourth quarter of 2018; • continued planning the construction of our 68-bed joint venture hospital with Novant Health, Inc. in Winston-Salem, North Carolina. The hospital is expected to begin operating in the fourth quarter of 2018; • continued our capacity expansions by adding 166 new beds to existing hospitals; and • continued development of the following de novo hospitals: (1) In June 2016, we were awarded a certificate of need (“CON”), acquired land, and began the design and permitting process. (2) In August 2016, we were awarded a CON, acquired land, and began the zoning, design, and permitting process. (3) In August 2014, we acquired land and began the design and permitting process. We also continued our growth efforts in our home health and hospice segment. During 2017, we: • acquired the assets of Celtic Healthcare of Maryland, Inc., a home health provider with locations in Owings Mill, Maryland and Rockville, Maryland in February 2017; • acquired the assets of two home health locations from Community Health Services, Inc. located in Owensboro, Kentucky and Elizabethtown, Kentucky in February 2017; • acquired the assets of two home health locations from Bio Care Home Health Services, Inc. and Kinsman Enterprises, Inc. located in Irving, Texas and Longview, Texas in May 2017; • acquired the assets of four home health locations from VNA Healthtrends located in Bourbonnais, Illinois; Des Plaines, Illinois; Schererville, Indiana; and Tempe, Arizona in July 2017 and two additional home health locations in Forsyth, Illinois and Canton, Ohio in August 2017; • acquired the assets of a home health location from Ware Visiting Nurses Services, Inc. located in Savannah, Georgia in October 2017; • acquired the assets of a home health location from Pickens County Health Care Authority located in Carrollton, Alabama in October 2017; and • began accepting patients at our new home health location in Braintree, Massachusetts and new hospice locations in Amarillo, Texas and Austin, Texas. To support our growth efforts, we continued taking steps to further increase the strength and flexibility of our balance sheet. Specifically, during the second quarter of 2017, we exercised the early redemption option and subsequently retired all $320 million of 2.00% Convertible Senior Subordinated Notes due 2043 (the “Convertible Notes”). During the third quarter of 2017, we amended our existing credit agreement to increase the size of our revolving credit facility from $600 million to $700 million, decrease the balance of our term loan facilities by approximately $110 million to $300 million, reduce the interest rate spread by 25 basis points, extend the agreement's maturity by two years to 2022, and amend the covenants to, among other things, allow for additional capacity for investments, restricted payments, and capital expenditures. For additional information regarding these actions, see Note 9, Long-term Debt, to the accompanying consolidated financial statements and the “Liquidity and Capital Resources” section of this Item. We also continued our shareholder distributions by repurchasing 0.9 million shares of our common stock in the open market for approximately $38 million during 2017. In addition, we continued paying a quarterly cash dividend of $0.24 per share on our common stock in the first three quarters of 2017. On July 20, 2017, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.25 per share that was paid on October 16, 2017, and we paid the same per share quarterly dividend on January 16, 2018. See the “Liquidity and Capital Resources” section of this Item. We further positioned ourselves for the healthcare industry’s movement to integrated delivery payment models, value-based purchasing, and post-acute site neutrality. We launched a company-wide rebranding and name change initiative to reflect and reinforce our expanding national footprint and our strategy to deliver high-quality, cost-effective care across the post-acute continuum. We completed a TeamWorks initiative to extend best practices for coordinated clinical protocols and discharge planning across all markets where we offer both facility- and home-based services and increased the clinical collaboration rate between our inpatient rehabilitation hospitals and home health agencies. For reference, as of December 31, 2017, approximately 60% of our hospitals were located within 30 miles of at least one of our home health locations. We completed the installation of our electronic clinical information system (“ACE-IT”) in our hospitals and enhanced its overall utilization via continuous in-service upgrades. We expanded our utilization of clinical data analytics designed to further improve patient outcomes. We formed the Post-Acute Innovation Center with Cerner Corporation to develop advanced analytics and predictive models to manage patients across the continuum of post-acute care. We also increased our participation in alternative payment models. Business Outlook We believe our business outlook remains positive. Favorable demographic trends, such as population aging, should increase long-term demand for facility-based and home-based care. While we treat patients of all ages, most of our patients are 65 and older, and the number of Medicare enrollees is expected to grow approximately 3% per year for the foreseeable future. We believe the demand for facility-based and home-based care will continue to increase as the U.S. population ages. We believe these factors align with our strengths in, and focus on, post-acute services. In addition, we believe we can address the demand for facility-based and home-based post-acute care services in markets where we currently do not have a presence by constructing or acquiring new hospitals and by acquiring or opening home health and hospice agencies in that extremely fragmented industry. We are an industry leader in the growing post-acute sector. As the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals, we believe we differentiate ourselves from our competitors based on the quality of our clinical outcomes, our cost-effectiveness, our financial strength, and our extensive application of technology. As the fourth largest provider of Medicare-certified skilled home health services in terms of revenues, we believe we differentiate ourselves from our competitors by the application of a highly integrated technology platform, our ability to manage a variety of care pathways, and a proven track record of consummating and integrating acquisitions. We have invested considerable resources into clinical and management systems and protocols that have allowed us to consistently produce high-quality outcomes for our patients while continuing to contain cost growth. Our proprietary hospital management reporting system aggregates data from each of our key business systems into a comprehensive reporting package used by the management teams in our hospitals, as well as executive management, and allows them to analyze data and trends and create custom reports on a timely basis. Our commitment to technology also includes ACE-IT. We believe this system will improve patient care and safety, enhance staff recruitment and retention, and set the stage for connectivity with other providers and health information exchanges. Our home health and hospice segment also uses information technology to enhance patient care and manage the business by utilizing Homecare HomebaseSM, an industry leading comprehensive information platform designed to manage the entire patient work flow and allow home health providers to process clinical, compliance, and marketing information as well as analyze data and trends for management purposes using custom reports on a timely basis. Homecare Homebase also allows providers to share valuable data with payors to promote better patient outcomes on a more cost-effective basis. All of these systems allow us to enhance our clinical and business processes. Our information systems allow us to collect, analyze, and share information on a timely basis, making us an ideal partner for other healthcare providers in a coordinated care delivery environment. Our short-term priorities include our operational initiatives. The implementation of our rebranding and name change reflects our expanding national footprint and our strategy to deliver high-quality, cost-effective care across the post-acute continuum. Through the Post-Acute Innovation Center, we will combine our clinical expertise with Cerner’s technology in an effort to assume a leading position in the development and utilization of market-specific clinical decision support tools. We will also continue to enhance the clinical collaboration efforts between our two segments, refine and expand our predictive data analytics to further improve patient outcomes, and increase our participation in alternative payment models. Longer term, the nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain and will likely remain so for some time, as the development and implementation of new care delivery and payment systems will require significant time and resources. Furthermore, many of the alternative approaches being explored may not work as intended. However, as outlined in the “Key Challenges-Changes to Our Operating Environment Resulting from Healthcare Reform” section below, our goal is to position the Company in a prudent manner to be responsive to industry shifts. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2022. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate. We have significant availability under our revolving credit facility, and we continue to generate strong cash flows from operations. We intend to deploy free cash flow to fund the growth opportunities in both of our business segments and augment these investments with shareholder distributions, including a regular quarterly cash dividend on our common stock. For these and other reasons, we believe we will be able to adapt to changes in reimbursement, sustain our business model, and grow through acquisition and consolidation opportunities as they arise. Key Challenges Healthcare is a highly-regulated industry facing many well-publicized regulatory and reimbursement challenges. The industry also is facing uncertainty associated with the efforts, primarily arising from initiatives included in the Patient Protection and Affordable Care Act (as subsequently amended, the “2010 Healthcare Reform Laws”), to identify and implement workable coordinated care and integrated delivery payment models. Successful healthcare providers are those able to adapt to changes in the regulatory and operating environments, build strategic relationships across the healthcare continuum, and consistently provide high-quality, cost-effective care. We believe we have the necessary capabilities - change agility, strategic relationships, quality of patient outcomes, cost effectiveness, and ability to capitalize on growth opportunities - to adapt to and succeed in a dynamic, highly regulated industry, and we have a proven track record of doing so. As we continue to execute our business plan, the following are some of the challenges we face. • Operating in a Highly Regulated Industry. We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These rules and regulations have affected, or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the costs of compliance, mandating new documentation standards, requiring additional licensure or certification, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and limiting our ability to enter new markets or add new capacity to existing hospitals and agencies. Ensuring continuous compliance with extensive laws and regulations is an operating requirement for all healthcare providers. We have invested, and will continue to invest, substantial time, effort, and expense in implementing and maintaining training programs as well as internal controls and procedures designed to ensure regulatory compliance, and we are committed to continued adherence to these guidelines. More specifically, because Medicare comprises a significant portion of our Net operating revenues, it is particularly important for us to remain compliant with the laws and regulations governing the Medicare program and related matters including anti-kickback and anti-fraud requirements. If we were unable to remain compliant with these regulations, our financial position, results of operations, and cash flows could be materially, adversely impacted. Concerns held by federal policymakers about the federal deficit and national debt levels, as well as other healthcare policy priorities, could result in enactment of legislation affecting portions of the Medicare program, including post-acute care services we provide. It is not clear whether Congress will pass legislation to modify or repeal the provisions of the 2010 Healthcare Reform Laws most relevant to us, nor is it clear what, if any, other Medicare-related changes may ultimately be enacted and signed into law or otherwise implemented or caused by the Trump Administration through regulatory procedures, but it is possible that any reductions in Medicare spending will have a material impact on reimbursements for healthcare providers generally and post-acute providers specifically. We cannot predict what, if any, changes in Medicare spending or modifications to the healthcare laws and regulations will result from future budget or other legislative or regulatory initiatives. On February 9, 2018, President Trump signed into law the Bipartisan Budget Act of 2018 (the “2018 Budget Act”). The 2018 Budget Act requires CMS to update the home health prospective payment system (the “HH-PPS”) with a market basket update of 1.5% and eliminates the productivity adjustment for 2020. The 2018 Budget Act also mandates several significant changes to the HH-PPS, including establishing in 2020 a 30-day unit of service for home health payment purposes to replace the current 60-day episode of payment methodology. We cannot predict the impact of these significant changes to the HH-PPS on our home health agencies and their Medicare reimbursements. See Item 1A, Risk Factors, for additional discussion on changes included in the 2018 Budget Act. The Medicare Payment Advisory Commission (“MedPAC”) is an independent agency that advises Congress on issues affecting Medicare and makes payment policy recommendations to Congress and CMS for a variety of Medicare payment systems including, among others, the inpatient rehabilitation facility prospective payment system (the “IRF-PPS”) and the HH-PPS. Congress and CMS are not obligated to adopt MedPAC recommendations, and, based on outcomes in previous years, there can be no assurance those recommendations will be adopted. However, MedPAC’s recommendations have, and may in the future, become the basis for subsequent legislative or regulatory action. In recent years, MedPAC has made several recommendations that would significantly impact post-acute reimbursement systems if ultimately adopted. See Item 1A, Risk Factors, for additional discussion on MedPAC’s payment policy recommendations. Each year, CMS adopts rules that update pricing and otherwise amend the respective payment systems. On July 31, 2017, CMS released its notice of final rulemaking for Fiscal Year 2018 under the IRF-PPS (the “2018 IRF Rule”). Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the 2018 IRF Rule’s release and incorporates other adjustments included in it, we believe the 2018 Final IRF Rule will result in a net increase to our Medicare payment rates of approximately 0.8% effective October 1, 2017, prior to the impact of sequestration. On November 1, 2017, CMS released its notice of final rulemaking for calendar year 2018 for home health agencies under the HH-PPS (the “2018 HH Rule”). Based on our analysis, we believe the 2018 HH Rule, after taking into account the 2018 Budget Act, will result in a net decrease to our Medicare home health payment rates of approximately 0.5% effective for episodes ending in calendar year 2018, prior to the impact of sequestration. For additional details of the 2018 IRF Rule, 2018 HH Rule, and sequestration as well as other proposed and adopted legislative and regulatory actions that may be material to our business, see Item 1, Business, “Sources of Revenues” and Item 1A, Risk Factors. Reimbursement claims made by healthcare providers, including inpatient rehabilitation hospitals as well as home health and hospice agencies, are subject to audit from time to time by governmental payors and their agents, such as the Medicare Administrative Contractors (“MACs”), fiscal intermediaries and carriers, as well as the Office of Inspector General, CMS, and state Medicaid programs. These audits as well as the ordinary course claim reviews of our billings result in payment denials. Healthcare providers can challenge any denials through an administrative appeals process that can be extremely lengthy, taking up to seven years or longer. For additional details of these claim reviews, See Item 1A, Risk Factors and Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” to the accompanying consolidated financial statements. See also Item 1, Business, “Sources of Revenues” and “Regulation,” and Item 1A, Risk Factors, to this report and Note 17, Contingencies and Other Commitments, “Governmental Inquiries and Investigations,” to the accompanying consolidated financial statements. • Changes to Our Operating Environment Resulting from Healthcare Reform. Many provisions within the 2010 Healthcare Reform Laws have impacted, or could in the future impact, our business. Most notable for us are Medicare reimbursement reductions, such as reductions to annual market basket updates to providers and reimbursement rate rebasing adjustments, and promotion of alternative payment models, such as accountable care organizations (“ACOs”) and bundled payment initiatives (“BPCI”). Our challenges related to healthcare reform are discussed in Item 1, Business, “Sources of Revenues,” and Item 1A, Risk Factors. While the change in administration has added to regulatory uncertainty, the healthcare industry in general has been facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models. In these models, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the efficiency and overall value and quality of the services they provide to a patient. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new care delivery and payment model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are attempting to position the Company in preparation for whatever changes are ultimately made to the delivery system as discussed in Item 1, Business, “Competitive Strengths.” Given the complexity and the number of changes in the 2010 Healthcare Reform Laws and other pending regulatory initiatives, we cannot predict their ultimate impact. As noted above, it is not clear whether Congress will pass legislation to modify or repeal the 2010 Healthcare Laws, nor can we predict whether other legislation affecting Medicare and post-acute care providers will be enacted, or what actions the Trump Administration may take or cause through the regulatory process that may result in modifications to the 2010 Healthcare Laws or the Medicare program. Therefore, the ultimate nature and timing of the transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and regulations and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. Additionally, in October 2014, President Obama signed into law the IMPACT Act. The IMPACT Act was developed on a bi-partisan basis by the House Ways and Means and Senate Finance Committees and incorporated feedback from healthcare providers and provider organizations that responded to the Committees’ solicitation of post-acute payment reform ideas and proposals. It directs the United States Department of Health and Human Services (“HHS”), in consultation with healthcare stakeholders, to implement standardized data collection processes for post-acute quality and outcome measures. Although the IMPACT Act does not specifically call for the development of a new post-acute payment system, we believe this act will lay the foundation for possible future post-acute payment policies that would be based on patients’ medical conditions and other clinical factors rather than the setting where the care is provided, also referred to as “site neutral” reimbursement. For additional details on the IMPACT Act, see Item 1A, Risk Factors. • Maintaining Strong Volume Growth. Various factors, including competition and increasing regulatory and administrative burdens, may impact our ability to maintain and grow our hospital, home health, and hospice volumes. In any particular market, we may encounter competition from local or national entities with longer operating histories or other competitive advantages, such as acute care hospitals who provide post-acute services similar to ours or other post-acute providers with relationships with referring acute care hospitals or physicians. Aggressive payment review practices by Medicare contractors, aggressive enforcement of regulatory policies by government agencies, and restrictive or burdensome rules, regulations or statutes governing admissions practices may lead us to not accept patients who would be appropriate for and would benefit from the services we provide. In addition, from time to time, we must get regulatory approval to expand our services and locations in states with certificate of need laws. This approval may be withheld or take longer than expected. In the case of new-store volume growth, the addition of hospitals, home health agencies, and hospice agencies to our portfolio also may be difficult and take longer than expected. • Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk Factors, for a discussion of competition for staffing, shortages of qualified personnel, and other factors that may increase our labor costs. Recruiting and retaining qualified personnel for our inpatient hospitals and home health and hospice agencies remain a high priority for us. We attempt to maintain a comprehensive compensation and benefits package that allows us to remain competitive in this challenging staffing environment while remaining consistent with our goal of being a high-quality, cost-effective provider of post-acute services. See also Item 1, Business, and Item 1A, Risk Factors. These key challenges notwithstanding, we believe we have a strong business model, a strong balance sheet, and a proven track record of achieving strong financial and operational results. We are attempting to position the Company to respond to changes in the healthcare delivery system and believe we will be in a position to take advantage of any opportunities that arise as the industry moves to this new stage. We believe we are positioned to continue to grow, adapt to external events, and create value for our shareholders in 2018 and beyond. Results of Operations Payor Mix During 2017, 2016, and 2015, we derived consolidated Net operating revenues from the following payor sources: Our payor mix is weighted heavily towards Medicare. We receive Medicare reimbursements under the IRF-PPS, the HH-PPS, and the Hospice-PPS. For additional information regarding Medicare reimbursement, see the “Sources of Revenues” section of Item 1, Business. As part of the Balanced Budget Act of 1997, Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or “Medicare Advantage.” The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (under Medicare Parts A and B) or enrollment in a health maintenance organization, preferred provider organization, point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services. Net operating revenues also include other revenues generated from management and administrative fees and other non-patient care services. These other revenues are included in “other income” in the above table. Our Results From 2015 through 2017, our consolidated results of operations were as follows: Provision for Doubtful Accounts and Operating Expenses as a % of Net Operating Revenues In the discussion that follows, we use “same-store” comparisons to explain the changes in certain performance metrics and line items within our financial statements. We calculate same-store comparisons based on hospitals and home health locations open throughout both the full current period and prior periods presented. These comparisons include the financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 2017 Compared to 2016 Net Operating Revenues Our consolidated Net operating revenues increased in 2017 compared to 2016 primarily from pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. Provision for Doubtful Accounts Provision for doubtful accounts decreased in 2017 compared to 2016 in terms of dollars and as a percent of Net operating revenues primarily due to a reduction in pre-payment claims denials in our inpatient rehabilitation segment. For additional information on claims denials, see Item 1, Business, “Sources of Revenues-Medicare Reimbursement,” and of the TPE program, see Item 1A, Risk Factors, of this report. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals and home health and hospice agencies, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2017 compared to 2016 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2017 and 2016 development activities, salary increases for our employees, and an increase in benefit costs. Salaries and benefits as a percent of Net operating revenues increased during 2017 compared to 2016 primarily as a result of an increase in full-time equivalents and salary and benefit cost increases. Full-time equivalents increased due to staffing increases at the former Reliant hospitals since their acquisition on October 1, 2015 and the ramping up of new hospitals in Hot Springs, Arkansas; Bryan, Texas; Broken Arrow, Oklahoma; Modesto, California; Gulfport, Mississippi; Westerville, Ohio; Jackson, Tennessee; and Pearland, Texas. Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals and home health and hospice agencies. These expenses include such items as contract services, non-income related taxes, professional fees, utilities, insurance, and repairs and maintenance. Other operating expenses increased during 2017 compared to 2016 primarily due to increased patient volumes and hurricane-related expenses and losses. Other operating expenses during 2016 included a $3.3 million gain from the divestiture of our home health pediatric services in November 2016. See Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements. Other operating expenses increased as a percent of Net operating revenues during 2017 compared to 2016 due to the aforementioned divestiture gain, IME adjustment described in the “Segment Results of Operations” section of this Item, and hurricane-related expenses and losses. Supplies Supplies expense includes all costs associated with supplies used while providing patient care. Specifically, these costs include pharmaceuticals, food, needles, bandages, and other similar items. Supplies increased in terms of dollars during 2017 compared to 2016 due primarily to increased patient volumes. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our home office in Birmingham, Alabama. These expenses also include stock-based compensation expenses. General and administrative expenses increased in 2017 compared to 2016 in terms of dollars and as a percent of Net operating revenues due primarily to increased corporate salary and benefit costs, including expenses associated with stock appreciation rights, our rebranding and name change, and the TeamWorks clinical collaboration initiative. The total rebranding investment is estimated to be approximately $25 to $30 million, to be incurred between 2017 and 2019. For additional information on stock appreciation rights, see Note 13, Share-Based Payments, to the accompanying consolidated financial statements, on the rebranding and name change, see the “Executive Overview” section of this Item, and on the TeamWorks clinical collaboration initiative, see Item 1, Business, “Overview of the Company-Competitive Strengths,” of this Item. Depreciation and Amortization Depreciation and amortization increased during 2017 compared to 2016 due to our acquisitions and capital expenditures throughout 2016 and 2017. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt during 2017 primarily resulted from exercising the early redemption option on all $320 million of Convertible Notes resulting in the issuance of 8.9 million shares of common stock. The Loss on early extinguishment of debt during 2016 resulted from the redemptions of our 2022 Notes in 2016. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The decrease in Interest expense and amortization of debt discounts and fees in 2017 compared to 2016 primarily resulted from the redemptions of our 2022 Notes in 2016. Cash paid for interest approximated $151 million and $164 million in 2017 and 2016, respectively. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2017 increased compared to 2016 due to increased Net operating revenues as discussed above. Provision for Income Tax Expense On December 22, 2017, the US enacted the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, which is commonly referred to as “US tax reform,” significantly changes US corporate income tax laws by, among other things, reducing the US corporate income tax rate from 35% to 21% starting in 2018. As a result, we recorded a net charge of $1.2 million during the fourth quarter of 2017. This amount consists of three components: (i) a $10.1 million charge resulting from the remeasurement of our net federal deferred tax assets based on the new lower corporate income tax rate, (ii) a $14.7 million credit resulting from the remeasurement of our net state deferred tax assets as a result of the decreased federal benefit implicit in the new lower corporate income tax rate, and (iii) a $5.8 million charge resulting from the remeasurement of our net valuation allowances for state NOLs as a result of the decreased federal benefit implicit in the new lower corporate income tax rate. The net charge of $1.2 million did not have a material impact on our effective tax rate. In addition, we adopted the Tax Act’s provisions allowing for 100% bonus depreciation on qualifying assets placed in service after September 27, 2017, which resulted in additional bonus depreciation deductions of $8.8 million in the fourth quarter of 2017. Our cash payments for income taxes approximated $95 million, net of refunds, in 2017. These payments were based on estimates of taxable income for 2017, net of tax deferral associated with pre-payment claims denials as discussed in Note 15, Income Taxes, to the accompanying consolidated financial statements. We estimate we will pay approximately $105 million to $135 million of cash income taxes, net of refunds, in 2018. The Tax Act included revisions to Internal Revenue Code §451 that may eliminate this deferral of revenue for tax purposes and require us to pay tax on such denied claims. We are currently evaluating this provision of the Tax Act and its impact on the tax deferral associated with pre-payment claims denials we received in 2017. The upper end of our estimate of 2018 cash taxes considers 100% of the deferred revenue will be reversed. In 2017 and 2016, current income tax expense was $85.0 million and $31.0 million, respectively. Our effective income tax rate for 2017 was 32.4%. The Provision for income tax expense in 2017 was less than the federal statutory rate primarily due to: (1) the impact of noncontrolling interests and (2) share-based windfall tax benefits offset by (3) state and other income tax expense. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” for a discussion of the allocation of income or loss related to pass-through entities, which is referred to as the impact of noncontrolling interests in this discussion. Our effective income tax rate for 2016 was 34.0%. Our Provision for income tax expense in 2016 was less than the federal statutory rate primarily due to: (1) the impact of noncontrolling interests offset by (2) state and other income tax expense. In certain jurisdictions, we do not expect to generate sufficient income to use all of the available state NOLs and other credits prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable tax jurisdiction, or if the timing of future tax deductions differs from our expectations. We recognize the financial statement effects of uncertain tax positions when it is more likely than not, based on the technical merits, a position will be sustained upon examination by and resolution with the taxing authorities. Total remaining gross unrecognized tax benefits were $0.3 million and $2.8 million as of December 31, 2017 and 2016, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests The increase in Net income attributable to noncontrolling interests during 2017 compared to the same period of 2016 primarily resulted from increased profitability of our joint ventures and a net tax benefit resulting from the application of the Tax Act’s new corporate income tax rate to our joint venture entities’ deferred tax liabilities. 2016 Compared to 2015 Net Operating Revenues Our consolidated Net operating revenues increased in 2016 compared to 2015 primarily from strong volume growth in both of our operating segments and included the effect of our acquisitions of Reliant on October 1, 2015 and CareSouth on November 2, 2015. See additional discussion in the “Segment Results of Operations” section of this Item. Provision for Doubtful Accounts The change in our Provision for doubtful accounts as a percent of Net operating revenues in 2016 compared to 2015 was primarily due to aging-based reserves resulting from continued administrative payment delays at our largest MAC. For additional information, see Item 1, Business, “Sources of Revenues-Medicare Reimbursement,” of this report. Salaries and Benefits Salaries and benefits increased in 2016 compared to 2015 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2015 development activities, the acquisitions of Reliant and CareSouth, a salary increase given to all eligible nonmanagement hospital employees effective in October of each year, and an increase in benefit costs. Salaries and benefits as a percent of Net operating revenues increased during 2016 compared to 2015 primarily as a result of salary and benefit cost increases, Medicare home health reimbursement rate cuts, and the ramping up of new hospitals in Franklin, Tennessee; Hot Springs, Arkansas; Bryan, Texas; Broken Arrow, Oklahoma; and Modesto, California. Other Operating Expenses Other operating expenses increased during 2016 compared to 2015 primarily due to the acquisitions of Reliant and CareSouth and increased patient volumes at our hospitals offset by a $3.3 million gain from the divestiture of our home health pediatric services in November 2016. See Note 18, Segment Reporting, to the accompanying consolidated financial statements. Other operating expenses during 2015 included the settlement of an employee sexual harassment matter that was not covered by insurance. Other operating expenses decreased as a percent of Net operating revenues during 2016 compared to 2015 due to our increasing revenues, primarily as a result of the acquisitions of Reliant and CareSouth, and to the aforementioned divestiture and settlement. Occupancy costs Occupancy costs include amounts paid for rent associated with leased hospitals, outpatient rehabilitation satellite clinics, and home health and hospice agencies, including common area maintenance and similar charges. Occupancy costs increased during 2016 compared to 2015 in terms of dollars and as a percent of Net operating revenues due to the acquisition of Reliant, which leased all of its hospitals. Supplies Supplies increased during 2016 compared to 2015 due primarily to increased patient volumes. Supplies decreased as a percent of Net operating revenues during 2016 compared to 2015 primarily due to supply chain efficiencies including the continued transition of brand name drugs to generic. General and Administrative Expenses General and administrative expenses increased in 2016 compared to 2015 due primarily to increased corporate full-time equivalents, benefit costs, and stock compensation expenses offset by transaction costs related to the acquisitions of Reliant and CareSouth. General and administrative expenses decreased as a percent of Net operating revenues in 2016 compared to 2015 primarily due to our increasing revenues, primarily as a result of the acquisitions of Reliant and CareSouth. Depreciation and Amortization Depreciation and amortization increased during 2016 compared to 2015 due to our acquisitions and capital expenditures throughout 2015 and 2016. Government, Class Action, and Related Settlements The loss included in Government, class action, and related settlements in 2015 resulted from a settlement discussed in Note 17, Contingencies and Other Commitments, to the consolidated financial statements accompanying our Annual Report on Form 10-K for the year ended December 31, 2015 (the “2015 Form 10-K”). Professional Fees - Accounting, Tax, and Legal Professional fees-accounting, tax, and legal for 2016 and 2015 related primarily to legal and consulting fees for continued litigation and support matters discussed in Note 17, Contingencies and Other Commitments, to the consolidated financial statements accompanying the 2015 Form 10-K. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt during 2016 resulted from the redemptions of our 7.75% Senior Notes due 2022 in March, May, and September of 2016. The Loss on early extinguishment of debt during 2015 primarily resulted from the redemption of our 8.125% Senior Notes due 2020 in April 2015. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees in 2016 compared to 2015 resulted from an increase in average borrowings due to our use of debt to fund the acquisitions of Reliant and CareSouth. Our average cash interest rate remained relatively flat during 2016 compared to 2015. Cash paid for interest approximated $164 million and $121 million in 2016 and 2015, respectively. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income for 2015 included a $1.2 million realized gain from the sale of all the common stock of Surgical Care Affiliates (“SCA”), our former surgery centers division and a $2.0 million gain related to the increase in fair value of our option to purchase up to a 5% equity interest in SCA from April 1, 2015 (the date it became exercisable) to April 13, 2015 (the date we exercised the option). See Note 12, Fair Value Measurements, to the consolidated financial statements accompanying the 2015 Form 10-K. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2016 increased compared to 2015 due to increased Net operating revenues primarily as a result of the acquisitions of Reliant and CareSouth. Provision for Income Tax Expense As discussed above, our effective income tax rate for 2016 was 34.0%. The Provision for income tax expense in 2016 was less than the federal statutory rate primarily due to: (1) the impact of noncontrolling interests offset by (2) state and other income tax expense. Our effective income tax rate for 2015 was 35.9%. Our Provision for income tax expense in 2015 was greater than the federal statutory rate of 35% primarily due to: (1) state and other income tax expense and (2) an increase in our valuation allowance offset by (3) the impact of noncontrolling interests. The increase in our valuation allowance in 2015 related primarily to changes to our state apportionment percentages resulting from the acquisitions of EHHI, Reliant, and CareSouth and changes to our current forecast of earnings in each jurisdiction. Total remaining gross unrecognized tax benefits were $2.8 million and $2.9 million as of December 31, 2016 and 2015, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. There can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing pharmaceutical costs has enabled us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions were not material to our operations in 2017, 2016, or 2015, and therefore, are not presented as a separate discussion within this Item. Segment Results of Operations Our internal financial reporting and management structure is focused on the major types of services provided by Encompass Health. We manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information regarding our business segments, including a detailed description of the services we provide, financial data for each segment, and a reconciliation of total segment Adjusted EBITDA to income from continuing operations before income tax expense, see Note 18, Segment Reporting, to the accompanying consolidated financial statements. Inpatient Rehabilitation During the years ended December 31, 2017, 2016 and 2015, our inpatient rehabilitation segment derived its Net operating revenues from the following payor sources: Additional information regarding our inpatient rehabilitation segment’s operating results for the years ended December 31, 2017, 2016 and 2015, is as follows: * Full-time equivalents included in the above table represent our employees who participate in or support the operations of our hospitals and include an estimate of full-time equivalents related to contract labor. We actively manage the productive portion of our Salaries and benefits utilizing certain metrics, including employees per occupied bed, or “EPOB.” This metric is determined by dividing the number of full-time equivalents, including an estimate of full-time equivalents from the utilization of contract labor, by the number of occupied beds during each period. The number of occupied beds is determined by multiplying the number of licensed beds by our occupancy percentage. Provision for Doubtful Accounts and Operating Expenses as a % of Net Operating Revenues 2017 Compared to 2016 Net Operating Revenues Net operating revenues were 5.5% higher for 2017 compared to 2016. This increase included a 4.0% increase in patient discharges and a 2.0% increase in net patient revenue per discharge. Discharge growth included a 1.8% increase in same-store discharges. Discharge growth from new stores resulted from our joint ventures in Hot Springs, Arkansas (February 2016), Bryan, Texas (August 2016), Broken Arrow, Oklahoma (August 2016), Gulfport, Mississippi (April 2017), Westerville, Ohio (April 2017), and Jackson, Tennessee (July 2017), as well as the opening of wholly owned hospitals in Modesto, California (October 2016) and Pearland, Texas (October 2017). Growth in net patient revenue per discharge resulted primarily from patient mix (higher percentage of stroke and neurological patients) offset by the negative impact of an approximate $5 million reduction in prior period cost report adjustments and a 2016 benefit of a retroactive indirect medical education (“IME”) adjustment of approximately $4 million at the former Reliant hospital in Woburn, Massachusetts. The decrease in outpatient and other revenues in 2017 compared to 2016 was primarily due to the closure of six outpatient programs in the latter half of 2016. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our joint ventures and acquisitions discussed above. Adjusted EBITDA The increase in Adjusted EBITDA for the inpatient rehabilitation segment in 2017 compared to 2016 primarily resulted from revenue growth, as discussed above. A decline in Provision for doubtful accounts and flat group medical expenses also contributed to the growth. Expense ratios were negatively impacted by the aforementioned IME adjustment and hurricane-related expenses. The lack of growth in group medical expense favorably impacted Salaries and benefits as a percent of Net operating revenues and served to offset the impact of merit and incentive compensation increases and the ramping up of new stores on this ratio. Other operating expenses increased as a percent of Net operating revenues primarily due to increased provider tax expense in the fourth quarter of 2017 and the impact of favorable franchise tax recoveries in the fourth quarter of 2016. The Provision for doubtful accounts as a percent of Net operating revenues decreased primarily due to a reduction in new pre-payment claims denials, as previously discussed. We provided an approximate 3% salary increase to our nonmanagement hospital employees effective October 1, 2017. Benefit costs are expected to increase 8% to 12% in 2018 due to lower group medical expenses in 2017. 2016 Compared to 2015 Net Operating Revenues Net operating revenues were 13.9% higher for 2016 compared to 2015. This increase included a 10.8% increase in patient discharges and a 2.9% increase in net patient revenue per discharge. Discharge growth included a 1.7% increase in same-store discharges. Discharge growth from new stores resulted from our joint ventures in Hot Springs, Arkansas (February 2016); Bryan, Texas (August 2016); and Broken Arrow, Oklahoma (August 2016), our wholly owned hospitals that opened in Franklin, Tennessee (December 2015) and Modesto California (October 2016), and our acquisitions of Reliant (October 2015) and Cardinal Hill in Lexington, Kentucky (May 2015). Growth in net patient revenue per discharge resulted primarily from patient mix (higher percentage of stroke patients and the integration of the Reliant hospitals) and by the the aforementioned IME adjustment. Our revenues in 2016 were positively impacted by this adjustment to our third-party payor estimates for 2014, 2015, and the year-to-date period through July 2016. In addition, net patient revenue per discharge growth in 2016 benefited from an approximate $5 million SSI adjustment that negatively impacted revenue in 2015. CMS periodically retroactively updates SSI ratios that are used to determine adjustments to Medicare payment rates for low-income patients. In the second quarter of 2015, CMS updated the ratios for fiscal year 2013, which resulted in adjustments to our third-party payor estimates for 2013, 2014, and year-to-date period through July 2015. Outpatient revenues increased during 2016 compared to 2015 due to the acquisition of Reliant. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our joint ventures and acquisitions discussed above. Adjusted EBITDA The increase in Adjusted EBITDA in 2016 compared to 2015 primarily resulted from revenue growth, as discussed above. All operating expenses as a percent of Net operating revenues benefited in 2016 by the aforementioned IME adjustment. Salaries and benefits in 2016 included a year-over-year decline in group medical costs. Other operating expenses decreased as a percent of revenue due primarily to the 2015 settlement of an employee sexual harassment matter that was not covered by insurance. Occupancy costs increased as a percent of Net operating revenues due to the acquisition of Reliant. Supplies expense decreased as a percent of revenue due to continued supply chain efficiencies including the continued transition of brand name drugs to generic. The Provision for doubtful accounts as a percent of Net operating revenues increased from 1.7% in 2015 to 1.9% in 2016 due to aging-based reserves resulting from continued administrative payment delays at the Company's largest MAC. Home Health and Hospice During the years ended December 31, 2017, 2016 and 2015, our home health and hospice segment derived its Net operating revenues from the following payor sources: Additional information regarding our home health and hospice segment’s operating results for the years ended December 31, 2017, 2016 and 2015, is as follows: Provision for Doubtful Accounts and Operating Expenses as a % of Net Operating Revenues 2017 Compared to 2016 Net Operating Revenues Home health and hospice revenue was 14.2% higher during 2017 compared to 2016. This increase included a 17.0% increase in home health admissions and was impacted by a 1.1% decrease in revenue per episode. Home health revenue growth resulted from strong same-store and new-store volume growth. Home health admission growth included a 11.4% increase in same-store admissions. The decrease in revenue per episode resulted from Medicare reimbursement rate cuts partially offset by changes in patient mix and reconciliation payments attributed to various alternative payment models (e.g., BPCI; ACOs). The increase in hospice and other revenue primarily resulted from acquisitions completed in 2016. For additional information on BPCI and ACOs, see Item 1A, Risk Factors. The percentage of our home health and hospice revenue derived from Medicaid decreased during 2017 compared to 2016 as a result of the divestiture of our pediatric home health assets in November 2016. See Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our acquisitions discussed above. Adjusted EBITDA The increase in Adjusted EBITDA during 2017 compared to 2016 primarily resulted from revenue growth and staffing productivity gains. Adjusted EBITDA for the segment during 2017 was impacted by Medicare reimbursement rate cuts, higher cost per visit (driven by an increased percentage of therapy patients) and salary and benefit cost increases as a result of continued investments in additional sales and marketing associates. We provide annual merit increases to our nonmanagement home health and hospice employees on their respective anniversary dates which averaged 3% in 2017 and are expected to remain at that level in 2018. 2016 Compared to 2015 Net Operating Revenues Home health and hospice revenue was 34.6% higher during 2016 compared to 2015. This increase included a 43.6% increase in home health admissions and was impacted by a 1.3% decrease in revenue per episode. Home health admission growth included a 13.7% increase in same-store admissions. Home health admission growth from new stores resulted primarily from the acquisition of CareSouth in November 2015. Revenue per episode was impacted by the Medicare home health reimbursement rate cuts that became effective January 1, 2016 and lower revenue per episode at CareSouth due to patient mix. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report regarding CareSouth and Encompass' other acquisitions throughout 2015. Adjusted EBITDA The increase in Adjusted EBITDA during 2016 compared to 2015 primarily resulted from revenue growth. Adjusted EBITDA for the segment during 2016 was impacted by Medicare reimbursement rate cuts, higher cost per visit (driven by an increased percentage of therapy patients), salary and benefit costs increases, a $3.3 million gain from the divestiture of our home health pediatric assets, and expenses related to the integration of CareSouth. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Pursuing and achieving those objectives allows us to support the execution of our operating and strategic plans and weather temporary disruptions in the capital markets and general business environment. Maintaining adequate liquidity is a function of our unrestricted Cash and cash equivalents and our available borrowing capacity. Maintaining flexibility in our capital structure is a function of, among other things, the amount of debt maturities in any given year, the options for debt prepayments without onerous penalties, and limiting restrictive terms and maintenance covenants in our debt agreements. Consistent with these objectives, during the second quarter of 2017 we exercised the early redemption option and subsequently retired all $320 million of the Convertible Notes reducing our long-term debt balance by approximately $278 million. Substantially all of the holders elected to convert their Convertible Notes to shares of our common stock, which resulted in the issuance of 8.9 million shares from treasury stock. We redeemed $0.6 million in principal at par in cash. As a result of these transactions, we recorded a $10.4 million Loss on early extinguishment of debt in the second quarter of 2017. In September 2017, we amended our existing credit agreement to increase the size of our revolving credit facility from $600 million to $700 million, decrease the balance of our term loan facilities by approximately $110 million to $300 million, reduce the interest rate spread by 25 basis points, extend the agreement's maturity by two years to 2022, and amend the covenants to, among other things, allow for additional capacity for investments, restricted payments, and capital expenditures. As a result of this amendment, we recorded a $0.3 million Loss on early extinguishment of debt in the third quarter of 2017. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2022. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate, and we have significant availability under our revolving credit facility. We continue to generate strong cash flows from operations, and we have significant flexibility with how we choose to invest our cash and return capital to shareholders. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Current Liquidity As of December 31, 2017, we had $54.4 million in Cash and cash equivalents. This amount excludes $62.4 million in Restricted cash and $62.0 million of restricted marketable securities ($44.2 million of restricted marketable securities are included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 4, Cash and Marketable Securities, to the accompanying consolidated financial statements. In addition to Cash and cash equivalents, as of December 31, 2017, we had approximately $570 million available to us under our revolving credit facility. Our credit agreement governs the substantial majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to $100 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. In calculating the leverage ratio under our credit agreement, we are permitted to use pro forma Adjusted EBITDA, the calculation of which includes historical income statement items and pro forma adjustments resulting from (1) the dispositions and repayments or incurrence of debt and (2) the investments, acquisitions, mergers, amalgamations, consolidations and operational changes from acquisitions to the extent such items or effects are not yet reflected in our trailing four-quarter financial statements. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As of December 31, 2017, the maximum leverage ratio requirement per our credit agreement was 4.50x and the minimum interest coverage ratio requirement was 3.0x, and we were in compliance with these covenants. Based on Adjusted EBITDA for 2017 and the interest rate in effect under our credit agreement during the three-month period ended December 31, 2017, if we had drawn on the first day and maintained the maximum amount of outstanding draws under our revolving credit facility for the entire year, we would still be in compliance with the maximum leverage ratio and minimum interest coverage ratio requirements. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2022, and our bonds all mature in 2023 and beyond. See the “Contractual Obligations” section below for information related to our contractual obligations as of December 31, 2017. We acquired a significant portion of our home health and hospice business when we purchased EHHI Holdings, Inc. (“EHHI”) on December 31, 2014. In the acquisition, we acquired all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to Encompass Health Home Health Holdings, Inc. (“Holdings”), a subsidiary of Encompass Health and an indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. Those sellers were members of EHHI management, and they contributed a portion of their shares of common stock of EHHI, valued at approximately $64 million on the acquisition date, in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. At any time after December 31, 2017, each management investor has the right (but not the obligation) to have his or her shares of Holdings stock repurchased by Encompass Health for a cash purchase price per share equal to the fair value. The fair value is determined using the product of the trailing 12-month specified performance measure for Holdings and a specified median market price multiple based on a basket of public home health companies. Specifically, up to one-third of each management investor’s shares of Holdings stock may be sold prior to December 31, 2018; two-thirds of each management investor’s shares of Holdings stock may be sold prior to December 31, 2019; and all of each management investor’s shares of Holdings stock may be sold thereafter. At any time after December 31, 2019, Encompass Health will have the right (but not the obligation) to repurchase all or any portion of the shares of Holdings stock owned by one or more management investors for a cash purchase price per share equal to the fair value. As of December 31, 2017, the value of those outstanding shares of Holdings was approximately $192 million. In February 2018, each management investor exercised the right to sell one-third of his or her shares of Holdings stock to Encompass Health, representing approximately 5.6% of the outstanding shares of the common stock of Holdings. On February 21, 2018, Encompass Health settled the acquisition of those shares upon payment of approximately $65 million in cash. See also Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common stock and distribution of common stock dividends, including the potential growth of the quarterly cash dividend on our common stock, recognizing that these actions may increase our leverage ratio. See also the “Authorizations for Returning Capital to Stakeholders” section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years ended December 31, 2017, 2016, and 2015 (in millions): 2017 Compared to 2016 Operating activities. The increase in Net cash provided by operating activities during 2017 compared to 2016 primarily resulted from revenue growth, as described above, and improved collection of accounts receivable offset by increased payments for income taxes following the exhaustion of our federal net operating loss in the first quarter of 2017. Investing activities. The increase in Net cash used in investing activities during 2017 compared to 2016 resulted primarily from the increase in cash used for capital expenditures and the decrease in the net change in restricted cash as well as the proceeds received from the divestiture of our home health pediatric assets in 2016. See Note 7. Goodwill and Other Intangibles, to the accompanying consolidated financial statements. Financing activities. The decrease in Net cash used in financing activities during 2017 compared to 2016 primarily resulted from the proceeds received from the exercising of stock warrants and decreases in borrowings on the revolving credit facility, common stock repurchases, and principal debt payments, including the redemption of $176 million of the 2022 Notes in March, May, and September of 2016. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. 2016 Compared to 2015 Operating activities. The increase in Net cash provided by operating activities during 2016 compared to 2015 primarily resulted from revenue growth, as described above, and changes to payroll-related liabilities. Investing activities. The decrease in Net cash used in investing activities during 2016 compared to 2015 resulted primarily from the decrease in cash used in the acquisition of businesses offset by the proceeds received from the divestiture of our home health pediatric assets in 2016. Cash outflows were significantly higher in 2015 due to the acquisitions of Reliant and CareSouth described in Note 2, Business Combinations, to the accompanying consolidated financial statements. Financing activities. The decrease in Net cash used in financing activities during 2016 compared to 2015 primarily resulted from the 2015 debt transactions, including the public offering of the 2023 Notes, the additional offering of the 2024 Notes, and the private offering of the 2025 Notes to fund the acquisitions of Reliant and CareSouth as discussed and defined in Note 9, Long-term Debt, to the accompanying consolidated financial statements. Contractual Obligations Our consolidated contractual obligations as of December 31, 2017 are as follows (in millions): (a) Included in long-term debt are amounts owed on our bonds payable and other notes payable. These borrowings are further explained in Note 9, Long-term Debt, to the accompanying consolidated financial statements. (b) Interest on our fixed rate debt is presented using the stated interest rate. Interest expense on our variable rate debt is estimated using the rate in effect as of December 31, 2017. Interest pertaining to our credit agreement is included to its ultimate maturity date. Interest related to capital lease obligations is excluded from this line. Future minimum payments, which are accounted for as interest, related to sale/leaseback transactions involving real estate accounted for as financings are included in this line (see Note 6, Property and Equipment, and Note 9, Long-term Debt, to the accompanying consolidated financial statements). Amounts exclude amortization of debt discounts, amortization of loan fees, or fees for lines of credit that would be included in interest expense in our consolidated statements of operations. (c) Amounts include interest portion of future minimum capital lease payments. (d) Our inpatient rehabilitation segment leases approximately 17% of its hospitals as well as other property and equipment under operating leases in the normal course of business. Our home health and hospice segment leases relatively small office spaces in the localities it serves, space for its corporate office, and other equipment under operating leases in the normal course of business. Some of our hospital leases contain escalation clauses based on changes in the Consumer Price Index while others have fixed escalation terms. The minimum lease payments do not include contingent rental expense. Some lease agreements provide us with the option to renew the lease or purchase the leased property. Our future operating lease obligations would change if we exercised these renewal options and if we entered into additional operating lease agreements. For more information, see Note 6, Property and Equipment, to the accompanying consolidated financial statements. (e) Future operating lease obligations and purchase obligations are not recognized in our consolidated balance sheet. (f) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on Encompass Health and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. Our purchase obligations primarily relate to software licensing and support. (g) Because their future cash outflows are uncertain, the following noncurrent liabilities are excluded from the table above: general liability, professional liability, and workers’ compensation risks, noncurrent amounts related to third-party billing audits, stock appreciation rights, and deferred income taxes. Also, as of December 31, 2017, we had $0.3 million of total gross unrecognized tax benefits. For more information, see Note 10, Self-Insured Risks, Note 13, Share-Based Payments, Note 15, Income Taxes, and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements. (h) The table above does not include Redeemable noncontrolling interests of $220.9 million because of the uncertainty surrounding the timing and amounts of any related cash outflows. See Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year ended December 31, 2017, we made capital expenditures of approximately $245 million for property and equipment and capitalized software. These expenditures in 2017 are exclusive of approximately $39 million in net cash related to our acquisition activity. During 2018, we expect to spend approximately $280 million to $350 million for capital expenditures. Approximately $130 million to $150 million of this budgeted amount is considered nondiscretionary expenditures, which we may refer to in other filings as “maintenance” expenditures. In addition, we expect to spend approximately $50 million to $100 million on home health and hospice acquisitions during 2018. Actual amounts spent will be dependent upon the timing of construction projects and acquisition opportunities for our home health and hospice business. Authorizations for Returning Capital to Stakeholders In October 2016, February 2017, and May 2017, our board of directors declared cash dividends of $0.24 per share that were paid in January 2017, April 2017, and July 2017, respectively. On July 20, 2017, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.25 per share, that was paid on October 16, 2017 to stockholders of record on October 2, 2017. On October 20, 2017, our board of directors declared a cash dividend of $0.25 per share, that was paid on January 16, 2018 to stockholders of record on January 2, 2018. On February 23, 2018, our board of directors declared a cash dividend of $0.25 per share, payable on April 16, 2018 to stockholders of record on April 2, 2018. We expect quarterly dividends to be paid in January, April, July, and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates as well as the per share amounts, will be at the discretion of our board of directors after consideration of various factors, including our capital position and alternative uses of funds. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our revolving credit facility. On February 14, 2014, our board of directors approved an increase in our existing common stock repurchase authorization from $200 million to $250 million. As of December 31, 2017, approximately $58 million remained under this authorization. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. During 2017, we repurchased 0.9 million shares of our common stock in the open market for approximately $38 million under this repurchase authorization using cash on hand. Future repurchases under this authorization generally are expected to be funded using a combination of cash on hand and availability under our $700 million revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 9, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement-our interest coverage ratio and our leverage ratio-could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might be on terms less favorable to us than those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. In general terms, the credit agreement definition of Adjusted EBITDA, therein referred to as “Adjusted Consolidated EBITDA,” allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to $10 million in a year may be cash expenditures), (2) any losses from discontinued operations and closed locations, (3) costs and expenses, including legal fees and expert witness fees, incurred with respect to litigation associated with stockholder derivative litigation, (4) share-based compensation expense, and (5) cost and expenses in connection with the Encompass Health rebranding. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent they increase consolidated Net income. Under the credit agreement, the Adjusted EBITDA calculation does not include net income attributable to noncontrolling interests and includes (1) gain or loss on disposal of assets, (2) professional fees unrelated to the stockholder derivative litigation, (3) unusual or nonrecurring cash expenditures in excess of $10 million, and (4) pro forma adjustments resulting from debt transactions and development activities. Items falling within the credit agreement’s “unusual or nonrecurring” classification, may occur in future periods, but these items and amounts recognized can vary significantly from period to period and may not directly relate to our ongoing operating performance. Accordingly, these items may not be indicative of our ongoing performance, so the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Our Adjusted EBITDA for the years ended December 31, 2017, 2016, and 2015 was as follows (in millions): Reconciliation of Net Income to Adjusted EBITDA Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA Growth in Adjusted EBTIDA in 2017 compared to 2016 resulted primarily from revenue growth. Growth in Adjusted EBITDA in 2016 compared to 2015 resulted primarily from revenue growth in both operating segments due to the acquisitions of Reliant and CareSouth. For additional information see the “Results of Operations” and “Segment Results of Operations” sections of this Item. Off-Balance Sheet Arrangements In accordance with the definition under SEC rules, the following qualify as off-balance sheet arrangements: • any obligation under certain guarantees or contracts; • a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that serves as credit, liquidity, or market risk support to that entity for such assets; • any obligation under certain derivative instruments; and • any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the registrant, or engages in leasing, hedging, or research and development services with the registrant. As of December 31, 2017, we do not have any material off-balance sheet arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2017, we are not involved in any unconsolidated SPE transactions. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates, and judgments to ensure our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, as they require our most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the audit committee of our board of directors. Revenue Recognition We recognize net patient revenue in the reporting period in which we perform the service based on our current billing rates (i.e., gross charges) less actual adjustments and estimated discounts for contractual allowances (principally for patients covered by Medicare, Medicare Advantage, Medicaid, and other third-party payors). See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues,” to the accompanying consolidated financial statements for a complete discussion of our revenue recognition policies. Our patient accounting systems calculate contractual allowances on a patient-by-patient basis based on the rates in effect for each primary third-party payor. Certain other factors that are considered and could influence the level of our reserves are assumed to remain consistent with the experience for patients discharged in similar time periods for the same payor classes, and additional reserves are provided to account for these factors. Management continually reviews the contractual estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. In addition, laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Due to complexities involved in determining amounts ultimately due under reimbursement arrangements with third-party payors, which are often subject to interpretation and review, we may receive reimbursement for healthcare services authorized and provided that is different from our estimates, and such differences could be material. However, we continually review the amounts actually collected in subsequent periods in order to determine the amounts by which our estimates differed. Historically, such differences have not been material from either a quantitative or qualitative perspective. Allowance for Doubtful Accounts The collection of outstanding receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. We provide for accounts receivable that could become uncollectible by establishing an allowance to reduce the carrying value of such receivables to their estimated net realizable value. See Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” and Note 5, Accounts Receivable, to the accompanying consolidated financial statements for a complete discussion of our policies related to the allowance for doubtful accounts. We estimate our allowance for doubtful accounts based on the aging of our accounts receivable, our historical collection experience for each type of payor, and other relevant factors so that the remaining receivables, net of allowances, are reflected at their estimated net realizable values. Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. Our collection risks include patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding and pre-payment claim reviews by our respective MACs. In addition, reimbursement claims made by health care providers are subject to audit from time to time by governmental payors and their agents. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. See Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” to the accompanying consolidated financial statements. As of December 31, 2017 and 2016, $176.8 million and $172.0 million, or 25.2% and 26.0%, respectively, of our patient accounts receivable represented denials by MACs that were in the pre-payment medical necessity review process. During the years ended December 31, 2017, 2016, and 2015, we wrote off $8.9 million, $3.5 million, and $2.6 million, respectively, of previously denied claims while we collected $10.7 million, $9.2 million, and $7.4 million, respectively, of previously denied claims. The table below shows a summary of our net accounts receivable balances as of December 31, 2017 and 2016. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, “Accounts Receivable and the Allowance for Doubtful Accounts,” to the accompanying consolidated financial statements. Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers’ compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers’ compensation risks are insured through a wholly owned insurance subsidiary. See Note 10, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost of reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers’ compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are certain of the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: • historical claims experience; • trending of loss development factors; • trends in the frequency and severity of claims; • coverage limits of third-party insurance; • demographic information; • statistical confidence levels; • medical cost inflation; • payroll dollars; and • hospital patient census. The time period to resolve claims can vary depending upon the jurisdiction, the nature, and the form of resolution of the claims. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. See Note 10, Self-Insured Risks, to the accompanying consolidated financial statements for additional information. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management’s estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as of October 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our inpatient rehabilitation and home health and hospice reporting units. We assess qualitative factors in each reporting unit to determine whether it is necessary to perform the first step of the two-step quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not a reporting unit’s fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must proceed to Step 1, we would determine the fair value of the applicable reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of the reporting units determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting units. The income approach includes the use of each reporting unit’s projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management’s best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company’s stock price. See Note 1, Summary of Significant Accounting Policies, “Goodwill and Other Intangibles,” and Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets; • Industry and market considerations and changes in healthcare regulations, including reimbursement and compliance requirements under the Medicare and Medicaid programs; • Cost factors, such as an increase in labor, supply, or other costs; • Overall financial performance, such as negative or declining cash flows or a decline in actual or forecasted revenue or earnings; • Other relevant company-specific events, such as material changes in management or key personnel or outstanding litigation; • Material events, such as a change in the composition or carrying amount of each reporting unit’s net assets, including acquisitions and dispositions; and • Consideration of the relationship of our market capitalization to our book value, as well as a sustained decrease in our share price. In the fourth quarter of 2017, we performed our annual evaluation of goodwill and determined no adjustment to impair goodwill was necessary. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our inpatient rehabilitation and home health and hospice reporting units are not at risk for any impairment charges. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” and Note 15, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year ended December 31, 2017, we increased our valuation allowance by $7.9 million. As of December 31, 2017, we had a remaining valuation allowance of $35.8 million which primarily related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the NOLs before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management’s estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as of December 31, 2017 will be realized, no such assurances can be provided. If management’s expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, “Litigation Reserves,” and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding ForwardLooking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. Executive Overview Our Business We are the nation’s leading owner and operator of inpatient rehabilitation hospitals and a leader in homebased care, offering services in 36 states and Puerto Rico. As discussed in this Item, “Segment Results of Operations,” we manage our operations in two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. On July 10, 2017, we announced the plan to rebrand and change our name from HealthSouth Corporation to Encompass Health Corporation. On October 20, 2017, our board of directors approved an amended and restated certificate of incorporation in order to change the name effective as of January 1, 2018. Along with the corporate name change, the NYSE ticker symbol for our common stock changed from “HLS” to “EHC.” Our operations in both business segments will transition to the Encompass Health branding on a rolling basis. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 31 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2017, we operate 127 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture which we account for using the equity method of accounting. In addition to our hospitals, we manage four inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 80% of our Net operating revenues for the year ended December 31, 2017. Home Health and Hospice Our home health and hospice business is the nation’s fourth largest provider of Medicarecertified skilled home health services in terms of revenues. Our home health services include a comprehensive range of Medicarecertified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. We also provide hospice services to terminally ill patients and their families that address patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. As of December 31, 2017, we provide home health and hospice services in 237 locations across 28 states, with concentrations in the Southeast and Texas. In addition, two of these home health locations operate as joint ventures which we account for using the equity method of accounting. Our home health and hospice segment represented approximately 20% of our Net operating revenues for the year ended December 31, 2017. See also Item 1, Business, and Item 1A, Risk Factors, of this report, Note 18, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” section of this Item. 2017 Overview In 2017, we focused on the following strategic priorities: providing highquality, costeffective care to patients in our existing markets; achieving organic growth at our existing inpatient rehabilitation hospitals, home health agencies, and hospice agencies; expanding our services to more patients [/INST] Positive. </s>

Encompass Health Corp

2019-02-27

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. We have revised our financial statements as of and for the year ended December 31, 2017 to correct an error in the accounting for deferred income taxes. Accordingly, the MD&A set forth below reflect the effects of this revision. See details in Note 1, Summary of Significant Accounting Policies, “Revision of Previously Issued Financial Statements,” to the accompanying consolidated financial statements. Executive Overview Our Business We are a leading provider of integrated healthcare services, offering both facility-based and home-based patient care through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As of December 31, 2018, our national footprint spans 36 states and Puerto Rico. As discussed in this Item, “Segment Results of Operations,” we manage our operations in two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. In 2018, we undertook a rebranding to reinforce our strategy and position as an integrated provider of facility-based and home-based patient care. As part of the rebranding, we changed our corporate name from HealthSouth Corporation to Encompass Health Corporation and the NYSE ticker symbol for our common stock from “HLS” to “EHC.” Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 32 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2018, we operate 130 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture that we account for using the equity method of accounting. In addition to our hospitals, we manage five inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 78% of our Net operating revenues for the year ended December 31, 2018. Home Health and Hospice Our home health and hospice business is the nation’s fourth largest provider of Medicare-certified skilled home health services in terms of revenues. Our home health services include a comprehensive range of Medicare-certified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. We also provide hospice services to terminally ill patients and their families that address patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. As of December 31, 2018, we provide home health and hospice services across 278 locations and 30 states, with concentrations in the Southeast and Texas. In addition, two of these home health agencies operate as joint ventures that we account for using the equity method of accounting. Our home health and hospice segment represented approximately 22% of our Net operating revenues for the year ended December 31, 2018. See also Item 1, Business, and Item 1A, Risk Factors, of this report, Note 18, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” section of this Item. 2018 Overview In 2018, we focused on the following strategic priorities: • providing high-quality, cost-effective care to patients in our existing markets; • achieving organic growth at our existing inpatient rehabilitation hospitals, home health agencies, and hospice agencies; • expanding our services to more patients who require these services by constructing and acquiring hospitals in new markets and acquiring and opening home health and hospice agencies in new markets; • making shareholder distributions via common stock dividends and repurchases of our common stock; and • positioning the Company for success in the evolving healthcare delivery system through key operational initiatives that include implementing the rebranding and name change, developing and implementing post-acute solutions, enhancing clinical collaboration between our inpatient rehabilitation hospitals and home health locations, refining and expanding use of clinical data analytics to further improve patient outcomes, and participating in alternative payment models. During 2018, Net operating revenues increased 9.3% over 2017 due primarily to pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. Within our inpatient rehabilitation segment, discharge growth of 4.6% coupled with a 2.2% increase inpatient revenue per discharge in 2018 generated 6.5% growth in net patient revenue compared to 2017. Discharge growth included a 2.8% increase in same-store discharges. Within our home health and hospice segment, home health admission growth of 10.0% coupled with the impact of a 0.6% decrease in revenue per episode in 2018 contributed to 20.5% growth in home health and hospice revenue compared to 2017. Home health admission growth included a 5.6% increase in same-store admissions. Many of our quality and outcome measures remained above both inpatient rehabilitation and home health industry averages. Not only did we treat more patients and enhance outcomes, we did so in a cost-effective manner. See the “Results of Operations” section of this Item. Our growth efforts continued to yield positive results in 2018. In our inpatient rehabilitation segment, we: • entered into an agreement with Saint Alphonsus Regional Medical Center in February 2018 to own and operate a new 40-bed inpatient rehabilitation hospital in Boise, Idaho. The joint venture hospital is expected to begin operating in the third quarter of 2019 subject to customary closing conditions, including regulatory approvals; • began operating our new 34-bed inpatient rehabilitation hospital in Shelby County, Alabama in April 2018 and our new 38-bed inpatient rehabilitation hospital in Bluffton, South Carolina (formerly referred to as Hilton Head, South Carolina) in June 2018; • began operating a 29-bed inpatient rehabilitation hospital in Murrells Inlet, South Carolina with our joint venture partner, Tidelands Health, in September 2018; • began operating our new 68-bed inpatient rehabilitation hospital in Winston-Salem, North Carolina with our joint venture partner, Novant Health Inc., in October 2018; • continued the construction of our new 40-bed joint venture hospital with University Medical Center Health System in Lubbock, Texas. The hospital is expected to begin operating in the second quarter of 2019; • continued our capacity expansions by adding 26 new beds to existing hospitals; and • continued development of the following de novo hospitals: We also continued our growth efforts in our home health and hospice segment. On May 1, 2018, we completed the acquisition of privately owned Camellia Healthcare and affiliated entities (“Camellia”). The Camellia portfolio consisted of 18 hospice, 14 home health, and 2 private duty locations in Mississippi, Alabama, Louisiana and Tennessee. The Camellia acquisition leveraged our home health and hospice operating platform across key certificate of need states and strengthened our geographic presence in the Southeastern United States. We funded the cash purchase price of the acquisition with cash on hand and borrowings under our revolving credit facility. We expect to realize a tax benefit with an estimated present value of $20 million to $25 million related to this transaction. In addition to completing the Camellia transaction, we acquired two home health locations located in Birmingham, Alabama, and Talladega, Alabama and four hospice locations located in Oklahoma City, Oklahoma; Las Vegas, Nevada; Talladega, Alabama; and El Paso, Texas. We also began accepting patients at our seven new home health locations in Owasso, Oklahoma; Atlanta, Georgia; Vernon, Alabama; Boise, Idaho; Henderson, Nevada; Worcester, Massachusetts; and Bluffton, South Carolina. We also continued our shareholder distributions by paying a quarterly cash dividend of $0.25 per share on our common stock in the first three quarters of 2018. On July 24, 2018, our board of directors approved an increase in our quarterly cash dividend to $0.27 per share. See the “Liquidity and Capital Resources” section of this Item. We further positioned ourselves for the healthcare industry’s movement to integrated delivery payment models, value-based purchasing, and post-acute site neutrality. We recently completed our company-wide rebranding and name change initiative to reflect and reinforce our expanding national footprint and our strategy to deliver high-quality, cost-effective care across the post-acute continuum. We increased the clinical collaboration rate between our inpatient rehabilitation hospitals and home health locations. We developed and piloted a longitudinal patient record to manage patients across the post-acute continuum and a 90-day post-acute readmission prediction model. We began using patient care navigators to follow a patient throughout an episode of care. We also refined and expanded use of clinical data analytics to further improve patient outcomes and lower cost of care. Business Outlook We believe our business outlook remains positive. Favorable demographic trends, such as population aging, should increase long-term demand for the services we provide. While we treat patients of all ages, most of our patients are 65 and older, and the number of Medicare enrollees is expected to grow approximately 3% per year for the foreseeable future. We believe the demand for the services we provide will continue to increase as the U.S. population ages. We believe these factors align with our strengths in, and focus on, post-acute services. In addition, we believe we can address the demand for facility-based and home-based post-acute care services in markets where we currently do not have a presence by constructing or acquiring new hospitals and by acquiring or opening home health and hospice agencies in those extremely fragmented industries. We are a leading provider of integrated healthcare services, offering both facility-based and home-based patient care through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. We are committed to delivering high-quality, cost-effective, integrated patient care across the healthcare continuum with a primary focus on the post-acute sector. As the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals, we believe we differentiate ourselves from our competitors based on the quality of our clinical outcomes, our cost-effectiveness, our financial strength, and our extensive application of technology. As the fourth largest provider of Medicare-certified skilled home health services in terms of revenues, we believe we differentiate ourselves from our competitors by the application of a highly integrated technology platform, our ability to manage a variety of care pathways, and a proven track record of consummating and integrating acquisitions. We have invested considerable resources into clinical and management systems and protocols that have allowed us to consistently produce high-quality outcomes for our patients while continuing to contain cost growth. Our proprietary hospital management reporting system aggregates data from each of our key business systems into a comprehensive reporting package used by the management teams in our hospitals, as well as executive management, and allows them to analyze data and trends and create custom reports on a timely basis. Our commitment to technology also includes our electronic clinical information system (“ACE-IT”). ACE-IT allows us to interface with the clinical information systems of acute care hospitals to facilitate patient transfers, reduce readmissions, and enhance patient outcomes. We also believe this system will improve patient care and safety, enhance staff recruitment and retention, and set the stage for connectivity with other providers and health information exchanges. Our home health and hospice segment uses information technology to enhance patient care and manage the business by utilizing Homecare HomebaseSM, an industry leading comprehensive information platform designed to manage the entire patient work flow and allow home health providers to process clinical, compliance, financial, and marketing information as well as analyze data and trends for management purposes using custom reports on a timely basis. Homecare Homebase also allows us to share valuable data with payors to promote better patient outcomes on a more cost-effective basis. All of these systems allow us to enhance our clinical and business processes. Our information systems allow us to collect, analyze, and share information on a timely basis, making us an ideal partner for other healthcare providers in a coordinated care delivery environment. Our priorities include operational initiatives that build on momentum from 2018. Through clinical collaboration between our inpatient rehabilitation hospitals and home health agencies we further our pursuit of quality patient outcomes and improved patient experiences. We believe our clinical collaboration efforts have and will continue to contribute to reductions in discharges to skilled nursing facilities, higher discharges to home, and improved patient satisfaction. Due to the need of post-acute care for stroke patients, we are attempting to build our stroke market share by leveraging our strategic sponsorship of the American Heart Association/American Stroke Association, clinical collaboration, and hospital participation in The Joint Commission's Disease-Specific Care Certification Program. We will also continue to develop and implement post-acute solutions by leveraging our clinical expertise, large post-acute datasets, electronic medical record technologies, and strategic partnerships to drive improved patient outcomes and lower cost of care across the entire post-acute episode. The Medicare reimbursement systems for both inpatient rehabilitation and home health are subject to potentially significant changes. We will prepare for the transition to the new IRF patient assessment measures, commonly referred to as “CARE Tool” measures, and the implementation of the home health Patient-Driven Groupings Model (“PDGM”). For additional information see “Key Challenges” below as well as Item 1, Business, and Item 1A, Risk Factors. The nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain, as the development and implementation of new care delivery and payment systems will require significant time and resources. Furthermore, many of the alternative approaches being explored may not work as intended. However, as outlined in Item 1, Business, “Competitive Strengths”, our goal is to position the Company in a prudent manner to be responsive to industry shifts. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2022. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate. We have significant availability under our revolving credit facility, and we continue to generate strong cash flows from operations. Strong and consistent free cash flow generated by our Company, together with our relatively low financial leverage and the unfunded commitment of our revolving credit facility, provides substantial capacity to pursue growth opportunities in both of our business segments while continuing to invest in our operational initiatives and capital structure strategy. For these and other reasons, we believe we will be able to adapt to changes in reimbursement, sustain our business model, and grow through acquisition and consolidation opportunities as they arise. Key Challenges Healthcare is a highly-regulated industry facing many well-publicized regulatory and reimbursement challenges. The industry also is facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models as well as post-acute site neutrality in Medicare reimbursement. The Medicare reimbursement systems for both inpatient rehabilitation and home health are subject to potentially significant changes in the next two years. The future of many aspects of healthcare regulation remains uncertain. Successful healthcare providers are those able to adapt to changes in the regulatory and operating environments, build strategic relationships across the healthcare continuum, and consistently provide high-quality, cost-effective care. We believe we have the necessary capabilities - change agility, strategic relationships, quality of patient outcomes, cost effectiveness, and ability to capitalize on growth opportunities - to adapt to and succeed in a dynamic, highly regulated industry, and we have a proven track record of doing so. As we continue to execute our business plan, the following are some of the challenges we face. • Operating in a Highly Regulated Industry. We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These rules and regulations have affected, or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the costs of compliance, mandating new documentation standards, requiring additional licensure or certification, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and limiting our ability to enter new markets or add new capacity to existing hospitals and agencies. Ensuring continuous compliance with extensive laws and regulations is an operating requirement for all healthcare providers. We have invested, and will continue to invest, substantial time, effort, and expense in implementing and maintaining training programs as well as internal controls and procedures designed to ensure regulatory compliance, and we are committed to continued adherence to these guidelines. More specifically, because Medicare comprises a significant portion of our Net operating revenues, failure to comply with the laws and regulations governing the Medicare program and related matters, including anti-kickback and anti-fraud requirements, could materially and adversely affect us. The federal government’s reliance on sub-regulatory guidance, such as handbooks, FAQs, internal memoranda, and press releases, presents a unique challenge to compliance efforts. Such sub-regulatory guidance purports to explain validly promulgated regulations but often expands or supplements existing regulations without constitutionally and statutorily required notice and comment and other procedural protections. Without procedural protections, sub-regulatory guidance poses a risk above and beyond reasonable efforts to follow validly promulgated regulations, particularly when the agency or Medicare Administrative Contractor (“MAC”) seeking to enforce such sub-regulatory guidance is not the agency or MAC issuing the guidance. If we were unable to remain compliant with these regulations, our financial position, results of operations, and cash flows could be materially, adversely impacted. Concerns held by federal policymakers about the federal deficit and national debt levels, as well as other healthcare policy priorities, could result in enactment of legislation affecting portions of the Medicare program, including post-acute care services we provide. It is not clear what, if any, Medicare-related changes may ultimately be enacted and signed into law or otherwise implemented or caused by the Trump Administration through regulatory procedures, but it is possible that any reductions in Medicare spending will have a material impact on reimbursements for healthcare providers generally and post-acute providers specifically. We cannot predict what, if any, changes in Medicare spending or modifications to the healthcare laws and regulations will result from future budget or other legislative or regulatory initiatives. On February 9, 2018, President Trump signed into law the Bipartisan Budget Act of 2018 (the “2018 Budget Act”). The 2018 Budget Act requires CMS to update the home health prospective payment system (the “HH-PPS”) with a market basket update of 1.5% and eliminates the productivity adjustment for 2020. The 2018 Budget Act also mandates several significant changes to the HH-PPS, including replacing in 2020 the 60-day unit of payment with a 30-day unit of payment methodology, while retaining the 60-day episode. We cannot predict the impact of these significant changes to the HH-PPS on our home health agencies and their Medicare reimbursements. See Item 1A, Risk Factors, for additional discussion on changes included in the 2018 Budget Act. The Medicare Payment Advisory Commission (“MedPAC”) is an independent agency that advises Congress on issues affecting Medicare and makes payment policy recommendations to Congress and CMS for a variety of Medicare payment systems including, among others, the inpatient rehabilitation facility prospective payment system (the “IRF-PPS”) and the HH-PPS. Congress and CMS are not obligated to adopt MedPAC recommendations, and, based on outcomes in previous years, there can be no assurance those recommendations will be adopted. However, MedPAC’s recommendations have, and may in the future, become the basis for subsequent legislative or regulatory action. In recent years, MedPAC has made several recommendations that would significantly impact post-acute reimbursement systems if ultimately adopted. See Item 1A, Risk Factors, for additional discussion on MedPAC’s payment policy recommendations. Each year, CMS adopts rules that update pricing and otherwise amend the respective payment systems. On July 31, 2018, CMS released its notice of final rulemaking for Fiscal Year 2019 under the IRF-PPS (the “2019 IRF Rule”). Based on our analysis which utilizes, among other things, the acuity of our patients over the 12-month period prior to the 2019 IRF Rule’s release and incorporates other adjustments included in it, we believe the 2019 Final IRF Rule will result in a net increase to our Medicare payment rates of approximately 1.2% effective October 1, 2018. Additionally, the 2019 IRF Rule finalized a change to the IRF-PPS, effective October 1, 2019, that replaces the FIM™ assessment instrument with new patient assessment measures, commonly referred to as “CARE Tool” measures. We and the IRF industry are still assessing the nature and magnitude of any impact this might have on aggregate Medicare reimbursements, which impact will depend in part on additional data and updates to be included in future rulemaking by CMS. On October 31, 2018, CMS released its notice of final rulemaking for calendar year 2019 for home health agencies under the HH-PPS (the “2019 HH Rule”). Based on our analysis, we believe the 2019 HH Rule will result in a net increase to our Medicare home health payment rates of approximately 1.5% effective for episodes ending in calendar year 2019. Additionally, pursuant to the requirements of the 2018 Budget Act, the 2019 HH Rule sets out significant changes to the HH-PPS that will be adopted effective for calendar year 2020. The new payment system, referred to as the Patient-Driven Groupings Model (“PDGM”), replaces the current 60-day episode of payment methodology with 30-day payment periods and eliminates therapy usage as a factor in adjusting case-mix weighting. CMS previously proposed but has not yet adopted a 6.4% reduction in the base payment rate for 2020 intended to offset the provider behavioral changes that CMS assumes PDGM will drive. Based on 2017 data, and assuming no change in the foregoing and other factors, which are subject to potentially significant change, we estimate an approximate 3.8% incremental reduction (after 1.3% net market basket update mandated by the 2018 Budget Act) in Medicare payments assuming the PDGM is implemented on a budget neutral basis. For additional details of the 2019 IRF Rule, 2019 HH Rule, and other proposed and adopted legislative and regulatory actions that may be material to our business, see Item 1A, Risk Factors. Reimbursement claims made by healthcare providers, including inpatient rehabilitation hospitals as well as home health and hospice agencies, are subject to audit from time to time by governmental payors and their agents, such as the MACs, fiscal intermediaries and carriers, as well as the Office of Inspector General, CMS, and state Medicaid programs. These audits as well as the ordinary course claim reviews of our billings result in payment denials, including recoupment of previously paid claims from current account receivables. Healthcare providers can challenge any denials through an administrative appeals process that can be extremely lengthy, taking up to eight years or longer. For additional details of these claim reviews, See Item 1A, Risk Factors and Note 1, Summary of Significant Accounting Policies, “Accounts Receivable,” to the accompanying consolidated financial statements. See also Item 1, Business, “Sources of Revenues” and “Regulation,” and Item 1A, Risk Factors, to this report and Note 17, Contingencies and Other Commitments, “Governmental Inquiries and Investigations,” to the accompanying consolidated financial statements. • Changes to Our Operating Environment Resulting from Healthcare Reform. Many provisions within the 2010 Healthcare Reform Laws have impacted, or could in the future impact, our business. Most notable for us are Medicare reimbursement reductions, such as reductions to annual market basket updates to providers and reimbursement rate rebasing adjustments, and promotion of alternative payment models, such as accountable care organizations (“ACOs”) and bundled payment initiatives such as the Bundled Payment for Care Improvement Initiative (“BPCI”), the Comprehensive Care for Joint Replacement (“CJR”) program, and the BPCI-Advanced program. Our challenges related to healthcare reform are discussed in Item 1, Business, “Sources of Revenues,” and Item 1A, Risk Factors. While the change in administration has added to regulatory uncertainty, the healthcare industry in general has been facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models. In these models, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the efficiency and overall value and quality of the services they provide to a patient. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new care delivery and payment model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are attempting to position the Company in preparation for whatever changes are ultimately made to the delivery system. As discussed in Item 1, Business, the future of the 2010 Healthcare Reform Laws as well as the nature and substance of any replacement reform legislation enacted remain uncertain, nor can we predict whether other legislation affecting Medicare and post-acute care providers will be enacted, or what actions the Trump Administration may take or cause through the regulatory process that may result in modifications to the 2010 Healthcare Laws or the Medicare program. Therefore, the ultimate nature and timing of the transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and regulations and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. Additionally, in October 2014, President Obama signed into law the IMPACT Act. The IMPACT Act was developed on a bi-partisan basis by the House Ways and Means and Senate Finance Committees and incorporated feedback from healthcare providers and provider organizations that responded to the Committees’ solicitation of post-acute payment reform ideas and proposals. It directs the United States Department of Health and Human Services (“HHS”), in consultation with healthcare stakeholders, to implement standardized data collection processes for post-acute quality and outcome measures. Although the IMPACT Act does not specifically call for the development of a new post-acute payment system, we believe this act will lay the foundation for possible future post-acute payment policies that would be based on patients’ medical conditions and other clinical factors rather than the setting where the care is provided, also referred to as “site neutral” reimbursement. For additional details on the IMPACT Act and efforts to implement a unified post-acute care payment system, see Item 1A, Risk Factors. • Maintaining Strong Volume Growth. Various factors, including competition and increasing regulatory and administrative burdens, may impact our ability to maintain and grow our hospital, home health, and hospice volumes. In any particular market, we may encounter competition from local or national entities with longer operating histories or other competitive advantages, such as acute care hospitals who provide post-acute services similar to ours or other post-acute providers with relationships with referring acute care hospitals or physicians. Aggressive payment review practices by Medicare contractors, aggressive enforcement of regulatory policies by government agencies, and restrictive or burdensome rules, regulations or statutes governing admissions practices may lead us to not accept patients who would be appropriate for and would benefit from the services we provide. In addition, from time to time, we must get regulatory approval to expand our services and locations in states with certificate of need laws. This approval may be withheld or take longer than expected. In the case of new-store volume growth, the addition of hospitals, home health agencies, and hospice agencies to our portfolio also may be difficult and take longer than expected. • Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk Factors, for a discussion of competition for staffing, shortages of qualified personnel, and other factors that may increase our labor costs. Recruiting and retaining qualified personnel, including management, for our inpatient hospitals and home health and hospice agencies remain a high priority for us. We attempt to maintain a comprehensive compensation and benefits package that allows us to remain competitive in this challenging staffing environment while remaining consistent with our goal of being a high-quality, cost-effective provider of post-acute services. See also Item 1, Business, and Item 1A, Risk Factors. These key challenges notwithstanding, we believe we have a strong business model, a strong balance sheet, and a proven track record of achieving strong financial and operational results. We are attempting to position the Company to respond to changes in the healthcare delivery system and believe we will be in a position to take advantage of any opportunities that arise as the industry moves to this new stage. We believe we are positioned to continue to grow, adapt to external events, and create value for our shareholders in 2019 and beyond. Results of Operations Payor Mix During 2018, 2017, and 2016, we derived consolidated Net operating revenues from the following payor sources: Our payor mix is weighted heavily towards Medicare. We receive Medicare reimbursements under the IRF-PPS, the HH-PPS, and the Hospice-PPS. For additional information regarding Medicare reimbursement, see the “Sources of Revenues” section of Item 1, Business. As part of the Balanced Budget Act of 1997, Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or “Medicare Advantage.” The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (under Medicare Parts A and B) or enrollment in a health maintenance organization, preferred provider organization, point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services. Net operating revenues also include other revenues generated from management and administrative fees and other non-patient care services. These other revenues are included in “other income” in the above table. Our Results From 2016 through 2018, our consolidated results of operations were as follows: (*) 2017 amounts have been revised to correct an error in our deferred tax assets as discussed in Note 1, Summary of Significant Accounting Policies, “Revision of Previously Issued Financial Statements,” to the accompanying consolidated financial statements. Operating Expenses as a % of Net Operating Revenues In the discussion that follows, we use “same-store” comparisons to explain the changes in certain performance metrics and line items within our financial statements. We calculate same-store comparisons based on hospitals and home health locations open throughout both the full current period and prior periods presented. These comparisons include the financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 2018 Compared to 2017 Net Operating Revenues Our consolidated Net operating revenues increased in 2018 compared to 2017 primarily from pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. Our consolidated Net operating revenues in 2018 benefited from a year-over-year reduction in revenue reserves as a result of a reduction in pre-payment claims denials in our inpatient rehabilitation segment. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals and home health and hospice agencies, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2018 compared to 2017 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our development activities, salary increases for our employees, and an increase in benefit costs. Salaries and benefits as a percent of Net operating revenues during 2018 was flat compared to 2017. Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals and home health and hospice agencies. These expenses include such items as contract services, non-income related taxes, professional fees, utilities, insurance, and repairs and maintenance. Other operating expenses increased during 2018 compared to 2017 primarily due to increased patient volumes and hurricane-related expenses and losses. Other operating expenses increased as a percent of Net operating revenues during 2018 compared to 2017 due primarily to increases in contract services and provider taxes. Supplies Supplies expense includes all costs associated with supplies used while providing patient care. Specifically, these costs include pharmaceuticals, food, needles, bandages, and other similar items. Supplies increased during 2018 compared to 2017 due primarily to increased patient volumes. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our home office in Birmingham, Alabama. These expenses also include stock-based compensation expenses. General and administrative expenses increased in 2018 compared to 2017 in terms of dollars and as a percent of Net operating revenues due primarily to increased corporate salary and benefit costs, including expenses associated with stock appreciation rights, and costs associated with our rebranding. The 2018 SARs expense was approximately $56 million compared to approximately $26 million in 2017. The 2018 rebranding expenses were approximately $11 million compared to approximately $6 million in 2017. For additional information on stock appreciation rights, see Note 13, Share-Based Payments, to the accompanying consolidated financial statements, and on the rebranding, see the “Executive Overview” section of this Item. Depreciation and Amortization Depreciation and amortization increased during 2018 compared to 2017 due to our capital expenditures and development activities throughout 2017 and 2018. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Government, Class Action, and Related Settlements The amount in Government, class action, and related settlements in 2018 related primarily to a $48 million loss contingency accrual we established in the fourth quarter of 2018 for the potential settlement of the investigation being conducted by the United States Department of Justice. See Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information on this matter. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt during 2017 primarily resulted from exercising the early redemption option on all $320 million of Convertible Notes resulting in the issuance of 8.9 million shares of common stock. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The decrease in Interest expense and amortization of debt discounts and fees in 2018 compared to 2017 primarily resulted from the redemption of the 2.0% Convertible Senior Subordinated Notes due 2043 in June 2017. Cash paid for interest approximated $150 million and $151 million in 2018 and 2017, respectively. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2018 decreased compared to 2017 due primarily to the contingency accrual we established in the fourth quarter of 2018, as discussed above. Provision for Income Tax Expense Our effective income tax rate for 2018 was 24.1% which was greater than the federal statutory rate primarily due to: (1) state and other income tax expense and (2) nondeductible settlements offset by (3) the impact of noncontrolling interests. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” for a discussion of the allocation of income or loss related to pass-through entities, which is referred to as the impact of noncontrolling interests in this discussion. Our Provision for income tax expense declined in 2018 compared to 2017 due primarily to the impact of the 2017 Tax Cuts and Jobs Act (the “Tax Act”) discussed below and in Note 15, Income Taxes, to the accompanying consolidated financial statements. Our effective income tax rate for 2017 was 29.4% which was less than the federal statutory rate primarily due to: (1) the impact of noncontrolling interests, (2) the impact of the Tax Act and (3) share-based windfall tax benefits offset by (4) state and other income tax expense. On December 22, 2017, the US enacted the Tax Act. The Tax Act, which is commonly referred to as “US tax reform,” significantly changes US corporate income tax laws by, among other things, reducing the US corporate income tax rate from 35% to 21% starting in 2018. Our cash payments for income taxes approximated $115 million, net of refunds, in 2018. These payments were based on estimates of taxable income for 2018. We estimate we will pay approximately $110 million to $130 million of cash income taxes, net of refunds, in 2019. Our estimate of 2019 cash taxes considers that some or all of the deferred revenue discussed in Note 15, Income Taxes, to the accompanying consolidated financial statements, will be reversed. In 2018 and 2017, current income tax expense was $128.0 million and $85.0 million, respectively. In certain jurisdictions, we do not expect to generate sufficient income to use all of the available state NOLs and other credits prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable tax jurisdiction, if the timing of future tax deductions differs from our expectations, or pursuant to changes in state tax laws and rates. We recognize the financial statement effects of uncertain tax positions when it is more likely than not, based on the technical merits, a position will be sustained upon examination by and resolution with the taxing authorities. Total remaining gross unrecognized tax benefits were $0.9 million and $0.3 million as of December 31, 2018 and 2017, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests The increase in Net income attributable to noncontrolling interests during 2018 compared to the same period of 2017 primarily resulted from our 2017 joint ventures and increased profitability of our existing joint ventures. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our 2017 joint ventures. 2017 Compared to 2016 Net Operating Revenues Our consolidated Net operating revenues increased in 2017 compared to 2016 primarily from pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. Our consolidated Net operating revenues in 2017 benefited from a year-over-year reduction in revenue reserves as a result of a reduction in pre-payment claims denials in our inpatient rehabilitation segment. Salaries and Benefits Salaries and benefits increased in 2017 compared to 2016 primarily due to increased patient volumes, including an increase in the number of full-time equivalents as a result of our 2017 and 2016 development activities, salary increases for our employees, and an increase in benefit costs. Salaries and benefits as a percent of Net operating revenues increased during 2017 compared to 2016 primarily as a result of an increase in full-time equivalents, which contributed to higher employees per occupied bed, and salary and benefit cost increases. Full-time equivalents increased due to staffing increases at the former Reliant hospitals since their acquisition on October 1, 2015 and the ramping up of new hospitals in Hot Springs, Arkansas; Bryan, Texas; Broken Arrow, Oklahoma; Modesto, California; Gulfport, Mississippi; Westerville, Ohio; Jackson, Tennessee; and Pearland, Texas. Other Operating Expenses Other operating expenses increased during 2017 compared to 2016 primarily due to increased patient volumes and hurricane-related expenses and losses. Other operating expenses during 2016 included a $3.3 million gain from the divestiture of our home health pediatric services in November 2016. See Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements. Other operating expenses increased as a percent of Net operating revenues during 2017 compared to 2016 due to the aforementioned divestiture gain, IME adjustment described in the “Segment Results of Operations” section of this Item, and hurricane-related expenses and losses. Supplies Supplies increased in terms of dollars during 2017 compared to 2016 due primarily to increased patient volumes. General and Administrative Expenses General and administrative expenses increased in 2017 compared to 2016 in terms of dollars and as a percent of Net operating revenues due primarily to increased corporate salary and benefit costs, including expenses associated with stock appreciation rights, our rebranding and name change, and the TeamWorks clinical collaboration initiative. For additional information on stock appreciation rights, see Note 13, Share-Based Payments, to the accompanying consolidated financial statements, on the rebranding and name change, see the “Executive Overview” section of this Item, and on the TeamWorks clinical collaboration initiative, see Item 1, Business, “Overview of the Company-Competitive Strengths,” of this report. Depreciation and Amortization Depreciation and amortization increased during 2017 compared to 2016 due to our acquisitions and capital expenditures throughout 2016 and 2017. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt during 2017 primarily resulted from exercising the early redemption option on all $320 million of Convertible Notes resulting in the issuance of 8.9 million shares of common stock. The Loss on early extinguishment of debt during 2016 resulted from the redemptions of our 2022 Notes in 2016. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The decrease in Interest expense and amortization of debt discounts and fees in 2017 compared to 2016 primarily resulted from the redemptions of our 2022 Notes in 2016. Cash paid for interest approximated $151 million and $164 million in 2017 and 2016, respectively. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2017 increased compared to 2016 due to increased Net operating revenues as discussed above. Provision for Income Tax Expense Our effective income tax rate for 2017 was 29.4% which was less than the federal statutory rate primarily due to: (1) the impact of noncontrolling interests, (2) the impact of the Tax Act and (3) share-based windfall tax benefits offset by (4) state and other income tax expense. As discussed above, 2017 also included the impact of the Tax Act. Our effective income tax rate for 2016 was 34.0%. Our Provision for income tax expense in 2016 was less than the federal statutory rate primarily due to: (1) the impact of noncontrolling interests offset by (2) state and other income tax expense. Total remaining gross unrecognized tax benefits were $0.3 million and $2.8 million as of December 31, 2017 and 2016, respectively. See Note 15, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests The increase in Net income attributable to noncontrolling interests during 2017 compared to the same period of 2016 primarily resulted from increased profitability of our joint ventures and a net tax benefit resulting from the application of the Tax Act’s new corporate income tax rate to our joint venture entities’ deferred tax liabilities. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. There can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing pharmaceutical costs has enabled us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions were not material to our operations in 2018, 2017, or 2016, and therefore, are not presented as a separate discussion within this Item. Segment Results of Operations Our internal financial reporting and management structure is focused on the major types of services provided by Encompass Health. We manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information regarding our business segments, including a detailed description of the services we provide, financial data for each segment, and a reconciliation of total segment Adjusted EBITDA to income from continuing operations before income tax expense, see Note 18, Segment Reporting, to the accompanying consolidated financial statements. Inpatient Rehabilitation During the years ended December 31, 2018, 2017 and 2016, our inpatient rehabilitation segment derived its Net operating revenues from the following payor sources: Additional information regarding our inpatient rehabilitation segment’s operating results for the years ended December 31, 2018, 2017 and 2016, is as follows: * Full-time equivalents included in the above table represent our employees who participate in or support the operations of our hospitals and include an estimate of full-time equivalents related to contract labor. We actively manage the productive portion of our Salaries and benefits utilizing certain metrics, including employees per occupied bed, or “EPOB.” This metric is determined by dividing the number of full-time equivalents, including an estimate of full-time equivalents from the utilization of contract labor, by the number of occupied beds during each period. The number of occupied beds is determined by multiplying the number of licensed beds by our occupancy percentage. Operating Expenses as a % of Net Operating Revenues 2018 Compared to 2017 Net Operating Revenues Net operating revenues were 6.5% higher for 2018 compared to 2017. This increase included a 4.6% increase in patient discharges and a 2.2% increase in net patient revenue per discharge. Discharge growth included a 2.8% increase in same-store discharges. Discharge growth from new stores resulted from our joint ventures in Gulfport, Mississippi (April 2017), Westerville, Ohio (April 2017), Jackson, Tennessee (July 2017), Murrells Inlet, South Carolina (September 2018) and Winston-Salem, North Carolina (October 2018), as well as wholly owned hospitals in Pearland, Texas (October 2017), Shelby County, Alabama (April 2018), and Bluffton, South Carolina (June 2018). Growth in net patient revenue per discharge primarily resulted from an increase in reimbursement rates from all payors and improvements in discharge destinations. The decrease in outpatient and other revenues in 2018 compared to 2017 was primarily due to the continued closures of hospital-based outpatient programs. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our joint ventures discussed above. Adjusted EBITDA The increase in Adjusted EBITDA for the inpatient rehabilitation segment in 2018 compared to 2017 primarily resulted from revenue growth, as discussed above. Expense ratios benefited from retroactive price adjustments and a year-over-year reduction in revenue reserves, as discussed above. Salaries and benefits as a percent of Net operating revenues benefited from labor management and higher volumes, which contributed to lower employees per occupied bed. Other operating expenses increased as a percent of Net operating revenues primarily due to increases in contract services and provider taxes. 2017 Compared to 2016 Net Operating Revenues Net operating revenues were 6.0% higher for 2017 compared to 2016. This increase included a 4.0% increase in patient discharges and a 2.4% increase in net patient revenue per discharge. Discharge growth included a 3.2% increase in same-store discharges. Discharge growth from new stores resulted from our joint ventures in Hot Springs, Arkansas (February 2016), Bryan, Texas (August 2016), Broken Arrow, Oklahoma (August 2016), Gulfport, Mississippi (April 2017), Westerville, Ohio (April 2017), and Jackson, Tennessee (July 2017), as well as the opening of wholly owned hospitals in Modesto, California (October 2016) and Pearland, Texas (October 2017). Growth in net patient revenue per discharge resulted primarily from patient mix (higher percentage of stroke and neurological patients) offset by the negative impact of an approximate $5 million reduction in prior period cost report adjustments and a 2016 benefit of a retroactive indirect medical education (“IME”) adjustment of approximately $4 million at the former Reliant hospital in Woburn, Massachusetts. The decrease in outpatient and other revenues in 2017 compared to 2016 was primarily due to the closure of six outpatient programs in the latter half of 2016. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our joint ventures discussed above. Adjusted EBITDA The increase in Adjusted EBITDA for the inpatient rehabilitation segment in 2017 compared to 2016 primarily resulted from revenue growth, as discussed above. A decline in revenue reserves and flat group medical expenses also contributed to the growth. Expense ratios were negatively impacted by the aforementioned IME adjustment and hurricane-related expenses. The lack of growth in group medical expense favorably impacted Salaries and benefits as a percent of Net operating revenues and served to offset the impact of merit and incentive compensation increases and the ramping up of new stores on this ratio. Other operating expenses increased as a percent of Net operating revenues primarily due to increased provider tax expense in the fourth quarter of 2017 and the impact of favorable franchise tax recoveries in the fourth quarter of 2016. Home Health and Hospice During the years ended December 31, 2018, 2017 and 2016, our home health and hospice segment derived its Net operating revenues from the following payor sources: Additional information regarding our home health and hospice segment’s operating results for the years ended December 31, 2018, 2017 and 2016, is as follows: Operating Expenses as a % of Net Operating Revenues 2018 Compared to 2017 Net Operating Revenues Revenue growth of 20.5% in the home health and hospice segment was primarily driven by volume growth, including a 5.6% increase in home health same-store admissions and the impact of the Camellia Healthcare acquisition in May 2018. The year-over-year decrease in revenue per episode resulted from Medicare reimbursement rate cuts that were partially offset by changes in patient mix. Hospice revenue increased primarily due to acquisitions and same-store admission growth of 24.6%. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our acquisitions discussed above. Adjusted EBITDA The increase in Adjusted EBITDA during 2018 compared to 2017 primarily resulted from revenue growth, as discussed above. Expense ratios were negatively impacted by Medicare reimbursement rate cuts. Cost of services as a percent of Net operating revenues increased for 2018 compared to 2017 primarily due to merit increases and the integration of Camellia offset by continued focus on caregiver optimization and productivity in home health and increased scale and efficiencies in hospice. Support and overhead costs as a percent of Net operating revenues decreased for 2018 compared to 2017 primarily due to operating leverage resulting from revenue growth. 2017 Compared to 2016 Net Operating Revenues Home health and hospice revenue was 13.9% higher during 2017 compared to 2016. This increase included a 17.0% increase in home health admissions and was impacted by a 1.1% decrease in revenue per episode. Home health revenue growth resulted from strong volume growth, which included an 11.4% increase in same-store admissions. The decrease in revenue per episode resulted from Medicare reimbursement rate cuts partially offset by changes in patient mix and reconciliation payments attributed to various alternative payment models (e.g., BPCI; ACOs). The increase in hospice revenue primarily resulted from acquisitions. For additional information on BPCI and ACOs, see Item 1A, Risk Factors. The percentage of our home health and hospice revenue derived from Medicaid decreased during 2017 compared to 2016 as a result of the divestiture of our pediatric home health assets in November 2016. See Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements. Adjusted EBITDA The increase in Adjusted EBITDA during 2017 compared to 2016 primarily resulted from revenue growth and staffing productivity gains. Adjusted EBITDA for the segment during 2017 was impacted by Medicare reimbursement rate cuts, higher cost per visit (driven by an increased percentage of therapy patients) and salary and benefit cost increases as a result of continued investments in additional sales and marketing associates. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Pursuing and achieving those objectives allow us to support the execution of our operating and strategic plans and weather temporary disruptions in the capital markets and general business environment. Maintaining adequate liquidity is a function of our unrestricted Cash and cash equivalents and our available borrowing capacity. Maintaining flexibility in our capital structure is a function of, among other things, the amount of debt maturities in any given year, the options for debt prepayments without onerous penalties, and limiting restrictive terms and maintenance covenants in our debt agreements. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2022. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate, and we have significant availability under our revolving credit facility. We continue to generate strong cash flows from operations, and we have significant flexibility with how we choose to invest our cash and return capital to shareholders. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Current Liquidity As of December 31, 2018, we had $69.2 million in Cash and cash equivalents. This amount excludes $64.3 million in restricted cash ($59.0 million included in Restricted cash and $5.3 million included in Other long-term assets in our consolidated balance sheet) and $62.0 million of restricted marketable securities (included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 4, Cash and Marketable Securities, to the accompanying consolidated financial statements. In addition to Cash and cash equivalents, as of December 31, 2018, we had approximately $633 million available to us under our revolving credit facility. Our credit agreement governs the substantial majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to $100 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. In calculating the leverage ratio under our credit agreement, we are permitted to use pro forma Adjusted EBITDA, the calculation of which includes historical income statement items and pro forma adjustments resulting from (1) the dispositions and repayments or incurrence of debt and (2) the investments, acquisitions, mergers, amalgamations, consolidations and operational changes from acquisitions to the extent such items or effects are not yet reflected in our trailing four-quarter financial statements. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As of December 31, 2018, the maximum leverage ratio requirement per our credit agreement was 4.50x and the minimum interest coverage ratio requirement was 3.0x, and we were in compliance with these covenants. Based on Adjusted EBITDA for 2018 and the interest rate in effect under our credit agreement during the three-month period ended December 31, 2018, if we had drawn on the first day and maintained the maximum amount of outstanding draws under our revolving credit facility for the entire year, we would still be in compliance with the maximum leverage ratio and minimum interest coverage ratio requirements. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2022, and our bonds all mature in 2023 and beyond. See the “Contractual Obligations” section below for information related to our contractual obligations as of December 31, 2018. We acquired a significant portion of our home health and hospice business when we purchased EHHI Holdings, Inc. (“EHHI”) on December 31, 2014. In the acquisition, we acquired all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to Encompass Health Home Health Holdings, Inc. (“Holdings”), a subsidiary of Encompass Health and an indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. Those sellers were members of EHHI management, and they contributed a portion of their shares of common stock of EHHI, valued at approximately $64 million on the acquisition date, in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. At any time after December 31, 2017, each management investor has the right (but not the obligation) to have his or her shares of Holdings stock repurchased by Encompass Health for a cash purchase price per share equal to the fair value. Specifically, up to one-third of each management investor’s shares of Holdings stock may be sold prior to December 31, 2018; two-thirds of each management investor’s shares of Holdings stock may be sold prior to December 31, 2019; and all of each management investor’s shares of Holdings stock may be sold thereafter. At any time after December 31, 2019, Encompass Health will have the right (but not the obligation) to repurchase all or any portion of the shares of Holdings stock owned by one or more management investors for a cash purchase price per share equal to the fair value. The fair value is determined using the product of the trailing twelve-month adjusted EBITDA measure for Holdings and a specified median market price multiple based on a basket of public home health companies and transactions, after adding cash and deducting indebtedness that includes the outstanding principal balance under any intercompany notes. In February 2018, each management investor exercised the right to sell one-third of his or her shares of Holdings stock to Encompass Health, representing approximately 5.6% of the outstanding shares of the common stock of Holdings. On February 21, 2018, Encompass Health settled the acquisition of those shares upon payment of approximately $65 million in cash. As of December 31, 2018, the fair value of those outstanding shares of Holdings owned by management investors is approximately $223 million. See also Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. In conjunction with the EHHI acquisition, we granted stock appreciation rights (“SARs”) based on Holdings common stock to certain members of EHHI management at closing. Half of the SARs vested on December 31, 2018 with the remainder vesting on December 31, 2019. Upon exercise, each SAR must be settled for cash in the amount by which the per share fair value of Holdings’ common stock on the exercise date exceeds the per share fair value on the grant date. As of December 31, 2018, the fair value of the SARs is approximately $87 million, of which approximately $48 million is included in Other current liabilities and approximately $39 million is included in Other long-term liabilities in the consolidated balance sheet included in Part IV, Item 15, Financial Statements, of this report. See also Note 13, Share-Based Payments, to the accompanying consolidated financial statements. In February 2019, members of the management team exercised a portion of their vested SARs for approximately $13 million in cash. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common stock and distribution of common stock dividends, including the potential growth of the quarterly cash dividend on our common stock, recognizing that these actions may increase our leverage ratio. See also the “Authorizations for Returning Capital to Stakeholders” section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years ended December 31, 2018, 2017, and 2016 (in millions): 2018 Compared to 2017 Operating activities. The increase in Net cash provided by operating activities during 2018 compared to 2017 primarily resulted from revenue growth, as described above, and improved collection of accounts receivable as a result of fewer claims denials. Investing activities. The increase in Net cash used in investing activities during 2018 compared to 2017 resulted primarily from the acquisition of Camellia Healthcare described in Note 2, Business Combinations, to the accompanying consolidated financial statements, and capital expenditures. Financing activities. The decrease in Net cash used in financing activities during 2018 compared to 2017 primarily resulted from the decrease in cash used for principal payments on net debt and repurchases of common stock offset by our purchase of one-third of the equity interests held by the home health and hospice management team during the first quarter of 2018. See also Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. 2017 Compared to 2016 Operating activities. The increase in Net cash provided by operating activities during 2017 compared to 2016 primarily resulted from revenue growth, as described above, and improved collection of accounts receivable offset by increased payments for income taxes following the exhaustion of our federal net operating loss in the first quarter of 2017. Investing activities. The increase in Net cash used in investing activities during 2017 compared to 2016 resulted primarily from the increase in cash used for capital expenditures as well as the proceeds received from the divestiture of our home health pediatric assets in 2016. See Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements. Financing activities. The decrease in Net cash used in financing activities during 2017 compared to 2016 primarily resulted from the proceeds received from the exercising of stock warrants and decreases in borrowings on the revolving credit facility, common stock repurchases, and principal debt payments, including the redemption of $176 million of the 2022 Notes in March, May, and September of 2016. See Note 9, Long-term Debt, to the accompanying consolidated financial statements. Contractual Obligations Our consolidated contractual obligations as of December 31, 2018 are as follows (in millions): (a) Included in long-term debt are amounts owed on our bonds payable and other notes payable. These borrowings are further explained in Note 9, Long-term Debt, to the accompanying consolidated financial statements. (b) Interest on our fixed rate debt is presented using the stated interest rate. Interest expense on our variable rate debt is estimated using the rate in effect as of December 31, 2018. Interest pertaining to our credit agreement and bonds is included to their respective ultimate maturity dates. Interest related to capital lease obligations is excluded from this line. Future minimum payments, which are accounted for as interest, related to sale/leaseback transactions involving real estate accounted for as financings are included in this line (see Note 6, Property and Equipment, and Note 9, Long-term Debt, to the accompanying consolidated financial statements). Amounts exclude amortization of debt discounts, amortization of loan fees, or fees for lines of credit that would be included in interest expense in our consolidated statements of operations. (c) Amounts include interest portion of future minimum capital lease payments. (d) Our inpatient rehabilitation segment leases approximately 17% of its hospitals as well as other property and equipment under operating leases in the normal course of business. Our home health and hospice segment leases relatively small office spaces in the localities it serves, space for its corporate office, and other equipment under operating leases in the normal course of business. Some of our hospital leases contain escalation clauses based on changes in the Consumer Price Index while others have fixed escalation terms. The minimum lease payments do not include contingent rental expense. Some lease agreements provide us with the option to renew the lease or purchase the leased property. Our future operating lease obligations would change if we exercised these renewal options and if we entered into additional operating lease agreements. For more information, see Note 6, Property and Equipment, to the accompanying consolidated financial statements. (e) Future operating lease obligations and purchase obligations are not recognized in our consolidated balance sheet. (f) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on Encompass Health and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. Our purchase obligations primarily relate to software licensing and support. (g) Because their future cash outflows are uncertain, the following noncurrent liabilities are excluded from the table above: general liability, professional liability, and workers’ compensation risks, noncurrent amounts related to third-party billing audits, stock appreciation rights, and deferred income taxes. Also, as of December 31, 2018, we had $0.9 million of total gross unrecognized tax benefits. For more information, see Note 10, Self-Insured Risks, Note 13, Share-Based Payments, Note 15, Income Taxes, and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements. (h) The table above does not include Redeemable noncontrolling interests of $261.7 million because of the uncertainty surrounding the timing and amounts of any related cash outflows. See Note 11, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year ended December 31, 2018, we made capital expenditures of approximately $276 million for property and equipment and capitalized software. These expenditures in 2018 are exclusive of approximately $144 million in net cash related to our acquisition activity. During 2019, we expect to spend approximately $375 million to $445 million for capital expenditures. Approximately $160 million to $170 million of this budgeted amount is considered nondiscretionary expenditures, which we may refer to in other filings as “maintenance” expenditures. In addition, we expect to spend approximately $50 million to $100 million on home health and hospice acquisitions during 2019. Actual amounts spent will be dependent upon the timing of construction projects and acquisition opportunities for our home health and hospice business. Authorizations for Returning Capital to Stakeholders In October 2017, February 2018, and May 2018, our board of directors declared cash dividends of $0.25 per share that were paid in January 2018, April 2018, and July 2018, respectively. On July 24, 2018, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.27 per share, that was paid on October 15, 2018. On October 26, 2018, our board of directors declared a cash dividend of $0.27 per share, that was paid on January 15, 2019 to stockholders of record on January 2, 2019. On February 21, 2019, our board of directors declared a cash dividend of $0.27 per share, payable on April 15, 2019 to stockholders of record on April 1, 2019. We expect quarterly dividends to be paid in January, April, July, and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates as well as the per share amounts, will be at the discretion of our board of directors after consideration of various factors, including our capital position and alternative uses of funds. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our revolving credit facility. On October 28, 2013, we announced our board of directors authorized the repurchase of up to $200 million of our common stock, which amount was subsequently increased to $250 million. On July 24, 2018, our board approved resetting the aggregate common stock repurchase authorization to $250 million. As of December 31, 2018, approximately $250 million remained under this authorization. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. Future repurchases under this authorization generally are expected to be funded using a combination of cash on hand and availability under our $700 million revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 9, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement-our interest coverage ratio and our leverage ratio-could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might be on terms less favorable to us than those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. In general terms, the credit agreement definition of Adjusted EBITDA, therein referred to as “Adjusted Consolidated EBITDA,” allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to $10 million in a year may be cash expenditures), (2) any losses from discontinued operations and closed locations, (3) costs and expenses, including legal fees and expert witness fees, incurred with respect to litigation associated with stockholder derivative litigation, (4) share-based compensation expense, and (5) cost and expenses in connection with the Encompass Health rebranding. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent they increase consolidated Net income. Under the credit agreement, the Adjusted EBITDA calculation does not include net income attributable to noncontrolling interests and includes (1) gain or loss on disposal of assets and hedging and equity instruments, (2) professional fees unrelated to the stockholder derivative litigation, (3) unusual or nonrecurring cash expenditures in excess of $10 million, and (4) pro forma adjustments resulting from debt transactions and development activities. Items falling within the credit agreement’s “unusual or nonrecurring” classification may occur in future periods, but these items and amounts recognized can vary significantly from period to period and may not directly relate to our ongoing operating performance. Accordingly, these items may not be indicative of our ongoing liquidity or performance, so the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Our Adjusted EBITDA for the years ended December 31, 2018, 2017, and 2016 was as follows (in millions): Reconciliation of Net Income to Adjusted EBITDA (*) 2017 amounts have been revised to correct an error in our deferred tax assets as discussed in Note 1, Summary of Significant Accounting Policies, “Revision of Previously Issued Financial Statements,” to the accompanying consolidated financial statements. Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA Growth in Adjusted EBITDA in 2018 compared to 2017 resulted primarily from revenue growth. Growth in Adjusted EBITDA in 2017 compared to 2016 also resulted primarily from revenue growth. For additional information see the “Results of Operations” and “Segment Results of Operations” sections of this Item. Off-Balance Sheet Arrangements In accordance with the definition under SEC rules, the following qualify as off-balance sheet arrangements: • any obligation under certain guarantees or contracts; • a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that serves as credit, liquidity, or market risk support to that entity for such assets; • any obligation under certain derivative instruments; and • any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the registrant, or engages in leasing, hedging, or research and development services with the registrant. As of December 31, 2018, we do not have any material off-balance sheet arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2018, we are not involved in any unconsolidated SPE transactions. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates, and judgments to ensure our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, as they require our most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the audit committee of our board of directors. Revenue Recognition We recognize net operating revenue in the reporting period in which we perform the service based on our best estimate of the transaction price for the type of service provided to the patient. Our estimate of the transaction price includes estimates of price concessions for such items as contractual allowances (principally for patients covered by Medicare, Medicare Advantage, Medicaid, and other third-party payors), potential adjustments that may arise from payment and other reviews, and uncollectible amounts. See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues,” to the accompanying consolidated financial statements of this report for a complete discussion of our revenue recognition policies. Our patient accounting systems calculate contractual allowances on a patient-by-patient basis based on the rates in effect for each primary third-party payor. Certain other factors that are considered and could influence the estimated transaction price are assumed to remain consistent with the experience for patients discharged in similar time periods for the same payor classes, and additional adjustments are provided to account for these factors. Management continually reviews the revenue transaction price estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. In addition, laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Due to complexities involved in determining amounts ultimately due under reimbursement arrangements with third-party payors, which are often subject to interpretation and review, we may receive reimbursement for healthcare services authorized and provided that is different from our estimates, and such differences could be material. However, we continually review the amounts actually collected in subsequent periods in order to determine the amounts by which our estimates differed. Historically, such differences have not been material from either a quantitative or qualitative perspective. The collection of outstanding receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. Our primary collection risks relate to patient responsibility amounts and claims reviews conducted by MACs or other contractors. The table below shows a summary of our net accounts receivable balances as of December 31, 2018 and 2017. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, “Accounts Receivable,” to the accompanying consolidated financial statements. Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. Our collection risks include patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding and pre-payment claim reviews by our respective MACs. In addition, reimbursement claims made by health care providers are subject to audit from time to time by governmental payors and their agents. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues” and “Accounts Receivable,” to the accompanying consolidated financial statements of this report. Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers’ compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers’ compensation risks are insured through a wholly owned insurance subsidiary. See Note 10, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost of reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers’ compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are certain of the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: • historical claims experience; • trending of loss development factors; • trends in the frequency and severity of claims; • coverage limits of third-party insurance; • demographic information; • statistical confidence levels; • medical cost inflation; • payroll dollars; and • hospital patient census. The time period to resolve claims can vary depending upon the jurisdiction, the nature, and the form of resolution of the claims. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. See Note 10, Self-Insured Risks, to the accompanying consolidated financial statements for additional information. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management’s estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as of October 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our inpatient rehabilitation and home health and hospice reporting units. We assess qualitative factors in each reporting unit to determine whether it is necessary to perform the first step of the two-step quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not a reporting unit’s fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must proceed to Step 1, we would determine the fair value of the applicable reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of the reporting units determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting units. The income approach includes the use of each reporting unit’s projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management’s best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company’s stock price. See Note 1, Summary of Significant Accounting Policies, “Goodwill and Other Intangibles,” and Note 7, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets; • Industry and market considerations and changes in healthcare regulations, including reimbursement and compliance requirements under the Medicare and Medicaid programs; • Cost factors, such as an increase in labor, supply, or other costs; • Overall financial performance, such as negative or declining cash flows or a decline in actual or forecasted revenue or earnings; • Other relevant company-specific events, such as material changes in management or key personnel or outstanding litigation; • Material events, such as a change in the composition or carrying amount of each reporting unit’s net assets, including acquisitions and dispositions; and • Consideration of the relationship of our market capitalization to our book value, as well as a sustained decrease in our share price. In the fourth quarter of 2018, we performed our annual evaluation of goodwill and determined no adjustment to impair goodwill was necessary. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our inpatient rehabilitation and home health and hospice reporting units are not at risk for any impairment charges. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” and Note 15, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year ended December 31, 2018, we decreased our valuation allowance by $2.1 million. As of December 31, 2018, we had a remaining valuation allowance of $33.7 million which primarily related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the NOLs before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management’s estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as of December 31, 2018 will be realized, no such assurances can be provided. If management’s expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, “Litigation Reserves,” and Note 17, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding ForwardLooking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. We have revised our financial statements as of and for the year ended December 31, 2017 to correct an error in the accounting for deferred income taxes. Accordingly, the MD&A set forth below reflect the effects of this revision. See details in Note 1, Summary of Significant Accounting Policies, “Revision of Previously Issued Financial Statements,” to the accompanying consolidated financial statements. Executive Overview Our Business We are a leading provider of integrated healthcare services, offering both facilitybased and homebased patient care through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As of December 31, 2018, our national footprint spans 36 states and Puerto Rico. As discussed in this Item, “Segment Results of Operations,” we manage our operations in two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business, see Item 1, Business. In 2018, we undertook a rebranding to reinforce our strategy and position as an integrated provider of facilitybased and homebased patient care. As part of the rebranding, we changed our corporate name from HealthSouth Corporation to Encompass Health Corporation and the NYSE ticker symbol for our common stock from “HLS” to “EHC.” Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 32 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2018, we operate 130 inpatient rehabilitation hospitals, including one hospital that operates as a joint venture that we account for using the equity method of accounting. In addition to our hospitals, we manage five inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 78% of our Net operating revenues for the year ended December 31, 2018. Home Health and Hospice Our home health and hospice business is the nation’s fourth largest provider of Medicarecertified skilled home health services in terms of revenues. Our home health services include a comprehensive range of Medicarecertified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. We also provide hospice services to terminally ill patients and their families that address patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. As of December 31, 2018, we provide home health and hospice services across 278 locations and 30 states, with concentrations in the Southeast and Texas. In addition, two of these home health agencies operate as joint ventures that we account for using the equity method of accounting. Our home health and hospice segment represented approximately 22% of our Net operating revenues for the year ended December 31, 2018. See also Item 1, Business, and Item 1A, Risk Factors, of this report, Note 18, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” section of this Item [/INST] Negative. </s>

Encompass Health Corp

2020-02-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding Forward-Looking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. In addition, management’s discussion and analysis of our results of operations and cash flows for the year ended December 31, 2018 compared to the year ended December 31, 2017 may be found in, Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on February 27, 2019. Executive Overview Our Business We are a national leader in integrated healthcare services, offering both facility-based and home-based patient care through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As of December 31, 2019, our national footprint spans 37 states and Puerto Rico. As discussed in this Item, “Segment Results of Operations,” we manage our operations in two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business and reportable segments, see Item 1, Business and Item 1A, Risk Factors, of this report, Note 19, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” section of this Item. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 33 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2019, we operate 133 inpatient rehabilitation hospitals and manage four inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 76% of our Net operating revenues for the year ended December 31, 2019. Home Health and Hospice Our home health business is the nation’s fourth largest provider of Medicare-certified skilled home health services in terms of revenues. Our home health services include a comprehensive range of Medicare-certified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. Our hospice business is the nation’s eleventh largest provider of Medicare-certified hospice services in terms of revenues. We provide hospice services to terminally ill patients and their families that address patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. As of December 31, 2019, we provide home health services in 245 locations and hospice services in 83 locations across 31 states, with concentrations in the Southeast and Texas. In addition, two of these home health agencies operate as joint ventures that we account for using the equity method of accounting. Our home health and hospice segment represented approximately 24% of our Net operating revenues for the year ended December 31, 2019. 2019 Overview In 2019, we focused on the following strategic priorities: • providing high-quality, cost-effective care to patients in our existing markets; • achieving organic growth at our existing inpatient rehabilitation hospitals and home health and hospice locations; • expanding our services to more patients who require post-acute healthcare services by constructing and acquiring hospitals in new markets and acquiring and opening home health and hospice locations in new markets; • making shareholder distributions via common stock dividends and repurchases of our common stock; and • positioning the Company for success in the evolving healthcare delivery system through key operational initiatives that include increasing clinical collaboration between our inpatient rehabilitation hospitals and home health locations, building stroke market share, developing and implementing post-acute solutions, transitioning to the new inpatient rehabilitation patient assessment measures, commonly referred to as “Section GG” measures, and preparing for implementation of the home health Patient-Driven Groupings Model (“PDGM”). During 2019, Net operating revenues increased 7.7% over 2018 due primarily to pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. Within our inpatient rehabilitation segment, discharge growth of 3.9% coupled with a 1.5% increase in inpatient revenue per discharge in 2019 generated 5.0% growth in net patient revenue compared to 2018. Discharge growth included a 1.8% increase in same-store discharges. Within our home health and hospice segment, home health admission growth of 16.3% and hospice admission growth of 39.8% contributed to 17.3% growth in home health and hospice revenue compared to 2018. Home health admission growth and hospice admission growth included a 7.7% and 12.2% increase, respectively, in same-store admissions. Many of our quality and outcome measures remained above both inpatient rehabilitation and home health industry averages. Not only did we treat more patients and enhance outcomes, we did so in a cost-effective manner. See the “Results of Operations” and “Segment Results of Operations” sections of this Item. Our growth efforts continued to yield positive results in 2019. In our inpatient rehabilitation segment, we: • began operating a 40-bed inpatient rehabilitation hospital in Lubbock, Texas with our joint venture partner, University Medical Center Health System, in May 2019; • began operating a 40-bed inpatient rehabilitation hospital in Boise, Idaho with our joint venture partner, Saint Alphonsus Regional Medical Center, in July 2019; • amended the joint venture agreement related to our 51-bed Yuma Rehabilitation Hospital which resulted in a change in accounting for this hospital from the equity method of accounting to a consolidated entity; • began operating our new 40-bed inpatient rehabilitation hospital in Katy, Texas in September 2019; • continued our capacity expansions by adding 152 new beds to existing hospitals; and • continued development of the following hospitals: * We began operating this hospital in February 2020. We also continued our growth efforts in our home health and hospice segment. On July 1, 2019, we completed the acquisition of privately owned Alacare Home Health and Hospice (“Alacare”) for a cash purchase price of $217.8 million. The Alacare portfolio consisted of 23 home health and 23 hospice locations in Alabama. We funded the transaction with cash on hand and borrowings under our revolving credit facility. In connection with this transaction, we expect to realize an income tax benefit with an estimated present value of approximately $30 million. For additional information regarding this transaction, see Note 2, Business Combinations, to the accompanying consolidated financial statements. In addition to completing the Alacare transaction, we acquired two home health locations in East Providence, Rhode Island and Westport, Massachusetts and began accepting patients at our two new home health locations in Columbia, South Carolina and Vero Beach, Florida. We also began accepting patients at our two new hospice locations in Burleson, Texas and Greensburg, Pennsylvania. To support our growth efforts, we continued taking steps to further increase the strength and flexibility of our balance sheet. Specifically, we redeemed $100 million of the outstanding principal balance of the 5.75% Senior Notes due 2024 (the “2024 Notes”) in June 2019. In September 2019, we issued $500 million of 4.50% Senior Notes due 2028 at par and $500 million of 4.75% Senior Notes due 2030 (the “New Notes”) at par, which resulted in approximately $983 million in net proceeds from the public offering. We used the proceeds to fund the purchase of equity and vested stock appreciation rights from management investors of our home health and hospice segment, redeem $400 million of our 2024 Notes, and repay borrowings under our revolving credit facility. In November 2019, we amended our existing credit agreement to, among other things, increase the size of our revolving credit facility from $700 million to $1 billion and extend the agreement's maturity by two years to 2024. For additional information regarding these transactions, see Note 10, Long-term Debt, Note 12, Redeemable Noncontrolling Interests, and Note 14, Share-Based Payments, to the accompanying consolidated financial statements and the “Liquidity and Capital Resources” section of this Item. We also continued our shareholder distributions by paying a quarterly cash dividend of $0.27 per share on our common stock in January, April, and July of this year. On July 23, 2019, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.28 per share that was paid in October 2019. On October 25, 2019, our board of directors declared a cash dividend of $0.28 per share, that was paid on January 15, 2020 to stockholders of record on January 2, 2020. In addition, we repurchased 0.8 million shares of our common stock in the open market for approximately $46 million during 2019. For additional information see the “Liquidity and Capital Resources” section of this Item. During 2019, we continued to increase the clinical collaboration rate between our inpatient rehabilitation hospitals and home health locations. We increased stroke market share by continuing to meet the needs of patients recovering from a stroke, as discussed in Item 1, Business, “Competitive Strengths.” We developed and implemented post-acute solutions that focus on improving patient outcomes and lowering the cost of care by reducing hospital readmissions across the entire episode of care. Additionally, we transitioned to the new inpatient rehabilitation Section GG measures on October 1, 2019 and prepared for the implementation of the home health PDGM on January 1, 2020, which are both discussed further below and in Item 1, Business, and Item 1A, Risk Factors. Business Outlook We believe our business outlook remains positive. Demographic trends, such as population aging, should continue to increase long-term demand for the services we provide. While we treat patients of all ages, most of our patients are 65 and older, and the number of Medicare enrollees is expected to grow approximately 3% per year for the foreseeable future. Even more specifically, the average age of our patients is approximately 76, and the population group ranging in ages from 75 to 79 is expected to grow at approximately 5% per year through 2026. We believe the demand for the services we provide will continue to increase as the U.S. population ages. We believe these factors align with our strengths in, and focus on, post-acute services. In addition, we believe we can address the demand for facility-based and home-based post-acute care services in markets where we currently do not have a presence by constructing or acquiring new hospitals and by acquiring or opening home health and hospice agencies in those extremely fragmented industries. We are a leading provider of integrated healthcare services, offering both facility-based and home-based patient care through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. We are committed to delivering high-quality, cost-effective, integrated patient care across the healthcare continuum with a primary focus on the post-acute sector. As the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals, we believe we differentiate ourselves from our competitors based on the quality of our clinical outcomes, our cost-effectiveness, our financial strength, and our extensive application of technology. As the fourth largest provider of Medicare-certified skilled home health services in terms of revenues, we believe we differentiate ourselves from our competitors by the application of a highly integrated technology platform, our ability to manage a variety of care pathways, and a proven track record of consummating and integrating acquisitions. The nature and timing of the transformation of the current healthcare system to coordinated care delivery and payment models is uncertain, as the development and implementation of new care delivery and payment systems will require significant time and resources. Furthermore, many of the alternative approaches being explored may not work as intended. However, our goal is to position the Company in a prudent manner to be responsive to industry shifts. We have invested in our core business and created an infrastructure that enables us to provide high-quality care on a cost-effective basis. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2023. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate. We have significant availability under our revolving credit facility, and we continue to generate strong cash flows from operations. Strong and consistent free cash flow generated by our Company, together with the unfunded commitment of our revolving credit facility, provides substantial capacity to pursue growth opportunities in both of our business segments while continuing to invest in our operational initiatives and capital structure strategy. For these and other reasons, we believe we will be able to adapt to changes in reimbursement, sustain our business model, and grow through acquisition and consolidation opportunities as they arise. See also Item 1, Business, “Competitive Strengths” and “Strategy and 2020 Strategic Priorities.” Key Challenges Healthcare is a highly-regulated industry facing many well-publicized regulatory and reimbursement challenges. The industry also is facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models as well as post-acute site neutrality in Medicare reimbursement. The Medicare reimbursement systems for both inpatient rehabilitation and home health are undergoing significant changes. The future of many aspects of healthcare regulation remains uncertain. Successful healthcare providers are those able to adapt to changes in the regulatory and operating environments, build strategic relationships across the healthcare continuum, and consistently provide high-quality, cost-effective care. We believe we have the necessary capabilities - change agility, strategic relationships, quality of patient outcomes, cost effectiveness, and ability to capitalize on growth opportunities - to adapt to and succeed in a dynamic, highly regulated industry, and we have a proven track record of doing so. As we continue to execute our business plan, the following are some of the challenges we face. • Operating in a Highly Regulated Industry. We are required to comply with extensive and complex laws and regulations at the federal, state, and local government levels. These rules and regulations have affected, or could in the future affect, our business activities by having an impact on the reimbursement we receive for services provided or the costs of compliance, mandating new documentation standards, requiring additional licensure or certification, regulating our relationships with physicians and other referral sources, regulating the use of our properties, and limiting our ability to enter new markets or add new capacity to existing hospitals and agencies. Ensuring continuous compliance with extensive laws and regulations is an operating requirement for all healthcare providers. We have invested, and will continue to invest, substantial time, effort, and expense in implementing and maintaining training programs as well as internal controls and procedures designed to ensure regulatory compliance, and we are committed to continued adherence to these guidelines. More specifically, because Medicare comprises a significant portion of our Net operating revenues, failure to comply with the laws and regulations governing the Medicare program and related matters, including anti-kickback and anti-fraud requirements, could materially and adversely affect us. The federal government’s reliance on sub-regulatory guidance, such as handbooks, FAQs, internal memoranda, and press releases, presents a unique challenge to compliance efforts. For additional details on sub-regulatory guidance, See Item 1A, Risk Factors. Reimbursement claims made by healthcare providers, including inpatient rehabilitation hospitals as well as home health and hospice agencies, are subject to audit from time to time by governmental payors and their agents, such as the Medicare Administrative Contractors (“MACs”), fiscal intermediaries and carriers, as well as the Office of Inspector General, CMS, and state Medicaid programs. These audits as well as the ordinary course claim reviews of our billings result in payment denials, including recoupment of previously paid claims from current accounts receivable. Healthcare providers can challenge any denials through an administrative appeals process that can be extremely lengthy, taking several years. For additional details of these claim reviews, See Item 1, Business, “Sources of Revenues,” Item 1A, Risk Factors, and Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues” and “Accounts Receivable,” to the accompanying consolidated financial statements. In June 2019, CMS commenced the Home Health Review Choice Demonstration (“RCD”) in Illinois. RCD is intended to test whether pre-claim review improves methods for the identification, investigation, and prosecution of Medicare fraud and whether the pre-claim review helps reduce expenditures while maintaining or improving quality of care. The demonstration expanded to Ohio in September 2019 and will be expanded to Texas in March 2020 and in North Carolina and Florida in May 2020. We operate agencies (representing approximately 44% of our home health Medicare claims) in these five states. For additional details of the RCD program, see Item 1A, Risk Factors. See also Item 1, Business, “Regulation,” and Item 1A, Risk Factors, to this report and Note 18, Contingencies and Other Commitments, “Governmental Inquiries and Investigations,” to the accompanying consolidated financial statements. • Changes to Our Operating Environment Resulting from Healthcare Reform. Concerns held by federal policymakers about the federal deficit and national debt levels, as well as other healthcare policy priorities, could result in enactment of legislation affecting portions of the Medicare program, including post-acute care services we provide. It is not clear what, if any, Medicare-related changes may ultimately be enacted and signed into law or otherwise implemented, but it is possible that any reductions in Medicare spending will have a material impact on reimbursements for healthcare providers generally and post-acute providers specifically. We cannot predict what, if any, changes in Medicare spending or modifications to the healthcare laws and regulations will result from future budget or other legislative or regulatory initiatives. Many provisions within the 2010 Healthcare Reform Laws have impacted, or could in the future impact, our business. Most notable for us are Medicare reimbursement reductions, such as reductions to annual market basket updates to providers and reimbursement rate rebasing adjustments, and promotion of alternative payment models, such as accountable care organizations (“ACOs”) and bundled payment initiatives including the Bundled Payments for Care Improvement Initiative Advanced (“BPCI Advanced”) and the Comprehensive Care for Joint Replacement (“CJR”) program. The Center for Medicare and Medicaid Innovation (“CMMI”) plays a key role in the development of many of these new payment and service delivery models. Our challenges related to healthcare reform are discussed in Item 1, Business, “Sources of Revenues,” and Item 1A, Risk Factors. The healthcare industry in general has been facing uncertainty associated with the efforts to identify and implement workable coordinated care and integrated delivery payment models. In these models, hospitals, physicians, and other care providers work together to provide coordinated healthcare on a more efficient, patient-centered basis. These providers are then paid based on the efficiency and overall value and quality of the services they provide to a patient. While this is consistent with our goal and proven track record of being a high-quality, cost-effective provider, broad-based implementation of a new care delivery and payment model would represent a significant transformation for the healthcare industry. As the industry and its regulators explore this transformation, we are attempting to position the Company in preparation for whatever changes are ultimately made to the delivery system. As discussed in Item 1, Business, the future of the 2010 Healthcare Reform Laws as well as the nature and substance of any other healthcare legislation remain uncertain, nor can we predict whether other legislation affecting Medicare and post-acute care providers will be enacted, or what actions the Trump Administration may take through the regulatory process that may result in modifications to the 2010 Healthcare Laws or the Medicare program. Therefore, the ultimate nature and timing of any transformation of the healthcare delivery system is uncertain, and will likely remain so for some time. We will continue to evaluate these laws and regulations and position the Company for this industry shift. Based on our track record, we believe we can adapt to these regulatory and industry changes. Further, we have engaged, and will continue to engage, actively in discussions with key legislators and regulators to attempt to ensure any healthcare laws or regulations adopted or amended promote our goal of high-quality, cost-effective care. Each year, CMS adopts rules that update pricing and otherwise amend the respective payment systems. On July 31, 2019, CMS released its notice of final rulemaking for fiscal year 2020 under the inpatient rehabilitation facility prospective payment system (the “2020 IRF Rule”). Based on the market basket update, our analysis of the Section GG changes and the other adjustments included in the 2020 IRF Rule and other factors, we currently estimate Medicare payment rates for our inpatient rehabilitation segment will be flat to up 0.75% in fiscal year 2020 (effective October 1, 2019). On October 31, 2019, CMS released its notice of final rulemaking for calendar year 2020 for home health agencies under the home health prospective payment system (the “2020 HH Rule”). Based on the market basket update, our analysis of PDGM’s significant changes to the reimbursement model and the other adjustments included in the 2020 HH Rule as well as other factors, we currently estimate Medicare payment rates for our home health business will decrease between 2.0% and 3.0% in 2020. For additional details of the 2020 IRF Rule, 2020 HH Rule, and other proposed and adopted legislative and regulatory actions that may be material to our business, see Item 1, Business, and Item 1A, Risk Factors. • Maintaining Strong Volume Growth. Various factors, including competition and increasing regulatory and administrative burdens, may impact our ability to maintain and grow our hospital, home health, and hospice volumes. In any particular market, we may encounter competition from local or national entities with longer operating histories or other competitive advantages, such as acute care hospitals who provide post-acute services similar to ours or other post-acute providers with relationships with referring acute care hospitals or physicians. Aggressive payment review practices by Medicare contractors, aggressive enforcement of regulatory policies by government agencies, and restrictive or burdensome rules, regulations or statutes governing admissions practices may lead us to not accept patients who would be appropriate for and would benefit from the services we provide. In addition, from time to time, we must get regulatory approval to expand our services and locations in states with certificate of need laws. This approval may be withheld or take longer than expected. In the case of new-store volume growth, the addition of hospitals, home health agencies, and hospice agencies to our portfolio also may be difficult and take longer than expected. • Recruiting and Retaining High-Quality Personnel. See Item 1A, Risk Factors, for a discussion of competition for staffing, shortages of qualified personnel, and other factors that may increase our labor costs. Recruiting and retaining qualified personnel, including management, for our inpatient hospitals and home health and hospice agencies remain a high priority for us. We attempt to maintain a comprehensive compensation and benefits package that allows us to remain competitive in this challenging staffing environment while remaining consistent with our goal of being a high-quality, cost-effective provider of post-acute services. These key challenges notwithstanding, we believe we have a strong business model, a strong balance sheet, and a proven track record of achieving strong financial and operational results. We are attempting to position the Company to respond to changes in the healthcare delivery system and believe we will be in a position to take advantage of any opportunities that arise as the industry moves to this new stage. We believe we are positioned to continue to adapt to external events and create value for our shareholders in 2020 and beyond. Results of Operations Payor Mix During 2019, 2018, and 2017, we derived consolidated Net operating revenues from the following payor sources: Our payor mix is weighted heavily towards Medicare. We receive Medicare reimbursements under the IRF-PPS, the HH-PPS, and the hospice payment system (the “Hospice-PS”). For additional information regarding Medicare reimbursement, see the “Sources of Revenues” section of Item 1, Business. As part of the Balanced Budget Act of 1997, Congress created a program of private, managed healthcare coverage for Medicare beneficiaries. This program has been referred to as Medicare Part C, or “Medicare Advantage.” The program offers beneficiaries a range of Medicare coverage options by providing a choice between the traditional fee-for-service program (under Medicare Parts A and B) or enrollment in a health maintenance organization, preferred provider organization, point-of-service plan, provider sponsor organization, or an insurance plan operated in conjunction with a medical savings account. Our consolidated Net operating revenues consist primarily of revenues derived from patient care services. Net operating revenues also include other revenues generated from management and administrative fees and other non-patient care services. These other revenues are included in “other income” in the above table. Our Results From 2017 through 2019, our consolidated results of operations were as follows: Operating Expenses as a % of Net Operating Revenues In the discussion that follows, we use “same-store” comparisons to explain the changes in certain performance metrics and line items within our financial statements. We calculate same-store comparisons based on hospitals and home health and hospice locations open throughout both the full current period and prior periods presented. These comparisons include the financial results of market consolidation transactions in existing markets, as it is difficult to determine, with precision, the incremental impact of these transactions on our results of operations. 2019 Compared to 2018 Net Operating Revenues Our consolidated Net operating revenues increased in 2019 compared to 2018 primarily from pricing and volume growth in our inpatient rehabilitation segment and volume growth in our home health and hospice segment. See additional discussion in the “Segment Results of Operations” section of this Item. Salaries and Benefits Salaries and benefits are the most significant cost to us and represent an investment in our most important asset: our employees. Salaries and benefits include all amounts paid to full- and part-time employees who directly participate in or support the operations of our hospitals and home health and hospice agencies, including all related costs of benefits provided to employees. It also includes amounts paid for contract labor. Salaries and benefits increased in 2019 compared to 2018 primarily due to salary increases for our employees, increased benefits costs, and increased patient volumes, including an increase in the number of full-time equivalents as a result of our development activities. As a percent of Net operating revenues, Salaries and benefits increased during 2019 compared to 2018 primarily as a result of higher salaries and benefits cost increases compared to revenue pricing increases. See additional discussion in the “Segment Results of Operations” section of this Item. Other Operating Expenses Other operating expenses include costs associated with managing and maintaining our hospitals and home health and hospice agencies. These expenses include such items as contract services, non-income related taxes, professional fees, utilities, insurance, and repairs and maintenance. Other operating expenses increased during 2019 compared to 2018 primarily due to increased patient volumes. As a percent of Net operating revenues, Other operating expenses decreased during 2019 compared to 2018 primarily due to operating leverage resulting from revenue growth. See additional discussion in the “Segment Results of Operations” section of this Item. General and Administrative Expenses General and administrative expenses primarily include administrative expenses such as information technology services, human resources, corporate accounting, legal services, and internal audit and controls that are managed from our home office in Birmingham, Alabama. These expenses also include stock-based compensation expenses. General and administrative expenses increased in 2019 compared to 2018 in terms of dollars and as a percent of Net operating revenues due primarily to increased corporate salaries and benefits costs, including expenses associated with stock appreciation rights (“SARs”), offset by lower costs associated with our rebranding. The 2019 SARs expense was approximately $82 million compared to approximately $56 million in 2018. The 2019 rebranding expenses were approximately $1 million compared to approximately $11 million in 2018. For additional information on SARs, see Note 14, Share-Based Payments, to the accompanying consolidated financial statements, and on the rebranding, see Item 1, Business. Depreciation and Amortization Depreciation and amortization increased during 2019 compared to 2018 due to our capital expenditures and development activities throughout 2018 and 2019. We expect Depreciation and amortization to increase going forward as a result of our recent and ongoing capital investments. Government, Class Action, and Related Settlements The amount in Government, class action, and related settlements in 2018 related primarily to a $48 million loss contingency accrual we established in the fourth quarter of 2018 for the potential settlement of the investigation being conducted by the United States Department of Justice (the “DOJ”). We settled the DOJ investigation in 2019. See Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information on this matter. Loss on Early Extinguishment of Debt The Loss on early extinguishment of debt during 2019 resulted from the June and November redemptions of our 2024 Notes. See Note 10, Long-term Debt, to the accompanying consolidated financial statements. Interest Expense and Amortization of Debt Discounts and Fees The increase in Interest expense and amortization of debt discounts and fees in 2019 compared to 2018 primarily resulted from the September 2019 issuances of our 2028 Notes and 2030 Notes offset by the June and November 2019 redemptions of our 2024 Notes. Cash paid for interest approximated $156 million and $150 million in 2019 and 2018, respectively. See Note 10, Long-term Debt, to the accompanying consolidated financial statements. Other Income Other income for 2019 included a $19.2 million gain as a result of our consolidation of Yuma Rehabilitation Hospital and the remeasurement of our previously held equity interest at fair value. See Note 9, Investments in and Advances to Nonconsolidated Affiliates, to the consolidated financial statements. Income from Continuing Operations Before Income Tax Expense Our pre-tax income from continuing operations in 2019 increased compared to 2018 primarily due to increased Net operating revenues and the gain resulting from the consolidation of Yuma Rehabilitation Hospital, as discussed above, offset by the contingency accrual we established in the fourth quarter of 2018, as discussed above. Provision for Income Tax Expense Our Provision for income tax expense declined in 2019 compared to 2018 due primarily to the Government, class action, and related settlements discussed in Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. See also Note 16, Income Taxes, to the accompanying consolidated financial statements. On December 22, 2017, the US enacted the 2017 Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act, which is commonly referred to as “US tax reform,” significantly changed US corporate income tax laws by, among other things, reducing the US corporate income tax rate from 35% to 21% starting in 2018. See Note 16, Income Taxes, to the accompanying consolidated financial statements for further discussion. Our cash payments for income taxes approximated $104 million, net of refunds, in 2019. These payments were based on estimates of taxable income for 2019. We estimate we will pay approximately $60 million to $80 million of cash income taxes, net of refunds, in 2020. In 2019 and 2018, current income tax expense was $75.9 million and $128.0 million, respectively. In certain jurisdictions, we do not expect to generate sufficient income to use all of the available state NOLs and other credits prior to their expiration. This determination is based on our evaluation of all available evidence in these jurisdictions including results of operations during the preceding three years, our forecast of future earnings, and prudent tax planning strategies. It is possible we may be required to increase or decrease our valuation allowance at some future time if our forecast of future earnings varies from actual results on a consolidated basis or in the applicable tax jurisdiction, if the timing of future tax deductions differs from our expectations, or pursuant to changes in state tax laws and rates. See Note 16, Income Taxes, to the accompanying consolidated financial statements and the “Critical Accounting Estimates” section of this Item. Net Income Attributable to Noncontrolling Interests The increase in Net income attributable to noncontrolling interests during 2019 compared to the same period of 2018 primarily resulted from increased profitability of our joint ventures and the July 1, 2019 consolidation of our Yuma Rehabilitation Hospital, as discussed above, which created a new noncontrolling interest. Impact of Inflation The impact of inflation on the Company will be primarily in the area of labor costs. The healthcare industry is labor intensive. Wages and other expenses increase during periods of inflation and when labor shortages occur in the marketplace. There can be no guarantee we will not experience increases in the cost of labor, as the need for clinical healthcare professionals is expected to grow. In addition, increases in healthcare costs are typically higher than inflation and impact our costs under our employee benefit plans. Managing these costs remains a significant challenge and priority for us. Suppliers pass along rising costs to us in the form of higher prices. Our supply chain efforts and our continual focus on monitoring and actively managing medical supplies and pharmaceutical costs has enabled us to accommodate increased pricing related to supplies and other operating expenses over the past few years. However, we cannot predict our ability to cover future cost increases. It should be noted that we have little or no ability to pass on these increased costs associated with providing services to Medicare and Medicaid patients due to federal and state laws that establish fixed reimbursement rates. Relationships and Transactions with Related Parties Related party transactions were not material to our operations in 2019, 2018, or 2017, and therefore, are not presented as a separate discussion within this Item. Segment Results of Operations Our internal financial reporting and management structure is focused on the major types of services provided by Encompass Health. We manage our operations using two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information regarding our business segments, including a detailed description of the services we provide, financial data for each segment, and a reconciliation of total segment Adjusted EBITDA to income from continuing operations before income tax expense, see Note 19, Segment Reporting, to the accompanying consolidated financial statements. Inpatient Rehabilitation During the years ended December 31, 2019, 2018 and 2017, our inpatient rehabilitation segment derived its Net operating revenues from the following payor sources: Additional information regarding our inpatient rehabilitation segment’s operating results for the years ended December 31, 2019, 2018 and 2017, is as follows: * Full-time equivalents included in the above table represent our employees who participate in or support the operations of our hospitals and include an estimate of full-time equivalents related to contract labor. We actively manage the productive portion of our Salaries and benefits utilizing certain metrics, including employees per occupied bed, or “EPOB.” This metric is determined by dividing the number of full-time equivalents, including an estimate of full-time equivalents from the utilization of contract labor, by the number of occupied beds during each period. The number of occupied beds is determined by multiplying the number of licensed beds by our occupancy percentage. Operating Expenses as a % of Net Operating Revenues 2019 Compared to 2018 Net Operating Revenues Revenue growth during 2019 compared to 2018 resulted from volume growth and an increase in net patient revenue per discharge. Discharge growth from new stores resulted from our joint ventures in Murrells Inlet, South Carolina (September 2018), Winston-Salem, North Carolina (October 2018), Lubbock, Texas (May 2019), and Boise, Idaho (July 2019), as well as wholly owned hospitals in Shelby County, Alabama (April 2018), Bluffton, South Carolina (June 2018), and Katy, Texas (September 2019). New-store growth also resulted from the consolidation of our Yuma Rehabilitation Hospital effective July 1, 2019. Discharge growth included a 1.8% increase in same-store discharges. Growth in net patient revenue per discharge primarily resulted from an increase in reimbursement rates and improvements in discharge destinations. The decrease in outpatient and other revenues in 2019 compared to 2018 was primarily due to the continued closures of hospital-based outpatient programs. See Note 2, Business Combinations, to the accompanying consolidated financial statements for information regarding our joint ventures discussed above. See Note 9, Investments in and Advances to Nonconsolidated Affiliates, to the consolidated financial statements for information regarding the consolidation of our Yuma Rehabilitation Hospital. Adjusted EBITDA The increase in Adjusted EBITDA for the inpatient rehabilitation segment in 2019 compared to 2018 primarily resulted from revenue growth, as discussed above. Salaries and benefits as a percent of Net operating revenues increased primarily due to higher salaries and wages per full-time equivalent, inclusive of approximately $3.5 million of training and education costs associated with the transition to CMS Section GG, as discussed in Item 1, Business, and Item 1A, Risk Factors. Home Health and Hospice During the years ended December 31, 2019, 2018 and 2017, our home health and hospice segment derived its Net operating revenues from the following payor sources: Additional information regarding our home health and hospice segment’s operating results for the years ended December 31, 2019, 2018 and 2017, is as follows: Operating Expenses as a % of Net Operating Revenues 2019 Compared to 2018 Net Operating Revenues Revenue growth during 2019 compared to 2018 was primarily driven from volume growth. Volume growth included a 7.7% increase in home health same-store admissions and the impact of the acquisition of Alacare on July 1, 2019 and Camellia Healthcare on May 1, 2018. Revenue per episode decreased primarily due to the patient mix of the former Alacare locations and the timing of episodes. Hospice revenue increased primarily due to the acquisition of Alacare and same-store admissions growth of 12.2%. See Note 2, Business Combinations, to the accompanying consolidated financial statements of this report for information regarding our acquisitions discussed above. Adjusted EBITDA The increase in Adjusted EBITDA during 2019 compared to 2018 primarily resulted from revenue growth, as discussed above. Cost of services as a percent of Net operating revenues for 2019 compared to 2018 decreased primarily due to improvements in caregiver optimization and productivity in home health partially offset by higher costs at the former Alacare locations. Support and overhead costs as a percent of Net operating revenues for 2019 compared to 2018 increased primarily due to expenses associated with the integration of Alacare. Liquidity and Capital Resources Our primary sources of liquidity are cash on hand, cash flows from operations, and borrowings under our revolving credit facility. The objectives of our capital structure strategy are to ensure we maintain adequate liquidity and flexibility. Pursuing and achieving those objectives allow us to support the execution of our operating and strategic plans and weather temporary disruptions in the capital markets and general business environment. Maintaining adequate liquidity is a function of our unrestricted Cash and cash equivalents and our available borrowing capacity. Maintaining flexibility in our capital structure is a function of, among other things, the amount of debt maturities in any given year, the options for debt prepayments without onerous penalties, and limiting restrictive terms and maintenance covenants in our debt agreements. Consistent with these objectives, in June 2019, we redeemed $100 million of the outstanding principal amount of the 2024 Notes using cash on hand and capacity under our revolving credit facility. Pursuant to the terms of the 2024 Notes, this optional redemption was made at a price of 101.917%, which resulted in a total cash outlay of approximately $102 million. As a result of this redemption, we recorded a $2.3 million Loss on early extinguishment of debt in the second quarter of 2019. In September 2019, we issued $500 million of the 2028 Notes at par and $500 million of the 2030 Notes at par (the “New Notes”), which resulted in approximately $983 million in net proceeds from the public offering. We used the net proceeds from the offering of the New Notes to fund the purchase of equity and vested stock appreciation rights from management investors of our home health and hospice segment, redeem $400 million of our 2024 Notes as described below, and repay borrowings under our revolving credit facility. In November 2019, we redeemed $400 million of the outstanding principal amount of our 2024 Notes. Pursuant to the terms of the 2024 Notes, this optional redemption was made at a price of 100.958%, which resulted in a total cash outlay of approximately $404 million. As a result of this redemption, we recorded a $5.4 million Loss on early extinguishment of debt in the fourth quarter of 2019. Also in November 2019, we amended our existing credit agreement to, among other things, increase the size of our revolving credit facility from $700 million to $1 billion and extend the agreement's maturity by two years to 2024. We have been disciplined in creating a capital structure that is flexible with no significant debt maturities prior to 2023. We continue to have a strong, well-capitalized balance sheet, including a substantial portfolio of owned real estate, and we have significant availability under our revolving credit facility. We continue to generate strong cash flows from operations, and we have significant flexibility with how we choose to invest our cash and return capital to shareholders. See Note 10, Long-term Debt, to the accompanying consolidated financial statements. Current Liquidity As of December 31, 2019, we had $94.8 million in Cash and cash equivalents. This amount excludes $64.8 million in restricted cash ($57.4 million included in Restricted cash and $7.4 million included in Other long-term assets in our consolidated balance sheet) and $76.1 million of restricted marketable securities (included in Other long-term assets in our consolidated balance sheet). Our restricted assets pertain primarily to obligations associated with our captive insurance company, as well as obligations we have under agreements with joint venture partners. See Note 4, Cash and Marketable Securities, to the accompanying consolidated financial statements. In addition to Cash and cash equivalents, as of December 31, 2019, we had approximately $916 million available to us under our revolving credit facility. Our credit agreement governs the substantial majority of our senior secured borrowing capacity and contains a leverage ratio and an interest coverage ratio as financial covenants. Our leverage ratio is defined in our credit agreement as the ratio of consolidated total debt (less up to $300 million of cash on hand) to Adjusted EBITDA for the trailing four quarters. In calculating the leverage ratio under our credit agreement, we are permitted to use pro forma Adjusted EBITDA, the calculation of which includes historical income statement items and pro forma adjustments resulting from (1) the dispositions and repayments or incurrence of debt and (2) the investments, acquisitions, mergers, amalgamations, consolidations and operational changes from acquisitions to the extent such items or effects are not yet reflected in our trailing four-quarter financial statements. Our interest coverage ratio is defined in our credit agreement as the ratio of Adjusted EBITDA to consolidated interest expense, excluding the amortization of financing fees, for the trailing four quarters. As of December 31, 2019, the maximum leverage ratio requirement per our credit agreement was 4.50x and the minimum interest coverage ratio requirement was 3.0x, and we were in compliance with these covenants. Based on Adjusted EBITDA for 2019 and the interest rate in effect under our credit agreement during the three-month period ended December 31, 2019, if we had drawn on the first day and maintained the maximum amount of outstanding draws under our revolving credit facility for the entire year, we would still be in compliance with the maximum leverage ratio and minimum interest coverage ratio requirements. We do not face near-term refinancing risk, as the amounts outstanding under our credit agreement do not mature until 2024, and our bonds all mature in 2023 and beyond. See the “Contractual Obligations” section below for information related to our contractual obligations as of December 31, 2019. We acquired a significant portion of our home health and hospice business when we purchased EHHI Holdings, Inc. (“EHHI”) on December 31, 2014. In the acquisition, we acquired all of the issued and outstanding equity interests of EHHI, other than equity interests contributed to Encompass Health Home Health Holdings, Inc. (“Holdings”), a subsidiary of Encompass Health and an indirect parent of EHHI, by certain sellers in exchange for shares of common stock of Holdings. Those sellers were members of EHHI management, and they contributed a portion of their shares of common stock of EHHI, valued at approximately $64 million on the acquisition date, in exchange for approximately 16.7% of the outstanding shares of common stock of Holdings. At any time after December 31, 2017, each management investor has the right (but not the obligation) to have his or her shares of Holdings stock repurchased by Encompass Health for a cash purchase price per share equal to the fair value. Specifically, up to one-third of each management investor’s shares of Holdings stock may be sold prior to December 31, 2018; two-thirds of each management investor’s shares of Holdings stock may be sold prior to December 31, 2019; and all of each management investor’s shares of Holdings stock may be sold thereafter. At any time after December 31, 2019, Encompass Health will have the right (but not the obligation) to repurchase all or any portion of the shares of Holdings stock owned by one or more management investors for a cash purchase price per share equal to the fair value. The fair value is determined using the product of the trailing twelve-month adjusted EBITDA measure for Holdings and a specified median market price multiple based on a basket of public home health companies and transactions, after adding cash and deducting indebtedness that includes the outstanding principal balance under any intercompany notes. In February 2018, each management investor exercised the right to sell one-third of his or her shares of Holdings stock to Encompass Health, representing approximately 5.6% of the outstanding shares of the common stock of Holdings. On February 21, 2018, Encompass Health settled the acquisition of those shares upon payment of approximately $65 million in cash. In July 2019, we received additional exercise notices, representing approximately 5.6% of the outstanding shares of the common stock of Holdings. In September 2019, Encompass Health settled the acquisition of those shares upon payment of approximately $163 million in cash. As of December 31, 2019, the fair value of those outstanding shares of Holdings owned by management investors is approximately $208 million. In January 2020, we received additional exercise notices, representing approximately 4.3% of the outstanding shares of the common stock of Holdings. In February 2020, Encompass Health settled the acquisition of those shares upon payment of approximately $162 million in cash. Upon settlement of these exercises, approximately $46 million of the shares of Holdings held by two management investors remained outstanding. On February 20, 2020, Encompass Health entered into exchange agreements (each, an “Exchange Agreement”) with these two management investors, pursuant to which they have the right to exchange all of the remaining shares of Holdings held by them for shares of common stock of Encompass Health (the “EHC Shares”). Each of the Exchange Agreements provides that the management investor must deliver a written exchange notice (an “Exchange Notice”) to Encompass Health in order to exchange his or her remaining shares of Holdings for EHC Shares. Each Exchange Agreement further provides that the number of EHC Shares to be delivered to the management investor is to be determined by dividing the fair value of the shares of Holdings held by the management investor on the date of the Exchange Agreement by the last reported sales price of Encompass Health’s common stock on the New York Stock Exchange (the “NYSE”) on the date of delivery of the Exchange Notice. On February 20, 2020, Encompass Health received an Exchange Notice from each of the management investors. Based on the last sales price of Encompass Health’s common stock on the NYSE on February 20, 2020, Encompass Health anticipates delivering an aggregate of approximately 561,000 EHC Shares, less than 0.6% of the total number of outstanding shares of the Encompass Health’s common stock, to the management investors. The settlement of the exchanges is expected to occur prior to the end of the first quarter of 2020. Encompass Health anticipates issuing the EHC Shares from its treasury shares. See also Note 12, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. In conjunction with the EHHI acquisition, we granted stock appreciation rights (“SARs”) based on Holdings common stock to certain members of EHHI management at closing. Half of the SARs vested on December 31, 2018 with the remainder vesting on December 31, 2019. Upon exercise, each SAR must be settled for cash in the amount by which the per share fair value of Holdings’ common stock on the exercise date exceeds the per share fair value on the grant date. In February 2019, members of the management team exercised a portion of their vested SARs for approximately $13 million in cash. In July 2019, members of the management team exercised the remainder of the vested SARs, which resulted in cash distributions of approximately $55 million. As of December 31, 2019, the fair value of the remaining 115,545 SARs is approximately $101 million, all of which is included in Other current liabilities in the accompanying consolidated balance sheet. In January 2020, members of the management team exercised the remaining SARs and in February 2020, we settled those awards upon payment of approximately $101 million in cash. See also Note 14, Share-Based Payments, to the accompanying consolidated financial statements. We anticipate we will continue to generate strong cash flows from operations that, together with availability under our revolving credit facility, will allow us to invest in growth opportunities and continue to improve our existing business. We also will continue to consider additional shareholder value-enhancing strategies such as repurchases of our common stock and distribution of common stock dividends, including the potential growth of the quarterly cash dividend on our common stock, recognizing that these actions may increase our leverage ratio. See also the “Authorizations for Returning Capital to Stakeholders” section of this Item. See Item 1A, Risk Factors, for a discussion of risks and uncertainties facing us. Sources and Uses of Cash The following table shows the cash flows provided by or used in operating, investing, and financing activities for the years ended December 31, 2019, 2018, and 2017 (in millions): 2019 Compared to 2018 Operating activities. The decrease in Net cash provided by operating activities during 2019 compared to 2018 primarily resulted from the payment to management investors of our home health and hospice segment for vested stock appreciation rights, the settlement payment associated with the investigation conducted by the United States Department of Justice, and an increase in Accounts receivable due to volume increases in both segments during 2019. See Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. Investing activities. The increase in Net cash used in investing activities during 2019 compared to 2018 resulted primarily from the acquisition of Alacare, as described in Note 2, Business Combinations, to the accompanying consolidated financial statements, and an increase in purchases of property and equipment during 2019. Financing activities. The increase in Net cash provided by financing activities during 2019 compared to 2018 primarily resulted from the public offering of the New Notes in September 2019 offset by cash used for principal payments on net debt, repurchases of common stock, and the purchase of equity interests held by the home health and hospice management team during the third quarter of 2019. See also See Note 10, Long-term Debt, and Note 12, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Contractual Obligations Our consolidated contractual obligations as of December 31, 2019 are as follows (in millions): (a) Included in long-term debt are amounts owed on our bonds payable and other notes payable. These borrowings are further explained in Note 10, Long-term Debt, to the accompanying consolidated financial statements. (b) Interest on our fixed rate debt is presented using the stated interest rate. Interest expense on our variable rate debt is estimated using the rate in effect as of December 31, 2019. Interest pertaining to our credit agreement and bonds is included to their respective ultimate maturity dates. Interest related to finance lease obligations is excluded from this line (see Note 7, Leases, and Note 10, Long-term Debt, to the accompanying consolidated financial statements). Amounts exclude amortization of debt discounts, amortization of loan fees, or fees for lines of credit that would be included in interest expense in our consolidated statements of operations. (c) Amounts include interest portion of future minimum finance lease payments. (d) Our inpatient rehabilitation segment leases approximately 14% of its hospitals as well as other property and equipment under operating leases in the normal course of business. Our home health and hospice segment leases relatively small office spaces in the localities it serves, space for its corporate office, and other equipment under operating leases in the normal course of business. Amounts include interest portion of future minimum operating lease payments. For more information, see Note 7, Leases, to the accompanying consolidated financial statements. (e) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on Encompass Health and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. Our purchase obligations primarily relate to software licensing and support and medical equipment. Purchase obligations are not recognized in our consolidated balance sheet. (f) Because their future cash outflows are uncertain, the following noncurrent liabilities are excluded from the table above: general liability, professional liability, and workers’ compensation risks, noncurrent amounts related to third-party billing audits, SARs, and deferred income taxes. As discussed above, the remaining SARs were exercised and settled during the first quarter of 2020. For more information, see Note 11, Self-Insured Risks, Note 14, Share-Based Payments, and Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements. (g) The table above does not include Redeemable noncontrolling interests of $239.6 million because of the uncertainty surrounding the timing and amounts of any related cash outflows. As discussed above, a portion of the outstanding shares of Holdings were exercised and settled during the first quarter of 2020. See Note 12, Redeemable Noncontrolling Interests, to the accompanying consolidated financial statements. Our capital expenditures include costs associated with our hospital refresh program, de novo projects, capacity expansions, technology initiatives, and building and equipment upgrades and purchases. During the year ended December 31, 2019, we made capital expenditures of approximately $404 million for property and equipment, intangible assets, and capitalized software. These expenditures in 2019 are exclusive of approximately $232 million in net cash related to our acquisition activity. During 2020, we expect to spend approximately $440 million to $510 million for capital expenditures. Approximately $155 million to $165 million of this budgeted amount is considered nondiscretionary expenditures, which we may refer to in other filings as “maintenance” expenditures. In addition, we expect to spend approximately $50 million to $100 million on home health and hospice acquisitions during 2020. Actual amounts spent will be dependent upon the timing of construction projects and acquisition opportunities for our home health and hospice business. Authorizations for Returning Capital to Stakeholders In October 2018, February 2019, and May 2019, our board of directors declared cash dividends of $0.27 per share that were paid in January 2019, April 2019, and July 2019, respectively. On July 23, 2019, our board of directors approved an increase in our quarterly dividend and declared a cash dividend of $0.28 per share, that was paid on October 15, 2019. On October 25, 2019, our board of directors declared a cash dividend of $0.28 per share, that was paid on January 15, 2020 to stockholders of record on January 2, 2020. We expect quarterly dividends to be paid in January, April, July, and October. However, the actual declaration of any future cash dividends, and the setting of record and payment dates as well as the per share amounts, will be at the discretion of our board of directors after consideration of various factors, including our capital position and alternative uses of funds. Cash dividends are expected to be funded using cash flows from operations, cash on hand, and availability under our revolving credit facility. On October 28, 2013, we announced our board of directors authorized the repurchase of up to $200 million of our common stock, which amount was subsequently increased to $250 million. On July 24, 2018, our board approved resetting the aggregate common stock repurchase authorization to $250 million. As of December 31, 2019, approximately $204 million remained under this authorization. The repurchase authorization does not require the repurchase of a specific number of shares, has an indefinite term, and is subject to termination at any time by our board of directors. Subject to certain terms and conditions, including a maximum price per share and compliance with federal and state securities and other laws, the repurchases may be made from time to time in open market transactions, privately negotiated transactions, or other transactions, including trades under a plan established in accordance with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. During 2019, we repurchased 0.8 million shares of our common stock in the open market for approximately $46 million under this repurchase authorization using cash on hand. Future repurchases under this authorization generally are expected to be funded using a combination of cash on hand and availability under our $1 billion revolving credit facility. Adjusted EBITDA Management believes Adjusted EBITDA as defined in our credit agreement is a measure of our ability to service our debt and our ability to make capital expenditures. We reconcile Adjusted EBITDA to Net income and to Net cash provided by operating activities. We use Adjusted EBITDA on a consolidated basis as a liquidity measure. We believe this financial measure on a consolidated basis is important in analyzing our liquidity because it is the key component of certain material covenants contained within our credit agreement, which is discussed in more detail in Note 10, Long-term Debt, to the accompanying consolidated financial statements. These covenants are material terms of the credit agreement. Noncompliance with these financial covenants under our credit agreement-our interest coverage ratio and our leverage ratio-could result in our lenders requiring us to immediately repay all amounts borrowed. If we anticipated a potential covenant violation, we would seek relief from our lenders, which would have some cost to us, and such relief might be on terms less favorable to us than those in our existing credit agreement. In addition, if we cannot satisfy these financial covenants, we would be prohibited under our credit agreement from engaging in certain activities, such as incurring additional indebtedness, paying common stock dividends, making certain payments, and acquiring and disposing of assets. Consequently, Adjusted EBITDA is critical to our assessment of our liquidity. In general terms, the credit agreement definition of Adjusted EBITDA, therein referred to as “Adjusted Consolidated EBITDA,” allows us to add back to consolidated Net income interest expense, income taxes, and depreciation and amortization and then add back to consolidated Net income (1) all unusual or nonrecurring items reducing consolidated Net income (of which only up to $10 million in a year may be cash expenditures), (2) any losses from discontinued operations, (3) non-ordinary course fees, costs and expenses incurred with respect to any litigation or settlement, (4) share-based compensation expense, (5) costs and expenses associated with changes in the fair value of marketable securities, (6) costs and expenses associated with the issuance or prepayment debt and acquisitions, and (7) any restructuring charges not in excess of 20% of Adjusted Consolidated EBITDA. We also subtract from consolidated Net income all unusual or nonrecurring items to the extent they increase consolidated Net income. Under the credit agreement, the Adjusted EBITDA calculation does not require us to deduct net income attributable to noncontrolling interests or gains on fair value adjustments of hedging and equity instruments, disposal of assets, and development activities. It also does not allow us to add back losses on fair value adjustments of hedging instruments or unusual or nonrecurring cash expenditures in excess of $10 million. These items and amounts, in addition to the items falling within the credit agreement’s “unusual or nonrecurring” classification, may occur in future periods, but can vary significantly from period to period and may not directly relate to, or be indicative of, our ongoing liquidity or operating performance. Accordingly, the Adjusted EBITDA calculation presented here includes adjustments for them. Adjusted EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States of America, and the items excluded from Adjusted EBITDA are significant components in understanding and assessing financial performance. Therefore, Adjusted EBITDA should not be considered a substitute for Net income or cash flows from operating, investing, or financing activities. Because Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA, as presented, may not be comparable to other similarly titled measures of other companies. Revenues and expenses are measured in accordance with the policies and procedures described in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. Our Adjusted EBITDA for the years ended December 31, 2019, 2018, and 2017 was as follows (in millions): Reconciliation of Net Income to Adjusted EBITDA Reconciliation of Net Cash Provided by Operating Activities to Adjusted EBITDA Growth in Adjusted EBITDA in 2019 compared to 2018 resulted primarily from revenue growth. For additional information see the “Results of Operations” and “Segment Results of Operations” sections of this Item. Off-Balance Sheet Arrangements In accordance with the definition under SEC rules, the following qualify as off-balance sheet arrangements: • any obligation under certain guarantees or contracts; • a retained or contingent interest in assets transferred to an unconsolidated entity or similar entity or similar arrangement that serves as credit, liquidity, or market risk support to that entity for such assets; • any obligation under certain derivative instruments; and • any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the registrant, or engages in leasing, hedging, or research and development services with the registrant. As of December 31, 2019, we do not have any material off-balance sheet arrangements. As part of our ongoing business, we do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities (“SPEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2019, we are not involved in any unconsolidated SPE transactions. Critical Accounting Estimates Our consolidated financial statements are prepared in accordance with GAAP. In connection with the preparation of our financial statements, we are required to make assumptions and estimates about future events and apply judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends, and other factors we believe to be relevant at the time we prepared our consolidated financial statements. On a regular basis, we review the accounting policies, assumptions, estimates, and judgments to ensure our consolidated financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material. Our significant accounting policies are discussed in Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements. We believe the following accounting estimates are the most critical to aid in fully understanding and evaluating our reported financial results, as they require our most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. We have reviewed these critical accounting estimates and related disclosures with the audit committee of our board of directors. Revenue Recognition We recognize net operating revenue in the reporting period in which we perform the service based on our best estimate of the transaction price for the type of service provided to the patient. Our estimate of the transaction price includes estimates of price concessions for such items as contractual allowances (principally for patients covered by Medicare, Medicare Advantage, Medicaid, and other third-party payors), potential adjustments that may arise from payment and other reviews, and uncollectible amounts. See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues,” to the accompanying consolidated financial statements of this report for a complete discussion of our revenue recognition policies. Our patient accounting systems calculate contractual allowances on a patient-by-patient basis based on the rates in effect for each primary third-party payor. Certain other factors that are considered and could influence the estimated transaction price are assumed to remain consistent with the experience for patients discharged in similar time periods for the same payor classes, and additional adjustments are provided to account for these factors. Management continually reviews the revenue transaction price estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. In addition, laws and regulations governing the Medicare and Medicaid programs are complex and subject to interpretation. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Due to complexities involved in determining amounts ultimately due under reimbursement arrangements with third-party payors, which are often subject to interpretation and review, we may receive reimbursement for healthcare services authorized and provided that is different from our estimates, and such differences could be material. However, we continually review the amounts actually collected in subsequent periods in order to determine the amounts by which our estimates differed. Historically, such differences have not been material from either a quantitative or qualitative perspective. The collection of outstanding receivables from third-party payors and patients is our primary source of cash and is critical to our operating performance. Our primary collection risks relate to patient responsibility amounts and claims reviews conducted by MACs or other contractors. The table below shows a summary of our net accounts receivable balances as of December 31, 2019 and 2018. Information on the concentration of total patient accounts receivable by payor class can be found in Note 1, Summary of Significant Accounting Policies, “Accounts Receivable,” to the accompanying consolidated financial statements. Changes in general economic conditions (such as increased unemployment rates or periods of recession), business office operations, payor mix, or trends in federal or state governmental and private employer healthcare coverage could affect our collection of accounts receivable. Our collection risks include patient accounts for which the primary insurance carrier has paid the amounts covered by the applicable agreement, but patient responsibility amounts (deductibles and co-payments) remain outstanding, pre-payment claim reviews by our respective MACs, and reimbursement claims audits by governmental or other payors and their agents. As of December 31, 2019 and 2018, $144.5 million and $149.3 million of our patient accounts receivable represented denials that were under review or audit in our inpatient rehabilitation segment. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. See Note 1, Summary of Significant Accounting Policies, “Net Operating Revenues” and “Accounts Receivable,” to the accompanying consolidated financial statements of this report. Self-Insured Risks We are self-insured for certain losses related to professional liability, general liability, and workers’ compensation risks. Although we obtain third-party insurance coverage to limit our exposure to these claims, a substantial portion of our professional liability, general liability, and workers’ compensation risks are insured through a wholly owned insurance subsidiary. See Note 11, Self-Insured Risks, to the accompanying consolidated financial statements for a more complete discussion of our self-insured risks. Our self-insured liabilities contain uncertainties because management must make assumptions and apply judgment to estimate the ultimate cost of reported claims and claims incurred but not reported as of the balance sheet date. Our reserves and provisions for professional liability, general liability, and workers’ compensation risks are based largely upon semi-annual actuarial calculations prepared by third-party actuaries. Periodically, we review our assumptions and the valuations provided by third-party actuaries to determine the adequacy of our self-insurance reserves. The following are certain of the key assumptions and other factors that significantly influence our estimate of self-insurance reserves: historical claims experience; trending of loss development factors; trends in the frequency and severity of claims; coverage limits of third-party insurance; demographic information; statistical confidence levels; medical cost inflation; payroll dollars; and hospital patient census. The time period to resolve claims can vary depending upon the jurisdiction, the nature, and the form of resolution of the claims. The estimation of the timing of payments beyond a year can vary significantly. In addition, if current and future claims differ from historical trends, our estimated reserves for self-insured claims may be significantly affected. Our self-insurance reserves are not discounted. Given the number of factors used to establish our self-insurance reserves, we believe there is limited benefit to isolating any individual assumption or parameter from the detailed computational process and calculating the impact of changing that single item. Instead, we believe the sensitivity in our reserve estimates is best illustrated by changes in the statistical confidence level used in the computations. Using a higher statistical confidence level increases the estimated self-insurance reserves. The following table shows the sensitivity of our recorded self-insurance reserves to the statistical confidence level (in millions): We believe our efforts to improve patient safety and overall quality of care, as well as our efforts to reduce workplace injuries, have helped contain our ultimate claim costs. See Note 11, Self-Insured Risks, to the accompanying consolidated financial statements for additional information. We believe our self-insurance reserves are adequate to cover projected costs. Due to the considerable variability that is inherent in such estimates, there can be no assurance the ultimate liability will not exceed management’s estimates. If actual results are not consistent with our assumptions and judgments, we may be exposed to gains or losses that could be material. Goodwill Absent any impairment indicators, we evaluate goodwill for impairment as of October 1st of each year. We test goodwill for impairment at the reporting unit level and are required to make certain subjective and complex judgments on a number of matters, including assumptions and estimates used to determine the fair value of our inpatient rehabilitation and home health and hospice reporting units. We assess qualitative factors in each reporting unit to determine whether it is necessary to perform the quantitative goodwill impairment test. The quantitative impairment test is required only if we conclude it is more likely than not a reporting unit’s fair value is less than its carrying amount. If, based on our qualitative assessment, we were to believe we must perform the quantitative goodwill impairment test, we would determine the fair value of the applicable reporting unit using generally accepted valuation techniques including the income approach and the market approach. We would validate our estimates under the income approach by reconciling the estimated fair value of the reporting units determined under the income approach to our market capitalization and estimated fair value determined under the market approach. Values from the income approach and market approach would then be evaluated and weighted to arrive at the estimated aggregate fair value of the reporting units. The income approach includes the use of each reporting unit’s projected operating results and cash flows that are discounted using a weighted-average cost of capital that reflects market participant assumptions. The projected operating results use management’s best estimates of economic and market conditions over the forecasted period including assumptions for pricing and volume, operating expenses, and capital expenditures. Other significant estimates and assumptions include cost-saving synergies and tax benefits that would accrue to a market participant under a fair value methodology. The market approach estimates fair value through the use of observable inputs, including the Company’s stock price. See Note 1, Summary of Significant Accounting Policies, “Goodwill and Other Intangibles,” and Note 8, Goodwill and Other Intangible Assets, to the accompanying consolidated financial statements for additional information. The following events and circumstances are certain of the qualitative factors we consider in evaluating whether it is more likely than not the fair value of a reporting unit is less than its carrying amount: • Macroeconomic conditions, such as deterioration in general economic conditions, limitations on accessing capital, or other developments in equity and credit markets; • Industry and market considerations and changes in healthcare regulations, including reimbursement and compliance requirements under the Medicare and Medicaid programs; • Cost factors, such as an increase in labor, supply, or other costs; • Overall financial performance, such as negative or declining cash flows or a decline in actual or forecasted revenue or earnings; • Other relevant company-specific events, such as material changes in management or key personnel or outstanding litigation; • Material events, such as a change in the composition or carrying amount of each reporting unit’s net assets, including acquisitions and dispositions; • Consideration of the relationship of our market capitalization to our book value, as well as a sustained decrease in our share price; and • Length of time since most recent qualitative analysis. In the fourth quarter of 2019, we performed our annual evaluation of goodwill and determined no adjustment to impair goodwill was necessary. If actual results are not consistent with our assumptions and estimates, we may be exposed to goodwill impairment charges. However, at this time, we continue to believe our inpatient rehabilitation and home health and hospice reporting units are not at risk for any impairment charges. Income Taxes We provide for income taxes using the asset and liability method. We also evaluate our tax positions and establish assets and liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. See Note 1, Summary of Significant Accounting Policies, “Income Taxes,” and Note 16, Income Taxes, to the accompanying consolidated financial statements for a more complete discussion of income taxes and our policies related to income taxes. The application of income tax law is inherently complex. Laws and regulations in this area are voluminous and are often ambiguous. We are required to make many subjective assumptions and judgments regarding our income tax exposures. Interpretations of and guidance surrounding income tax laws and regulations change over time. As such, changes in our subjective assumptions and judgments can materially affect amounts recognized in our consolidated financial statements. The ultimate recovery of certain of our deferred tax assets is dependent on the amount and timing of taxable income we will ultimately generate in the future, as well as other factors. A high degree of judgment is required to determine the extent a valuation allowance should be provided against deferred tax assets. On a quarterly basis, we assess the likelihood of realization of our deferred tax assets considering all available evidence, both positive and negative. Our operating performance in recent years, the scheduled reversal of temporary differences, our forecast of taxable income in future periods in each applicable tax jurisdiction, our ability to sustain a core level of earnings, and the availability of prudent tax planning strategies are important considerations in our assessment. Our forecast of future earnings includes assumptions about patient volumes, payor reimbursement, labor costs, hospital operating expenses, and interest expense. Based on the weight of available evidence, we determine if it is more likely than not our deferred tax assets will be realized in the future. Our liability for unrecognized tax benefits contains uncertainties because management is required to make assumptions and to apply judgment to estimate the exposures associated with our various filing positions which are periodically audited by tax authorities. In addition, our effective income tax rate is affected by changes in tax law, the tax jurisdictions in which we operate, and the results of income tax audits. During the year ended December 31, 2019, we increased our valuation allowance by $4.7 million. As of December 31, 2019, we had a remaining valuation allowance of $38.4 million which primarily related to state NOLs. At the state jurisdiction level, we determined it was necessary to maintain a valuation allowance due to uncertainties related to our ability to utilize a portion of the NOLs before they expire. The amount of the valuation allowance has been determined for each tax jurisdiction based on the weight of all available evidence, as described above, including management’s estimates of taxable income for each jurisdiction in which we operate over the periods in which the related deferred tax assets will be recoverable. While management believes the assumptions included in its forecast of future earnings are reasonable and it is more likely than not the net deferred tax asset balance as of December 31, 2019 will be realized, no such assurances can be provided. If management’s expectations for future operating results on a consolidated basis or at the state jurisdiction level vary from actual results due to changes in healthcare regulations, general economic conditions, or other factors, we may need to increase our valuation allowance, or reverse amounts recorded currently in the valuation allowance, for all or a portion of our deferred tax assets. Similarly, future adjustments to our valuation allowance may be necessary if the timing of future tax deductions is different than currently expected. Our income tax expense in future periods will be reduced or increased to the extent of offsetting decreases or increases, respectively, in our valuation allowance in the period when the change in circumstances occurs. These changes could have a significant impact on our future earnings. Assessment of Loss Contingencies We have legal and other contingencies that could result in significant losses upon the ultimate resolution of such contingencies. See Note 1, Summary of Significant Accounting Policies, “Litigation Reserves,” and Note 18, Contingencies and Other Commitments, to the accompanying consolidated financial statements for additional information. We have provided for losses in situations where we have concluded it is probable a loss has been or will be incurred and the amount of loss is reasonably estimable. A significant amount of judgment is involved in determining whether a loss is probable and reasonably estimable due to the uncertainty involved in determining the likelihood of future events and estimating the financial statement impact of such events. If further developments or resolution of a contingent matter are not consistent with our assumptions and judgments, we may need to recognize a significant charge in a future period related to an existing contingent matter. Business Combinations We account for acquisitions of entities that qualify as business combinations under the acquisition method of accounting. Under the acquisition method of accounting, the total consideration is allocated to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values at the acquisition date. The excess of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. During the measurement period, which may be up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. In determining the fair value of assets acquired and liabilities assumed in a business combination, we primarily use the income and multi-period excess earnings approaches to estimate the value of our most significant acquired intangible assets. Both income approaches utilize projected operating results and cash flows and include significant assumptions such as base revenue, revenue growth rate, projected EBITDA margin, discount rates, rates of increase in operating expenses, and the future effective income tax rates. The valuations of our significant acquired businesses have been performed by a third-party valuation specialist under our management’s supervision. We believe that the estimated fair value assigned to the assets acquired and liabilities assumed is based on reasonable assumptions and estimates that marketplace participants would use. However, such assumptions are inherently uncertain and actual results could differ from those estimates. Future changes in our assumptions or the interrelationship of those assumptions may result in purchase price allocations that are different than those recorded in recent years. Acquisition related costs are not considered part of the consideration paid and are expensed as operating expenses as incurred. Contingent consideration, if any, is measured at fair value initially on the acquisition date as well as subsequently at the end of each reporting period until the contingency is resolved and settlement occurs. Subsequent adjustments to contingent considerations are recorded in our consolidated statements of operations. We include the results of operations of the businesses acquired as of the beginning of the acquisition dates. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, see Note 1, Summary of Significant Accounting Policies, to the accompanying consolidated financial statements.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the accompanying consolidated financial statements and related notes. This MD&A is designed to provide the reader with information that will assist in understanding our consolidated financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our consolidated financial statements. See “Cautionary Statement Regarding ForwardLooking Statements” on page ii of this report for a description of important factors that could cause actual results to differ from expected results. See also Item 1A, Risk Factors. In addition, management’s discussion and analysis of our results of operations and cash flows for the year ended December 31, 2018 compared to the year ended December 31, 2017 may be found in, Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10K for the year ended December 31, 2018, filed with the SEC on February 27, 2019. Executive Overview Our Business We are a national leader in integrated healthcare services, offering both facilitybased and homebased patient care through our network of inpatient rehabilitation hospitals, home health agencies, and hospice agencies. As of December 31, 2019, our national footprint spans 37 states and Puerto Rico. As discussed in this Item, “Segment Results of Operations,” we manage our operations in two operating segments which are also our reportable segments: (1) inpatient rehabilitation and (2) home health and hospice. For additional information about our business and reportable segments, see Item 1, Business and Item 1A, Risk Factors, of this report, Note 19, Segment Reporting, to the accompanying consolidated financial statements, and the “Results of Operations” section of this Item. Inpatient Rehabilitation We are the nation’s largest owner and operator of inpatient rehabilitation hospitals in terms of patients treated and discharged, revenues, and number of hospitals. We provide specialized rehabilitative treatment on both an inpatient and outpatient basis. We operate hospitals in 33 states and Puerto Rico, with concentrations in the eastern half of the United States and Texas. As of December 31, 2019, we operate 133 inpatient rehabilitation hospitals and manage four inpatient rehabilitation units through management contracts. Our inpatient rehabilitation segment represented approximately 76% of our Net operating revenues for the year ended December 31, 2019. Home Health and Hospice Our home health business is the nation’s fourth largest provider of Medicarecertified skilled home health services in terms of revenues. Our home health services include a comprehensive range of Medicarecertified home nursing services to adult patients in need of care. These services include, among others, skilled nursing, physical, occupational, and speech therapy, medical social work, and home health aide services. Our hospice business is the nation’s eleventh largest provider of Medicarecertified hospice services in terms of revenues. We provide hospice services to terminally ill patients and their families that address patients’ physical needs, including pain control and symptom management, and to provide emotional and spiritual support. As of December 31, 2019, we provide home health services in 245 locations and hospice services in 83 locations across 31 states, with concentrations in the Southeast and Texas. In addition, two of these home health agencies operate as joint ventures that we account for using the equity method of accounting. Our home health and hospice segment represented approximately 24% of our Net operating revenues for the year ended December 31, 2019. 2019 Overview In 2019, we focused on the following strategic priorities: providing highquality, costeffective care to patients in our existing markets; achieving organic growth at our existing inpatient rehabilitation hospitals and home health and hosp [/INST] Positive. </s>

FERRO CORP

2015-02-25

2014-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview - Update During the year ended December 31, 2014, net sales were down $77.0 million, or 6.5%, compared with 2013. Of the decline, $74.7 million relates to the sale of our North American and Asian metal powders business and exit of solar pastes. Excluding the impact of the sold product lines, net sales in the continuing business was down $2.3 million compared to 2013. Performance Coatings and Pigments, Powders and Oxides net sales were down compared with 2013 by $11.8 million and $8.1 million, respectively, which were partially mitigated by strong performance in Performance Colors and Glass, which achieved strong sales improvement of $17.7 million compared with 2013. Despite the decline in net sales, gross profit increased $7.4 million compared with 2013. As a percentage of net sales excluding precious metals, gross profit rate increased approximately 140 basis points to 26.8%, from 25.4% in the prior year. For the year ended December 31, 2014, selling, general and administrative (“SG&A”) expenses were up $136.0 million, or 90.2%, compared with 2013, primarily driven by the pension and other postretirement benefits mark-to-market adjustment. In 2014, the adjustment resulted in a loss of $82.3 million in SG&A, while in 2013, the adjustment resulted in a gain of $69.5 million. For the year ended December 31, 2014, net income was $86.2 million, compared with net income of $72.4 million in 2013, and net income attributable to common shareholders was $86.1 million, compared with net income attributable to common shareholders of $71.9 million in 2013. Loss from continuing operations was $8.6 million for the year ended December 31, 2014, compared with income from continuing operations of $63.9 million in 2013. Gross profit in 2014 was $285.1 million, compared with $277.7 million in 2013. 2014 Transactional Activity Disposition of the Polymer Additives Business During the fourth quarter of 2014, we completed the sale of substantially all of the assets in our North America-based Polymer Additives business to Polymer Additives, Inc. for $153.5 million in cash. The sale resulted in a gain of $72.7 million and net cash proceeds of $149.5 million. Cash proceeds were used to repay debt under the revolving credit facility and will be used to fund strategic growth opportunities. This disposition was part of our value creation strategy, as we turn our focus to our core functional coatings and color businesses. Excluded from the transaction was our Europe-based Polymer Additives assets. Our Europe-based Polymer Additives assets are being separately marketed for sale. Acquisition of Vetriceramici S.p.A During the fourth quarter of 2014, Ferro Coatings Italy S.R.L., a 100% owned subsidiary of Ferro, acquired 100% of the outstanding common shares and voting interest of Vetriceramici S.p.A. (“Vetriceramici”) for €87.2 million in cash. The sale closed on December 1, 2014 for a purchase price of $108.9 million, based on the exchange rate on that date. Vetriceramici is an Italian manufacturing, marketing and distribution group that offers a range of products (principally ceramic glazes, frits, inks and screen printing bases) to its customers for the production of ceramic tiles, with some diversification in the glass sector. Vetriceramici currently has manufacturing facilities in Italy and Mexico, a mixing plant in Poland and research and development and sales offices in Italy and Turkey. Vetriceramici is a leading global supplier of specialty products that enhance the appearance and improve the durability of high-end ceramic tile. Its product line includes high-value, specialty frits and grits (finely-milled frits), glazes, digital inks, and other specialized tile coatings. Additionally, Vetriceramici has developed high-value forehearth color solutions that deliver greater production flexibility, lower manufacturing costs and improved inventory management to customers. The acquisition is expected to improve our growth opportunities by enhancing our product portfolio and improving our position in important growth markets, including the U.S., Mexico, Turkey, and Eastern Europe. We expect to achieve favorable synergies and cost reductions. Disposition of the Specialty Plastics Business During the third quarter of 2014, we completed the sale of substantially all of the assets in our Specialty Plastics business to A. Schulman, Inc. for $91.0 million in cash. The sale resulted in a gain of $54.9 million and net cash proceeds of $88.3 million. Cash proceeds were used to pay down the 7.785% Senior Notes, as discussed below. This disposition was part of our value creation strategy, as we turn our focus to our core functional coatings and color businesses. Acquisition of Turkey Assets During the third quarter of 2014, the Company acquired certain commercial assets of a reseller of our porcelain enamel products in Turkey for a cash purchase price of $6.7 million. Our porcelain enamel sales to this entity in 2013 were approximately $6.0 million. This action was an initial step to strengthen sales in growing geographic markets, such as Turkey. 7.875% Senior Note Tender Offer As discussed in Note 8, we completed a tender offer for our Senior Notes resulting in the purchase of $143.0 million of notes, with the remaining outstanding notes of $107.0 million being redeemed during the third quarter of 2014. New Credit Facility As discussed in Note 8, on July 31, 2014, the Company entered into a new credit facility (the “New Credit Facility”) with PNC Bank, National Association (“PNC”), as the Administrative Agent, the Collateral Agent and an Issuer, JPMorgan Chase Bank, N.A., as the Syndication Agent and an Issuer, the other agents party thereto and various financial institutions as lenders (the “Lenders”). The New Credit Facility refinances and replaces the 2013 Amended Credit Facility. The New Credit Facility consists of a $200 million secured revolving line of credit with a term of five years and a $300 million secured term loan facility with a term of seven years. Up to $100 million of the revolving line of credit will be available to certain of the Company’s subsidiaries in the form of revolving loans denominated in Euros. Under the terms of the New Credit Facility, the Company is entitled, subject to the satisfaction of certain conditions, to request additional commitments under the revolving line of credit or term loans in the aggregate principal amount of up to $200 million to the extent that existing or new lenders agree to provide such additional commitments and/or term loans. The refinancing of the 7.875% Senior Notes and the 2013 Amended Credit Facility reduced interest expense and further enhanced strategic flexibility. Outlook During 2014, the Company made significant progress on its value creation strategy by reducing infrastructure costs, improving gross margins and reshaping the business portfolio. The Company has renewed its strategic focus on its core glass-based coatings business by divesting its Specialty Plastics business and substantially all of the assets in our North America-based Polymer Additives assets in the second half of 2014. During the fourth quarter of 2014, the Company also made an investment in the core coatings business by successfully acquiring Vetriceramici, a manufacturer of high end tile coatings. Through the divestitures of Specialty Plastics and our North America-based Polymer Additives businesses, we realized net cash proceeds of $237.8 million, portions of which were used to pay down debt, as well as fund the acquisition of Vetriceramici. At December 31, 2014, our cash balance was $140.5 million, which will provide financial flexibility to pursue additional strategic options in 2015. Going into 2015, we are focused on the successful integration of our acquisition of Vetriceramici. We are focused on achieving the identified acquisition synergies and will continue to execute our value creation strategy including pursuing value-creating growth opportunities in our core performance materials businesses and pursuing opportunities to optimize our cost structure and make our business processes and systems more efficient, and optimize tax planning opportunities. During 2015, we also expect to face some challenges, particularly as it pertains to foreign currency movements, specifically the Euro, which we expect to have a significant negative impact on our 2015 reported operating results, relative to 2014 exchange rates. In 2014, 45.0%, of our net sales excluding precious metals originated from Europe. The results of these business, as they are reported in U.S. dollars, would be adversely impacted by movement in the Euro exchange rate, assuming foreign currency rates remain unchanged from current levels. In addition, the Company anticipates continued pricing pressure in our Performance Coatings segment, principally related to our tile products. In 2014, negative pricing impacted our Performance Coatings reportable segment sales by approximately $19.0 million. In 2015, we will continue our focus on divesting our Europe-based Polymer Additives assets, including the Antwerp, Belgium dibenzoates manufacturing assets, and related Polymer Additives European headquarters and lab facilities. The assets associated with this facility are currently classified held-for-sale on our consolidated balance sheets, and we remain committed to the established plan to divest this asset. For 2015, we expect sales growth of 10 - 12%, including the addition of Vetriceramici and excluding the adverse impact of the changes in foreign currency. Excluding Vetriceramici, we expect the underlying business, on a constant currency basis, to generate sales growth of approximately 5% for 2015, including growth generated from new capital projects. We expect gross profit margins to increase over 2014 levels, due to higher sales volumes, the addition of the higher-end Vetriceramici product line, and expected higher gross margins related to our capital investments. In addition, we will continue to focus on reducing costs in SG&A and manufacturing related operations. We expect the result of our efforts in all of these areas will allow the Company during 2015 to significantly improve profitability and generate $50 - $60 million of free cash flow. Results of Operations - Consolidated Comparison of the years ended December 31, 2014 and 2013 For the year ended December 31, 2014, loss from continuing operations was $8.6 million, compared with income from continuing operations of $63.9 million in 2013. For the year ended December 31, 2014, net income was $86.2 million, compared with net income of $72.4 million in 2013. For the year ended December 31, 2014, net income attributable to common shareholders was $86.1 million, or $0.99 per share, compared with net earnings attributable to common shareholders of $71.9 million, or $0.83 per share in 2013. Net Sales Net sales decreased by $77.0 million, or 6.5%, in the year ended December 31, 2014, compared with the prior year. Net sales excluding precious metals decreased $26.2 million, driven by decreased sales in our Pigments, Powders and Oxides segment of $35.6 million, primarily due to the sale of our North American and Asian metal powders business and exit of solar pastes during 2013, and decreased sales in our Performance Coatings segment of $11.8 million. Partially mitigating these declines were increased sales in our Performance Colors and Glass segment of $21.2 million. Sales of precious metals were down compared with the prior year primarily due to the sale of our North American and Asian metal powders business and the exit of solar pastes which contributed $47.2 million of the decline. Gross Profit Gross profit increased $7.4 million, or 2.7%, in 2014 to $285.1 million, compared with $277.7 million in 2013. The significant driver of the increased gross profit was strong performance in our Performance Colors and Glass segment which exceeded prior year gross profit by $22.1 million, primarily driven by higher sales volumes and favorable mix, favorable product pricing, and favorable manufacturing costs. This increase was partially offset by lower gross profit in our Pigments, Powders and Oxides and Performance Coatings segments. Geographic Revenues The decline in net sales excluding precious metals of $26.2 million, compared with 2013, was driven by declines in all regions. The decline in sales is largely driven by the sale of our North American and Asian metal powders business and exit of solar pastes, which resulted in a decrease of $27.5 million, partially mitigated by higher sales in the United States for Performance Colors and Glass products of $11.2 million. In addition, lower sales in Latin America were due to decreased sales in our Performance Coatings and Pigments, Powders and Oxides segments of $5.5 million and $3.0 million, respectively, partially offset by higher sales in Performance Colors and Glass. The decline in sales in Europe in 2014 compared with 2013 was attributable to lower sales of Performance Coatings products of $1.9 million, partially mitigated by slightly higher sales of Pigments, Powders and Oxides products compared to the prior year. The following table presents our sales on the basis of where the sold product was shipped to, as compared to the table above that shows sales on the basis of where the sale originated. Selling, General and Administrative Expense The following table presents selling, general and administrative (“SG&A”) expenses attributable to operating sites and regional costs outside the United States together as Performance Materials, and regional costs attributable to the United States and other Corporate costs together as Corporate. Performance Materials and Corporate SG&A expenses exclude the impact of the annual mark-to-market adjustment on our pension and other postretirement benefit plans, as the volatility in this adjustment does not allow for a meaningful comparison of underlying SG&A costs between periods. The following represents the components with significant changes between 2014 and 2013: SG&A expenses were $136.0 million higher in 2014 compared with the prior year. As a percentage of net sales excluding precious metals, SG&A expenses increased from 13.8% in the prior year to 26.9% in 2014. The most significant driver of the increase in SG&A expenses in 2014 was the mark-to-market loss on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $82.3 million, and is included within the pension and other postretirement benefits line above. The adjustment was primarily related to changes in actuarial assumptions used in calculating the value of the U.S. pension liability. In 2014, the discount rate used to value the liability declined by 100 basis points, compared with the prior year, thereby increasing the value of the liability by approximately $50 million. In addition, during the fourth quarter of 2014, the Company adopted the use of new mortality tables within its calculation assumptions, which had a one-time impact of increasing the liability. The new mortality tables reflect underlying increases in life expectancy of participants, thus driving longer benefit payment periods. The impact of the change in mortality assumption on the U.S. pension liability was an increase of the liability of approximately $18 million. In 2013, the mark-to-market adjustments resulted in an actuarial gain of $69.5 million. The 2013 gain was primarily driven by the change in discount rate used to value the liability, which increased by 95 basis points, compared with 2012, resulting in a reduction in the value of the liability. Excluding the impacts of the mark-to-market adjustments, SG&A expenses decreased 100 basis points from 20.2% in the prior year to 19.2% in 2014. Various restructuring activities executed in 2013 that had a full year impact in 2014 drove the decrease in personnel expenses. The decreases were partially offset by higher stock-based compensation expense due to higher grants to retirement-eligible employees that require accelerated expense recognition, and the impact of improved stock price on our liability based awards. Restructuring and Impairment Charges Restructuring and impairment charges decreased significantly in 2014 compared with 2013. The primary drivers of the decline were the decrease in employee severance cost of $18.2 million in 2014 compared with 2013 and the various 2013 impairment charges of $10.8 million that did not recur in 2014. Many of our restructuring activities commenced during the first half of 2013, thereby driving the higher prior year expenses. We had fewer restructuring activities during 2014. Interest Expense Interest expense in 2014 decreased $3.9 million compared with 2013, primarily due to the amendment of our revolving credit facility and retirement of the 7.875% Senior Notes. Additionally, interest expense decreased due to additional interest capitalization related to the construction project at our Antwerp, Belgium facility. Income Tax Expense In 2014, we recorded an income tax benefit of $34.2 million, or 79.9% of loss before income taxes, compared with income tax expense of $14.3 million, or 18.3% of income before taxes in 2013. The 2014 effective tax rate was greater than the statutory income tax rate of 35% primarily as a result of a $17.4 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized in the current year, the release of valuation allowances concluded to no longer be necessary and the expiration of fully valued tax attributes, $15.2 million of benefit related to current year domestic foreign tax credit generated and utilized, and foreign tax rate differences from the statutory income tax rate of 35%. The 2013 effective tax rate was less than the statutory income tax rate of 35% primarily as a result of a $21.1 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized and the expiration of fully valued tax credits, offset by a $6.8 million charge related to the expiration of the fully valued tax credits. Comparison of the years ended December 31, 2013 and 2012 For the year ended December 31, 2013, income from continuing operations was $63.9 million, compared with a $386.1 million loss from continuing operations in 2012. For the year ended December 31, 2013, net income was $72.4 million, compared with net loss of $373.0 million in 2012. For the year ended December 31, 2013, net income attributable to common shareholders was $71.9 million, or $0.83 earnings per share, compared with net loss attributable to common shareholders of $374.3 million, or $4.34 loss per share in 2012. Net Sales Net sales decreased by $79.1 million, or 6.2% in the year ended December 31, 2013, compared with the prior year. Net sales excluding precious metals decreased $3.1 million compared with the prior year, primarily due to lower sales within Pigments, Powders and Oxides of $20 million, driven by lower volumes for solar pastes, partially offset by higher sales within Performance Colors and Glass of $10.3 million due to higher volumes and favorable mix. Additionally, higher sales in Performance Coatings of $6.7 million was driven by favorable volumes, mix and foreign currency impacts, partially offset by lower pricing. Sales of precious metals were down with the prior year due to the exit of solar pastes, and lower sales in our North American and Asian metal powders product lines prior to being sold in the fourth quarter of 2013. Gross Profit Gross profit increased $44.3 million, or 19.0% in 2013 compared with the prior year, and as a percentage of net sales excluding precious metals, gross profit increased 420 basis points to 25.4%. The primary drivers of the increased gross profit were higher pricing and favorable manufacturing costs in Performance Colors and Glass and favorable volume and mix and lower manufacturing costs in Performance Coatings. Geographic Revenues There was a decline in net sales excluding precious metals of $3.1 million, compared with the 2012. The increased sales in Europe was due to higher sales of decorative and industrial products within Performance Colors and Glass, partially offset by lower sales of automotive products and higher sales of digital inks and frits and glazes in Performance Coatings. The decline in sales in the United States was primarily driven by the exit of solar pastes which resulted in a decrease of $16.2 million. Sales increased in Asia Pacific due to higher sales of frits and glazes, digital inks and porcelain enamel in Performance Coatings, and sales decreased in Latin America due to weaker sales of tile related products. Selling, General and Administrative Expense The following table presents selling, general and administrative expenses attributable to operating sites and regional costs outside the United States together as Performance Materials, and regional costs attributable to the United States and other corporate costs together as Corporate. Corporate SG&A expenses exclude the impact of the annual mark-to-market adjustment on our pension and other postretirement benefit plans, as the volatility in this adjustment does not allow for a meaningful comparison of underlying Corporate SG&A costs between periods. The following represent the components with significant changes between 2013 and 2012: SG&A expenses were $121.1 million lower in 2013 compared with the prior year. As a percentage of net sales excluding precious metals, SG&A expenses decreased 1,100 basis points from 24.8% in the prior year to 13.8% in 2013. The most significant driver of the decline in SG&A expenses in 2013 was the mark-to-market gain on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $69.5 million and is included within the pension and other postretirement benefits above. In 2012, the mark-to-market adjustments resulted in an actuarial loss of $23.2 million. Excluding the impact of the mark-to-market adjustment, SG&A expenses decreased 250 basis points from 22.7% in the prior year to 20.2% in 2013. Various restructuring activities executed in 2013 drove the decrease in personnel expenses. Our expenses related to idle sites have decreased in 2013 as a result of selling the majority of our idle sites during the year. The decreases were partially offset by higher incentive compensation of approximately $17.8 million due to strong performance in 2013. Incentive compensation in 2012 was $0.6 million, driven by not meeting performance targets. Strong performance in 2013 was the primary driver of increased stock-based compensation expense. Restructuring and Impairment Charges Restructuring and impairment charges decreased significantly in 2013 compared with 2012. The primary drivers of the decrease were the 2012 impairment charges of $153.6 million taken against goodwill related to our Electronics Materials reporting unit and $46.8 million related to property, plant and equipment associated with solar and metal powders related assets in 2012. Restructuring charges increased $22.9 million in 2013 when compared with 2012 driven by various restructuring activities executed during the year. Interest Expense Interest expense in 2013 decreased compared with the prior year, primarily due to the allocation of corporate level interest to discontinued operations, partially offset by the write-off of deferred financing fees resulting from amending our revolving credit facility and the commitment amount being reduced from $350 million to $250 million. Income Tax Expense In 2013, income tax expense was $14.3 million, or 18.3% of income before income taxes, compared with an income tax expense of $97.6 million, or (33.8)% of loss before income taxes in 2012. The 2013 effective tax rate was less than the statutory income tax rate of 35% primarily as a result of a $21.1 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized in the current year and the expiration of fully valued tax credits, offset by a $6.8 million charge related to the expiration of the fully valued tax credits. The 2012 effective tax rate was a significant negative effective tax rate compared to the normalized effective tax rate primarily as a result of a $166.7 million charge to increase the valuation allowances, a $4.1 million charge related to the expiration of certain tax credits, and the tax impact of the book goodwill impairment. Results of Operations - Segment Information Comparison of the years ended December 31, 2014 and 2013 Performance Coatings Net sales decreased in Performance Coatings compared with 2013, primarily due to lower sales of our porcelain enamel products of $6.9 million, and our tile frits and glazes, and colors product lines of $6.1 million and $5.7 million, respectively. These declines were partially mitigated by increased sales of our digital inks product line of $6.4 million. Other tile product line sales declined $3.3 million. Net sales in 2014 included $3.8 million for the month of December related to our acquisition of Vetriceramici. Sales were impacted by higher sales volumes of $9.4 million, favorable mix of $15.2 million, lower product pricing of $19.0 million and unfavorable foreign currency impacts of $17.4 million. Our product pricing continues to be impacted by competitive pressures in our digital inks product line. Gross profit decreased from 2013, and was driven by favorable sales volumes and mix of $4.3 million, lower product pricing impacts of $19.0 million, favorable raw material impacts of $12.2 million, lower manufacturing costs of $1.3 million and unfavorable foreign currency impacts of $2.2 million. Net sales in 2014 decreased $11.8 million compared with 2013 due to lower sales in all regions. The decline in sales in Europe was attributable lower sales of our porcelain enamel products, partially mitigated by higher sales of tile products, including Vetriceramici sales during December. The decline in sales in 2014 in Latin America, compared to 2013, was due to lower sales of our tile color and porcelain enamel products, partially mitigated by higher sales of digital inks products. The decline in Asia Pacific was driven by lower sales of tile products, primarily frits and glaze products, which was partially mitigated by higher sales of digital inks products. The decline in the United States was all attributable to porcelain enamel products. Performance, Colors and Glass Net sales excluding precious metals increased $21.2 million in 2014 compared with 2013, with increases in all of our product lines. Net sales excluding precious metals were impacted by higher sales volumes of $21.8 million, unfavorable mix of $1.1 million, higher product pricing of $2.6 million and unfavorable foreign currency impacts of $2.1 million. Gross profit increased in 2014, compared with 2013, due to favorable sales volumes and mix of $17.8 million, higher product pricing impacts of $2.6 million, unfavorable raw material impacts of $6.7 million, lower manufacturing costs of $9.2 million and unfavorable foreign currency impacts of $0.7 million. The increase in 2014 in net sales excluding precious metals of $21.2 million compared with 2013 reflected higher sales in all regions and in all product lines. Pigments, Powders and Oxides Net sales excluding precious metals decreased in 2014 compared with 2013, primarily due to the sale of our North American and Asian metal powders business and exit of solar pastes, which comprised approximately $27.5 million of the decrease. The remainder of the decrease in net sales excluding precious metals of $8.1 million was primarily due to lower sales of our surface polishing materials in 2014 compared with 2013. Gross profit declined in 2014 compared with 2013 and was primarily the result of exited and sold businesses, which contributed to $6.0 million of gross profit in the prior year that did not recur in the current year. The decrease in gross profit in 2014 was due to lower sales volumes and mix of $15.1 million, which was partially mitigated by favorable raw material impacts of $2.6 million and lower manufacturing costs of $5.0 million. The decrease in net sales excluding precious metals of $35.6 million in 2014, compared with 2013, was due to lower sales in the United States, Latin America and Asia Pacific, which were partially mitigated by higher sales in Europe. The decline in sales in the United States and Asia Pacific was primarily driven by the sale of our North American and Asian metal powders business which contributed $27.5 million in the prior year that did not recur. Also contributing to the decline in the U.S. was lower sales of our surface polishing materials. Partially mitigating the decline in Asia Pacific were higher sales of our pigments products. The decline in Latin America was driven by lower sales of our pigments products. Comparison of the years ended December 31, 2013 and 2012 Performance Coatings Sales increased in Performance Coatings primarily due to increased sales of our frits and glazes, porcelain enamel and digital ink products of $11.1 million, $6.4 million and $12.4 million, respectively. The higher sales were partially offset by a decline in colors of $19.3 million and other tile products of $6.3 million, including $2.2 million of lower sales volume due to the sale of our Argentinian borate mine in 2013. Sales were impacted by higher sales volumes of $30.1 million, favorable mix of $4.5 million, lower product pricing of $27.0 million and favorable foreign currency impacts of $6.1 million. Gross profit increased from 2012, and was driven by favorable sales volumes and mix of $9.5 million, lower product pricing of $30.9 million, lower manufacturing costs of $41.3 million and favorable foreign currency impacts of $1.5 million. The net sales increase of $6.7 million compared with 2012 reflected higher sales in all regions, except Latin America. The increased sales in Europe was attributable to higher sales of our porcelain enamels, digital inks and frits and glaze products, partially offset by lower sales of our color products. The decline in sales in Latin America, compared to 2012, was due to lower sales in all product lines except frits and glazes and digital inks. The increased sales in Asia Pacific were driven by higher sales of our frits and glazes, digital inks and porcelain enamels, partially offset by lower sales of color products. The United States remained relatively flat as compared to 2012 with a 2.4% increase in porcelain enamel sales. Performance Colors and Glass Net sales excluding precious metals increased compared with the prior year, primarily driven by sales of our decorative and industrial products, partially offset by a decrease in sales of our automotive products. Net sales excluding precious metals were impacted by higher volumes of $6.0 million, favorable mix of $1.0 million, higher pricing of $4.2 million and negative foreign currency impacts of $0.9 million. The decline in precious metal sales was due to lower sales volumes in our electronic and automotive product lines. Gross profit increased from 2012, impacted by unfavorable volumes and mix of $1.1 million, higher product pricing impacts of $4.2 million, unfavorable foreign currency impacts of $0.4 million, and lower manufacturing costs of $8.3 million, driven by lower raw material pricing of $6.6 million. The increase in net sales excluding precious metals of $10.3 million compared with the 2012, reflected higher sales in all regions in our decorative and industrial product lines, partially offset by a decline in sales in all regions in our automotive product line. Pigments, Powders and Oxides Net sales excluding precious metals decreased primarily due to the exit of solar pastes during the first quarter of 2013, which comprised approximately $18.3 million of the decrease compared to the prior year. Additionally, sales decreased approximately $0.8 million in our North American and Asian metal powders product lines from the prior year until they were sold during the fourth quarter of 2013. The decrease in sales of precious metals was fully attributable to the exit of solar pastes and the sale of our North American and Asian metals powders business. Sales were further affected by higher sales volumes of $10.5 million, unfavorable product mix of $8.9 million and lower pricing of $1.9 million. Gross profit increased as compared to the prior year due to lower manufacturing costs $4.5 million, partially offset by lower pricing of $1.8 million. The decrease in net sales excluding precious metals of $20.0 million compared with 2012 was due to lower sales in the United States and Asia Pacific, while Europe and Latin America remained relatively flat. The decline in sales in the United States and Asia Pacific of $18.8 million and $3.0 million, respectively, was primarily driven by the exit of solar pastes in the first quarter of 2013 which contributed $18.3 million in the prior year that did not recur. Also, contributing to the decline in the U.S. were lower sales of our pigment and polishing materials. Summary of Cash Flows for the years ended December 31, 2014, 2013, and 2012 Operating activities. Cash flows from operating activities increased $42.0 million in 2014 compared to 2013. The primary drivers of the change were an increase of $13.8 million in net income compared with 2013, as well as a reduction in payments associated with restructuring activities of $11.8 million. Further, net income was impacted by significant non-cash charges during the year for the mark-to-market adjustment of our pension and other postretirement benefits liabilities and the extinguishment of our 7.875% Senior Notes, as well as gains on divestitures of $124.0. The increases were partially mitigated by a cash outflow of $12.3 million in 2014 related to working capital, which was a decline from the cash inflow of $6.3 million in 2013. Investing activities. Cash flows from investing activities increased approximately $58.0 million in 2014. The increase was driven primarily by net proceeds from the sales of our North America-based Polymer Additives assets and Specialty Plastics business of $149.5 million and $88.3 million, respectively, partially offset by cash outflows of $108.9 million for the acquisition of Vetriceramici and $6.7 million to acquire certain commercial assets of a reseller of our porcelain enamel products in Turkey. Capital expenditures increased $19.5 million in 2014, compared with 2013. The higher capital expenditures were costs incurred for the ongoing project at our Antwerp, Belgium facility. Financing activities. Cash flows from financing activities increased $18.6 million in 2014, compared with 2013. The increase was due to net borrowings on our term loan facility of $300.0 million, partially offset by the repayment of the 7.875% Senior Notes of $260.5 million. Further, we had a cash outflow of $44.4 million in 2014, a decrease of $45.1 million compared with 2013, related to repayment of debt outstanding under our accounts receivable securitization program that expired during the year, as well as our revolving credit facility that was amended during 2014. We have paid no dividends on our common stock since 2009. Capital Resources and Liquidity Major debt instruments that were outstanding during 2014 are described below. New Credit Facility On July 31, 2014, the Company entered into a new credit facility (the “New Credit Facility”) with a group of Lenders to refinance the majority of its then outstanding debt, as discussed below. The New Credit Facility consists of a $200 million secured revolving line of credit with a term of five years and a $300 million secured term loan facility with a term of seven years. The New Credit Facility replaces the prior $250 million revolving credit facility and provided funding to repurchase the 7.875% Senior Notes. Subject to certain conditions, the Company can request up to $200 million of additional commitments under the New Credit Facility, though the lenders are not required to provide such additional commitments. In addition, up to $100 million of the revolving line of credit will be available to certain of the Company’s subsidiaries in the form of revolving loans denominated in Euros. Certain of the Company’s U.S. subsidiaries have guaranteed the Company’s obligations under the New Credit Facility and such obligations are secured by (a) substantially all of the personal property of the Company and the U.S. subsidiary guarantors and (b) a pledge of 100% of the stock of most of the Company’s U.S. subsidiaries and 65% of most of the stock of the Company’s first tier foreign subsidiaries. Interest Rate - Term Loan: The interest rates applicable to the term loans will be, at the Company’s option, equal to either a base rate or a London Interbank Offered Rate (“LIBOR”) rate plus, in both cases, an applicable margin. · The base rate will be the highest of (i) the federal funds rate plus 0.50%, (ii) PNC’s prime rate or (iii) the daily LIBOR rate plus 1.00%. · The applicable margin for base rate loans is 2.25%. · The LIBOR rate will be set as quoted by Bloomberg and shall not be less than 0.75%. · The applicable margin for LIBOR rate loans is 3.25%. · For LIBOR rate loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2014, the Company had borrowed $299.3 million under the term loan facility at an annual rate of 4.0%. There were no additional borrowings available under the term loan facility. Interest Rate - Revolving Credit Line: The interest rates applicable to loans under the revolving credit line will be, at the Company’s option, equal to either a base rate or a LIBOR rate plus an applicable variable margin. The variable margin will be based on the ratio of (a) the Company’s total consolidated debt outstanding at such time to (b) the Company’s consolidated EBITDA computed for the period of four consecutive fiscal quarters most recently ended. · The base rate will be the highest of (i) the federal funds rate plus 0.50%, (ii) PNC’s prime rate or (iii) the daily LIBOR rate plus 1.00%. · The applicable margin for base rate loans will vary between 1.50% and 2.00%. · The LIBOR rate will be set as quoted by Bloomberg for U.S. Dollars. · The applicable margin for LIBOR Rate Loans will vary between 2.50% and 3.00%. · For LIBOR rate loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2014, there were no borrowings under the revolving credit facility. After reductions for outstanding letters of credit secured by these facilities, we had $194.7 million of additional borrowings available at December 31, 2014. The New Credit Facility contains customary restrictive covenants including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. The New Credit Facility also contains standard provisions relating to conditions of borrowing and customary events of default, including the non-payment of obligations by the Company and the bankruptcy of the Company. Under the secured revolving credit facility, we are subject to certain financial covenants. The covenants include requirements for a leverage ratio and an interest coverage ratio. If an event of default occurs, all amounts outstanding under the New Credit Facility may be accelerated and become immediately due and payable. At December 31, 2014, we were in compliance with the covenants of the New Credit Facility. Receivable Sales Programs We had an asset securitization program for Ferro’s U.S. trade accounts receivable where we sold undivided variable percentage interests in our domestic receivables to various purchasers, and could obtain up to $50 million in the form of cash or letters of credit. Advances received under this program were accounted for as borrowings secured by the receivables and included in net cash provided by financing activities. The purchasers had no recourse to Ferro’s other assets for failure of payment of the receivables as a result of the lack of creditworthiness, or financial inability to pay, of the related obligor. The program expired in May 2014 in accordance with its terms and the outstanding debt was repaid at that time. In 2011, we entered into several international programs to sell with recourse trade accounts receivable to financial institutions. Advances received under these programs are accounted for as borrowings secured by the receivables and included in net cash provided by financing activities. During the fourth quarter of 2013, the international factoring programs expired and were not renewed. 7.875% Senior Notes In 2010, we issued $250 million of 7.875% Senior Notes due 2018 (the “Senior Notes”). The Senior Notes were issued at par and bore interest at a rate of 7.875% per year, payable semiannually in arrears on February 15 and August 15 of each year and had a maturity date of August 15, 2018. In July 2014, the Company commenced a tender offer for all of the Senior Notes at a price of $1,043.62 per $1,000.00 principal amount. Approximately $143.0 million of the Senior Notes were purchased through the tender offer and the remaining $107.0 million were redeemed in the third quarter of 2014 at prices ranging from 100% to 103.938% of the principal amount, in accordance with their terms. In conjunction with the redemption of the Senior Notes, we recorded a charge of $13.5 million, which is comprised of a repurchase premium of $10.5 million and the write-off of unamortized issuance costs of $3.0 million. This charge is included within Loss on extinguishment of debt in the consolidated statements of operations for the year ended December 31, 2014. Revolving Credit Facility In 2010, we entered into the Third Amended and Restated Credit Agreement with a group of lenders for a five-year, $350 million multi-currency senior revolving credit facility, which was amended in March of 2013 (the “2013 Amended Credit Facility”) to provide additional operating flexibility. During the third quarter of 2014, the 2013 Amended Credit Facility was terminated and repaid in full. In conjunction with the termination, the Company recorded a charge of approximately $0.9 million, which is included within Loss on extinguishment of debt in our consolidated statements of operations for the year ended December 31, 2014. Off Balance Sheet Arrangements Consignment and Customer Arrangements for Precious Metals. We use precious metals, primarily silver, in the production of some of our products. We obtain most precious metals from financial institutions under consignment agreements (generally referred to as our precious metals consignment program). The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign and the period of consignment. These fees were $0.8 million, $3.0 million and $6.5 million for 2014, 2013, and 2012 respectively. We had on hand precious metals owned by participants in our precious metals consignment program of $26.6 million at December 31, 2014 and $30.8 million at December 31, 2013, measured at fair value based on market prices for identical assets and net of credits. The consignment agreements under our precious metals program involve short-term commitments that typically mature within 30 to 90 days of each transaction and are typically renewed on an ongoing basis. As a result, the Company relies on the continued willingness of financial institutions to participate in these arrangements to maintain this source of liquidity. On occasion, we have been required to deliver cash collateral. While no deposits were outstanding at December 31, 2014, or December 31, 2013, we may be required to furnish cash collateral in the future based on the quantity and market value of the precious metals under consignment and the amount of collateral-free lines provided by the financial institutions. The amount of cash collateral required is subject to review by the financial institutions and can be changed at any time at their discretion, based in part on their assessment of our creditworthiness. Bank Guarantees and Standby Letters of Credit. At December 31, 2014, the Company and its subsidiaries had bank guarantees and standby letters of credit issued by financial institutions that totaled $7.3 million. These agreements primarily relate to Ferro’s insurance programs, foreign energy purchase contracts and foreign tax payments. Other Financing Arrangements We maintain other lines of credit to provide global flexibility for Ferro’s short-term liquidity requirements. These facilities are uncommitted lines for our international operations and totaled $10.8 million at December 31, 2014. We had $9.3 million of additional borrowings available under these lines at December 31, 2014. Liquidity Requirements Our primary sources of liquidity are available cash and cash equivalents, available lines of credit under the New Credit Facility, and cash flows from operating activities. As of December 31, 2014, we had $140.5 million of cash and cash equivalents. Cash generated in the U.S. is generally used to pay down amounts outstanding under our revolving credit facility and for general corporate purposes. If needed, we could repatriate the majority of cash held by foreign subsidiaries without the need to accrue and pay U.S. income taxes. We do not anticipate a liquidity need requiring such repatriation of these funds to the U.S. Our liquidity requirements primarily include debt service, purchase commitments, labor costs, working capital requirements, restructuring expenditures, capital investments, precious metals cash collateral requirements, and postretirement obligations. We expect to meet these requirements in the long term through cash provided by operating activities and availability under existing credit facilities or other financing arrangements. Cash flows from operating activities are primarily driven by earnings before noncash charges and changes in working capital needs. In 2014, cash flows from investing and operating activities were used to fund our financing activities. Additionally, we used the borrowing available under the New Credit Facility and the proceeds from the sale of Specialty Plastics to retire the entire amount of Senior Notes during 2014. We had additional borrowing capacity of $194.7 million at December 31, 2014, available under various credit facilities, primarily our revolving credit facility. Our credit facilities contain a number of restrictive covenants, including those described in more detail in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. These covenants include customary operating restrictions, including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. We are also subject to customary financial covenants under our credit facilities, including a leverage ratio and an interest coverage ratio. These covenants under our credit facilities restrict the amount of our borrowings, reducing our flexibility to fund ongoing operations and strategic initiatives. These facilities are described in more detail in “Capital Resources and Liquidity” under Item 7 and in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. The most critical of these ratios is the leverage ratio for the revolving credit facility. As of December 31, 2014, we were in compliance with our maximum leverage ratio covenant of 3.75x as our actual ratio was 1.74x, providing $70.2 million of EBITDA cushion on the leverage ratio, as defined within our New Credit Facility. To the extent that economic conditions in key markets deteriorate or we are unable to meet our business projections and EBITDA falls below approximately $100 million for rolling four quarters, based on reasonably consistent debt levels with those as of December 31, 2014, we could become unable to maintain compliance with our leverage ratio covenant. In such case, our lenders could demand immediate payment of outstanding amounts and we would need to seek alternate financing sources to pay off such debts and to fund our ongoing operations. Such financing may not be available on favorable terms, if at all. Difficulties experienced in global capital markets could affect the ability or willingness of counterparties to perform under our various lines of credit, forward contracts, and precious metals program. These counterparties are major, reputable, multinational institutions, all having investment-grade credit ratings, except for one, which is not rated. Accordingly, we do not anticipate counterparty default. However, an interruption in access to external financing could adversely affect our business prospects and financial condition. We assess on an ongoing basis our portfolio of businesses, as well as our financial and capital structure, to ensure that we have sufficient capital and liquidity to meet our strategic objectives. As part of this process, from time to time we evaluate the possible divestiture of businesses that are not critical to our core strategic objectives and, where appropriate, pursue the sale of such businesses and assets such as sales we completed in 2013 and 2014. We also evaluate and pursue acquisition opportunities that we believe will enhance our strategic position. Generally, we publicly announce divestiture and acquisition transactions only when we have entered into definitive agreements relating to those transactions. The Company’s aggregate amount of contractual obligations for the next five years and thereafter is set forth below: _____________________ (1) Loans Payable includes our loans payable to banks. (2) Long-term debt excludes imputed interest and executory costs on capitalized lease obligations. (3) Interest represents only contractual payments for fixed-rate debt. (4) Purchase commitments are noncancelable contractual obligations for raw materials and energy. (5) We have not projected payments past 2015 due to uncertainties in estimating the amount and period of any payments. We have $36.9 million in gross liabilities related to unrecognized tax benefits, including $1.1 of accrued interest and penalties that are not included in the above table since we cannot reasonably predict the timing of cash settlements with various taxing authorities. (6) The funding amounts are based on the minimum contributions required under our various plans and applicable regulations in each respective country. We have not projected contributions past 2016 due to uncertainties regarding the assumptions involved in estimating future required contributions. Critical Accounting Policies When we prepare our consolidated financial statements we are required to make estimates and assumptions that affect the amounts we report in the consolidated financial statements and footnotes. We consider the policies discussed below to be more critical than other policies because their application requires our most subjective or complex judgments. These estimates and judgments arise because of the inherent uncertainty in predicting future events. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors. Revenue Recognition We recognize sales typically when we ship goods to our customers and when all of the following criteria are met: · Persuasive evidence of an arrangement exists; · The selling price is fixed or determinable; · Collection is reasonably assured; and · Title and risk of loss has passed to our customers. In order to ensure the revenue recognition in the proper period, we review material sales contracts for proper cut-off based upon the business practices and legal requirements of each country. For sales of products containing precious metals, we report revenues gross along with their corresponding cost of sales to arrive at gross profit. We record revenues this way because we act as the principal in the transactions into which we enter. Restructuring and Cost Reduction Programs In recent years, we have developed and initiated several restructuring programs across a number of our business segments with the objectives of leveraging our global scale, realigning and lowering our cost structure, and optimizing capacity utilization. The programs are primarily associated with North America, Europe and Asia Pacific. Management continues to evaluate our businesses, and therefore, there may be additional provisions for new plan initiatives, as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Restructuring charges include both termination benefits and asset writedowns. We estimate accruals for termination benefits based on various factors including length of service, contract provisions, local legal requirements, projected final service dates, and salary levels. We also analyze the carrying value of long-lived assets and record estimated accelerated depreciation through the anticipated end of the useful life of the assets affected by the restructuring or record an asset impairment. In all likelihood, this accelerated depreciation will result in reducing the net book value of those assets to zero at the date operations cease. While we believe that changes to our estimates are unlikely, the accuracy of our estimates depends on the successful completion of numerous actions. Changes in our estimates could increase our restructuring costs to such an extent that it could have a material impact on the Company’s results of operations, financial position, or cash flows. Other events, such as negotiations with unions and works councils, may also delay the resulting cost savings. Accounts Receivable and the Allowance for Doubtful Accounts Ferro sells its products to customers in diversified industries throughout the world. No customer or related group of customers represents greater than 10% of net sales or accounts receivable. We perform ongoing credit evaluations of our customers and require collateral principally for export sales, when industry practices allow and as market conditions dictate, subject to our ability to negotiate secured terms relative to competitive offers. We regularly analyze significant customer accounts and provide for uncollectible accounts based on historical experience, customer payment history, the length of time the receivables are past due, the financial health of the customer, economic conditions, and specific circumstances, as appropriate. Changes in these factors could result in additional allowances. Customer accounts we conclude to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. Historically, write-offs of uncollectible accounts have been within our expectations. Goodwill We review goodwill for impairment each year using a measurement date of October 31st or more frequently in the event of an impairment indicator. We annually, or more frequently as warranted, evaluate the appropriateness of our reporting units utilizing operating segments as the starting point of our analysis. In the event of a change in our reporting units, we would allocate goodwill based on the relative fair value. We estimate the fair values of the reporting units associated with these assets using the average of both the income approach and the market approach, which we believe provides a reasonable estimate of the reporting units’ fair values, unless facts and circumstances exist that indicate more representative fair values. The income approach uses projected cash flows attributable to the reporting units over their useful lives and allocates certain corporate expenses to the reporting units. We use historical results, trends and our projections of market growth, internal sales efforts and anticipated cost structure assumptions to estimate future cash flows. Using a risk-adjusted, weighted-average cost of capital, we discount the cash flow projections to the measurement date. The market approach estimates a price reasonably expected to be paid by a market participant in the purchase of similar businesses. If the fair value of any reporting unit was determined to be less than its carrying value, we would proceed to the second step and obtain comparable market values or independent appraisals of its assets and liabilities to determine the amount of any impairment. The significant assumptions and ranges of assumptions we used in our impairment analyses of goodwill at October 31, 2014 and 2013, were as follows: Our estimates of fair value can be adversely affected by a variety of factors. Reductions in actual or projected growth or profitability at our reporting units due to unfavorable market conditions or significant increases in cost structure could lead to the impairment of any related goodwill. Additionally, an increase in inflation, interest rates or the risk-adjusted, weighted-average cost of capital could also lead to a reduction in the fair value of one or more of our reporting units and therefore lead to the impairment of goodwill. Based on our 2014 annual impairment test performed as of October 31, 2014, the fair values of the remaining reporting units tested for impairment exceeded the carrying values of the respective reporting units by amounts ranging from 50% to 280% at the 2014 measurement date. The lowest cushion relates to the Pigments, Powders and Oxides reporting unit, which had a goodwill balance of $9.7 million at December 31, 2014. A future potential impairment is possible for any of these reporting units if actual results are materially less than forecasted results. Some of the factors that could negatively affect our cash flows and, as a result, not support the carrying values of our reporting units are: new environmental regulations or legal restrictions on the use of our products that would either reduce our product revenues or add substantial costs to the manufacturing process, thereby reducing operating margins; new technologies that could make our products less competitive or require substantial capital investment in new equipment or manufacturing processes; and substantial downturns in economic conditions. Long-Lived Asset Impairment The Company’s long-lived assets include property, plant and equipment, and amortizable intangible assets. We review property, plant and equipment and amortizable intangible assets for impairment whenever events or circumstances indicate that their carrying values may not be recoverable. The following are examples of such events or changes in circumstances: · An adverse change in the business climate or market price of a long-lived asset or asset group; · An adverse change in the extent or manner in which a long-lived asset or asset group is used or in its physical condition; · Current operating losses for a long-lived asset or asset group combined with a history of such losses or projected or forecasted losses that demonstrate that the losses will continue; or · A current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise significantly disposed of before the end of its previously estimated useful life. The carrying amount of property, plant and equipment and amortizable intangible assets is not recoverable if the carrying value of the asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group. In the event of impairment, we recognize a loss for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of review. Income Taxes The breadth of our operations and complexity of income tax regulations require us to assess uncertainties and make judgments in estimating the ultimate amount of income taxes we will pay. Our income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. The final income taxes we pay are based upon many factors, including existing income tax laws and regulations, negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation, and resolution of disputes arising from federal, state and international income tax audits. The resolution of these uncertainties may result in adjustments to our income tax assets and liabilities in the future. Deferred income taxes result from differences between the financial and tax basis of our assets and liabilities. We adjust our deferred income tax assets and liabilities for changes in income tax rates and income tax laws when changes are enacted. We record valuation allowances to reduce deferred income tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and the magnitude of appropriate valuation allowances against deferred income tax assets. The realization of these assets is dependent on generating future taxable income, our ability to carry back or carry forward net operating losses and credits to offset tax liabilities, as well as successful implementation of various tax strategies to generate tax where net operating losses or credit carryforwards exist. In evaluating our ability to realize the deferred income tax assets, we rely principally on the reversal of existing temporary differences, the availability of tax planning strategies, and forecasted income. We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Our estimate of the potential outcome of any uncertain tax positions is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. We record a liability for the difference between the benefit recognized and measured based on a more-likely-than-not threshold and the tax position taken or expected to be taken on the tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. We report tax-related interest and penalties as a component of income tax expense. Derivative Financial Instruments We use derivative financial instruments in the normal course of business to manage our exposure to fluctuations in interest rates, foreign currency exchange rates, commodity prices, and precious metal prices. The accounting for derivative financial instruments can be complex and can require significant judgment. Generally, the derivative financial instruments that we use are not complex, and observable market-based inputs are available to measure their fair value. We do not engage in speculative transactions for trading purposes. Financial instruments, including derivative financial instruments, expose us to counterparty credit risk for nonperformance. We manage our exposure to counterparty credit risk through minimum credit standards and procedures to monitor concentrations of credit risk. We enter into these derivative financial instruments with major, reputable, multinational financial institutions. Accordingly, we do not anticipate counter-party default. We continuously evaluate the effectiveness of derivative financial instruments designated as hedges to ensure that they are highly effective. In the event the hedge becomes ineffective, we discontinue hedge treatment. Except as noted below, we do not expect any changes in our risk policies or in the nature of the transactions we enter into to mitigate those risks. We manage foreign currency risks in a wide variety of foreign currencies principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions arising from international trade. Our objective in entering into these forward contracts is to preserve the economic value of nonfunctional currency cash flows. Our principal foreign currency exposures relate to the Euro, the British Pound Sterling, the Japanese Yen, and the Chinese Yuan. We mark these forward contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as other income or expense from foreign currency transactions. Precious metals (primarily silver, gold, platinum and palladium) represent a significant portion of raw material costs in our electronics products. When we enter into a fixed price sales contract at the customer’s request to establish the price for the precious metals content of the order, we also enter into a forward purchase arrangement with a precious metals supplier to completely cover the value of the precious metals content. Our current precious metal contracts are designated as normal purchase contracts, which are not marked to market. We also purchase portions of our energy requirements, including natural gas and electricity, under fixed price contracts to reduce the volatility of cost changes. Our current energy contracts are designated as normal purchase contracts, which are not marked to market. Pension and Other Postretirement Benefits We sponsor defined benefit plans in the U.S. and many countries outside the U.S., and we also sponsor retiree medical benefits for a segment of our salaried and hourly work force within the U.S. The U.S. pension plans represent approximately 82% of pension plan assets, 76% of benefit obligations and 75% of net periodic pension cost. The assumptions we use in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. We meet with our actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. We determine the discount rate for the U.S. pension and retiree medical plans based on a bond model. Using the pension plans’ projected cash flows, the bond model considers all possible bond portfolios that produce matching cash flows and selects the portfolio with the highest possible yield. These portfolios are based on bonds with a quality rating of AA or better under either Moody’s Investor Services, Inc. or Standard & Poor’s Rating Group, but exclude certain bonds, such as callable bonds, bonds with small amounts outstanding, and bonds with unusually high or low yields. The discount rates for the non-U.S. plans are based on a yield curve method, using AA-rated bonds applicable in their respective capital markets. The duration of each plan’s liabilities is used to select the rate from the yield curve corresponding to the same duration. For the market-related value of plan assets, we use fair value, rather than a calculated value that recognizes changes in fair value in a systematic and rational manner over several years. We calculate the expected return on assets at the beginning of the year for defined benefit plans as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. In determining the expected returns, we consider both historical performance and an estimate of future long-term rates of return. The Company consults with and considers the opinion of its actuaries in developing appropriate return assumptions. Our target asset allocation percentages are 35% fixed income, 60% equity, and 5% other investments for U.S. plans and 75% fixed income, 24% equity, and 1% other investments for non-U.S. plans. In 2014, investment returns on average plan assets were approximately 7% within U.S. plans and 20% within non-U.S. plans. In 2013, investment returns on average plan assets were approximately 15% within U.S. plans and 6% within non-U.S. plans. Future actual pension expense will depend on future investment allocation and performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans. All other assumptions are reviewed periodically by our actuaries and us and may be adjusted based on current trends and expectations as well as past experience in the plans. During the fourth quarter of 2014, the Company adopted the use of new mortality tables within its calculation assumptions, which had a one-time impact of increasing the liability. The new mortality tables reflect underlying increases in life expectancy of participants, thus driving longer benefit payment periods. The impact of the change in mortality assumption on the U.S. pension liability was an increase of the liability of approximately $18 million. The following table provides the sensitivity of net annual periodic benefit costs for our pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25-basis-point decrease in both the discount rate and asset return assumption: The following table provides the rates used in the assumptions and the changes between 2014 and 2013: Our overall net periodic benefit cost for all defined benefit plans was $84.4 million in 2014 compared with net periodic benefit income of $68.9 million in 2013. The change is mainly the result of mark to market actuarial net losses in the current year compared to mark to market actuarial net gains in 2013. For 2015, assuming expected returns on plan assets and no actuarial gains or losses, we expect our overall net periodic benefit income to be approximately $7.6 million, compared with income of approximately $4.6 million in 2014 on a comparable basis. Inventories We value inventory at the lower of cost or market, with cost determined utilizing the first-in, first-out (FIFO) method. We periodically evaluate the net realizable value of inventories based primarily upon their age, but also upon assumptions of future usage in production, customer demand and market conditions. Inventories have been reduced to the lower of cost or realizable value by allowances for slow moving or obsolete goods. If actual circumstances are less favorable than those projected by management in its evaluation of the net realizable value of inventories, additional write-downs may be required. Slow moving, excess or obsolete materials are specifically identified and may be physically separated from other materials, and we rework or dispose of these materials as time and manpower permit. Environmental Liabilities Our manufacturing facilities are subject to a broad array of environmental laws and regulations in the countries in which they are located. The costs to comply with complex environmental laws and regulations are significant and will continue for the foreseeable future. We expense these recurring costs as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations. We also accrue for environmental remediation costs when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events. Inherent uncertainties exist in such evaluations primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress or as additional technical or legal information becomes available. Impact of Newly Issued Accounting Pronouncements Refer to Note 2 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K for a discussion of accounting standards we recently adopted or will be required to adopt.

<s>[INST] During the year ended December 31, 2014, net sales were down $77.0 million, or 6.5%, compared with 2013. Of the decline, $74.7 million relates to the sale of our North American and Asian metal powders business and exit of solar pastes. Excluding the impact of the sold product lines, net sales in the continuing business was down $2.3 million compared to 2013. Performance Coatings and Pigments, Powders and Oxides net sales were down compared with 2013 by $11.8 million and $8.1 million, respectively, which were partially mitigated by strong performance in Performance Colors and Glass, which achieved strong sales improvement of $17.7 million compared with 2013. Despite the decline in net sales, gross profit increased $7.4 million compared with 2013. As a percentage of net sales excluding precious metals, gross profit rate increased approximately 140 basis points to 26.8%, from 25.4% in the prior year. For the year ended December 31, 2014, selling, general and administrative (“SG&A”) expenses were up $136.0 million, or 90.2%, compared with 2013, primarily driven by the pension and other postretirement benefits marktomarket adjustment. In 2014, the adjustment resulted in a loss of $82.3 million in SG&A, while in 2013, the adjustment resulted in a gain of $69.5 million. For the year ended December 31, 2014, net income was $86.2 million, compared with net income of $72.4 million in 2013, and net income attributable to common shareholders was $86.1 million, compared with net income attributable to common shareholders of $71.9 million in 2013. Loss from continuing operations was $8.6 million for the year ended December 31, 2014, compared with income from continuing operations of $63.9 million in 2013. Gross profit in 2014 was $285.1 million, compared with $277.7 million in 2013. 2014 Transactional Activity Disposition of the Polymer Additives Business During the fourth quarter of 2014, we completed the sale of substantially all of the assets in our North Americabased Polymer Additives business to Polymer Additives, Inc. for $153.5 million in cash. The sale resulted in a gain of $72.7 million and net cash proceeds of $149.5 million. Cash proceeds were used to repay debt under the revolving credit facility and will be used to fund strategic growth opportunities. This disposition was part of our value creation strategy, as we turn our focus to our core functional coatings and color businesses. Excluded from the transaction was our Europebased Polymer Additives assets. Our Europebased Polymer Additives assets are being separately marketed for sale. Acquisition of Vetriceramici S.p.A During the fourth quarter of 2014, Ferro Coatings Italy S.R.L., a 100% owned subsidiary of Ferro, acquired 100% of the outstanding common shares and voting interest of Vetriceramici S.p.A. (“Vetriceramici”) for €87.2 million in cash. The sale closed on December 1, 2014 for a purchase price of $108.9 million, based on the exchange rate on that date. Vetriceramici is an Italian manufacturing, marketing and distribution group that offers a range of products (principally ceramic glazes, frits, inks and screen printing bases) to its customers for the production of ceramic tiles, with some diversification in the glass sector. Vetriceramici currently has manufacturing facilities in Italy and Mexico, a mixing plant in Poland and research and development and sales offices in Italy and Turkey. Vetriceramici is a leading global supplier of specialty products that enhance the appearance and improve the durability [/INST] Positive. </s>

FERRO CORP

2016-02-24

2015-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview During the year ended December 31, 2015, net sales were down $36.3 million, or 3.3%, compared with 2014. The decrease was primarily due to unfavorable foreign currency impacts, which totaled approximately $132.4 million, partially offset by the sales from Nubiola of $56.9 million, which was acquired in the third quarter of 2015, and by the sales from Vetriceramici of $56.0 million, which was acquired in the fourth quarter of 2014. Despite the decline in net sales, gross profit increased $16.6 million compared with 2014. As a percentage of net sales excluding precious metals, gross profit rate increased approximately 230 basis points to 29.1%, from 26.8% in the prior year. For the year ended December 31, 2015, selling, general and administrative (“SG&A”) expenses decreased $69.9 million, or 24.4%, compared with 2014, primarily driven by the pension and other postretirement benefits mark-to-market adjustment and curtailment and settlement effects. In 2015, the adjustment resulted in a loss of $8.2 million in SG&A, while in 2014, the adjustment resulted in a loss of $88.5 million. For the year ended December 31, 2015, net income was $63.1 million, compared with net income of $86.2 million in 2014, and net income attributable to common shareholders was $64.1 million, compared with net income attributable to common shareholders of $86.1 million in 2014. Income from continuing operations was $99.9 million for the year ended December 31, 2015, compared with loss from continuing operations of $8.6 million in 2014. Gross profit in 2015 was $301.7 million, compared with $285.1 million in 2014. Outlook During 2015, despite challenging currency and global economic conditions, the Company delivered strong performance and continued to advance on our value creation strategy. During the past 18 months, we have invested in acquisitions that complement our existing businesses, provide attractive margins, and improve our capabilities in important growth markets. We are well positioned strategically to leverage our infrastructure and market leading positions to achieve or exceed our performance targets and generate stronger returns for our shareholders. We expect foreign currency to continue to have a negative impact on our results. The earnings improvement will be driven by contributions from acquisitions, organic sales growth and continued focus on reducing our direct and indirect purchasing costs. In addition, we intend to continue making acquisitions. We have a robust pipeline of acquisition targets and the financial flexibility to pursue them. Our acquisition growth objective is to invest $100 million annually to add assets that strengthen our product and technology portfolios, improve our market position, expand our global reach, and drive shareholder value. For 2016, we expect sales growth of 10 - 11%, including the addition of our acquisitions and excluding the adverse impact of the changes in foreign currency. We expect gross profit margins will improve by 50 - 100 basis points, based primarily on higher volumes, and improved business mix. In addition, we will continue to focus on reducing costs in SG&A and manufacturing related operations. We expect the result of our efforts in all of these areas will allow the Company to generate $80 - $90 million of free cash flow in 2016. We continue to be focused on integration of our recent acquisitions, including Al Salomi and Nubiola, which were acquired in 2015. Further, we are continuing efforts to divest our Europe-based Polymer Additives assets. These assets to be divested are classified as held-for-sale on our consolidated balance sheets. Results of Operations - Consolidated Comparison of the years ended December 31, 2015 and 2014 For the year ended December 31, 2015, income from continuing operations was $99.9 million, compared with loss from continuing operations of $8.6 million in 2014. For the year ended December 31, 2015, net income was $63.1 million, compared with net income of $86.2 million in 2014. For the year ended December 31, 2015, net income attributable to common shareholders was $64.1 million, or $0.74 per share, compared with net income attributable to common shareholders of $86.1 million, or $0.99 per share in 2014. Net Sales Net sales decreased by $36.3 million, or 3.3%, in the year ended December 31, 2015, compared with the prior year. Net sales excluding precious metals decreased $27.7 million, primarily driven by decreased sales in Performance Coatings and Performance Colors and Glass of $55.2 million and $28.0 million, respectively, partially mitigated by increased net sales in Pigments, Powders and Oxides of $55.5 million. The main driver of the decrease in net sales excluding precious metals was unfavorable foreign currency impacts, which totaled approximately $132.4 million, and unfavorable pricing impacts of $16.6 million, partially mitigated by $56.9 million of sales from Nubiola, which was acquired in the third quarter of 2015, and $56.0 million of sales from Vetriceramici, which was acquired in the fourth quarter of 2014. The decline in precious metal sales in 2015 was attributable to the expiration of tolling arrangements resulting from the sale of our North American and Asian metal powders business and exit of our solar pastes business in 2014, which contributed $5.7 million of the decrease and was driven by lower sales in Performance Colors and Glass of $2.9 million, compared with 2014. Gross Profit Gross profit increased $16.6 million, or 5.8%, in 2015 to $301.7 million, compared with $285.1 million in 2014 and as a percentage of net sales excluding precious metals, it increased 230 basis points to 29.1%. The significant driver of the increased gross profit was strong performance in our Pigments, Powders and Oxides segment which exceeded prior-year gross profit by $17.2 million, primarily driven by Nubiola, which was acquired in the third quarter of 2015. Gross profit was negatively impacted by a charge of $5.8 million related to a purchase price adjustment from the acquisition of Nubiola, which was acquired in the third quarter of 2015, for step up of inventory acquired and subsequently sold in the third quarter that will not recur. Geographic Revenues The following table presents our sales on the basis of where sales originated. The decline in net sales excluding precious metals of $27.7 million, compared with 2014, was driven by decreased sales in Europe, Asia Pacific and Latin America, partially mitigated by an increase in sales in the United States. The decline in sales in Europe was due to lower sales in Performance Colors and Glass and Performance Coatings of $20.4 million and $18.7 million, respectively, and was largely due to unfavorable foreign currency impacts. The decrease in Europe was partially mitigated by increased sales in Pigments, Powders and Oxides of $17.1 million, driven by sales from Nubiola, which was acquired in the third quarter of 2015. The decline in Asia Pacific was driven by lower sales of $22.6 million in Performance Coatings and the result of the sale of our North American and Asian metal powders business, which comprised $2.3 million of the decrease. The decrease was partially mitigated by an increase in sales in Pigments, Powders and Oxides primarily driven by sales from Nubiola of $6.9 million. The lower sales in Latin America was due to lower sales in Performance Coatings and Performance Colors and Glass of $8.9 million and $7.4 million, respectively, partially mitigated by higher sales in Pigments, Powders and Oxides of $13.2 million. The decline in sales in Latin America in Performance Coatings was primarily due to the unfavorable foreign currency impacts related to the change in currency exchange mechanisms in Venezuela during the first quarter of 2015 and the sale of our operating affiliate in Venezuela in the fourth quarter of 2015. The higher sales in the United States in 2015 compared to 2014, was driven by higher sales volumes within Pigments, Powders and Oxides and Performance Colors and Glass, partially offset by lower sales in Performance Coatings. The following table presents our sales on the basis of where sold products were shipped. Selling, General and Administrative Expense The following table presents selling, general and administrative expenses attributable to operating sites and regional costs outside the United States together as Performance Materials, and regional costs attributable to the United States and other Corporate costs together as Corporate. Performance Materials and Corporate SG&A expenses exclude the impact of the annual mark-to-market adjustment and curtailment and settlement effects on our pension and other postretirement benefit plans, as the volatility in this adjustment does not allow for a meaningful comparison of underlying SG&A costs between periods. The following table includes SG&A components with significant changes between 2015 and 2014: SG&A expenses were $69.9 million lower in 2015 compared with the prior year. As a percentage of net sales excluding precious metals, SG&A expenses decreased 600 basis points from 26.9% in 2014 to 20.9% in 2015. The most significant driver of the decrease in SG&A expenses in 2015 was the change in the mark-to-market loss and curtailment and settlement effects on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $80.3 million, and is included within the pension and other postretirement benefits line above. The expense in 2014 was primarily related to changes in actuarial assumptions used in calculating the value of the U.S. pension liability. In addition, during 2014, the Company adopted the use of new mortality tables within its calculation assumptions, which had a one-time impact of increasing the liability. The new mortality tables reflect underlying increases in life expectancy of participants, thus driving longer benefit payment periods. The impact of the change in mortality assumption on the U.S. pension liability was an increase of the liability of approximately $18 million. Excluding the impacts of the mark-to-market adjustments and curtailment and settlement effects, SG&A expenses increased 150 basis points from 18.6% in 2014 to 20.1% in 2015. Included in SG&A expenses were $8.1 million and $12.5 million of expenses attributable to Nubiola and Vetriceramici, which were acquired in the third quarter of 2015 and the fourth quarter of 2014, respectively. The increase in business development costs of $10.1 million was a result of higher costs associated with professional fees that were related to business development activities. These increases were offset by lower incentive compensation expense of $6.6 million, which is based on certain performance metrics, and lower bad debt expenses of $2.0 million. The decrease in SG&A is also a result of foreign currency impacts. Restructuring and Impairment Charges Restructuring and impairment charges increased in 2015 compared with 2014. The primary drivers were the increase in employee severance cost of $1.3 million in 2015 compared with 2014 and the early termination cost of a contract associated with restructuring a corporate function of $2.8 million during in 2015. The increase in restructuring and impairment charges was partially mitigated by a decrease of $2.5 million due to a lease termination charge that occurred in 2014. Interest Expense Interest expense in 2015 decreased $1.1 million compared with 2014, primarily due to the redemption of the 7.875% Senior Notes and refinancing of the 2013 Revolving Credit Facility during the third quarter of 2014. The decrease was partially offset by reduced interest capitalization related to the construction project at our Antwerp, Belgium facility in 2015 compared with 2014. Income Tax Expense In 2015, we recorded an income tax benefit of $45.1 million, or (82.3%) of income before income taxes, compared to an income tax benefit of $34.2 million, or 79.9% of loss before taxes in 2014. The 2015 effective tax rate was less than the statutory income tax rate of 35% primarily as a result of a $3.1 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized in the current year, $7.3 million benefit related to the expiration of fully valued tax credits and $63.3 million benefit for the release of valuation allowances deemed no longer necessary. The 2014 effective tax rate was greater than the statutory income tax rate of 35% primarily as a result of a $17.4 million benefit related to the release of valuation allowances for deferred tax assets that were utilized in the 2014, the release of valuation allowances deemed no longer necessary and the expiration of fully valued tax attributes, $15.2 million of benefit related to 2014 domestic foreign tax credit generated and utilized, and foreign tax rate differences from the statutory income tax rate of 35%. Comparison of the years ended December 31, 2014 and 2013 For the year ended December 31, 2014, loss from continuing operations was $8.6 million, compared with income from continuing operations of $63.9 million in 2013. For the year ended December 31, 2014, net income was $86.2 million, compared with net income of $72.4 million in 2013. For the year ended December 31, 2014, net income attributable to common shareholders was $86.1 million, or $0.99 earnings per share, compared with net income attributable to common shareholders of $71.9 million, or $0.83 earnings per share in 2013. Net Sales Net sales decreased by $77.0 million, or 6.5% in the year ended December 31, 2014, compared with the prior year. Net sales excluding precious metals decreased $26.2 million, driven by decreased sales in our Pigments, Powders and Oxides segment of $35.6 million, primarily due to the sale of our North American and Asian metal powders business and exit of solar pastes during 2013, and decreased sales in our Performance Coatings segment of $11.8 million. Partially mitigating these declines were increased sales in our Performance Colors and Glass segment of $21.2 million. Sales of precious metals were down compared with the prior year primarily due to the sale of our North American and Asian metal powders business and the exit of solar pastes which contributed $47.2 million of the decline. Gross Profit Gross profit increased $7.4 million, or 2.7% in 2014 to $285.1 million, compared with $277.7 million in 2013. The significant driver of the increased gross profit was strong performance in our Performance Colors and Glass segment which exceeded prior year gross profit by $22.1 million, primarily driven by higher sales volumes and favorable mix, favorable product pricing, and favorable manufacturing costs. This increase was partially offset by lower gross profit in our Pigments, Powders and Oxides and Performance Coatings segments. Geographic Revenues The following table presents our sales on the basis of where sales originated. The decline in net sales excluding precious metals of $26.2 million, compared with 2013, was driven by declines in all regions. The decline in sales was largely driven by the sale of our North American and Asian metal powders business and exit of solar pastes, which resulted in a decrease of $27.5 million, partially mitigated by higher sales in the United States for Performance Colors and Glass products of $11.2 million. In addition, lower sales in Latin America were due to decreased sales in our Performance Coatings and Pigments, Powders and Oxides segments of $5.5 million and $3.0 million, respectively, partially offset by higher sales in Performance Colors and Glass. The decline in sales in Europe in 2014 compared with 2013 was attributable to lower sales of Performance Coatings products of $1.9 million, partially mitigated by slightly higher sales of Pigments, Powders and Oxides products compared to the prior year. The following table presents our sales on the basis of where sold products were shipped. Selling, General and Administrative Expense The following table presents selling, general and administrative expenses attributable to operating sites and regional costs outside the United States together as Performance Materials, and regional costs attributable to the United States and other Corporate costs together as Corporate. Performance Materials and Corporate SG&A expenses exclude the impact of the annual mark-to-market adjustment and curtailment and settlement effects on our pension and other postretirement benefit plans, as the volatility in this adjustment does not allow for a meaningful comparison of underlying SG&A costs between periods. The following table includes SG&A components with significant changes between 2014 and 2013: SG&A expenses were $136.0 million higher in 2014 compared with the prior year. As a percentage of net sales excluding precious metals, SG&A expenses increased from 13.8% in the prior year to 26.9% in 2014. The most significant driver of the increase in SG&A expenses in 2014 was the mark-to-market loss and curtailment and settlement effects on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $88.5 million, and is included within the pension and other postretirement benefits line above. The adjustment was primarily related to changes in actuarial assumptions used in calculating the value of the U.S. pension liability. In 2014, the discount rate used to value the liability declined by 100 basis points, compared with the prior year, thereby increasing the value of the liability by approximately $50 million. In addition, during the fourth quarter of 2014, the Company adopted the use of new mortality tables within its calculation assumptions, which had a one-time impact of increasing the liability. The new mortality tables reflect underlying increases in life expectancy of participants, thus driving longer benefit payment periods. The impact of the change in mortality assumption on the U.S. pension liability was an increase of the liability of approximately $18 million. In 2013, the mark-to-market adjustments and curtailment and settlement effects resulted in an actuarial gain of $70.4 million. The 2013 gain was primarily driven by the change in discount rate used to value the liability, which increased by 95 basis points, compared with 2012, resulting in a reduction in the value of the liability. Excluding the impacts of the mark-to-market adjustments and curtailment and settlement effects, SG&A expenses decreased 170 basis points from 20.3% in the prior year to 18.6% in 2014. Various restructuring activities executed in 2013 that had a full year impact in 2014 drove the decrease in personnel expenses. The decreases were partially offset by higher stock-based compensation expense due to higher grants to retirement-eligible employees that require accelerated expense recognition, and the impact of improved stock price on our liability based awards. Restructuring and Impairment Charges Restructuring and impairment charges decreased significantly in 2014 compared with 2013. The primary drivers of the decline were the decrease in employee severance cost of $18.2 million in 2014 compared with 2013 and the various 2013 impairment charges of $10.8 million that did not recur in 2014. Many of our restructuring activities commenced during the first half of 2013, thereby driving the higher prior year expenses. We had fewer restructuring activities during 2014. Interest Expense Interest expense in 2014 decreased $3.9 million compared with 2013, primarily due to the amendment of our revolving credit facility and retirement of the 7.875% Senior Notes. Additionally, interest expense decreased due to additional interest capitalization related to the construction project at our Antwerp, Belgium facility. Income Tax Expense In 2014, we recorded an income tax benefit of $34.2 million, or 79.9% of loss before income taxes, compared with an income tax expense of $14.3 million, or 18.3% of income before taxes in 2013. The 2014 effective tax rate was greater than the statutory income tax rate of 35% primarily as a result of a $17.4 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized in 2014, the release of valuation allowances concluded to no longer be necessary and the expiration of fully valued tax attributes, $15.2 million of benefit related to 2014 domestic foreign tax credit generated and utilized, and foreign tax rate differences from the statutory income tax rate of 35%. The 2013 effective tax rate was less than the statutory income tax rate of 35% primarily as a result of a $21.1 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized and the expiration of fully valued tax credits, offset by a $6.8 million charge related to the expiration of the fully valued tax credits. Results of Operations - Segment Information Comparison of the years ended December 31, 2015 and 2014 Performance Coatings Net sales decreased in Performance Coatings compared with 2014 due to lower sales of frits and glazes, colors, porcelain enamels, digital inks and other tile product lines of $54.3 million, $17.9 million, $17.8 million, $12.8 million and $6.9 million, respectively. The sales decline was partially mitigated by an increase of $54.5 million in sales from Vetriceramici, which was acquired in the fourth quarter of 2014. A substantial portion of the decline in sales was attributed to unfavorable foreign currency impacts of $90.8 million and lower product pricing of $19.4 million, partially mitigated by favorable mix and higher sales volumes of $22.7 million and $32.3 million, respectively. Gross profit decreased from 2014, and was driven by lower product pricing impacts of $19.4 million and unfavorable foreign currency impacts of $18.7 million, partially mitigated by favorable volume and mix of 15.1 million, lower manufacturing costs of $11.1 million and favorable raw material impacts of $7.8 million. The net sales decrease of $55.2 million compared with 2014 reflected lower sales in all regions. The decline in Asia Pacific was driven by lower sales of frits and glaze products, digital inks, porcelain enamels, and colors of $12.4 million, $4.0 million, $3.3 million, and $2.9 million respectively. The decline in sales in Europe was attributable to lower sales of our porcelain enamel products, partially mitigated by higher sales of tile products, including Vetriceramici sales. The decline in sales in Latin America, compared to 2014 was due to lower sales in colors and porcelain enamel products, partially mitigated by higher sales of digital inks products. The decline in the United States was attributable to porcelain enamel products. Performance Colors and Glass Net sales excluding precious metals decreased $28.0 million in 2015 compared with 2014, with decreases of $18.0 million in decoration, $6.4 million in industrial products, $4.4 million in automotive, and $0.7 million in electronics, partially mitigated by an increase in sales of $1.5 million from Vetriceramici, which was acquired in the fourth quarter of 2014. Net sales excluding precious metals were impacted by unfavorable foreign currency impacts of $36.1 million and lower sales volume of $2.4 million, partially mitigated by favorable mix of $8.0 million and higher product pricing of $2.5 million. Gross profit decreased from 2014, due to unfavorable foreign currency impacts of $12.3 million, unfavorable sales volumes and mix of $6.8 million, and higher manufacturing costs of $1.0 million, partially mitigated by favorable raw material impacts of $10.9 million and higher product pricing impacts of $2.5 million. The decrease in net sales excluding precious metals of $28.0 million compared with 2014, was primarily driven by lower sales in decoration products and industrial products in Europe of $8.0 million and $7.5 million, respectively, and lower sales of decoration products in Latin America and Asia Pacific of $8.3 million and $3.0 million. The decrease was partially mitigated by higher sales in industrial products, electronics and decoration in the United States of $1.7 million, $1.5 million and $1.3 million, respectively. Pigments, Powders and Oxides Net sales excluding precious metals increased compared with 2014, primarily due to higher volume and mix of $60.6 million, of which $56.9 million is related to sales from the Nubiola acquisition in the third quarter of 2015. The increase in sales is also due to favorable product pricing impacts of $0.4 million, partially mitigated by unfavorable foreign currency impacts of $5.5 million. Gross profit increased from 2014 and was a result of favorable volume and mix of $13.1 million, lower manufacturing costs of $3.6 million, favorable raw material impacts of $1.3 million, and higher product pricing of $0.4 million, partially offset by unfavorable foreign currency impacts of $1.2 million. Gross profit was negatively impacted by a charge of $5.8 million related to a purchase price adjustment from the acquisition of Nubiola, which was acquired in the third quarter of 2015, for step up of inventory acquired and subsequently sold in the third quarter that will not recur. The increase in net sales excluding precious metals of $55.5 million compared with 2014 was due to higher sales across all regions. The increase in sales in the United States was driven by increases of $4.8 million in surface finishing products, $0.6 million in pigments, and $15.2 million by sales from Nubiola, which was acquired in the third quarter of 2015, partially mitigated by a decrease in sales of $0.5 million in liquid coatings. The increase in sales in Europe and Latin America was driven by sales from Nubiola of $21.2 million and $13.7 million, respectively, partially mitigated by a decrease in sales of $4.1 million and $0.5 million in pigments, respectively. The increase in sales in Asia Pacific was primarily driven by sales from Nubiola of $6.9 million, which were partially offset by the sale of our North American and Asian metal powders business, which contributed $2.3 million in the prior-year period. Comparison of the years ended December 31, 2014 and 2013 Performance Coatings Net sales decreased in Performance Coatings compared with 2013, primarily due to lower sales of our porcelain enamel products of $6.9 million, and our tile frits and glazes, and colors product lines of $6.1 million and $5.7 million, respectively. These declines were partially mitigated by increased sales of our digital inks product line of $6.4 million. Other tile product line sales declined $3.3 million. Net sales in 2014 included $3.8 million for the month of December related to our acquisition of Vetriceramici. Sales were impacted by higher sales volumes of $9.4 million, favorable mix of $15.2 million, lower product pricing of $19.0 million and unfavorable foreign currency impacts of $17.4 million. Our product pricing continues to be impacted by competitive pressures in our digital inks product line. Gross profit decreased from 2013, and was driven by favorable sales volumes and mix of $4.3 million, lower product pricing impacts of $19.0 million, favorable raw material impacts of $12.2 million, lower manufacturing costs of $1.3 million and unfavorable foreign currency impacts of $2.2 million Net sales in 2014 decreased $11.8 million compared with 2013 due to lower sales in all regions. The decline in sales in Europe was attributable to lower sales of our porcelain enamel products, partially mitigated by higher sales of tile products, including Vetriceramici sales during December. The decline in sales in 2014 in Latin America, compared to 2013, was due to lower sales of our tile color and porcelain enamel products, partially mitigated by higher sales of digital inks products. The decline in Asia Pacific was driven by lower sales of tile products, primarily frits and glaze products, which was partially mitigated by higher sales of digital inks products. The decline in the United States was all attributable to lower sales of porcelain enamel products. Performance Colors and Glass Net sales excluding precious metals increased $21.2 million in 2014 compared with 2013, with increases in all of our product lines. Net sales excluding precious metals were impacted by higher sales volumes of $21.8 million, unfavorable mix of $1.1 million, higher product pricing of $2.6 million and unfavorable foreign currency impacts of $2.1 million. Gross profit increased in 2014, compared with 2013, due to favorable sales volumes and mix of $17.8 million, higher product pricing impacts of $2.6 million, unfavorable raw material impacts of $6.7 million, lower manufacturing costs of $9.2 million, and unfavorable foreign currency impacts of $0.7 million. The increase in 2014 in net sales excluding precious metals of $21.2 million compared with 2013 reflected higher sales in all regions and in all product lines. Pigments, Powders and Oxides Net sales excluding precious metals decreased in 2014 compared with 2013, primarily due to the sale of our North American and Asian metal powders business and exit of solar pastes, which comprised approximately $27.5 million of the decrease. The remainder of the decrease in net sales excluding precious metals of $8.1 million was primarily due to lower sales of our surface polishing materials in 2014 compared with 2013. Gross profit declined in 2014 compared with 2013 and was primarily the result of exited and sold businesses, which contributed to $6.0 million of gross profit in the prior year that did not recur in the current year. The decrease in gross profit in 2014 was due to lower sales volumes and mix of $15.1 million, which was partially mitigated by favorable raw material impacts of $2.6 million and lower manufacturing costs of $5.0 million. The decrease in net sales excluding precious metals of $35.6 million in 2014, compared with 2013, was due to lower sales in the United States, Latin America and Asia Pacific, which were partially mitigated by higher sales in Europe. The decline in sales in the United States and Asia Pacific was primarily driven by the sale of our North American and Asian metal powders business which contributed $27.5 million in the prior year that did not recur. Also contributing to the decline in the U.S. was lower sales of our surface polishing materials. Partially mitigating the decline in Asia Pacific were higher sales of our pigments products. The decline in Latin America was driven by lower sales of our pigments products. Summary of Cash Flows for the years ended December 31, 2015, 2014, and 2013 Operating activities. Cash flows from operating activities decreased $9.3 million in 2015 compared to 2014. The change was driven by lower net income of $23.1 million. The decrease was partially mitigated by reduced payments associated with restructuring activities of $9.8 million and by a cash inflows of $12.2 million in 2015 related to working capital, compared to cash outflows of $12.3 million in 2014. Cash flows from operating activities increased $42.0 million in 2014 compared to 2013. The primary drivers of the change were an increase of $13.8 million in net income compared with 2013, as well as a reduction in payments associated with restructuring activities of $11.8 million. Further, net income was impacted by significant non-cash charges during the year for the mark-to-market adjustment of our pension and other postretirement benefits liabilities and the extinguishment of our 7.875% Senior Notes, as well as gains on divestitures of $124.0. The increases were partially mitigated by a cash outflow of $12.3 million in 2014 related to working capital, which was a decline from the cash inflow of $6.3 million in 2013. Investing activities. Cash flows from investing activities decreased approximately $319.8 million in 2015. The decrease was driven primarily by business acquisitions, net of cash acquired, of $202.2 million in 2015, compared to cash used for business acquisitions in 2014 of $115.6 million, partially offset by net proceeds from the sales of our North America-based Polymer Additives assets and Specialty Plastics business in 2014 of $149.5 million and $88.3 million, respectively. Capital expenditures decreased $10.7 million in 2015, compared with 2014. Cash flows from investing activities increased approximately $58.0 million in 2014, compared with 2013. The increase in 2014 was driven primarily by net proceeds from the sales, partially offset by cash outflows for the acquisition of Vetriceramici and to acquire certain commercial assets of a reseller of our porcelain enamel products in Turkey. Capital expenditures increased $19.5 million in 2014, compared with 2013. The higher capital expenditures were costs incurred for the ongoing project at our Antwerp, Belgium facility. Financing activities. Cash flows from financing activities increased $137.9 million in 2015, compared with 2014. The increase was primarily as a result of net borrowings on the revolving credit facility of $170.0 million in 2015 compared to a repayment of $9.2 million in 2014. Net borrowings in 2015 were primarily used to fund the acquisitions, the share repurchase program, and for other general business use. Further, we had a cash outflow of $41.0 million in 2014, related to repayment of debt outstanding under our accounts receivable securitization program that expired during the year. Cash flows from financing activities increased $18.6 million in 2014, compared with 2013. The increase was due to net borrowings on our term loan facility of $300.0 million, partially offset by the repayment of the 7.875% Senior Notes of $260.5 million. Further, we had a cash outflow of $44.4 million in 2014, a decrease of $45.1 million compared with 2013, related to repayment of debt outstanding under our accounts receivable securitization program that expired during the year, as well as our revolving credit facility that was amended during 2014. We have paid no dividends on our common stock since 2009. Capital Resources and Liquidity Major debt instruments that were outstanding during 2015 are described below. Credit Facility On July 31, 2014, the Company entered into a new credit facility (the “Credit Facility”) with a group of Lenders to refinance the majority of its then outstanding debt, as discussed below. The Credit Facility consists of a $200 million secured revolving line of credit with a term of five years and a $300 million secured term loan facility with a term of seven years. The Credit Facility replaces the prior $250 million revolving credit facility and provided funding to repurchase the 7.875% Senior Notes. Subject to certain conditions, the Company can request up to $200 million of additional commitments under the Credit Facility, though the lenders are not required to provide such additional commitments. In addition, up to $100 million of the revolving line of credit will be available to certain of the Company’s subsidiaries in the form of revolving loans denominated in Euros. Certain of the Company’s U.S. subsidiaries have guaranteed the Company’s obligations under the Credit Facility and such obligations are secured by (a) substantially all of the personal property of the Company and the U.S. subsidiary guarantors and (b) a pledge of 100% of the stock of most of the Company’s U.S. subsidiaries and 65% of most of the stock of the Company’s first tier foreign subsidiaries. Interest Rate - Term Loan: The interest rates applicable to the term loans will be, at the Company’s option, equal to either a base rate or a London Interbank Offered Rate (“LIBOR”) rate plus, in both cases, an applicable margin. · The base rate will be the highest of (i) the federal funds rate plus 0.50%, (ii) PNC’s prime rate or (iii) the daily LIBOR rate plus 1.00%. · The applicable margin for base rate loans is 2.25%. · The LIBOR rate will be set as quoted by Bloomberg and shall not be less than 0.75%. · The applicable margin for LIBOR rate loans is 3.25%. · For LIBOR rate loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2015, the Company had borrowed $296.3 million under the term loan facility at an annual rate of 4.0%. There were no additional borrowings available under the term loan facility. Interest Rate - Revolving Credit Line: The interest rates applicable to loans under the revolving credit line will be, at the Company’s option, equal to either a base rate or a LIBOR rate plus an applicable variable margin. The variable margin will be based on the ratio of (a) the Company’s total consolidated debt outstanding at such time to (b) the Company’s consolidated EBITDA computed for the period of four consecutive fiscal quarters most recently ended. · The base rate will be the highest of (i) the federal funds rate plus 0.50%, (ii) PNC’s prime rate or (iii) the daily LIBOR rate plus 1.00%. · The applicable margin for base rate loans will vary between 1.50% and 2.00%. · The LIBOR rate will be set as quoted by Bloomberg for U.S. Dollars. · The applicable margin for LIBOR Rate Loans will vary between 2.50% and 3.00%. · For LIBOR rate loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2015, the Company had borrowed $170.0 million under the revolving credit facilities at a weighted average interest rate of 3.1%. The borrowings on the revolving credit line were used to fund the acquisitions, the share repurchase program, and for other general business use. After reductions for outstanding letters of credit secured by these facilities, we had $25.6 million of additional borrowings available at December 31, 2015. The Credit Facility contains customary restrictive covenants including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. The Credit Facility also contains standard provisions relating to conditions of borrowing and customary events of default, including the non-payment of obligations by the Company and the bankruptcy of the Company. Under the secured revolving credit facility, we are subject to certain financial covenants. The covenants include requirements for a leverage ratio and an interest coverage ratio. If an event of default occurs, all amounts outstanding under the Credit Facility may be accelerated and become immediately due and payable. At December 31, 2015, we were in compliance with the covenants of the Credit Facility. Off Balance Sheet Arrangements Consignment and Customer Arrangements for Precious Metals. We use precious metals, primarily silver, in the production of some of our products. We obtain most precious metals from financial institutions under consignment agreements (generally referred to as our precious metals consignment program). The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign and the period of consignment. These fees were $0.8 million, $0.8 million and $3.0 million for 2015, 2014, and 2013 respectively. We had on hand precious metals owned by participants in our precious metals consignment program of $20.5 million at December 31, 2015 and $26.6 million at December 31, 2014, measured at fair value based on market prices for identical assets and net of credits. The consignment agreements under our precious metals program involve short-term commitments that typically mature within 30 to 90 days of each transaction and are typically renewed on an ongoing basis. As a result, the Company relies on the continued willingness of financial institutions to participate in these arrangements to maintain this source of liquidity. On occasion, we have been required to deliver cash collateral. While no deposits were outstanding at December 31, 2015, or December 31, 2014, we may be required to furnish cash collateral in the future based on the quantity and market value of the precious metals under consignment and the amount of collateral-free lines provided by the financial institutions. The amount of cash collateral required is subject to review by the financial institutions and can be changed at any time at their discretion, based in part on their assessment of our creditworthiness. Bank Guarantees and Standby Letters of Credit. At December 31, 2015, the Company and its subsidiaries had bank guarantees and standby letters of credit issued by financial institutions that totaled $8.1 million. These agreements primarily relate to Ferro’s insurance programs, foreign energy purchase contracts and foreign tax payments. Other Financing Arrangements We maintain other lines of credit to provide global flexibility for Ferro’s short-term liquidity requirements. These facilities are uncommitted lines for our international operations and totaled $8.0 million at December 31, 2015. We had $7.3 million of additional borrowings available under these lines at December 31, 2015. Liquidity Requirements Our primary sources of liquidity are available cash and cash equivalents, available lines of credit under the Credit Facility, and cash flows from operating activities. As of December 31, 2015, we had $58.4 million of cash and cash equivalents. Substantially all of our cash and cash equivalents were held by foreign subsidiaries. Cash generated in the U.S. is generally used to pay down amounts outstanding under our revolving credit facility and for general corporate purposes. If needed, we could repatriate the majority of cash held by foreign subsidiaries without the need to accrue and pay U.S. income taxes. We do not anticipate a liquidity need requiring such repatriation of these funds to the U.S. Our liquidity requirements primarily include debt service, purchase commitments, labor costs, working capital requirements, restructuring expenditures, capital investments, precious metals cash collateral requirements, and postretirement obligations. We expect to meet these requirements in the long term through cash provided by operating activities and availability under existing credit facilities or other financing arrangements. Cash flows from operating activities are primarily driven by earnings before noncash charges and changes in working capital needs. In 2015, cash flows from financing and operating activities were used to fund our investing activities. Additionally, we used the borrowings available under the Credit Facility to fund the acquisitions, the share repurchase program, and for other general business use. We had additional borrowing capacity $32.9 million at December 31, 2015, available under various credit facilities, primarily our revolving credit facility. Subsequent to December 31, 2015, the Company increased the commitment under the Credit Facility by $100 million and used a portion of the increase to repay $50 million of the term loan. Refer to Note 23 for additional details. Our credit facilities contain a number of restrictive covenants, including those described in more detail in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. These covenants include customary operating restrictions, including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. We are also subject to customary financial covenants under our credit facilities, including a leverage ratio and an interest coverage ratio. These covenants under our credit facilities restrict the amount of our borrowings, reducing our flexibility to fund ongoing operations and strategic initiatives. These facilities are described in more detail in “Capital Resources and Liquidity” under Item 7 and in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. The most critical of these ratios is the leverage ratio for the revolving credit facility. As of December 31, 2015, we were in compliance with our maximum leverage ratio covenant of 3.75x as our actual ratio was 3.07x, providing $28.2 million of EBITDA cushion on the leverage ratio, as defined within our Credit Facility. To the extent that economic conditions in key markets deteriorate or we are unable to meet our business projections and EBITDA falls below approximately $130 million for rolling four quarters, based on reasonably consistent debt levels with those as of December 31, 2015, we could become unable to maintain compliance with our leverage ratio covenant. In such case, our lenders could demand immediate payment of outstanding amounts and we would need to seek alternate financing sources to pay off such debts and to fund our ongoing operations. Such financing may not be available on favorable terms, if at all. Difficulties experienced in global capital markets could affect the ability or willingness of counterparties to perform under our various lines of credit, forward contracts, and precious metals program. These counterparties are major, reputable, multinational institutions, all having investment-grade credit ratings, except for one, which is not rated. Accordingly, we do not anticipate counterparty default. However, an interruption in access to external financing could adversely affect our business prospects and financial condition. We assess on an ongoing basis our portfolio of businesses, as well as our financial and capital structure, to ensure that we have sufficient capital and liquidity to meet our strategic objectives. As part of this process, from time to time we evaluate the possible divestiture of businesses that are not critical to our core strategic objectives and, where appropriate, pursue the sale of such businesses and assets such as sales we completed in 2014 and 2013. We also evaluate and pursue acquisition opportunities that we believe will enhance our strategic position such as the acquisitions we completed in 2015 and 2014. Generally, we publicly announce material divestiture and acquisition transactions only when we have entered into definitive agreements relating to those transactions. The Company’s aggregate amount of contractual obligations for the next five years and thereafter is set forth below: _____________________ (1) Loans Payable includes our loans payable to banks. (2) Long-term debt excludes imputed interest and executory costs on capitalized lease obligations and unamortized issuance costs on the term loan facility. (3) Interest represents only contractual payments for fixed-rate debt. (4) Purchase commitments are noncancelable contractual obligations for raw materials and energy. (5) We have not projected payments past 2016 due to uncertainties in estimating the amount and period of any payments. The amount above relates to our current income tax liability as of December 31, 2015. We have $32.3 million in gross liabilities related to unrecognized tax benefits, including $1.6 million of accrued interest and penalties that are not included in the above table since we cannot reasonably predict the timing of cash settlements with various taxing authorities. (6) The funding amounts are based on the minimum contributions required under our various plans and applicable regulations in each respective country. We have not projected contributions past 2017 due to uncertainties regarding the assumptions involved in estimating future required contributions. Critical Accounting Policies When we prepare our consolidated financial statements we are required to make estimates and assumptions that affect the amounts we report in the consolidated financial statements and footnotes. We consider the policies discussed below to be more critical than other policies because their application requires our most subjective or complex judgments. These estimates and judgments arise because of the inherent uncertainty in predicting future events. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors. Revenue Recognition We recognize sales typically when we ship goods to our customers and when all of the following criteria are met: · Persuasive evidence of an arrangement exists; · The selling price is fixed or determinable; · Collection is reasonably assured; and · Title and risk of loss has passed to our customers. In order to ensure the revenue recognition in the proper period, we review material sales contracts for proper cut-off based upon the business practices and legal requirements of each country. For sales of products containing precious metals, we report revenues gross along with their corresponding cost of sales to arrive at gross profit. We record revenues this way because we act as the principal in the transactions into which we enter. Restructuring and Cost Reduction Programs In recent years, we have developed and initiated several restructuring programs across a number of our business segments with the objectives of leveraging our global scale, realigning and lowering our cost structure, and optimizing capacity utilization. The programs are primarily associated with North America, Europe and Asia Pacific. Management continues to evaluate our businesses, and therefore, there may be additional provisions for new initiatives, as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Restructuring charges include both termination benefits and asset writedowns. We estimate accruals for termination benefits based on various factors including length of service, contract provisions, local legal requirements, projected final service dates, and salary levels. We also analyze the carrying value of long-lived assets and record estimated accelerated depreciation through the anticipated end of the useful life of the assets affected by the restructuring or record an asset impairment. In all likelihood, this accelerated depreciation will result in reducing the net book value of those assets to zero at the date operations cease. While we believe that changes to our estimates are unlikely, the accuracy of our estimates depends on the successful completion of numerous actions. Changes in our estimates could increase our restructuring costs to such an extent that it could have a material impact on the Company’s results of operations, financial position, or cash flows. Other events, such as negotiations with unions and works councils, may also delay the resulting cost savings. Accounts Receivable and the Allowance for Doubtful Accounts Ferro sells its products to customers in diversified industries throughout the world. No customer or related group of customers represents greater than 10% of net sales or accounts receivable. We perform ongoing credit evaluations of our customers and require collateral principally for export sales, when industry practices allow and as market conditions dictate, subject to our ability to negotiate secured terms relative to competitive offers. We regularly analyze significant customer accounts and provide for uncollectible accounts based on historical experience, customer payment history, the length of time the receivables are past due, the financial health of the customer, economic conditions, and specific circumstances, as appropriate. Changes in these factors could result in additional allowances. Customer accounts we conclude to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. Historically, write-offs of uncollectible accounts have been within our expectations. Goodwill We review goodwill for impairment each year using a measurement date of October 31st or more frequently in the event of an impairment indicator. We annually, or more frequently as warranted, evaluate the appropriateness of our reporting units utilizing operating segments as the starting point of our analysis. In the event of a change in our reporting units, we would allocate goodwill based on the relative fair value. We estimate the fair values of the reporting units associated with these assets using the average of both the income approach and the market approach, which we believe provides a reasonable estimate of the reporting units’ fair values, unless facts and circumstances exist that indicate more representative fair values. The income approach uses projected cash flows attributable to the reporting units over their useful lives and allocates certain corporate expenses to the reporting units. We use historical results, trends and our projections of market growth, internal sales efforts and anticipated cost structure assumptions to estimate future cash flows. Using a risk-adjusted, weighted-average cost of capital, we discount the cash flow projections to the measurement date. The market approach estimates a price reasonably expected to be paid by a market participant in the purchase of similar businesses. If the fair value of any reporting unit was determined to be less than its carrying value, we would proceed to the second step and obtain comparable market values or independent appraisals of its assets and liabilities to determine the amount of any impairment. The significant assumptions and ranges of assumptions we used in our impairment analyses of goodwill at October 31, 2015 and 2014, were as follows: Our estimates of fair value can be adversely affected by a variety of factors. Reductions in actual or projected growth or profitability at our reporting units due to unfavorable market conditions or significant increases in cost structure could lead to the impairment of any related goodwill. Additionally, an increase in inflation, interest rates or the risk-adjusted, weighted-average cost of capital could also lead to a reduction in the fair value of one or more of our reporting units and therefore lead to the impairment of goodwill. Based on our 2015 annual impairment test performed as of October 31, 2015, the fair values of the remaining reporting units tested for impairment exceeded the carrying values of the respective reporting units by amounts ranging from 11% to 381% at the 2015 measurement date. The lowest cushion relates to goodwill associated with the Performance Coatings operating segment, which had a goodwill balance of $43.5 million at December 31, 2015. A future potential impairment is possible for any of these reporting units if actual results are materially less than forecasted results. Some of the factors that could negatively affect our cash flows and, as a result, not support the carrying values of our reporting units are: new environmental regulations or legal restrictions on the use of our products that would either reduce our product revenues or add substantial costs to the manufacturing process, thereby reducing operating margins; new technologies that could make our products less competitive or require substantial capital investment in new equipment or manufacturing processes; and substantial downturns in economic conditions. Long-Lived Asset Impairment The Company’s long-lived assets include property, plant and equipment, and intangible assets. We review property, plant and equipment and intangible assets for impairment whenever events or circumstances indicate that their carrying values may not be recoverable. The following are examples of such events or changes in circumstances: · An adverse change in the business climate or market price of a long-lived asset or asset group; · An adverse change in the extent or manner in which a long-lived asset or asset group is used or in its physical condition; · Current operating losses for a long-lived asset or asset group combined with a history of such losses or projected or forecasted losses that demonstrate that the losses will continue; or · A current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise significantly disposed of before the end of its previously estimated useful life. The carrying amount of property, plant and equipment and intangible assets is not recoverable if the carrying value of the asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group. In the event of impairment, we recognize a loss for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of review. Income Taxes The breadth of our operations and complexity of income tax regulations require us to assess uncertainties and make judgments in estimating the ultimate amount of income taxes we will pay. Our income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. The final income taxes we pay are based upon many factors, including existing income tax laws and regulations, negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation, and resolution of disputes arising from federal, state and international income tax audits. The resolution of these uncertainties may result in adjustments to our income tax assets and liabilities in the future. Deferred income taxes result from differences between the financial and tax basis of our assets and liabilities. We adjust our deferred income tax assets and liabilities for changes in income tax rates and income tax laws when changes are enacted. We record valuation allowances to reduce deferred income tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and the magnitude of appropriate valuation allowances against deferred income tax assets. The realization of these assets is dependent on generating future taxable income, our ability to carry back or carry forward net operating losses and credits to offset tax liabilities, as well as successful implementation of various tax strategies to generate tax where net operating losses or credit carryforwards exist. In evaluating our ability to realize the deferred income tax assets, we rely principally on the reversal of existing temporary differences, the availability of tax planning strategies, and forecasted income. We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Our estimate of the potential outcome of any uncertain tax positions is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. We record a liability for the difference between the benefit recognized and measured based on a more-likely-than-not threshold and the tax position taken or expected to be taken on the tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. We report tax-related interest and penalties as a component of income tax expense. Derivative Financial Instruments We use derivative financial instruments in the normal course of business to manage our exposure to fluctuations in interest rates, foreign currency exchange rates, commodity prices, and precious metal prices. The accounting for derivative financial instruments can be complex and can require significant judgment. Generally, the derivative financial instruments that we use are not complex, and observable market-based inputs are available to measure their fair value. We do not engage in speculative transactions for trading purposes. Financial instruments, including derivative financial instruments, expose us to counterparty credit risk for nonperformance. We manage our exposure to counterparty credit risk through minimum credit standards and procedures to monitor concentrations of credit risk. We enter into these derivative financial instruments with major, reputable, multinational financial institutions. Accordingly, we do not anticipate counter-party default. We continuously evaluate the effectiveness of derivative financial instruments designated as hedges to ensure that they are highly effective. In the event the hedge becomes ineffective, we discontinue hedge treatment. Except as noted below, we do not expect any changes in our risk policies or in the nature of the transactions we enter into to mitigate those risks. We manage foreign currency risks in a wide variety of foreign currencies principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions arising from international trade. Our objective in entering into these forward contracts is to preserve the economic value of nonfunctional currency cash flows. Our principal foreign currency exposures relate to the Euro, the British Pound Sterling, the Japanese Yen, and the Chinese Yuan. We mark these forward contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as other income or expense from foreign currency transactions. Precious metals (primarily silver, gold, platinum and palladium) represent a significant portion of raw material costs in our electronics products. When we enter into a fixed price sales contract at the customer’s request to establish the price for the precious metals content of the order, we also enter into a forward purchase arrangement with a precious metals supplier to completely cover the value of the precious metals content. Our current precious metal contracts are designated as normal purchase contracts, which are not marked to market. We also purchase portions of our energy requirements, including natural gas and electricity, under fixed price contracts to reduce the volatility of cost changes. Our current energy contracts are designated as normal purchase contracts, which are not marked to market. Pension and Other Postretirement Benefits We sponsor defined benefit plans in the U.S. and many countries outside the U.S., and we also sponsor retiree medical benefits for a segment of our salaried and hourly work force within the U.S. The U.S. pension plans and retiree medical plans represent approximately 81% of pension plan assets, 70% of benefit obligations and 30% of net periodic pension income. The assumptions we use in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. We meet with our actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. We determine the discount rate for the U.S. pension and retiree medical plans based on a bond model. Using the pension plans’ projected cash flows, the bond model considers all possible bond portfolios that produce matching cash flows and selects the portfolio with the highest possible yield. These portfolios are based on bonds with a quality rating of AA or better under either Moody’s Investor Services, Inc. or Standard & Poor’s Rating Group, but exclude certain bonds, such as callable bonds, bonds with small amounts outstanding, and bonds with unusually high or low yields. The discount rates for the non-U.S. plans are based on a yield curve method, using AA-rated bonds applicable in their respective capital markets. The duration of each plan’s liabilities is used to select the rate from the yield curve corresponding to the same duration. For the market-related value of plan assets, we use fair value, rather than a calculated value. The market-related value recognizes changes in fair value in a systematic and rational manner over several years. We calculate the expected return on assets at the beginning of the year for defined benefit plans as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. In determining the expected returns, we consider both historical performance and an estimate of future long-term rates of return. The Company consults with and considers the opinion of its actuaries in developing appropriate return assumptions. Our target asset allocation percentages are 35% fixed income, 60% equity, and 5% other investments for U.S. plans and 75% fixed income, 24% equity, and 1% other investments for non-U.S. plans. In 2015, actual return on plan assets, were lower than the expected return. In 2014, investment returns on average plan assets were approximately 7% within U.S. plans and 20% within non-U.S. plans. Future actual pension expense will depend on future investment allocation and performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans. All other assumptions are reviewed periodically by our actuaries and us and may be adjusted based on current trends and expectations as well as past experience in the plans. During the fourth quarter of 2014, the Company adopted the use of new mortality tables within its calculation assumptions, which had a one-time impact of increasing the liability. The new mortality tables reflect underlying increases in life expectancy of participants, thus driving longer benefit payment periods. The impact of the change in mortality assumption on the U.S. pension liability was an increase of the liability of approximately $18 million. The following table provides the sensitivity of net annual periodic benefit costs for our pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25-basis-point decrease in both the discount rate and asset return assumption: The following table provides the rates used in the assumptions and the changes between 2015 and 2014: Our overall net periodic benefit cost for all defined benefit plans was $1.5 million in 2015 and $84.4 million in 2014. The change in 2014 is mainly the result of mark to market actuarial net losses in 2014. For 2016, assuming expected returns on plan assets and no actuarial gains or losses, we expect our overall net periodic benefit cost to be approximately $0.1 million, compared with income of approximately $7.6 million in 2015 on a comparable basis. Inventories We value inventory at the lower of cost or market, with cost determined utilizing the first-in, first-out (FIFO) method. We periodically evaluate the net realizable value of inventories based primarily upon their age, but also upon assumptions of future usage in production, customer demand and market conditions. Inventories have been reduced to the lower of cost or realizable value by allowances for slow moving or obsolete goods. If actual circumstances are less favorable than those projected by management in its evaluation of the net realizable value of inventories, additional write-downs may be required. Slow moving, excess or obsolete materials are specifically identified and may be physically separated from other materials, and we rework or dispose of these materials as time and manpower permit. Environmental Liabilities Our manufacturing facilities are subject to a broad array of environmental laws and regulations in the countries in which they are located. The costs to comply with complex environmental laws and regulations are significant and will continue for the foreseeable future. We expense these recurring costs as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations. We also accrue for environmental remediation costs when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events. Inherent uncertainties exist in such evaluations primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress or as additional technical or legal information becomes available. Impact of Newly Issued Accounting Pronouncements Refer to Note 2 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K for a discussion of accounting standards we recently adopted or will be required to adopt.

<s>[INST] During the year ended December 31, 2015, net sales were down $36.3 million, or 3.3%, compared with 2014. The decrease was primarily due to unfavorable foreign currency impacts, which totaled approximately $132.4 million, partially offset by the sales from Nubiola of $56.9 million, which was acquired in the third quarter of 2015, and by the sales from Vetriceramici of $56.0 million, which was acquired in the fourth quarter of 2014. Despite the decline in net sales, gross profit increased $16.6 million compared with 2014. As a percentage of net sales excluding precious metals, gross profit rate increased approximately 230 basis points to 29.1%, from 26.8% in the prior year. For the year ended December 31, 2015, selling, general and administrative (“SG&A”) expenses decreased $69.9 million, or 24.4%, compared with 2014, primarily driven by the pension and other postretirement benefits marktomarket adjustment and curtailment and settlement effects. In 2015, the adjustment resulted in a loss of $8.2 million in SG&A, while in 2014, the adjustment resulted in a loss of $88.5 million. For the year ended December 31, 2015, net income was $63.1 million, compared with net income of $86.2 million in 2014, and net income attributable to common shareholders was $64.1 million, compared with net income attributable to common shareholders of $86.1 million in 2014. Income from continuing operations was $99.9 million for the year ended December 31, 2015, compared with loss from continuing operations of $8.6 million in 2014. Gross profit in 2015 was $301.7 million, compared with $285.1 million in 2014. Outlook During 2015, despite challenging currency and global economic conditions, the Company delivered strong performance and continued to advance on our value creation strategy. During the past 18 months, we have invested in acquisitions that complement our existing businesses, provide attractive margins, and improve our capabilities in important growth markets. We are well positioned strategically to leverage our infrastructure and market leading positions to achieve or exceed our performance targets and generate stronger returns for our shareholders. We expect foreign currency to continue to have a negative impact on our results. The earnings improvement will be driven by contributions from acquisitions, organic sales growth and continued focus on reducing our direct and indirect purchasing costs. In addition, we intend to continue making acquisitions. We have a robust pipeline of acquisition targets and the financial flexibility to pursue them. Our acquisition growth objective is to invest $100 million annually to add assets that strengthen our product and technology portfolios, improve our market position, expand our global reach, and drive shareholder value. For 2016, we expect sales growth of 10 11%, including the addition of our acquisitions and excluding the adverse impact of the changes in foreign currency. We expect gross profit margins will improve by 50 100 basis points, based primarily on higher volumes, and improved business mix. In addition, we will continue to focus on reducing costs in SG&A and manufacturing related operations. We expect the result of our efforts in all of these areas will allow the Company to generate $80 $90 million of free cash flow in 2016. We continue to be focused on integration of our recent acquisitions, including Al Salomi and Nubiola, which were acquired in 2015. Further, we are continuing efforts to divest our Europebased Polymer Additives assets. These assets to be divested are classified as heldforsale on our consolidated balance sheets. Results of Operations Consolidated Comparison of the years ended December 31, 2015 and 2014 For the year ended December 31, 2015, income from continuing operations was $99.9 million [/INST] Negative. </s>

FERRO CORP

2017-03-01

2016-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview During the year ended December 31, 2016, net sales increased $70.0 million, or 6.5%, compared with 2015. The increase was driven by an increase in sales in Pigments, Powders and Oxides of $81.6 million, partially offset by a decrease in sales in Performance Coatings of $6.4 million and Performance Colors and Glass of $5.3 million. Gross profit increased $49.5 million compared with 2015. As a percentage of net sales, gross profit rate increased approximately 260 basis points to 30.7%, from 28.1% in the prior year. For the year ended December 31, 2016, selling, general and administrative (“SG&A”) expenses increased $24.8 million, or 11.4%, compared with 2015, primarily driven by the increase in expense in pension and other postretirement benefits of $14.9 million. For the year ended December 31, 2016, net loss was $19.9 million, compared with net income of $63.1 million in 2015, and net loss attributable to common shareholders was $20.8 million, compared with net income attributable to common shareholders of $64.1 million in 2015. Income from continuing operations was $44.6 million for the year ended December 31, 2016, compared with income from continuing operations of $99.9 million in 2015.  2016 Transactional Activity Business Acquisitions Acquisition of Cappelle: As discussed in Note 4, in the fourth quarter of 2016, the Company acquired 100% of the share capital of Belgium-based Cappelle Pigments NV (“Cappelle”), a leader in specialty, high-performance inorganic and organic pigments used in coatings, inks and plastics, for €40.0 million (approximately $42.4 million). Acquisition of ESL: As discussed in Note 4, in the fourth quarter of 2016, the Company acquired 100% of the membership interest of Electro-Science Laboratories, Inc. (“ESL”), a leader in electronic packaging materials for $78.0 million. Acquisition of Delta Performance Products: As discussed in Note 4, in the third quarter of 2016, the Company acquired certain assets of Delta Performance Products, LLC, for a cash purchase price of $4.4 million. Acquisition of Pinturas: As discussed in Note 4, in the second quarter of 2016, the Company acquired 100% of the equity of privately held Pinturas Benicarló, S.L. (“Pinturas”) for €16.5 million in cash (approximately $18.4 million). Acquisition of Ferer: As discussed in Note 4, in the first quarter of 2016, the Company completed the purchase of 100% of the equity of privately held Istanbul-based Ferer Dis Ticaret Ve Kimyasallar Anonim Sirketi A.S. (“Ferer”) for approximately $9.4 million in cash. Disposition of the Europe-based Polymer Additives business As discussed in Note 3, in the third quarter of 2016, the Company completed the disposition of the Europe-based Polymer Additives business to Plahoma Two AG, an affiliate of the LIVIA Group. Outlook The Company delivered strong performance throughout 2016. Sales increased 6.5% primarily due to acquisitions acquired within the last year. In addition, gross profit, as a percentage of net sales, increased to 30.7% from 28.1%. Partially offsetting the higher gross profit were increased SG&A costs, primarily driven by an increase in pension and postretirement benefits expense and incentive compensation expense. Our effective tax rate for 2016 was 28.6%. For 2017, we expect gross margin will continue to improve. We anticipate benefitting from strategic actions taken to improve growth in our core businesses and will continue to benefit from recent acquisitions. Raw material costs are expected to increase in 2017, however our expectation is to offset these cost increases through pricing actions, product reformulations and optimization actions. In addition, foreign currency exchange rates continue to be volatile, and we anticipate changes in rates will adversely impact reported results. We remain focused on the integration of our recent acquisitions and continue to work toward achieving the identified synergies. We will continue to focus on opportunities to optimize our cost structure and make our business processes and systems more efficient, and to leverage tax planning opportunities. We continue to expect cash flow from operating activities to be positive for 2017, providing additional liquidity.  Results of Operations - Consolidated Comparison of the years ended December 31, 2016 and 2015 For the year ended December 31, 2016, income from continuing operations was $44.6 million, compared with income from continuing operations of $99.9 million in 2015. For the year ended December 31, 2016, net loss was $19.9 million, compared with net income of $63.1 million in 2015. For the year ended December 31, 2016, net loss attributable to common shareholders was $20.8 million, or $0.25 loss per share, compared with net income attributable to common shareholders of $64.1 million, or $0.74 earnings per share in 2015. Net Sales    Net sales increased by $70.0 million, or 6.5%, in the year ended December 31, 2016, compared with the prior year. The net sales increase was driven by higher sales in Pigments, Powders and Oxides of $81.6 million, partially offset by a decrease in sales in Performance Colors and Glass of $5.3 million and Performance Coatings of $6.4 million. The increase in net sales was primarily driven by the sales from Nubiola of $66.3 million and sales from Al Salomi of $22.1 million, partially offset by a decrease in sales of frits and glazes from Latin America of $23.9 million. Gross Profit Gross profit increased $49.5 million, or 16.4%, in 2016 to $351.2 million, compared with $301.7 million in 2015 and, as a percentage of net sales, it increased 260 basis points to 30.7%. The significant driver of the increased gross profit was strong performance in our Pigments, Powders and Oxides segment which exceeded prior-year gross profit by $38.6 million, primarily driven by sales from Nubiola. The increase in gross profit was primarily due to an increase in sales volumes and mix of $48.6 million, decreases in raw material costs of $21.0 million and decreases in manufacturing costs of $11.1 million, partially offset by unfavorable product pricing of $15.0 million and unfavorable foreign currency impacts of $9.1 million. Geographic Revenues The following table presents our sales on the basis of where sales originated.   The increase in net sales of $70.0 million, compared with 2015, was driven by increased sales from Europe, Asia Pacific and the United States, partially mitigated by a decrease in sales from Latin America. The increase from Europe was primarily attributable to Nubiola sales of $24.6 million and an increase in Performance Coatings sales of $11.2 million and the increase from Asia Pacific was attributable to an increase in sales in all segments. The increase from the United States was attributable to an increase in sales in Pigments, Powders and Oxides of $29.4 million, partially offset by lower sales in Performance Colors and Glass of $11.5 million. The decrease in sales from Latin America was attributable to the sale of our interest in an operating affiliate in Venezuela in 2015 which contributed $8.4 million in net sales. The following table presents our sales on the basis of where sold products were shipped.    Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2016 and 2015.  SG&A expenses were $24.8 million higher in 2016 compared with the prior year. As a percentage of net sales, SG&A expenses increased 90 basis points from 20.2% in 2015 to 21.1% in 2016. The most significant driver of the increase in SG&A expenses in 2016 was the change in the mark-to-market loss and curtailment and settlement effects on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $8.1 million, and is included within the pension and other postretirement benefits line above. The expense in 2016 was higher than the prior year due to the loss from expected returns on plan assets exceeding actual returns and a decrease in the discount rate compared with the prior year. Excluding the impacts of the pension and other postretirement benefits expense, SG&A expenses decreased 30 basis points from 20.0% in 2015 to 19.7% in 2016. The increase in personnel expenses was attributable to the acquisitions acquired which contributed $5.5 million and the increase in incentive compensation was a result of the Company’s performance relative to targets for certain awards compared with the prior year. The following table presents SG&A expenses attributable to sales, research and development, and operations costs as strategic services and presents other SG&A costs as functional services.    SG&A expenses were $24.8 million higher in 2016, compared with 2015. The increase in SG&A expenses was driven by higher expenses in functional services due to the increase in pension and other postretirement benefit expense. The increase in strategic expenses was due to the increased expenses of $8.7 million associated with the acquisitions acquired within the last year and an increase in bad debt expense of $0.7 million in 2016, compared with 2015. Restructuring and Impairment Charges   Restructuring and impairment charges increased by $6.3 million in 2016, compared with 2015. The increase was driven by an impairment charge within our Tile Coating Systems reporting unit, a component of our Performance Coatings operating segment in 2016 of $13.2 million. This increase was partially mitigated by a decrease in employee severance cost of $2.7 million in 2016, compared with 2015 and the early termination cost of a contract associated with restructuring a corporate function of $2.8 million in 2015. Interest Expense  Interest expense in 2016 increased $6.4 million compared with 2015, primarily due to an increase in the average long-term debt balance for the 2016 period compared with 2015, as well as less interest capitalization associated with long-term capital projects, which was driven by the substantial completion of the Antwerp, Belgium facility in the fourth quarter of 2015. Income Tax Expense In 2016, we recorded an income tax expense of $17.9 million, or 28.6% of income before income taxes, compared to an income tax benefit of $45.1 million, or (82.3%) of income before income taxes in 2015. The 2016 effective tax rate is less than the statutory income tax rate of 35%, primarily as a result of a $5.5 million benefit related to greater levels of income earned in lower tax jurisdictions, $4.8 million net benefit for the release of valuation allowances related to deferred tax assets that were utilized in the current year, $2.0 million in net benefit for the release of valuation allowances, which are deemed no longer necessary based upon changes in the current and expected future years operating profits, $1.8 million benefit related to notional interest deductions, $2.8 million benefit for the generation of tax credits offset by a $4.1 million expense related to the impairment of book basis goodwill and a $2.1 million expense related to non-deductible expenses. The 2015 effective tax rate was less than the statutory income tax rate of 35% primarily as a result of a $3.8 million benefit related to greater levels of income earned in lower tax jurisdictions, $3.1 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized in the current year and $63.3 million benefit for the release of valuation allowances in certain jurisdictions, which are deemed no longer necessary based upon a change from a cumulative three-year loss to income and our expectation of sufficient future taxable income to be able to realize the respective benefits, offset by $2.4 million expense related to new uncertain tax positions and $1.7 million expense related to non-deductible expenses. Comparison of the years ended December 31, 2015 and 2014 For the year ended December 31, 2015, income from continuing operations was $99.9 million, compared with a loss from continuing operations of $8.6 million in 2014. For the year ended December 31, 2015, net income was $63.1 million, compared with net income of $86.2 million in 2014. For the year ended December 31, 2015, net income attributable to common shareholders was $64.1 million, or $0.74 earnings per share, compared with net income attributable to common shareholders of $86.1 million, or $0.99 earnings per share in 2014. Net Sales  Net sales decreased by $36.3 million, or 3.3% in the year ended December 31, 2015, compared with the prior year. Net sales decreased $36.3 million, primarily driven by a decrease in sales in Performance Coatings and Performance Colors and Glass of $55.2 million and $30.9 million, respectively, partially mitigated by an increase in net sales in Pigments, Powders and Oxides of $49.8 million. The main driver of the decrease in net sales was unfavorable foreign currency impacts, which totaled approximately $132.4 million, and unfavorable pricing impacts of $16.6 million, partially mitigated by $56.9 million of sales from Nubiola, which was acquired in the third quarter of 2015, and $56.0 million of sales from Vetriceramici, which was acquired in the fourth quarter of 2014. Gross Profit Gross profit increased $16.6 million, or 5.8% in 2015 to $301.7 million, compared with $285.1 million in 2014 and as a percentage of net sales, it increased 250 basis points to 28.1%. The significant driver of the increased gross profit was strong performance in our Pigments, Powders and Oxides segment which exceeded prior-year gross profit by $17.2 million, primarily driven by Nubiola, which was acquired in the third quarter of 2015. Gross profit was negatively impacted by a charge of $5.8 million related to a purchase price adjustment from the acquisition of Nubiola, for step up of inventory acquired and subsequently sold in the third quarter that will not recur. Geographic Revenues The following table presents our sales on the basis of where sales originated.  The decline in net sales of $36.3 million, compared with 2014, was driven by decreased sales from Europe, Asia Pacific and Latin America, partially mitigated by an increase in sales from the United States. The decline in sales from Europe was due to lower sales in Performance Colors and Glass and Performance Coatings of $23.0 million and $18.7 million, respectively, and was largely due to unfavorable foreign currency impacts. The decrease from Europe was partially mitigated by increased sales in Pigments, Powders and Oxides of $17.1 million, driven by sales from Nubiola, which was acquired in the third quarter of 2015. The decline from Asia Pacific was driven by lower sales of $22.6 million in Performance Coatings, lower sales of $4.5 million in Performance Colors and Glass and the result of the sale of our North American and Asian metal powders business, which comprised $7.5 million of the decrease. The lower sales from Latin America was due to lower sales in Performance Coatings and Performance Colors and Glass of $8.9 million and $7.4 million, respectively, partially mitigated by higher sales in Pigments, Powders and Oxides of $13.2 million. The decline in sales from Latin America in Performance Coatings was primarily due to the unfavorable foreign currency impacts related to the change in currency exchange mechanisms in Venezuela during the first quarter of 2015 and the sale of our operating affiliate in Venezuela in the fourth quarter of 2015. The higher sales from the United States in 2015 compared to 2014, was driven by higher sales volumes within Pigments, Powders and Oxides and Performance Colors and Glass, partially offset by lower sales in Performance Coatings. The following table presents our sales on the basis of where sold products were shipped.       Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2015 and 2014.    SG&A expenses were $69.9 million lower in 2015 compared with the prior year. As a percentage of net sales, SG&A expenses decreased 560 basis points from 25.8% in the prior year to 20.2% in 2015. The most significant driver of the decrease in SG&A expenses in 2015 was the change in the mark-to-market loss and curtailment and settlement effects on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $80.3 million, and is included within the pension and other postretirement benefits line above. The expense in 2014 was primarily related to changes in actuarial assumptions used in calculating the value of the U.S. pension liability. In addition, during 2014, the Company adopted the use of new mortality tables within its calculation assumptions, which had a one-time impact of increasing the liability. The new mortality tables reflect underlying increases in life expectancy of participants, thus driving longer benefit payment periods. The impact of the change in mortality assumption on the U.S. pension liability was an increase of the liability of approximately $18 million. Excluding the impacts of the pension and other postretirement benefits expense, SG&A expenses increased 190 basis points from 18.1% in 2014 to 20.0% in 2015. Included in SG&A expenses were $8.1 million and $12.5 million of expenses attributable to Nubiola and Vetriceramici, which were acquired in the third quarter of 2015 and the fourth quarter of 2014, respectively. The increase in business development costs of $10.1 million was a result of higher costs associated with professional fees that were related to business development activities. These increases were offset by lower incentive compensation expense of $6.6 million, which is based on certain performance metrics, and lower bad debt expenses of $2.0 million. The decrease in SG&A is also a result of foreign currency impacts.  The following table presents SG&A expenses attributable to sales, research and development and operations costs as strategic services and other SG&A expenses as functional services.   SG&A expenses were $69.1 million lower in 2015, compared with 2014. The decrease in SG&A expenses was driven by lower expenses in functional services from the change in the mark-to-market loss and curtailment and settlement effects on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $80.3 million, partially offset by an increase in business development expenses of $10.1 million. Lower SG&A expenses were also driven by lower incentive and stock-based compensation expense, partially offset by higher expenses in strategic services driven by the Vetriceramici and Nubiola acquisitions. Restructuring and Impairment Charges    Restructuring and impairment charges increased in 2015 compared with 2014. The primary drivers were the increase in employee severance cost of $1.3 million in 2015 compared with 2014 and the early termination cost of a contract associated with restructuring a corporate function of $2.8 million during in 2015. The increase in restructuring and impairment charges was partially mitigated by a decrease of $2.5 million due to a lease termination charge that occurred in 2014. Interest Expense   Interest expense in 2015 decreased $1.1 million compared with 2014, primarily due to the redemption of the 7.875% Senior Notes and refinancing of the 2013 Revolving Credit Facility during the third quarter of 2014. The decrease was partially offset by less interest capitalization associated with long-term capital projects, which was driven by the substantial completion of the Antwerp, Belgium facility in the fourth quarter of 2015. Income Tax Expense In 2015, we recorded an income tax benefit of $45.1 million, or (82.3%) of income before income taxes, compared to an income tax benefit of $34.2 million, or 79.9% of loss before taxes in 2014. The 2015 effective tax rate was less than the statutory income tax rate of 35% primarily as a result of $3.8 million benefit related to greater levels of income earned in lower tax jurisdictions, a $3.1 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized in the current year and $63.3 million benefit for the release of valuation allowances in certain jurisdictions, which are deemed no longer necessary based upon a change from a cumulative three-year loss to income and our expectation of sufficient future taxable income to be able to realize the respective benefits, offset by $2.4 million expense related to new uncertain tax positions and $1.7 million expense related to non-deductible expenses. The 2014 effective tax rate was greater than the statutory income tax rate of 35% primarily as a result of a $17.4 million benefit related to the release of valuation allowances for deferred tax assets that were utilized in the 2014, the release of valuation allowances deemed no longer necessary and the expiration of fully valued tax attributes, $15.2 million of benefit related to 2014 domestic foreign tax credit generated and utilized, and foreign tax rate differences from the statutory income tax rate of 35%. Results of Operations - Segment Information Comparison of the years ended December 31, 2016 and 2015 Performance Coatings      Net sales declined in Performance Coatings compared with 2015, primarily driven by a decrease in sales of $20.9 million in frits and glazes, and $8.4 million due to the sale of our Venezuela business, partially mitigated by $22.1 million in sales from Al Salomi. The decrease in net sales was impacted by unfavorable foreign currency impacts of $34.4 million and lower product pricing of $15.9 million, partially offset by increased sales volume and mix of $44.0 million. Gross profit increased $12.5 million from 2015, primarily driven by lower manufacturing costs of $4.6 million, higher sales volumes and mix of $23.2 million, and lower raw material costs of $7.9 million, partially offset by unfavorable product pricing impacts of $15.9 million and unfavorable foreign currency impacts of $7.3 million.    The net sales decrease of $6.4 million was driven by declines in sales from Latin America, partially mitigated by an increase in sales from Europe, Asia Pacific and the United States. The sales decline from Latin America included a decrease in sales in frits and glazes of $23.9 million and a decrease in sales from Venezuela of $8.4 million, partially mitigated by increased sales in digital inks and opacifiers of $5.7 million and $5.3 million, respectively. The increase in sales from Europe was primary attributable to $22.1 million in sales from Al Salomi, partially offset by decreased sales in digital inks and Vetriceramici products of $5.7 million and $4.6 million, respectively. The increase from Asia Pacific was primarily due to increased sales in digital inks and frits and glazes of $2.7 million and $2.5 million, partially offset by decreased sales in porcelain enamel of $1.3 million. The increase from the United States was fully attributable to increased sales in porcelain enamel of $0.3 million.  Performance Colors and Glass    Net sales decreased compared with 2015, primarily driven by lower sales of our electronics products and industrial products of $3.1 million and $2.8 million, respectively. Net sales were impacted by unfavorable foreign currency impacts of $4.9 million and unfavorable volume and mix of $1.0 million, partially mitigated by higher product pricing of $0.6 million. Gross profit increased from 2015, primarily due to lower raw material costs of $7.9 million, lower manufacturing costs of $1.9 million and higher product pricing of $0.6 million, partially offset by lower sales volumes and mix of $3.2 million and unfavorable foreign currency impacts of $1.6 million.    The net sales decline of $5.3 million was driven by lower sales from the United States and Latin America, partially mitigated by increased sales from Europe and Asia Pacific. The decrease in sales from the United States was attributable to lower sales across all product lines, and the decline in sales from Latin America was primarily due to lower sales of decoration products of $0.2 million. The increase in sales from Europe was partially attributable to increased sales of electronics and automobile products of $2.3 million and $1.4 million, respectively, partially offset by a decrease in sales in industrial products of $0.9 million. The increase in sales from Asia Pacific was primarily due to higher sales of automotive products of $3.4 million, partially offset by lower sales in decoration products of $0.3 million. Pigments, Powders and Oxides    Net sales increased compared with 2015, primarily due to higher sales from Nubiola products of $66.3 million, an increase in sales of surface technology products and of pigments of $6.1 million and $5.7 million, respectively, and an increase in sales from Cappelle of $2.2 million. Net sales were positively impacted by higher volumes and mix of $82.1 million and favorable product pricing of $0.4 million, partially offset by unfavorable foreign currency impacts of $0.8 million. Gross profit increased from 2015, primarily due to higher sales volumes and mix of $28.6 million, favorable raw material costs of $5.2 million, lower manufacturing costs of $4.6 million and favorable product pricing of $0.4 million, partially offset by unfavorable foreign currency impacts of $0.2 million. Gross profit was negatively impacted by a charge of $5.8 million in 2015, related to a purchase price adjustment from the acquisition of Nubiola for step up of inventory acquired and subsequently sold that will not recur.   The increase in net sales of $81.6 million compared with 2015 was due to higher sales across all regions. The increase in sales from the United States was driven by increased sales from Nuiobla of $17.7 million and increased sales in surface technology and pigments of $6.1 million and $3.6 million, respectively. The increase in sales from Europe and Latin America was driven by sales from Nubiola of $24.6 million and $14.6 million, respectively. The increase in sales from Asia Pacific was primarily driven by sales from Nubiola of $9.3 million and pigments of $2.5 million. Comparison of the years ended December 31, 2015 and 2014 Performance Coatings    Net sales decreased in Performance Coatings compared with 2014 due to lower sales of frits and glazes, colors, porcelain enamels, digital inks and other tile product lines of $54.3 million, $17.9 million, $17.8 million, $12.8 million and $6.9 million, respectively. The sales decline was partially mitigated by an increase of $54.5 million in sales from Vetriceramici, which was acquired in the fourth quarter of 2014. A substantial portion of the decline in sales was attributed to unfavorable foreign currency impacts of $90.8 million and lower product pricing of $19.4 million, partially mitigated by favorable mix and higher sales volumes of $22.7 million and $32.3 million, respectively. Gross profit decreased from 2014, and was driven by lower product pricing impacts of $19.4 million and unfavorable foreign currency impacts of $18.7 million, partially mitigated by favorable volume and mix of $15.1 million, lower manufacturing costs of $11.1 million and favorable raw material impacts of $7.8 million.   The net sales decrease of $55.2 million compared with 2014 reflected lower sales in all regions. The decline from Asia Pacific was driven by lower sales of frits and glaze products, digital inks, porcelain enamels, and colors of $12.4 million, $4.0 million, $3.3 million, and $2.9 million respectively. The decline in sales from Europe was attributable to lower sales of our porcelain enamel products, partially mitigated by higher sales of tile products, including Vetriceramici sales. The decline in sales from Latin America compared to 2014 was due to lower sales in colors and porcelain enamel products, partially mitigated by higher sales of digital inks products. The decline from the United States was attributable to porcelain enamel products. Performance Colors and Glass    Net sales decreased $30.9 million in 2015 compared with 2014, with decreases of $18.0 million in decoration, $6.4 million in industrial products, $7.1 million in automotive, and $0.9 million in electronics, partially mitigated by an increase in sales of $1.5 million from Vetriceramici, which was acquired in the fourth quarter of 2014. Net sales reflected unfavorable foreign currency impacts of $36.1 million and lower sales volume of $5.3 million, partially mitigated by favorable mix of $8.0 million and higher product pricing of $2.5 million. Gross profit decreased from 2014, due to unfavorable foreign currency impacts of $12.3 million, unfavorable sales volumes and mix of $6.8 million, and higher manufacturing costs of $1.0 million, partially mitigated by favorable raw material impacts of $10.9 million and higher product pricing impacts of $2.5 million.   The decrease in net sales of $30.9 million compared with 2014, was primarily driven by lower sales in decoration products and industrial products from Europe of $8.0 million and $7.5 million, respectively, and lower sales of decoration products from Latin America and Asia Pacific of $8.3 million and $3.0 million. The decrease was partially mitigated by higher sales in electronics products from the United States of $4.0 million. Pigments, Powders and Oxides    Net sales increased compared with 2014, primarily due to higher volume and mix of $54.9 million, of which $56.9 million is related to sales from the Nubiola acquisition in the third quarter of 2015. The increase in sales is also due to favorable product pricing impacts of $0.4 million, partially mitigated by unfavorable foreign currency impacts of $5.5 million. Gross profit increased from 2014 and was a result of favorable volume and mix of $13.1 million, lower manufacturing costs of $3.6 million, favorable raw material impacts of $1.3 million, and higher product pricing of $0.4 million, partially offset by unfavorable foreign currency impacts of $1.2 million. Gross profit was negatively impacted by a charge of $5.8 million related to a purchase price adjustment from the acquisition of Nubiola, which was acquired in the third quarter of 2015, for step up of inventory acquired and subsequently sold in the third quarter that will not recur.   The increase in net sales of $49.8 million in 2015 compared with 2014, was due to higher sales from the United States, Europe and Latin America. The increase in sales from the United States was driven by increases of $4.8 million in surface finishing products, $0.6 million in pigments, and $15.2 million by sales from Nubiola, which was acquired in the third quarter of 2015, partially offset by a decrease in sales of $0.5 million in liquid coatings. The increase in sales from Europe and Latin America was driven by sales from Nubiola of $21.2 million and $13.7 million, respectively, partially offset by a decrease in sales of $4.1 million and $0.5 million in pigments, respectively. Summary of Cash Flows for the years ended December 31, 2016, 2015, and 2014   Operating activities. Cash flows from operating activities increased $11.4 million in 2016 compared to 2015. The increase was due to lower cash outflows for other assets and liabilities of $28.0 million and higher earnings after consideration of non-cash items of $30.4 million, partially offset by higher cash outflows for working capital of $43.2 million. Cash flows from operating activities decreased $9.3 million in 2015 compared to 2014. The change was driven by lower net income of $23.1 million. The decrease was partially mitigated by reduced payments associated with restructuring activities of $9.8 million and by a cash inflows of $12.2 million in 2015 related to working capital, compared to cash outflows of $12.3 million in 2014. Investing activities. Cash flows from investing activities increased approximately $93.8 million in 2016. The increase was primarily due to lower cash outflows for business combinations of $72.6 million and lower capital expenditures of $18.1 million which was driven by lower spend for the Antwerp, Belgium facility. This facility was substantially completed in the fourth quarter of 2015. Cash flows from investing activities decreased approximately $319.8 million in 2015 compared with 2014. The decrease was driven primarily by business acquisitions, net of cash acquired, of $202.2 million in 2015, compared to cash used for business acquisitions in 2014 of $115.6 million, partially offset by net proceeds from the sales of our North America-based Polymer Additives assets and Specialty Plastics business in 2014 of $149.5 million and $88.3 million, respectively. Capital expenditures decreased $10.7 million in 2015 compared with 2014. Financing activities. Cash flows from financing activities decreased $37.7 million in 2016 compared with 2015, driven by the $50.0 million prepayment on the term loan facility that was made in January 2016 and a net borrowing decrease on the revolving credit facility of $28.4 million, partially mitigated by decreased purchase of treasury stock of $27.1 million and an increase in net borrowings on loans payable of $11.9 million. Cash flows from financing activities increased $137.9 million in 2015 compared with 2014. The increase was primarily the result of net borrowings on the revolving credit facility of $170.0 million in 2015 compared to a repayment of $9.2 million in 2014. Net borrowings in 2015 were primarily used to fund acquisitions, the Company’s share repurchase program, and for other general business use. Further, we had a cash outflow of $41.0 million in 2014, related to repayment of debt outstanding under our accounts receivable securitization program, which expired during the year. We have paid no dividends on our common stock since 2009. Capital Resources and Liquidity Major debt instruments that were outstanding during 2016 are described below. Credit Facility On July 31, 2014, the Company entered into a credit facility (the “Credit Facility”) with a group of lenders to refinance the majority of its then outstanding debt. The Credit Facility consisted of a $200 million secured revolving line of credit with a term of five years and a $300 million secured term loan facility with a term of seven years. On January 25, 2016, the Company amended the Credit Facility by entering into the Incremental Assumption Agreement (the “Incremental Agreement”) to increase the revolving line of credit commitment amount from $200 million to $300 million. The Company then used a portion of the increase in the revolving line of credit to repay $50 million of the term loan facility. The Credit Facility was amended and a portion of the outstanding term loan was repaid to increase the amount of total liquidity available under the Credit Facility and reduce the total cost of borrowings. On August 29, 2016, the Company amended the Credit Facility by entering into the Second Incremental Assumption Agreement (the “Second Incremental Agreement”) to increase the revolving line of credit commitment amount to $400 million. The increase in the revolving line of credit commitment was used for general corporate purposes, including acquisitions. Principal payments on the term loan facility of $0.75 million quarterly, are payable commencing December 31, 2014, with the remaining balance due on the maturity date. At December 31, 2016, the Company had borrowed $243.3 million under the term loan facility, taking into account all prior quarterly payments and the $50 million prepayment that was made in January 2016, at an annual rate of 4.0%. There are no additional borrowings available under the term loan facility. Certain of the Company’s U.S. subsidiaries have guaranteed the Company’s obligations under the Credit Facility and such obligations are secured by (a) substantially all of the personal property of the Company and the U.S. subsidiary guarantors and (b) a pledge of 100% of the stock of most of the Company’s U.S. subsidiaries and 65% of most of the stock of the Company’s first tier foreign subsidiaries. Interest Rate - Term Loan: The interest rates applicable to the term loans will be, at the Company’s option, equal to either a base rate or a London Interbank Offered Rate (“LIBOR”) rate plus, in both cases, an applicable margin. · The base rate will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate or (iii) the daily LIBOR rate plus 1.00%. · The applicable margin for base rate loans is 2.25%. · The LIBOR rate will be set as quoted by Bloomberg and shall not be less than 0.75%. · The applicable margin for LIBOR rate loans is 3.25%. · For LIBOR rate loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. Interest Rate - Revolving Credit Line: The interest rates applicable to loans under the revolving credit line will be, at the Company’s option, equal to either a base rate or a LIBOR rate plus an applicable variable margin. The variable margin will be based on the ratio of (a) the Company’s total consolidated debt outstanding at such time to (b) the Company’s consolidated EBITDA computed for the period of four consecutive fiscal quarters most recently ended. · The base rate will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate or (iii) the daily LIBOR rate plus 1.00%. · The applicable margin for base rate loans will vary between 1.50% and 2.00%. · The LIBOR rate will be set as quoted by Bloomberg for U.S. Dollars. · The applicable margin for LIBOR Rate Loans will vary between 2.50% and 3.00%. · For LIBOR rate loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration.  At December 31, 2016, the Company had borrowed $311.6 million under the revolving credit facilities at a weighted average interest rate of 3.5%. The borrowing on the revolving credit line was used to fund the acquisitions, the share repurchase programs, and for other general business purposes. After reductions for outstanding letters of credit secured by these facilities, we had $84.1 million of additional borrowings available under the revolving credit facilities at December 31, 2016. The Credit Facility contains customary restrictive covenants including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. The Credit Facility also contains standard provisions relating to conditions of borrowing and customary events of default, including the non-payment of obligations by the Company and the bankruptcy of the Company. Specific to the revolving credit facility, the Company is subject to financial covenants regarding the Company’s outstanding net indebtedness and interest coverage ratios. If an event of default occurs, all amounts outstanding under the Credit Facility may be accelerated and become immediately due and payable. The Company was in compliance with our maximum leverage ratio covenant, as defined within our Credit Facility, as of September 30, 2016. The financial covenants are not applicable as of December 31, 2016, due to the refinancing of the Credit Facility, which is described below. On February 14, 2017, the Company entered into a new credit facility (the “New Credit Facility”) with a group of lenders to refinance its outstanding Credit Facility and to provide liquidity for ongoing working capital requirements and general corporate purposes. The New Credit Facility consists of a $400 million secured revolving line of credit with a term of five years, a $357.5 million secured term loan facility with a term of seven years and a €250 million secured euro term loan facility with a term of seven years. Refer to Note 8 for further details on the New Credit Facility. Off Balance Sheet Arrangements Consignment and Customer Arrangements for Precious Metals. We use precious metals, primarily silver, in the production of some of our products. We obtain most precious metals from financial institutions under consignment agreements (generally referred to as our precious metals consignment program). The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign and the period of consignment. These fees were $0.8 million, $0.8 million and $0.8 million for 2016, 2015, and 2014 respectively. We had on hand precious metals owned by participants in our precious metals consignment program of $28.7 million at December 31, 2016 and $20.5 million at December 31, 2015, measured at fair value based on market prices for identical assets and net of credits. The consignment agreements under our precious metals program involve short-term commitments that typically mature within 30 to 90 days of each transaction and are typically renewed on an ongoing basis. As a result, the Company relies on the continued willingness of financial institutions to participate in these arrangements to maintain this source of liquidity. On occasion, we have been required to deliver cash collateral. While no deposits were outstanding at December 31, 2016, or December 31, 2015, we may be required to furnish cash collateral in the future based on the quantity and market value of the precious metals under consignment and the amount of collateral-free lines provided by the financial institutions. The amount of cash collateral required is subject to review by the financial institutions and can be changed at any time at their discretion, based in part on their assessment of our creditworthiness. Bank Guarantees and Standby Letters of Credit. At December 31, 2016, the Company and its subsidiaries had bank guarantees and standby letters of credit issued by financial institutions that totaled $6.4 million. These agreements primarily relate to Ferro’s insurance programs, foreign energy purchase contracts and foreign tax payments. Other Financing Arrangements We maintain other lines of credit to provide global flexibility for Ferro’s short-term liquidity requirements. These facilities are uncommitted lines for our international operations and totaled $7.3 million at December 31, 2016. We had $6.7 million of additional borrowings available under these lines at December 31, 2016. Liquidity Requirements Our primary sources of liquidity are available cash and cash equivalents, available lines of credit under the Credit Facility, and cash flows from operating activities. As of December 31, 2016, we had $45.6 million of cash and cash equivalents. Substantially all of our cash and cash equivalents were held by foreign subsidiaries. Cash generated in the U.S. is generally used to pay down amounts outstanding under our revolving credit facility and for general corporate purposes, including acquisitions. If needed, we could repatriate the majority of cash held by foreign subsidiaries without the need to accrue and pay U.S. income taxes. We do not anticipate a liquidity need requiring such repatriation of these funds to the U.S. Our liquidity requirements primarily include debt service, purchase commitments, labor costs, working capital requirements, restructuring expenditures, capital investments, precious metals cash collateral requirements, and postretirement obligations. We expect to meet these requirements in the long term through cash provided by operating activities and availability under existing credit facilities or other financing arrangements. Cash flows from operating activities are primarily driven by earnings before noncash charges and changes in working capital needs. In 2016, cash flows from financing and operating activities were used to fund our investing activities. Additionally, we used the borrowings available under the Credit Facility to fund the acquisitions, the share repurchase programs, and for other general business purposes. We had additional borrowing capacity $112.0 million at December 31, 2016, available under various credit facilities, primarily our revolving credit facility. Our credit facilities contain a number of restrictive covenants, including those described in more detail in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. These covenants include customary operating restrictions, including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. We are also subject to customary financial covenants under our credit facilities, including a leverage ratio and an interest coverage ratio. These covenants under our credit facilities restrict the amount of our borrowings, reducing our flexibility to fund ongoing operations and strategic initiatives. These facilities are described in more detail in “Capital Resources and Liquidity” under Item 7 and in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. The most critical of these ratios is the leverage ratio for the revolving credit facility. The Company was in compliance with the covenants, as defined within our Credit Facility, as of September 30, 2016. The financial covenants are not applicable as of December 31, 2016, due to the refinancing of the Credit Facility. Refer to Note 8 for further details on the New Credit Facility. Difficulties experienced in global capital markets could affect the ability or willingness of counterparties to perform under our various lines of credit, forward contracts, and precious metals program. These counterparties are major, reputable, multinational institutions, all having investment-grade credit ratings, except for one, which is not rated. Accordingly, we do not anticipate counterparty default. However, an interruption in access to external financing could adversely affect our business prospects and financial condition. We assess on an ongoing basis our portfolio of businesses, as well as our financial and capital structure, to ensure that we have sufficient capital and liquidity to meet our strategic objectives. As part of this process, from time to time we evaluate the possible divestiture of businesses that are not critical to our core strategic objectives and, where appropriate, pursue the sale of such businesses and assets such as sales we completed in 2014 and 2016. We also evaluate and pursue acquisition opportunities that we believe will enhance our strategic position such as the acquisitions we completed in 2016, 2015 and 2014. Generally, we publicly announce material divestiture and acquisition transactions only when we have entered into definitive agreements relating to those transactions. The Company’s aggregate amount of contractual obligations for the next five years and thereafter is set forth below:   _____________________ (1) Loans Payable includes our loans payable to banks. (2) Long-term debt excludes imputed interest and executory costs on capitalized lease obligations and unamortized issuance costs on the term loan facility. (3) Interest represents only contractual payments for fixed-rate debt. (4) Purchase commitments are noncancelable contractual obligations for raw materials and energy. (5) We have not projected payments past 2017 due to uncertainties in estimating the amount and period of any payments. The amount above relates to our current income tax liability as of December 31, 2016. We have $27.8 million in gross liabilities related to unrecognized tax benefits, including $3.1 million of accrued interest and penalties that are not included in the above table since we cannot reasonably predict the timing of cash settlements with various taxing authorities. (6) The funding amounts are based on the minimum contributions required under our various plans and applicable regulations in each respective country. We have not projected contributions past 2018 due to uncertainties regarding the assumptions involved in estimating future required contributions. Critical Accounting Policies When we prepare our consolidated financial statements we are required to make estimates and assumptions that affect the amounts we report in the consolidated financial statements and footnotes. We consider the policies discussed below to be more critical than other policies because their application requires our most subjective or complex judgments. These estimates and judgments arise because of the inherent uncertainty in predicting future events. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors. Revenue Recognition We recognize sales typically when we ship goods to our customers and when all of the following criteria are met: · Persuasive evidence of an arrangement exists; · The selling price is fixed or determinable; · Collection is reasonably assured; and · Title and risk of loss has passed to our customers. In order to ensure the revenue recognition in the proper period, we review material sales contracts for proper cut-off based upon the business practices and legal requirements of each country. For sales of products containing precious metals, we report revenues gross along with their corresponding cost of sales to arrive at gross profit. We record revenues this way because we act as the principal in the transactions into which we enter. Restructuring and Cost Reduction Programs In recent years, we have developed and initiated a global cost reduction program with the objectives of leveraging our global scale, realigning and lowering our cost structure, and optimizing capacity utilization. Management continues to evaluate our businesses, and therefore, there may be additional provisions for new optimization and cost-savings initiatives, as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Restructuring charges include both termination benefits and asset writedowns. We estimate accruals for termination benefits based on various factors including length of service, contract provisions, local legal requirements, projected final service dates, and salary levels. We also analyze the carrying value of long-lived assets and record estimated accelerated depreciation through the anticipated end of the useful life of the assets affected by the restructuring or record an asset impairment. In all likelihood, this accelerated depreciation will result in reducing the net book value of those assets to zero at the date operations cease. While we believe that changes to our estimates are unlikely, the accuracy of our estimates depends on the successful completion of numerous actions. Changes in our estimates could increase our restructuring costs to such an extent that it could have a material impact on the Company’s results of operations, financial position, or cash flows. Other events, such as negotiations with unions and works councils, may also delay the resulting cost savings. Accounts Receivable and the Allowance for Doubtful Accounts Ferro sells its products to customers in diversified industries throughout the world. No customer or related group of customers represents greater than 10% of net sales or accounts receivable. We perform ongoing credit evaluations of our customers and require collateral principally for export sales, when industry practices allow and as market conditions dictate, subject to our ability to negotiate secured terms relative to competitive offers. We regularly analyze significant customer accounts and provide for uncollectible accounts based on historical experience, customer payment history, the length of time the receivables are past due, the financial health of the customer, economic conditions, and specific circumstances, as appropriate. Changes in these factors could result in additional allowances. Customer accounts we conclude to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. Historically, write-offs of uncollectible accounts have been within our expectations. Goodwill We review goodwill for impairment each year using a measurement date of October 31st or more frequently in the event of an impairment indicator. We annually, or more frequently as warranted, evaluate the appropriateness of our reporting units utilizing operating segments as the starting point of our analysis. In the event of a change in our reporting units, we would allocate goodwill based on the relative fair value. We estimate the fair values of the reporting units associated with these assets using the average of both the income approach and the market approach, which we believe provides a reasonable estimate of the reporting units’ fair values, unless facts and circumstances exist that indicate more representative fair values. The income approach uses projected cash flows attributable to the reporting units over their useful lives and allocates certain corporate expenses to the reporting units. We use historical results, trends and our projections of market growth, internal sales efforts and anticipated cost structure assumptions to estimate future cash flows. Using a risk-adjusted, weighted-average cost of capital, we discount the cash flow projections to the measurement date. The market approach estimates a price reasonably expected to be paid by a market participant in the purchase of similar businesses. If the fair value of any reporting unit was determined to be less than its carrying value, we would proceed to the second step and obtain comparable market values or independent appraisals of its assets and liabilities to determine the amount of any impairment. The significant assumptions and ranges of assumptions we used in our impairment analyses of goodwill at October 31, 2016 and 2015, were as follows:     Our estimates of fair value can be adversely affected by a variety of factors. Reductions in actual or projected growth or profitability at our reporting units due to unfavorable market conditions or significant increases in cost structure could lead to the impairment of any related goodwill. Additionally, an increase in inflation, interest rates or the risk-adjusted, weighted-average cost of capital could also lead to a reduction in the fair value of one or more of our reporting units and therefore lead to the impairment of goodwill. Based on our 2016 annual impairment test performed as of October 31, 2016, we recognized an impairment loss of $13.2 million in our Tile Coating Systems reporting unit, a component of our Performance Coatings segment. For the remaining reporting units tested for impairment, the fair values exceeded the carrying values of the respective reporting units by amounts ranging from 27.2% to 303.7% at the 2016 measurement date. The lowest cushion relates to goodwill associated with the Performance Coatings reportable segment, which had a goodwill balance of $28.1 million at December 31, 2016. A future potential impairment is possible for any of these reporting units if actual results are materially less than forecasted results. Some of the factors that could negatively affect our cash flows and, as a result, not support the carrying values of our reporting units are: new environmental regulations or legal restrictions on the use of our products that would either reduce our product revenues or add substantial costs to the manufacturing process, thereby reducing operating margins; new technologies that could make our products less competitive or require substantial capital investment in new equipment or manufacturing processes; and substantial downturns in economic conditions. Long-Lived Asset Impairment The Company’s long-lived assets include property, plant and equipment, and intangible assets. We review property, plant and equipment and intangible assets for impairment whenever events or circumstances indicate that their carrying values may not be recoverable. The following are examples of such events or changes in circumstances: · An adverse change in the business climate or market price of a long-lived asset or asset group; · An adverse change in the extent or manner in which a long-lived asset or asset group is used or in its physical condition; · Current operating losses for a long-lived asset or asset group combined with a history of such losses or projected or forecasted losses that demonstrate that the losses will continue; or · A current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise significantly disposed of before the end of its previously estimated useful life. The carrying amount of property, plant and equipment and intangible assets is not recoverable if the carrying value of the asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group. In the event of impairment, we recognize a loss for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of review. Income Taxes The breadth of our operations and complexity of income tax regulations require us to assess uncertainties and make judgments in estimating the ultimate amount of income taxes we will pay. Our income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. The final income taxes we pay are based upon many factors, including existing income tax laws and regulations, negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation, and resolution of disputes arising from federal, state and international income tax audits. The resolution of these uncertainties may result in adjustments to our income tax assets and liabilities in the future. Deferred income taxes result from differences between the financial and tax basis of our assets and liabilities. We adjust our deferred income tax assets and liabilities for changes in income tax rates and income tax laws when changes are enacted. We record valuation allowances to reduce deferred income tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and the magnitude of appropriate valuation allowances against deferred income tax assets. The realization of these assets is dependent on generating future taxable income, our ability to carry back or carry forward net operating losses and credits to offset tax liabilities, as well as successful implementation of various tax strategies to generate tax where net operating losses or credit carryforwards exist. In evaluating our ability to realize the deferred income tax assets, we rely principally on the reversal of existing temporary differences, the availability of tax planning strategies, and forecasted income. We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Our estimate of the potential outcome of any uncertain tax positions is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. We record a liability for the difference between the benefit recognized and measured based on a more-likely-than-not threshold and the tax position taken or expected to be taken on the tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. We report tax-related interest and penalties as a component of income tax expense. Derivative Financial Instruments We use derivative financial instruments in the normal course of business to manage our exposure to fluctuations in interest rates, foreign currency exchange rates, and precious metal prices. The accounting for derivative financial instruments can be complex and can require significant judgment. Generally, the derivative financial instruments that we use are not complex, and observable market-based inputs are available to measure their fair value. We do not engage in speculative transactions for trading purposes. Financial instruments, including derivative financial instruments, expose us to counterparty credit risk for nonperformance. We manage our exposure to counterparty credit risk through minimum credit standards and procedures to monitor concentrations of credit risk. We enter into these derivative financial instruments with major, reputable, multinational financial institutions. Accordingly, we do not anticipate counter-party default. We continuously evaluate the effectiveness of derivative financial instruments designated as hedges to ensure that they are highly effective. In the event the hedge becomes ineffective, we discontinue hedge treatment. Except as noted below, we do not expect any changes in our risk policies or in the nature of the transactions we enter into to mitigate those risks. We manage foreign currency risks in a wide variety of foreign currencies principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions arising from international trade. Our objective in entering into these forward contracts is to preserve the economic value of nonfunctional currency cash flows. Our principal foreign currency exposures relate to the Euro, the Thailand Baht, the Indonesian Rupiah, the Japanese Yen, and the Romanian Leu. We mark these forward contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as other income or expense from foreign currency transactions. Precious metals (primarily silver, gold, platinum and palladium) represent a significant portion of raw material costs in our electronics products. When we enter into a fixed price sales contract at the customer’s request to establish the price for the precious metals content of the order, we also enter into a forward purchase arrangement with a precious metals supplier to completely cover the value of the precious metals content. Our current precious metal contracts are designated as normal purchase contracts, which are not marked to market. We also purchase portions of our energy requirements, including natural gas and electricity, under fixed price contracts to reduce the volatility of cost changes. Our current energy contracts are designated as normal purchase contracts, which are not marked to market. Pension and Other Postretirement Benefits We sponsor defined benefit plans in the U.S. and many countries outside the U.S., and we also sponsor retiree medical benefits for a segment of our salaried and hourly work force within the U.S. The U.S. pension plans and retiree medical plans represent approximately 89% of pension plan assets, 73% of benefit obligations and 24% of net periodic pension expense as of December 31, 2016. The assumptions we use in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. We meet with our actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. We determine the discount rate for the U.S. pension and retiree medical plans based on a bond model. Using the pension plans’ projected cash flows, the bond model considers all possible bond portfolios that produce matching cash flows and selects the portfolio with the highest possible yield. These portfolios are based on bonds with a quality rating of AA or better under either Moody’s Investor Services, Inc. or Standard & Poor’s Rating Group, but exclude certain bonds, such as callable bonds, bonds with small amounts outstanding, and bonds with unusually high or low yields. The discount rates for the non-U.S. plans are based on a yield curve method, using AA-rated bonds applicable in their respective capital markets. The duration of each plan’s liabilities is used to select the rate from the yield curve corresponding to the same duration. For the market-related value of plan assets, we use fair value, rather than a calculated value. The market-related value recognizes changes in fair value in a systematic and rational manner over several years. We calculate the expected return on assets at the beginning of the year for defined benefit plans as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. In determining the expected returns, we consider both historical performance and an estimate of future long-term rates of return. The Company consults with and considers the opinion of its actuaries in developing appropriate return assumptions. Our target asset allocation percentages are 35% fixed income, 60% equity, and 5% other investments for U.S. plans and 75% fixed income, 24% equity, and 1% other investments for non-U.S. plans. In 2016, investment returns on average plan assets were approximately 7% within the U.S. plans and 23% within non-U.S. plans. In 2015, actual return on plan assets, were lower than the expected return. Future actual pension expense will depend on future investment allocation and performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans. All other assumptions are reviewed periodically by our actuaries and us and may be adjusted based on current trends and expectations as well as past experience in the plans. During the fourth quarter of 2014, the Company adopted the use of new mortality tables within its calculation assumptions, which had a one-time impact of increasing the liability. The new mortality tables reflect underlying increases in life expectancy of participants, thus driving longer benefit payment periods. The impact of the change in mortality assumption on the U.S. pension liability was an increase of the liability of approximately $18 million. The following table provides the sensitivity of net annual periodic benefit costs for our pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25-basis-point decrease in both the discount rate and asset return assumption:    The following table provides the rates used in the assumptions and the changes between 2016 and 2015:   Our overall net periodic benefit cost for all defined benefit plans was $20.2 million in 2016 and $1.5 million in 2015. The change is mainly the result of increased mark to market actuarial net losses in 2016. For 2017, assuming expected returns on plan assets and no actuarial gains or losses, we expect our overall net periodic benefit income to be approximately $1.2 million, compared with income of approximately $0.1 million in 2016 on a comparable basis. Inventories We value inventory at the lower of cost or market, with cost determined utilizing the first-in, first-out (FIFO) method. We periodically evaluate the net realizable value of inventories based primarily upon their age, but also upon assumptions of future usage in production, customer demand and market conditions. Inventories have been reduced to the lower of cost or realizable value by allowances for slow moving or obsolete goods. If actual circumstances are less favorable than those projected by management in its evaluation of the net realizable value of inventories, additional write-downs may be required. Slow moving, excess or obsolete materials are specifically identified and may be physically separated from other materials, and we rework or dispose of these materials as time and manpower permit. Environmental Liabilities Our manufacturing facilities are subject to a broad array of environmental laws and regulations in the countries in which they are located. The costs to comply with complex environmental laws and regulations are significant and will continue for the foreseeable future. We expense these recurring costs as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations. We also accrue for environmental remediation costs when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events. Inherent uncertainties exist in such evaluations primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress or as additional technical or legal information becomes available. Impact of Newly Issued Accounting Pronouncements Refer to Note 2 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K for a discussion of accounting standards we recently adopted or will be required to adopt.

<s>[INST] During the year ended December 31, 2016, net sales increased $70.0 million, or 6.5%, compared with 2015. The increase was driven by an increase in sales in Pigments, Powders and Oxides of $81.6 million, partially offset by a decrease in sales in Performance Coatings of $6.4 million and Performance Colors and Glass of $5.3 million. Gross profit increased $49.5 million compared with 2015. As a percentage of net sales, gross profit rate increased approximately 260 basis points to 30.7%, from 28.1% in the prior year. For the year ended December 31, 2016, selling, general and administrative (“SG&A”) expenses increased $24.8 million, or 11.4%, compared with 2015, primarily driven by the increase in expense in pension and other postretirement benefits of $14.9 million. For the year ended December 31, 2016, net loss was $19.9 million, compared with net income of $63.1 million in 2015, and net loss attributable to common shareholders was $20.8 million, compared with net income attributable to common shareholders of $64.1 million in 2015. Income from continuing operations was $44.6 million for the year ended December 31, 2016, compared with income from continuing operations of $99.9 million in 2015.  2016 Transactional Activity Business Acquisitions Acquisition of Cappelle: As discussed in Note 4, in the fourth quarter of 2016, the Company acquired 100% of the share capital of Belgiumbased Cappelle Pigments NV (“Cappelle”), a leader in specialty, highperformance inorganic and organic pigments used in coatings, inks and plastics, for €40.0 million (approximately $42.4 million). Acquisition of ESL: As discussed in Note 4, in the fourth quarter of 2016, the Company acquired 100% of the membership interest of ElectroScience Laboratories, Inc. (“ESL”), a leader in electronic packaging materials for $78.0 million. Acquisition of Delta Performance Products: As discussed in Note 4, in the third quarter of 2016, the Company acquired certain assets of Delta Performance Products, LLC, for a cash purchase price of $4.4 million. Acquisition of Pinturas: As discussed in Note 4, in the second quarter of 2016, the Company acquired 100% of the equity of privately held Pinturas Benicarló, S.L. (“Pinturas”) for €16.5 million in cash (approximately $18.4 million). Acquisition of Ferer: As discussed in Note 4, in the first quarter of 2016, the Company completed the purchase of 100% of the equity of privately held Istanbulbased Ferer Dis Ticaret Ve Kimyasallar Anonim Sirketi A.S. (“Ferer”) for approximately $9.4 million in cash. Disposition of the Europebased Polymer Additives business As discussed in Note 3, in the third quarter of 2016, the Company completed the disposition of the Europebased Polymer Additives business to Plahoma Two AG, an affiliate of the LIVIA Group. Outlook The Company delivered strong performance throughout 2016. Sales increased 6.5% primarily due to acquisitions acquired within the last year. In addition, gross profit, as a percentage of net sales, increased to 30.7% from 28.1%. Partially offsetting the higher gross profit were increased SG&A costs, primarily driven by an increase in pension and postretirement benefits expense and incentive compensation expense. Our effective tax rate for 2016 was 28.6%. For 2017, we expect gross margin will continue to improve. We anticipate benefitting from strategic actions taken to improve growth in our core businesses and will continue [/INST] Positive. </s>

FERRO CORP

2018-02-28

2017-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview During the year ended December 31, 2017, net sales increased $251.5 million, or 22.0%, compared with 2016. The increase was driven by higher sales in Color Solutions, Performance Colors and Glass and Performance Coatings of $111.2 million, $73.2 million and $67.0 million, respectively. Gross profit increased $65.0 million compared with 2016. The increase in gross profit was attributable to increases across all of our segments, with increases in Color Solutions, Performance Colors and Glass and Performance Coatings of $29.4 million, $23.8 million and $6.3 million, respectively. As a percentage of net sales, gross profit rate decreased approximately 90 basis points to 29.8%, from 30.7% in the prior year. For the year ended December 31, 2017, selling, general and administrative (“SG&A”) expenses increased $16.9 million, or 7.0%, compared with 2016. As a percentage of net sales, SG&A expenses decreased 260 basis points from 21.1% in 2016 to 18.5% in 2017. For the year ended December 31, 2017, net income was $57.8 million, compared with net loss of $19.9 million in 2016, and net income attributable to common shareholders was $57.1 million, compared with net loss attributable to common shareholders of $20.8 million in 2016. Income from continuing operations was $57.8 million for the year ended December 31, 2017, compared with income from continuing operations of $44.6 million in 2016.  2017 Transactional Activity Business Acquisitions Acquisition of Endeka Group (“Endeka”): As discussed in Note 4, in the fourth quarter of 2017, the Company acquired 100% of the equity interests of Endeka, a global producer of high-value coatings and key raw materials for the ceramic tile market, for €72.7 million (approximately $84.6 million). Acquisition of Gardenia Quimica S.A. (“Gardenia”): As discussed in Note 4, in the third quarter of 2017, the Company acquired a majority interest in Gardenia for $3.0 million. Acquisition of Dip Tech Ltd. (“Dip-Tech”): As discussed in Note 4, in the third quarter of 2017, the Company acquired 100% of the equity interests of Dip-Tech, a leading provider of digital printing solutions for glass, for $76.0 million. Acquisition of S.P.C. Group s.r.l. and Smalti per Ceramiche, s.r.l (together “SPC”): As discussed in Note 4, in the second quarter of 2017, the Company acquired 100% of the equity interests of SPC, for €18.7 million (approximately $20.3 million). Outlook  The Company delivered strong performance throughout 2017, with notable sales and gross profit improvements, primarily due to increases in organic growth, contributions from businesses acquired within the past 12 months and optimization programs throughout the footprint. For 2018, we will continue to execute our value creation strategy, which includes organic and inorganic growth, and optimization. We expect organic growth through new products and repositioning of our portfolio to continue transitioning to the higher end of our target markets. We expect to continue investing at a level of approximately $100 to $150 million per year in strategic acquisitions. We are implementing optimization programs to improve efficiency and upgrade operations throughout our business.  Raw materials costs increased during 2017, putting pressure on gross margin. Over the long term, we are confident in our ability to mitigate raw material inflation, with a lag, due to our technological advances in reformulating compounds, pricing initiatives and optimization initiatives. For 2017, organic growth, new products and pricing initiatives completely offset raw material price increases. We expect price increases for some raw materials to continue in 2018. We expect to offset the cost increases with pricing actions, product reformulations and optimization actions.  We expect foreign currency rates to continue to be volatile in 2018, and changes in interest rates could adversely impact reported results.  We remain focused on the integration of recent acquisitions and continue to work toward achieving the identified synergies. We will concurrently focus on opportunities to optimize our cost structure and make our business processes and systems more efficient. We continue to expect cash flow from operating activities to be positive for 2018, providing additional liquidity  Results of Operations - Consolidated Comparison of the years ended December 31, 2017 and 2016 For the year ended December 31, 2017, income from continuing operations was $57.8 million, compared with income from continuing operations of $44.6 million in 2016. For the year ended December 31, 2017, net income was $57.8 million, compared with net loss of $19.9 million in 2016. For the year ended December 31, 2017, net income attributable to common shareholders was $57.1 million, or $0.68 earnings per share, compared with net loss attributable to common shareholders of $20.8 million, or $0.25 loss per share in 2016. Net Sales    Net sales increased by $251.5 million, or 22.0%, in the year ended December 31, 2017, compared with the prior year, with increased sales in Color Solutions, Performance Colors and Glass and Performance Coatings of $111.2 million, $73.2 million and $67.0 million, respectively. The increase in net sales was driven by both acquisitions and organic growth. Organically, Color Solutions grew $39.6 million, Performance Coatings grew $24.1 million and Performance Colors and Glass grew $11.8 million. Gross Profit Gross profit increased $65.0 million, or 18.5%, in 2017 to $416.2 million, compared with $351.2 million in 2016 and, as a percentage of net sales, it decreased 90 basis points to 29.8%. The increase in gross profit was attributable to increases across all of our segments, with increases in Color Solutions, Performance Colors and Glass and Performance Coatings of $29.4 million, $23.8 million and $6.3 million, respectively. The increase in gross profit was primarily attributable to acquisitions of $46.9 million, lower manufacturing and product costs of $28.8 million, driven by higher volume and mix, as well as strategic purchasing actions, favorable product pricing of $12.9 million, higher sales volumes and mix of $9.9 million, favorable foreign currency impacts of $0.3 million, partially offset by higher raw material costs of $39.3 million. Geographic Revenues The following table presents our sales on the basis of where sales originated.   The increase in net sales of $251.5 million, compared with 2016, was driven by higher sales from all regions. The increase in sales from Europe was attributable to higher sales in Color Solutions, Performance Coatings and Performance Colors and Glass of $69.3 million, $56.4 million and $42.8 million, respectively. The increase in sales from the United States was primarily attributable to higher sales in Color Solutions and Performance Colors and Glass of $33.0 million and $22.9 million, respectively. The increase in sales from Latin America and Asia Pacific was attributable to higher sales across all segments. The following table presents our sales on the basis of where sold products were shipped.    Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2017 and 2016.  SG&A expenses were $16.9 million higher in 2017 compared with the prior year. As a percentage of net sales, SG&A expenses decreased 260 basis points from 21.1% in 2016 to 18.5% in 2017. The most significant driver in SG&A expenses in 2017 was the change in the mark-to-market loss and curtailment and settlement effects on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $18.8 million, which is included within Pension and other postretirement benefits. The expense in 2017 was lower than the prior year primarily due to the gain from actual returns exceeding expected returns on plan assets on the U.S. pension plans. Excluding the impacts of the pension and other postretirement benefits expense, SG&A expenses decreased 80 basis points from 19.7% in 2016 to 18.9% in 2017. The higher SG&A expenses compared with the prior year are primarily driven by businesses acquired within the last year. The acquisitions were the primary driver of the increase in personnel expenses, research and development expenses and accounted for the entire increase in intangible asset amortization. The increase in business development expense is due to higher professional fees. The increase in stock-based compensation expense of $4.5 million is the result of the Company’s performance relative to targets for certain awards compared with the prior year, as well as increases in the Company’s stock price. The following table presents SG&A expenses attributable to sales, research and development, and operations costs as strategic services and presents other SG&A costs as functional services.    Restructuring and Impairment Charges   Restructuring and impairment charges decreased by $4.5 million in 2017, compared with 2016. The decrease was primarily attributable to an impairment charge in 2016 within our Tile Coating Systems reporting unit, a component of the Performance Coatings operating segment of $13.2 million. The decrease was partially offset by an increase due to an “other than temporary impairment” charge on an equity method investment of $1.6 million and costs associated with a restructuring plan in Italy, which includes $1.2 million of asset impairment associated with assets that have been taken out of service, as well as actions taken in connection with recent acquisitions designed to achieve our targeted synergies. Interest Expense  Interest expense in 2017 increased $6.2 million compared with 2016. The increase in interest expense was due to an increase in the average long-term debt balance during 2017, compared with 2016 and an increase of the amortization of debt issuance costs associated with the 2017 Credit Facility, partially offset by a favorable average borrowing rate as a result of the refinancing completed in the first quarter of 2017. Income Tax Expense On December 22, 2017, U.S. federal tax legislation, commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”), was signed into law, significantly changing the U.S. corporate income tax system. These changes include a federal statutory rate reduction from 35% to 21% effective January 1, 2018. Changes in tax rates and tax law are accounted for in the period of enactment. Accordingly, the Company’s net deferred tax assets were re-measured to reflect the reduction in the federal statutory rate, resulting in a $21.5 million increase in income tax expense for the year ended December 31, 2017. The Tax Act also changed the U.S. taxation of worldwide income. Accordingly, we have assessed the one-time mandatory deemed repatriation tax on accumulated foreign subsidiaries’ previously untaxed foreign earnings and profits and have preliminarily determined no tax is due. Additional provisions of the Tax Act which may have an impact to the Company include, but are not limited to, the repeal of the domestic production deduction, limitations on interest expense, accelerated depreciation that will allow for full expensing of qualified property, provisions related to performance-based executive compensation and international provisions, which generally establish a territorial-style system for taxing foreign-source income of domestic multinational corporations. We have recognized the provisional tax impacts related to the Tax Act under the guidance of SEC Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”). The ultimate impact may differ from these provisional amounts due to additional analysis, changes in interpretations and assumptions, additional regulatory guidance that may be issued, and actions we may take as a result of the Tax Act. Pursuant to SAB 118, adjustments to the provisional amounts recorded by the Company as of December 31, 2017, that are identified within a subsequent measurement period of up to one year from the enactment date will be included as an adjustment to income tax expense in the period the amounts are determined. In 2017, we recorded an income tax expense of $52.8 million, or 47.7% of income before income taxes, compared to an income tax expense of $17.9 million, or 28.6% of income before income taxes in 2016. The 2017 effective tax rate is greater than the statutory income tax rate of 35% primarily as a result of a net effect of a $21.5 million expense related to re-measuring the U.S. deferred tax assets as a result of the Tax Act, $5.6 million net expense related to uncertain tax positions and $8.0 million benefit related to foreign tax rate differences. The 2016 effective tax rate is less than the statutory income tax rate of 35%, primarily as a result of a $5.5 million net benefit related to greater levels of income earned in lower tax jurisdictions, $4.8 million net benefit for the release of valuation allowances related to deferred tax assets that were utilized in the current year, $2.0 million in net benefit for the release of valuation allowance, which are deemed no longer necessary based upon changes in the current and expected future years operating profits, $1.8 million benefit related to notional interest deductions, $2.8 million benefit for the generation of tax credits offset by a $4.1 expense related to the impairment of book basis goodwill and a $2.1 million expense related to non-deductible expenses. Comparison of the years ended December 31, 2016 and 2015 For the year ended December 31, 2016, income from continuing operations was $44.6 million, compared with income from continuing operations of $99.9 million in 2015. For the year ended December 31, 2016, net loss was $19.9 million, compared with net income of $63.1 million in 2015. For the year ended December 31, 2016, net loss attributable to common shareholders was $20.8 million, or $0.25 loss per share, compared with net income attributable to common shareholders of $64.1 million, or $0.74 earnings per share in 2015. Net Sales  Net sales increased by $70.0 million, or 6.5%, in the year ended December 31, 2016, compared with the prior year. The net sales increase was driven by higher sales in Color Solutions of $81.6 million, partially offset by a decrease in sales in Performance Colors and Glass of $5.3 million and Performance Coatings of $6.4 million. The increase in net sales was primarily driven by the sales from Nubiola of $66.3 million and sales from Al Salomi of $22.1 million, partially offset by a decrease in sales of frits and glazes from Latin America of $23.9 million. Gross Profit Gross profit increased $49.5 million, or 16.4%, in 2016 to $351.2 million, compared with $301.7 million in 2015 and as a percentage of net sales, it increased 260 basis points to 30.7%. The significant driver of the increased gross profit was strong performance in our Color Solutions segment which exceeded prior year gross profit by $38.6 million, primarily driven by sales from Nubiola. The increase in gross profit was driven by acquisitions of $40.4 million, decreases in raw material costs of $21.0 million, decreases in manufacturing and product costs of $11.1 million and increases in sales volumes and mix of $8.2 million, partially offset by unfavorable product pricing of $15.0 million and unfavorable foreign currency impacts of $9.1 million. Geographic Revenues The following table presents our sales on the basis of where sales originated.  The increase in net sales of $70.0 million, compared with 2015, was driven by increased sales from Europe, Asia Pacific and the United States, partially mitigated by a decrease in sales from Latin America. The increase from Europe was primarily attributable to Nubiola sales of $24.6 million and an increase in Performance Coatings sales of $11.2 million and the increase from Asia Pacific was attributable to an increase in sales in all segments. The increase from the United States was attributable to an increase in sales in Color Solutions of $29.4 million, partially offset by lower sales in Performance Colors and Glass of $11.5 million. The decrease in sales from Latin America was attributable to the sale of our interest in an operating affiliate in Venezuela in 2015 which contributed $8.4 million in net sales The following table presents our sales on the basis of where sold products were shipped.       Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2016 and 2015.    SG&A expenses were $24.8 million higher in 2016 compared with the prior year. As a percentage of net sales, SG&A expenses increased 90 basis points from 20.2% in 2015 to 21.1% in 2016. The most significant driver of the increase in SG&A expenses in 2016 was the change in the mark-to-market loss and curtailment and settlement effects on our defined benefit pension plans and postretirement health care and life insurance benefit plans of $8.1 million, which is included within the pension and other postretirement benefits line above. The expense in 2016 was higher than the prior year due to the loss from expected returns on plan assets exceeding actual returns and a decrease in the discount rate compared with the prior year. Excluding the impacts of the pension and other postretirement benefits expense, SG&A expenses decreased 30 basis points from 20.0% in 2015 to 19.7% in 2016. The increase in personnel expenses was attributable to the acquisitions acquired which contributed $5.5 million and the increase in incentive compensation was a result of the Company’s performance relative to targets for certain awards compared with the prior year.  The following table presents SG&A expenses attributable to sales, research and development and operations costs as strategic services and other SG&A costs as functional services.   Restructuring and Impairment Charges    Restructuring and impairment charges increased by $6.3 million in 2016, compared with 2015. The increase was driven by an impairment charge within our Tile Coating Systems reporting unit, a component of our Performance Coatings operating segment in 2016 of $13.2 million. This increase was partially mitigated by a decrease in employee severance cost of $2.7 million in 2016, compared with 2015 and the early termination cost of a contract associated with restructuring a corporate function of $2.8 million in 2015. . Interest Expense   Interest expense in 2016 increased $6.4 million compared with 2015, primarily due to an increase in the average long-term debt balance for the 2016 period compared with 2015, as well as less interest capitalization associated with long-term capital projects, which was driven by the substantial completion of the Antwerp, Belgium facility in the fourth quarter of 2015. Income Tax Expense In 2016, we recorded an income tax expense of $17.9 million, or 28.6% of income before income taxes, compared to an income tax benefit of $45.1 million, or (82.3%) of income before income taxes in 2015. The 2016 effective tax rate is less than the statutory income tax rate of 35%, primarily as a result of a $5.5 million benefit related to greater levels of income earned in lower tax jurisdictions, $4.8 million net benefit for the release of valuation allowances related to deferred tax assets that were utilized in the current year, $2.0 million in net benefit for the release of valuation allowances, which are deemed no longer necessary based upon changes in the current and expected future years operating profits, $1.8 million benefit related to notional interest deductions, $2.8 million benefit for the generation of tax credits offset by a $4.1 million expense related to the impairment of book basis goodwill and a $2.1 million expense related to non-deductible expenses. The 2015 effective tax rate was less than the statutory income tax rate of 35% primarily as a result of a $3.8 million benefit related to greater levels of income earned in lower tax jurisdictions, $3.1 million benefit for the release of the valuation allowances related to deferred tax assets that were utilized in the current year and $63.3 million benefit for the release of valuation allowances in certain jurisdictions, which are deemed no longer necessary based upon a change from a cumulative three-year loss to income and our expectation of sufficient future taxable income to be able to realize the respective benefits, offset by $2.4 million expense related to new uncertain tax positions and $1.7 million expense related to non-deductible expenses. Results of Operations - Segment Information Comparison of the years ended December 31, 2017 and 2016 Performance Coatings      Net sales increased in Performance Coatings by $67.0 million compared with the prior year, primarily driven by sales from SPC of $22.6 million, sales from Endeka of $18.3 million, and by organic growth across all product lines. The increase in net sales included higher sales volume and mix of $24.4 million, sales from acquisitions of $42.9 million and higher product pricing of $4.3 million, partially offset by unfavorable foreign currency impacts of $4.7 million. Gross profit increased $6.3 million from the prior year, primarily driven by gross profit from acquisitions of $9.5 million, lower manufacturing and product costs of $13.0 million, higher sales volumes and mix of $6.6 million and favorable product pricing impacts of $4.3 million, partially offset by higher raw material costs of $26.5 million, and unfavorable foreign currency impacts of $0.6 million.    Net sales increased by $67.0 million with increases in sales from all regions. The increase in sales from Europe was primarily driven by sales from SPC of $22.6 million, sales from Endeka of $16.8 million, and an increase in sales of porcelain enamel and colors of $5.7 million and $5.5 million, respectively. The sales increase from Latin America was primarily driven by higher sales of frits and glazes and porcelain enamel of $3.4 million and $1.4 million, respectively. The sales increase from Asia Pacific was primarily driven by higher sales of digital inks, sales from Endeka and higher sales of porcelain enamel of $4.4 million, $1.6 million and $1.2 million, respectively, partially offset by a decrease of frits and glazes sales of $1.8 million. The increase in sales from the United States was attributable to higher sales of porcelain enamel.  Performance Colors and Glass    The net sales increase of $73.2 million was primarily attributable to sales from ESL of $38.2 million and Dip-Tech of $18.2 million and organic growth in decoration products of $12.5 million. The increase in net sales included sales from acquisitions of $61.4 million, favorable volume and mix of $6.8 million, higher product pricing of $2.6 million and favorable foreign currency impacts of $2.5 million. Gross profit increased from the prior year, primarily due to gross profit from acquisitions of $21.2 million, favorable manufacturing and product costs of $4.8 million, higher product pricing of $2.6 million and favorable foreign currency impacts of $0.7 million, partially offset by unfavorable raw material costs of $3.8 million and lower sales volumes and mix of $1.7 million.    The net sales increase of $73.2 million was driven by higher sales from all regions. The increase in sales from Europe was primarily attributable to sales from acquisitions and higher sales of decoration products of $9.6 million. The increase in sales from the United States was driven by sales from ESL of $24.5 million and Dip-Tech of $3.3 million, partially offset by a decrease in sales of industrial products of $5.9 million. The increase from Asia Pacific was primarily due to higher sales of automobile and decoration products of $3.9 million and $1.1 million, respectively. The increase from Latin America was primarily driven by an increase in sales of decoration products of $2.1 million, partially offset by a decrease in sales of automobile and industrial products. Color Solutions    Net sales increased $111.2 million compared with the prior year, primarily due to sales from Cappelle of $69.5 million, and higher sales of pigments and surface technology products of $28.8 million and $12.7 million, respectively. The increase in net sales was driven by sales from acquisitions of $71.6 million, higher volumes and mix of $32.5 million, higher product pricing of $6.1 million and favorable foreign currency impacts of $1.0 million. Gross profit increased from the prior year, due to gross profit from acquisitions of $16.2 million, lower manufacturing and product costs of $10.9 million, higher product pricing of $6.1 million, higher sales volumes and mix of $5.0 million and favorable foreign currency impacts of $0.2 million, partially offset by unfavorable raw material costs of $9.0 million.    The net sales increase of $111.2 million was driven by higher sales from all regions. The increase in sales from Europe was primarily driven by sales from Cappelle of $58.3 million and higher sales of pigments of $11.0 million. The increase in sales from the United States was primarily driven by sales from Cappelle of $11.2 million, surface technology products of $12.7 million and pigments of $9.0 million. The increases in sales from Asia Pacific and Latin America of $5.6 million and $3.3 million, respectively, were driven by an increase in pigments sales. Comparison of the years ended December 31, 2016 and 2015 Performance Coatings    Net sales declined in Performance Coatings compared with 2015, primarily driven by a decrease in sales of $20.9 million in frits and glazes, and $8.4 million due to the sale of our Venezuela business, partially mitigated by $22.1 million in sales from Al Salomi. The decrease in net sales was impacted by unfavorable foreign currency impacts of $34.4 million and lower product pricing of $15.9 million, partially offset by increased sales from acquisitions of $22.1 million and higher volume and mix of $21.9 million. Gross profit increased $12.5 million from 2015, primarily driven by lower manufacturing and product costs of $4.6 million, higher sales volumes and mix of $17.8 million, lower raw material costs of $7.9 million and gross profit from acquisitions of $5.4 million, partially offset by unfavorable product pricing impacts of $15.9 million and unfavorable foreign currency impacts of $7.3 million.    The net sales decrease of $6.4 million was driven by declines in sales from Latin America, partially mitigated by an increase in sales from Europe, Asia Pacific and the United States. The sales decline from Latin America included a decrease in sales in frits and glazes of $23.9 million and a decrease in sales from Venezuela of $8.4 million, partially mitigated by increased sales in digital inks and opacifiers of $5.7 million and $5.3 million, respectively. The increase in sales from Europe was primary attributable to $22.1 million in sales from Al Salomi, partially offset by decreased sales in digital inks and Vetriceramici products of $5.7 million and $4.6 million, respectively. The increase from Asia Pacific was primarily due to increased sales in digital inks and frits and glazes of $2.7 million and $2.5 million, partially offset by decreased sales in porcelain enamel of $1.3 million. The increase from the United States was fully attributable to increased sales in porcelain enamel of $0.3 million. Performance Colors and Glass    Net sales decreased compared with 2015, primarily driven by lower sales of our electronics products and industrial products of $3.1 million and $2.8 million, respectively. Net sales were impacted by unfavorable volume and mix of $16.5 million and foreign currency impacts of $4.9 million, partially mitigated by sales from acquisitions of $15.5 million and higher product pricing of $0.6 million. Gross profit increased from 2015, primarily due to lower raw material costs of $7.9 million, gross profit from acquisitions of $6.3 million, lower manufacturing and product costs of $1.9 million and higher product pricing of $0.6 million, partially offset by lower sales volumes and mix of $9.6 million and unfavorable foreign currency impacts of $1.6 million.    The net sales decline of $5.3 million was driven by lower sales from the United States and Latin America, partially mitigated by increased sales from Europe and Asia Pacific. The decrease in sales from the United States was attributable to lower sales across all product lines, and the decline in sales from Latin America was primarily due to lower sales of decoration products of $0.2 million. The increase in sales from Europe was partially attributable to increased sales of electronics and automobile products of $2.3 million and $1.4 million, respectively, partially offset by a decrease in sales in industrial products of $0.9 million. The increase in sales from Asia Pacific was primarily due to higher sales of automotive products of $3.4 million, partially offset by lower sales in decoration products of $0.3 million. Color Solutions    Net sales increased compared with 2015, primarily due to higher sales from Nubiola products of $66.3 million, an increase in sales of surface technology products and of pigments of $6.1 million and $5.7 million, respectively, and an increase in sales from Cappelle of $2.2 million. Net sales were positively impacted by sales from acquisitions of $71.7 million, higher volumes and mix of $10.4 million and favorable product pricing of $0.4 million, partially offset by unfavorable foreign currency impacts of $0.8 million. Gross profit increased from 2015, primarily due to gross profit from acquisitions of $28.6 million, favorable raw material costs of $5.2 million, lower manufacturing and product costs of $4.6 million and favorable product pricing of $0.4 million, partially offset by unfavorable foreign currency impacts of $0.2 million. Gross profit was negatively impacted by a charge of $5.8 million in 2015, related to a purchase price adjustment from the acquisition of Nubiola for step up of inventory acquired and subsequently sold that will not recur.   The increase in net sales of $81.6 million compared with 2015 was due to higher sales across all regions. The increase in sales from the United States was driven by increased sales from Nuiobla of $17.7 million and increased sales in surface technology and pigments of $6.1 million and $3.6 million, respectively. The increase in sales from Europe and Latin America was driven by sales from Nubiola of $24.6 million and $14.6 million, respectively. The increase in sales from Asia Pacific was primarily driven by sales from Nubiola of $9.3 million and pigments of $2.5 million. Summary of Cash Flows for the years ended December 31, 2017, 2016, and 2015   Operating activities. Cash flows from operating activities increased $22.2 million in 2017 compared to 2016. The increase was primarily due to higher earnings after consideration of non-cash items, partially offset by higher cash outflows for net working capital of $15.7 million and other current assets and liabilities of $38.1 million. Cash flows from operating activities increased $11.4 million in 2016 compared to 2015. The increase was due to lower cash outflows for other assets and liabilities of $28.0 million and higher earnings after consideration of non-cash items of $30.4 million, partially offset by higher cash outflows for working capital of $43.2 million. Investing activities. Cash flows from investing activities decreased approximately $28.1 million in 2017. The decrease was primarily due to higher cash outflows for capital expenditures of $25.6 million. Cash flows from investing activities increased approximately $93.8 million in 2016. The increase was primarily due to lower cash outflows for business combinations of $72.6 million and lower capital expenditures of $18.1 million which was driven by lower spend for the Antwerp, Belgium facility. This facility capital project was substantially completed in the fourth quarter of 2015. Financing activities. Cash flows from financing activities increased $26.4 million in 2017 compared with 2016. As further discussed in Note 8, we paid off our 2014 Credit Facility and entered into our new Credit Facility, consisting of a $400 million secured revolving line of credit, a $357.5 million secured term loan facility and a €250 million secured euro term loan facility. This transaction resulted in additional borrowings in 2017 of $53.6 million compared to 2016. Further, compared to 2016, net repayments under loans payable was $24.2 million higher. Additionally, during 2017, we paid debt issuance costs related to the Credit Facility entered into during the period, partially offset by no repurchases of common stock being made during 2017. Cash flows from financing activities decreased $37.7 million in 2016 compared with 2015, driven by the $50.0 million prepayment on the term loan facility that was made in January 2016 and a net borrowing decrease on the revolving credit facility of $28.4 million, partially mitigated by decreased purchase of common stock of $27.1 million and an increase in net borrowings on loans payable of $11.9 million. We have paid no dividends on our common stock since 2009. Capital Resources and Liquidity Major debt instruments that were outstanding during 2017 are described below. Credit Facility On February 14, 2017, the Company entered into a new credit facility (the “Credit Facility”) with a group of lenders to refinance its then outstanding credit facility debt and to provide liquidity for ongoing working capital requirements and general corporate purposes. The Credit Facility consists of a $400 million secured revolving line of credit with a term of five years, a $357.5 million secured term loan facility with a term of seven years and a €250 million secured Euro term loan facility with a term of seven years. The term loans are payable in equal quarterly installments in an amount equal to 0.25% of the original principal amount of the term loans, with the remaining balance due on the maturity date thereof. In addition, the Company is required, on an annual basis, to make a prepayment of term loans until they are fully paid and then to the revolving loans in an amount equal to a portion of the Company’s excess cash flow, as calculated pursuant to the Credit Facility. Subject to the satisfaction of certain conditions, the Company can request additional commitments under the revolving line of credit or term loans in the aggregate principal amount of up to $250 million, to the extent that existing or new lenders agree to provide such additional commitments and/or term loans. The Company can also raise certain additional debt or credit facilities subject to satisfaction of certain covenant levels. Certain of the Company’s U.S. subsidiaries have guaranteed the Company’s obligations under the Credit Facility and such obligations are secured by (a) substantially all of the personal property of the Company and the U.S. subsidiary guarantors and (b) a pledge of 100% of the stock of certain of the Company’s U.S. subsidiaries and 65% of the stock of certain of the Company’s direct foreign subsidiaries. Interest Rate - Term Loans: The interest rates applicable to the U.S. term loans will be, at the Company’s option, equal to either a base rate or a LIBOR rate plus, in both cases, an applicable margin. The interest rates applicable to the Euro term loans will be a Euro Interbank Offered Rate (“EURIBOR”) rate plus an applicable margin. · The base rate for U.S. term loans will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate or (iii) the daily LIBOR rate plus 1.00%. The applicable margin for base rate loans is 1.50%. · The LIBOR rate for U.S. term loans shall not be less than 0.75% and the applicable margin for LIBOR rate U.S. term loans is 2.50%. · The EURIBOR rate for Euro term loans shall not be less than 0% and the applicable margin for EURIBOR rate loans is 2.75%. · For LIBOR rate term loans and EURIBOR rate term loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate or EURIBOR rate, as applicable, for the corresponding duration. At December 31, 2017, the Company had borrowed $354.8 million under the secured term loan facility at an interest rate of 4.07% and €248.1 million under the secured Euro term loan facility at an interest rate of 2.75%. At December 31, 2017, there were no additional borrowings available under the term loan facilities. We entered into interest rate swap agreements in the second quarter of 2017. These swaps converted $150 million and €90 million of our term loans from variable interest rates to fixed interest rates. At December 31, 2017, the effective interest rate for the term loan facilities after adjusting for the interest rate swap was 4.27% for the secured term loan facility and 3.00% for the Euro term loan facility. Interest Rate - Revolving Credit Line: The interest rates applicable to loans under the revolving credit line will be, at the Company’s option, equal to either a base rate or a LIBOR rate plus, in both cases, an applicable variable margin. The variable margin will be based on the ratio of (a) the Company’s total consolidated net debt outstanding at such time to (b) the Company’s consolidated EBITDA computed for the period of four consecutive fiscal quarters most recently ended. · The base rate for revolving loans will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate or (iii) the daily LIBOR rate plus 1.00%. The applicable margin for base rate loans will vary between 0.75% and 1.75%. · The LIBOR rate for revolving loans shall not be less than 0% and the applicable margin for LIBOR rate revolving loans will vary between 1.75% and 2.75%. · For LIBOR rate revolving loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2017, there were $78.0 million borrowings under the revolving credit line at an interest rate of 3.63%. The borrowing on the revolving credit line was used to fund acquisitions and for other general business purposes. After reductions for outstanding letters of credit secured by these facilities, we had $317.3 million of additional borrowings available under the revolving credit facilities at December 31, 2017. The Credit Facility contains customary restrictive covenants including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. The Credit Facility also contains standard provisions relating to conditions of borrowing and customary events of default, including the non-payment of obligations by the Company and the bankruptcy of the Company. Specific to the revolving credit facility, the Company is subject to a financial covenant regarding the Company’s maximum leverage ratio. If an event of default occurs, all amounts outstanding under the Credit Agreement may be accelerated and become immediately due and payable. At December 31, 2017, we were in compliance with the covenants of the Credit Facility.  2014 Credit Facility In 2014, the Company entered into a credit facility that was amended on January 25, 2016, and August 29, 2016, resulting in a $400 million secured revolving line of credit with a term of five years and a $300 million secured term loan facility with a term of seven years from the original issuance date (the “2014 Credit Facility”) with a group of lenders that was replaced on February 14, 2017, by the Credit Facility (as defined above). Off Balance Sheet Arrangements Consignment and Customer Arrangements for Precious Metals. We use precious metals, primarily silver, in the production of some of our products. We obtain most precious metals from financial institutions under consignment agreements. The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign and the period of consignment. These fees were $1.2 million, $0.8 million and $0.8 million for 2017, 2016, and 2015, respectively. We had on hand precious metals owned by participants in our precious metals consignment program of $37.7 million at December 31, 2017 and $28.7 million at December 31, 2016, measured at fair value based on market prices for identical assets and net of credits. The consignment agreements under our precious metals program involve short-term commitments that typically mature within 30 to 90 days of each transaction and are typically renewed on an ongoing basis. As a result, the Company relies on the continued willingness of financial institutions to participate in these arrangements to maintain this source of liquidity. On occasion, we have been required to deliver cash collateral. While no deposits were outstanding at December 31, 2017, or December 31, 2016, we may be required to furnish cash collateral in the future based on the quantity and market value of the precious metals under consignment and the amount of collateral-free lines provided by the financial institutions. The amount of cash collateral required is subject to review by the financial institutions and can be changed at any time at their discretion, based in part on their assessment of our creditworthiness. Bank Guarantees and Standby Letters of Credit. At December 31, 2017, the Company and its subsidiaries had bank guarantees and standby letters of credit issued by financial institutions that totaled $7.7 million. These agreements primarily relate to Ferro’s insurance programs, foreign energy purchase contracts and foreign tax payments. Other Financing Arrangements We maintain other lines of credit to provide global flexibility for Ferro’s short-term liquidity requirements. These facilities are uncommitted lines for our international operations and totaled $64.5 million at December 31, 2017. We had $39.4 million of additional borrowings available under these lines at December 31, 2017. Liquidity Requirements Our primary sources of liquidity are available cash and cash equivalents, available lines of credit under the Credit Facility, and cash flows from operating activities. As of December 31, 2017, we had $63.6 million of cash and cash equivalents. Substantially all of our cash and cash equivalents were held by foreign subsidiaries. Cash generated in the U.S. is generally used to pay down amounts outstanding under our revolving credit facility and for general corporate purposes, including acquisitions. If needed, we could repatriate the majority of cash held by foreign subsidiaries without the need to accrue and pay U.S. income taxes. We do not anticipate a liquidity need requiring such repatriation of these funds to the U.S. Our liquidity requirements primarily include debt service, purchase commitments, labor costs, working capital requirements, restructuring expenditures, acquisition costs, capital investments, precious metals cash collateral requirements, and postretirement benefit obligations. We expect to meet these requirements in the long term through cash provided by operating activities and availability under existing credit facilities or other financing arrangements. Cash flows from operating activities are primarily driven by earnings before noncash charges and changes in working capital needs. In 2017, cash flows from financing and operating activities were used to fund our investing activities. Additionally, we used the borrowings available under the Credit Facility to fund acquisitions and for other general business purposes. We had additional borrowing capacity of $356.7 million at December 31, 2017, available under various credit facilities, primarily our revolving credit facility. Our Credit Facility contains customary restrictive covenants, including those described in more detail in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. These covenants include customary restrictions, including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. Specific to the revolving credit facility, we are subject to a financial covenant regarding the Company’s maximum leverage ratio. This covenant under our Credit Facility restricts the amount of our borrowings, reducing our flexibility to fund ongoing operations and strategic initiatives. This facility is described in more detail in “Capital Resources and Liquidity” under Item 7 and in Note 8 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K.  As of December 31, 2017, we were in compliance with our maximum leverage ratio covenant of 4.25x as our actual ratio was 2.69x, providing $95.7 million of EBITDA cushion on the leverage ratio, as defined within the Credit Facility. To the extent that economic conditions in key markets deteriorate or we are unable to meet our business projections and EBITDA falls below approximately $160 million for a rolling four quarters, based on reasonably consistent net debt levels with those as of December 31, 2017, we could become unable to maintain compliance with our leverage ratio covenant. In such case, our lenders could demand immediate payment of outstanding amounts and we would need to seek alternate financing sources to pay off such debts and to fund our ongoing operations. Such financing may not be available on favorable terms, if at all. Difficulties experienced in global capital markets could affect the ability or willingness of counterparties to perform under our various lines of credit, forward contracts, and precious metals program. These counterparties are major, reputable, multinational institutions, all having investment-grade credit ratings. Accordingly, we do not anticipate counterparty default. However, an interruption in access to external financing could adversely affect our business prospects and financial condition. We assess on an ongoing basis our portfolio of businesses, as well as our financial and capital structure, to ensure that we have sufficient capital and liquidity to meet our strategic objectives. As part of this process, from time to time we evaluate the possible divestiture of businesses that are not critical to our core strategic objectives and, where appropriate, pursue the sale of such businesses and assets. We also evaluate and pursue acquisition opportunities that we believe will enhance our strategic position such as the acquisitions we completed in 2017, 2016 and 2015. Generally, we publicly announce material divestiture and acquisition transactions only when we have entered into a material definitive agreement or closed on those transactions.  The Company’s aggregate amount of contractual obligations for the next five years and thereafter is set forth below:   _____________________ (1) Loans Payable includes our loans payable to banks. (2) Long-term debt excludes imputed interest and executory costs on capitalized lease obligations and unamortized issuance costs on the term loan facility. (3) Interest represents only contractual payments for fixed-rate debt. (4) Purchase commitments are noncancelable contractual obligations for raw materials and energy, and exclude capital expenditures for property, plant and equipment. (5) We have not projected payments past 2018 due to uncertainties in estimating the amount and period of any payments. The amount above relates to our current income tax liability as of December 31, 2017. We have $25.6 million in gross liabilities related to unrecognized tax benefits, including $3.8 million of accrued interest and penalties that are not included in the above table since we cannot reasonably predict the timing of cash settlements with various taxing authorities. (6) The funding amounts are based on the minimum contributions required under our various plans and applicable regulations in each respective country. We have not projected contributions past 2019 due to uncertainties regarding the assumptions involved in estimating future required contributions. Critical Accounting Policies When we prepare our consolidated financial statements we are required to make estimates and assumptions that affect the amounts we report in the consolidated financial statements and footnotes. We consider the policies discussed below to be more critical than other policies because their application requires our most subjective or complex judgments. These estimates and judgments arise because of the inherent uncertainty in predicting future events. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors. Revenue Recognition We recognize sales typically when we ship goods to our customers and when all of the following criteria are met: · Persuasive evidence of an arrangement exists; · The selling price is fixed or determinable; · Collection is reasonably assured; and · Title and risk of loss has passed to our customers. In order to ensure the revenue recognition in the proper period, we review material sales contracts for proper cut-off based upon the business practices and legal requirements of each country. For sales of products containing precious metals, we report revenues on a gross basis along with their corresponding cost of sales to arrive at gross profit. We record revenues this way because we act as the principal in the transactions into which we enter. Restructuring and Cost Reduction Programs In recent years, we have developed and initiated global cost reduction programs with the objectives of leveraging our global scale, realigning and lowering our cost structure, and optimizing capacity utilization. Management continues to evaluate our businesses, and therefore, there may be additional provisions for new optimization and cost-savings initiatives, as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Restructuring charges include both termination benefits and asset writedowns. We estimate accruals for termination benefits based on various factors including length of service, contract provisions, local legal requirements, projected final service dates, and salary levels. We also analyze the carrying value of long-lived assets and record estimated accelerated depreciation through the anticipated end of the useful life of the assets affected by the restructuring or record an asset impairment. In all likelihood, this accelerated depreciation will result in reducing the net book value of those assets to zero at the date operations cease. While we believe that changes to our estimates are unlikely, the accuracy of our estimates depends on the successful completion of numerous actions. Changes in our estimates could increase our restructuring costs to such an extent that it could have a material impact on the Company’s results of operations, financial position, or cash flows. Other events, such as negotiations with unions and works councils, may also delay the resulting cost savings. Accounts Receivable and the Allowance for Doubtful Accounts Ferro sells its products to customers in diversified industries throughout the world. No customer or related group of customers represents greater than 10% of net sales or accounts receivable. We perform ongoing credit evaluations of our customers and require collateral principally for export sales, when industry practices allow and as market conditions dictate, subject to our ability to negotiate secured terms relative to competitive offers. We regularly analyze significant customer accounts and provide for uncollectible accounts based on historical experience, customer payment history, the length of time the receivables are past due, the financial health of the customer, economic conditions, and specific circumstances, as appropriate. Changes in these factors could result in additional allowances. Customer accounts we conclude to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. Historically, write-offs of uncollectible accounts have been within our expectations. Goodwill We review goodwill for impairment each year using a measurement date of October 31st or more frequently in the event of an impairment indicator. We annually, or more frequently as warranted, evaluate the appropriateness of our reporting units utilizing operating segments as the starting point of our analysis. In the event of a change in our reporting units, we would allocate goodwill based on the relative fair value. We estimate the fair values of the reporting units associated with these assets using the average of both the income approach and the market approach, which we believe provides a reasonable estimate of the reporting units’ fair values, unless facts and circumstances exist that indicate more representative fair values. The income approach uses projected cash flows attributable to the reporting units over their useful lives and allocates certain corporate expenses to the reporting units. We use historical results, trends and our projections of market growth, internal sales efforts and anticipated cost structure assumptions to estimate future cash flows. Using a risk-adjusted, weighted-average cost of capital, we discount the cash flow projections to the measurement date. The market approach estimates a price reasonably expected to be paid by a market participant in the purchase of similar businesses. If the fair value of any reporting unit was determined to be less than its carrying value, we would proceed to the second step and obtain comparable market values or independent appraisals of its assets and liabilities to determine the amount of any impairment. The significant assumptions and ranges of assumptions we used in our impairment analyses of goodwill at October 31, 2017 and 2016, were as follows:     Our estimates of fair value can be adversely affected by a variety of factors. Reductions in actual or projected growth or profitability at our reporting units due to unfavorable market conditions or significant increases in cost structure could lead to the impairment of any related goodwill. Additionally, an increase in inflation, interest rates or the risk-adjusted, weighted-average cost of capital could also lead to a reduction in the fair value of one or more of our reporting units and therefore lead to the impairment of goodwill. Based on our 2017 annual impairment test performed as of October 31, 2017, the fair values of the reporting units tested for impairment exceeded the carrying values of the respective reporting units by amounts ranging from 35.4% to 300.7% at the 2017 measurement date. The lowest cushion relates to goodwill associated with the Performance Coatings reportable segment, which had a goodwill balance of $38.2 million at December 31, 2017. During 2016, we recognized an impairment loss of $13.2 million in our Tile Coating Systems reporting unit, a component of our Performance Coatings segment. A future potential impairment is possible for any of these reporting units if actual results are materially less than forecasted results. Some of the factors that could negatively affect our cash flows and, as a result, not support the carrying values of our reporting units are: new environmental regulations or legal restrictions on the use of our products that would either reduce our product revenues or add substantial costs to the manufacturing process, thereby reducing operating margins; new technologies that could make our products less competitive or require substantial capital investment in new equipment or manufacturing processes; and substantial downturns in economic conditions. Long-Lived Asset Impairment The Company’s long-lived assets include property, plant and equipment, and intangible assets. We review property, plant and equipment and intangible assets for impairment whenever events or circumstances indicate that their carrying values may not be recoverable. The following are examples of such events or changes in circumstances: · An adverse change in the business climate of a long-lived asset or asset group; · An adverse change in the extent or manner in which a long-lived asset or asset group is used or in its physical condition; · Current operating losses for a long-lived asset or asset group combined with a history of such losses or projected or forecasted losses that demonstrate that the losses will continue; or · A current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise significantly disposed of before the end of its previously estimated useful life. The carrying amount of property, plant and equipment and intangible assets is not recoverable if the carrying value of the asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group. In the event of impairment, we recognize a loss for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of review. Income Taxes The breadth of our operations and complexity of income tax regulations require us to assess uncertainties and make judgments in estimating the ultimate amount of income taxes we will pay. Our income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. The final income taxes we pay are based upon many factors, including existing income tax laws and regulations, negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation, and resolution of disputes arising from federal, state and international income tax audits. The resolution of these uncertainties may result in adjustments to our income tax assets and liabilities in the future. Deferred income taxes result from differences between the financial and tax basis of our assets and liabilities. We adjust our deferred income tax assets and liabilities for changes in income tax rates and income tax laws when changes are enacted. We record valuation allowances to reduce deferred income tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and the magnitude of appropriate valuation allowances against deferred income tax assets. The realization of these assets is dependent on generating future taxable income, our ability to carry back or carry forward net operating losses and credits to offset tax liabilities, as well as successful implementation of various tax strategies to generate tax where net operating losses or credit carryforwards exist. In evaluating our ability to realize the deferred income tax assets, we rely principally on the reversal of existing temporary differences, the availability of tax planning strategies, and forecasted income. We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Our estimate of the potential outcome of any uncertain tax positions is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. We record a liability for the difference between the benefit recognized and measured based on a more-likely-than-not threshold and the tax position taken or expected to be taken on the tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. We report tax-related interest and penalties as a component of income tax expense. Derivative Financial Instruments We use derivative financial instruments in the normal course of business to manage our exposure to fluctuations in interest rates, foreign currency exchange rates, and precious metal prices. The accounting for derivative financial instruments can be complex and can require significant judgment. Generally, the derivative financial instruments that we use are not complex, and observable market-based inputs are available to measure their fair value. We do not engage in speculative transactions for trading purposes. The use of financial derivatives is managed under a policy that identifies the conditions necessary to identity the transaction as a financial derivative. Financial instruments, including derivative financial instruments, expose us to counterparty credit risk for nonperformance. We manage our exposure to counterparty credit risk through minimum credit standards and procedures to monitor concentrations of credit risk. We enter into these derivative financial instruments with major, reputable, multinational financial institutions. Accordingly, we do not anticipate counter-party default. We continuously evaluate the effectiveness of derivative financial instruments designated as hedges to ensure that they are highly effective. In the event the hedge becomes ineffective, we discontinue hedge treatment. Except as noted below, we do not expect any changes in our risk policies or in the nature of the transactions we enter into to mitigate those risks. Our exposure to interest rate changes arises from our debt agreements with variable interest rates. To reduce our exposure to interest rate changes on variable rate debt, we entered into interest rate swap agreements. These swaps are settled in cash, and the net interest paid or received is effectively recognized as interest expense. We mark these swaps to fair value and recognize the resulting gains or losses as other comprehensive income. To help protect the value of the Company’s net investment in European operations against adverse changes in exchange rates, the Company uses non-derivative financial instruments, such as its foreign currency denominated debt, as economic hedges of its net investments in certain foreign subsidiaries. We manage foreign currency risks in a wide variety of foreign currencies principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions arising from international trade. Our objective in entering into these forward contracts is to preserve the economic value of nonfunctional currency cash flows. Our principal foreign currency exposures relate to the Euro, the Thailand Baht, the Indonesian Rupiah, the Japanese Yen, the Chinese Renminbi and the Romanian Leu. We mark these forward contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as other income or expense from foreign currency transactions. Precious metals (primarily silver, gold, platinum and palladium) represent a significant portion of raw material costs in our electronics products. When we enter into a fixed price sales contract at the customer’s request to establish the price for the precious metals content of the order, we also enter into a forward purchase arrangement with a precious metals supplier to completely cover the value of the precious metals content. Our current precious metal contracts are designated as normal purchase contracts, which are not marked to market. We also purchase portions of our energy requirements, including natural gas and electricity, under fixed price contracts to reduce the volatility of cost changes. Our current energy contracts are designated as normal purchase contracts, which are not marked to market. Pension and Other Postretirement Benefits We sponsor defined benefit plans in the U.S. and many countries outside the U.S., and we also sponsor retiree medical benefits for a segment of our salaried and hourly work force within the U.S. The U.S. pension plans and retiree medical plans represent approximately 86% of pension plan assets, 69% of benefit obligations and 72% of net periodic pension expense as of December 31, 2017. The assumptions we use in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. We meet with our actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. We determine the discount rate for the U.S. pension and retiree medical plans based on a bond model. Using the pension plans’ projected cash flows, the bond model considers all possible bond portfolios that produce matching cash flows and selects the portfolio with the highest possible yield. These portfolios are based on bonds with a quality rating of AA or better under either Moody’s Investor Services, Inc. or Standard & Poor’s Rating Group, but exclude certain bonds, such as callable bonds, bonds with small amounts outstanding, and bonds with unusually high or low yields. The discount rates for the non-U.S. plans are based on a yield curve method, using AA-rated bonds applicable in their respective capital markets. The duration of each plan’s liabilities is used to select the rate from the yield curve corresponding to the same duration. For the market-related value of plan assets, we use fair value, rather than a calculated value. The market-related value recognizes changes in fair value in a systematic and rational manner over several years. We calculate the expected return on assets at the beginning of the year for defined benefit plans as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. In determining the expected returns, we consider both historical performance and an estimate of future long-term rates of return. The Company consults with and considers the opinion of its actuaries in developing appropriate return assumptions. Our target asset allocation percentages are 35% fixed income, 60% equity, and 5% other investments for U.S. plans and 75% fixed income, 24% equity, and 1% other investments for non-U.S. plans. In 2017, investment returns on average plan assets were approximately 16% within the U.S. plans and 3% within non-U.S. plans. In 2016, actual return on plan assets, were lower than the expected return. Future actual pension expense will depend on future investment allocation and performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans. All other assumptions are reviewed periodically by our actuaries and us and may be adjusted based on current trends and expectations as well as past experience in the plans. The following table provides the sensitivity of net annual periodic benefit costs for our pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25-basis-point decrease in both the discount rate and asset return assumption:    The following table provides the rates used in the assumptions and the changes between 2017 and 2016:   Our overall net periodic benefit credit for all defined benefit plans was $6.4 million in 2017 and a cost of $20.2 million in 2016. The change is mainly the result of mark to market actuarial net gains in 2017. For 2018, assuming expected returns on plan assets and no actuarial gains or losses, we expect our overall net periodic benefit income to be approximately $0.2 million, compared with income of approximately $1.2 million in 2017 on a comparable basis. Inventories We value inventory at the lower of cost or market, with cost determined utilizing the first-in, first-out (FIFO) method. We periodically evaluate the net realizable value of inventories based primarily upon their age, but also upon assumptions of future usage in production, customer demand and market conditions. Inventories have been reduced to the lower of cost or realizable value by allowances for slow moving or obsolete goods. If actual circumstances are less favorable than those projected by management in its evaluation of the net realizable value of inventories, additional write-downs may be required. Slow moving, excess or obsolete materials are specifically identified and may be physically separated from other materials, and we rework or dispose of these materials as time and manpower permit. Environmental Liabilities Our manufacturing facilities are subject to a broad array of environmental laws and regulations in the countries in which they are located. The costs to comply with complex environmental laws and regulations are significant and will continue for the foreseeable future. We expense these recurring costs as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations. We also accrue for environmental remediation costs and other obligations when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events. Inherent uncertainties exist in such evaluations primarily due to unknown conditions and other circumstances, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress or as additional technical or legal information becomes available. Impact of Newly Issued Accounting Pronouncements Refer to Note 2 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K for a discussion of accounting standards we recently adopted or will be required to adopt.

<s>[INST] During the year ended December 31, 2017, net sales increased $251.5 million, or 22.0%, compared with 2016. The increase was driven by higher sales in Color Solutions, Performance Colors and Glass and Performance Coatings of $111.2 million, $73.2 million and $67.0 million, respectively. Gross profit increased $65.0 million compared with 2016. The increase in gross profit was attributable to increases across all of our segments, with increases in Color Solutions, Performance Colors and Glass and Performance Coatings of $29.4 million, $23.8 million and $6.3 million, respectively. As a percentage of net sales, gross profit rate decreased approximately 90 basis points to 29.8%, from 30.7% in the prior year. For the year ended December 31, 2017, selling, general and administrative (“SG&A”) expenses increased $16.9 million, or 7.0%, compared with 2016. As a percentage of net sales, SG&A expenses decreased 260 basis points from 21.1% in 2016 to 18.5% in 2017. For the year ended December 31, 2017, net income was $57.8 million, compared with net loss of $19.9 million in 2016, and net income attributable to common shareholders was $57.1 million, compared with net loss attributable to common shareholders of $20.8 million in 2016. Income from continuing operations was $57.8 million for the year ended December 31, 2017, compared with income from continuing operations of $44.6 million in 2016.  2017 Transactional Activity Business Acquisitions Acquisition of Endeka Group (“Endeka”): As discussed in Note 4, in the fourth quarter of 2017, the Company acquired 100% of the equity interests of Endeka, a global producer of highvalue coatings and key raw materials for the ceramic tile market, for €72.7 million (approximately $84.6 million). Acquisition of Gardenia Quimica S.A. (“Gardenia”): As discussed in Note 4, in the third quarter of 2017, the Company acquired a majority interest in Gardenia for $3.0 million. Acquisition of Dip Tech Ltd. (“DipTech”): As discussed in Note 4, in the third quarter of 2017, the Company acquired 100% of the equity interests of DipTech, a leading provider of digital printing solutions for glass, for $76.0 million. Acquisition of S.P.C. Group s.r.l. and Smalti per Ceramiche, s.r.l (together “SPC”): As discussed in Note 4, in the second quarter of 2017, the Company acquired 100% of the equity interests of SPC, for €18.7 million (approximately $20.3 million). Outlook  The Company delivered strong performance throughout 2017, with notable sales and gross profit improvements, primarily due to increases in organic growth, contributions from businesses acquired within the past 12 months and optimization programs throughout the footprint. For 2018, we will continue to execute our value creation strategy, which includes organic and inorganic growth, and optimization. We expect organic growth through new products and repositioning of our portfolio to continue transitioning to the higher end of our target markets. We expect to continue investing at a level of approximately $100 to $150 million per year in strategic acquisitions. We are implementing optimization programs to improve efficiency and upgrade operations throughout our business.  Raw materials costs increased during 2017, putting pressure on gross margin. Over the long term, we are confident in our ability to mitigate raw material inflation, with a lag, due to our technological advances in reformulating compounds, pricing initiatives and optimization initiatives. For 2017, organic growth, new products and pricing initiatives completely offset raw [/INST] Positive. </s>

FERRO CORP

2019-02-27

2018-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview During the year ended December 31, 2018, net sales increased $215.7 million, or 15.4%, compared with 2017. The increase was driven by higher sales in Performance Coatings, Performance Colors and Glass and Color Solutions of $139.9 million, $42.8 million and $33.0 million, respectively. Gross profit increased $39.7 million compared with 2017. The increase in gross profit was attributable to increases across all of our segments, with increases in Performance Coatings, Color Solutions and Performance Colors and Glass and of $19.9 million, $11.2 million and $9.9 million, respectively. As a percentage of net sales, gross profit rate decreased approximately 150 basis points to 28.3%, from 29.8% in the prior year. For the year ended December 31, 2018, selling, general and administrative (“SG&A”) expenses increased $13.1 million, or 5.0%, compared with 2017. As a percentage of net sales, SG&A expenses decreased 170 basis points from 19.0% in 2017 to 17.3% in 2018. For the year ended December 31, 2018, net income was $80.9 million, compared with net income of $57.8 million in 2017, and net income attributable to common shareholders was $80.1 million, compared with net income attributable to common shareholders of $57.1 million in 2017. As previously disclosed on January 17, 2019, the Company is in the process of expanding its production facility in Villagran, Mexico, which will become the Company’s Manufacturing Center of Excellence for the Americas. The expansion of the Villagran facility is expected to significantly increase the revenue generated from products manufactured at that facility. With the expanded capacity in Villagran, the Company (i) will discontinue the production of glass enamels, other industrial specialty products, such as architectural glass coatings, and pigments at its Washington, Pennsylvania facility over the course of 2019 and into 2020, (ii) plans to discontinue production of porcelain enamel products at its Cleveland, Ohio facility and (iii) will close additional facilities in Latin America. As part of this optimization initiative, the Company is expanding its King of Prussia, Pennsylvania facility. Conductive glass coatings production will be discontinued at the Washington, Pennsylvania facility and will be produced at the King of Prussia, Pennsylvania facility, and the Company’s operations at its Vista, California facility will be transferred to the King of Prussia, Pennsylvania facility. In addition, the Company will be moving its Americas research and development center for glass products to its technology center in Independence, Ohio, where the Company is investing in expanded laboratory facilities. The Washington, Pennsylvania facility is expected to remain in operation until sometime in 2020. Production of specialty glasses for electronics applications will continue at the Cleveland, Ohio facility, and the Company will invest in the facility to equip it to serve as a logistics center. The Cleveland, Ohio facility also will serve as the Americas research and development center for the porcelain enamel business.  2018 Transactional Activity Transactions undertaken in 2018 included the following business acquisitions: Acquisition of Quimicer, S.A. (“Quimicer”): As discussed in Note 5, in the fourth quarter of 2018, the Company acquired 100% of the equity interests of Quimicer, for €27.0 million (approximately $31.3 million), including the assumption of debt of €5.2 million (approximately $6.1 million). Acquisition of UWiZ Technology Co., Ltd. (“UWiZ”): As discussed in Note 5, in the third quarter of 2018, the Company acquired 100% of the equity interest of UWiZ for TWD823.4 million (approximately $26.9 million). Acquisition of Ernst Diegel GmbH (“Diegel”): As discussed in Note 5, in the third quarter of 2018, the Company acquired 100% of the equity interests of Diegel, including the real property of a related party, for €12.1 million (approximately $14.0 million). Acquisition of MRA Laboratories, Inc. (“MRA”): As discussed in Note 5, in the second quarter of 2018, the Company acquired 100% of the equity interests of MRA, for $16.0 million. Acquisition of PT Ferro Materials Utama. (“FMU”): As discussed in Note 5, in the second quarter of 2018, the Company acquired 66% of the equity interests of FMU, for $2.7 million in cash, in addition to the forgiveness of debt of $9.2 million, bringing our total ownership to 100%. 2017 Transactional Activity Transactions undertaken in 2017 included the following business acquisitions: Acquisition of Endeka Group (“Endeka”): As discussed in Note 5, in the fourth quarter of 2017, the Company acquired 100% of the equity interests of Endeka, a global producer of high-value coatings and key raw materials for the ceramic tile market, for €72.8 million (approximately $84.8 million). Acquisition of Gardenia Quimica S.A. (“Gardenia”): As discussed in Note 5, in the third quarter of 2017, the Company acquired a majority interest in Gardenia for $3.0 million. On March 1, 2018, the Company acquired the remaining equity interest in Gardenia for $1.4 million. Acquisition of Dip Tech Ltd. (“Dip-Tech”): As discussed in Note 5, in the third quarter of 2017, the Company acquired 100% of the equity interests of Dip-Tech, a leading provider of digital printing solutions for glass, for $77.0 million. Acquisition of S.P.C. Group s.r.l. and Smalti per Ceramiche, s.r.l (together “SPC”): As discussed in Note 5, in the second quarter of 2017, the Company acquired 100% of the equity interests of SPC, for €18.7 million (approximately $20.3 million). Outlook  The Company delivered strong performance throughout 2018 with sales and gross profit improvements driven by increases in organic growth, contributions from businesses acquired and optimization initiatives. We continue to execute the dynamic innovation and optimization phase of our value creation strategy, which includes organic and inorganic growth and optimization. We expect organic growth through new products and positioning our portfolio to continue to transition to the higher end of our target markets. We also intend to advance the business through acquisitions, and investments in technology, facilities and equipment. We are implementing optimization initiatives throughout the Company to further improve efficiency, productivity and profitability. We will deploy capital for strategic acquisitions, share repurchases or debt repayment depending on what we deem appropriate based on market conditions, shareholder value creation and long term business objectives. Raw materials costs continued to increase through the majority of 2018, putting pressure on gross margin. Over the long term, we are confident in our ability to offset such increases with reformulated compounds, new product innovations, pricing initiatives and optimization efforts. We believe that, when taken as a whole, raw material prices have now peaked and are decreasing. We perceive a degree of macro-economic uncertainty and the potential for slower growth in the outlook for 2019 across several industries. We expect demand will continue for our technology-driven functional coatings and color solutions in the niche markets we focus on, and that we will continue to develop innovative new products. We have identified a number of optimization opportunities in our manufacturing and logistics operations and will continue to implement strategic optimization initiatives. Foreign currency rates may continue to be volatile through 2019 and changes in interest rates could adversely impact reported results. We expect cash flow from operating activities to continue to be positive for 2019, providing additional liquidity. Factors that could adversely affect our future performance include those described under the heading “Risk Factors” in Item 1A of Part I of this Annual Report on Form 10-K for the year ended December 31, 2018. Results of Operations - Consolidated Comparison of the years ended December 31, 2018 and 2017 For the year ended December 31, 2018, net income was $80.9 million, compared with net income of $57.8 million in 2017. For the year ended December 31, 2018, net income attributable to common shareholders was $80.1 million, or $0.95 earnings per share, compared with net income attributable to common shareholders of $57.1 million, or $0.68 earnings per share in 2017. Net Sales    Net sales increased by $215.7 million, or 15.4%, in the year ended December 31, 2018, compared with the prior year, with increased sales in Performance Coatings, Performance Colors and Glass and Color Solutions of $139.9 million, $42.8 million and $33.0 million, respectively. The increase in net sales was driven by both acquisitions and organic growth. Organic sales increased in Performance Coatings by $28.2 million, Color Solutions by $28.1 million, and Performance Colors and Glass by $22.6 million. Gross Profit Gross profit increased $39.7 million, or 9.5%, in 2018 to $455.9 million, compared with $416.2 million in 2017 and, as a percentage of net sales, it decreased 150 basis points to 28.3%. The increase in gross profit was attributable to increases across all of our segments, with increases in Performance Coatings, Color Solutions and Performance Colors and Glass of $19.9 million, $11.2 million and $9.9 million, respectively. The increase in gross profit was primarily attributable to favorable product pricing of $43.1 million, gross profit from acquisitions of $34.1 million, higher sales volumes and mix of $7.5 million, favorable foreign currency impacts of $5.3 million and lower manufacturing and product costs of $2.8 million, partially offset by higher raw material costs of $51.8 million. Geographic Revenues The following table presents our sales on the basis of where sales originated.   The increase in net sales of $215.7 million, compared with 2017, was driven by higher sales from EMEA, Asia Pacific and the United States, partially offset by a decrease in sales in Latin America. The increase in sales from EMEA was attributable to higher sales in Performance Coatings, Performance Colors and Glass and Color Solutions of $129.2 million, $32.0 million and $8.0 million, respectively. The increase in sales from Asia Pacific was attributable to higher sales in Performance Coatings, Performance Colors and Glass and Color Solutions of $13.9 million, $6.3 million and $5.3 million, respectively. The increase in sales from the United States was attributable to higher sales in Color Solutions, Performance Colors and Glass and Performance Coatings of $18.2 million, $2.7 million and $2.6 million, respectively. The decrease in sales from Latin America was attributable to lower sales in Performance Coatings of $5.8 million, partially mitigated by higher sales in Performance Colors and Glass and Color Solutions of $1.9 million and $1.5 million, respectively. The following table presents our sales on the basis of where sold products were shipped.   Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2018 and 2017.  SG&A expenses were $13.1 million higher in 2018 compared with the prior year. As a percentage of net sales, SG&A expenses decreased 170 basis points from 19.0% in 2017 to 17.3% in 2018. The higher SG&A expenses compared with the prior year were primarily driven by businesses acquired within the last year. The acquisitions were the primary driver of the increase in personnel expenses. The decrease in incentive compensation is the result of the Company’s performance relative to targets for certain awards compared to the prior year and the decrease in stock-based compensation expense of $3.3 million is the result of the Company’s performance relative to targets for certain awards compared with the prior year, as well as decreases in the Company’s stock price. The following table presents SG&A expenses attributable to sales, research and development, and operations costs as strategic services and presents other SG&A costs as functional services.    Restructuring and Impairment Charges   Restructuring and impairment charges increased $1.9 million in 2018, compared with 2017. The increase was primarily related to costs associated with integration of recent acquisitions and optimization programs. The increase was partially offset by an “other than temporary impairment” charge on an equity method investment of $1.6 million and costs associated with a restructuring plan in Italy, which includes $1.2 million of asset impairment associated with assets that were taken out of service in 2017, which didn’t occur in 2018. Interest Expense  Interest expense in 2018 increased $5.6 million compared with 2017. The increase in interest expense was primarily due to an increase in the average long-term debt balance during 2018, compared with 2017, partially offset by increased interest capitalization during 2018. Income Tax Expense In 2018, we recorded an income tax expense of $23.0 million, or 22.2 % of income before income taxes, compared to an income tax expense of $52.8 million, or 47.7% of income before income taxes in 2017. The 2018 effective tax rate is greater than the statutory income tax rate of 21% primarily as a result of a net effect of a $7.9 million net expense related to foreign tax rate differences, $3.5 million net expense resulting from foreign income tax audit settlements, $5.7 million net benefit related to tax credits and $4.1 million net benefit related to the release of valuation allowances related to deferred tax assets that were utilized in the current year or which are deemed no longer necessary based upon changes in the current and expected future years of operating profits. The 2017 effective tax rate is greater than the statutory income tax rate of 35% primarily as a result of a net effect of a $21.5 million expense related to re-measuring the U.S. deferred tax assets as a result of the Tax Act, $5.6 million net expense related to uncertain tax positions and $8.0 million benefit related to foreign tax rate differences. On December 22, 2017, U.S. federal tax legislation, commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”), was signed into law, significantly changing the U.S. corporate income tax system. These changes include a federal statutory rate reduction from 35% to 21% effective January 1, 2018. Changes in tax rates and tax law are accounted for in the period of enactment. Accordingly, the Company’s U.S. net deferred tax assets were re-measured to reflect the reduction in the federal statutory rate, resulting in a $21.5 million increase in income tax expense for the year ended December 31, 2017. The Tax Act also changed the U.S. taxation of worldwide income. The Tax Act contains many provisions which continue to be clarified through new regulations. Consistent with the guidance of SEC Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”), we completed our analysis within 2018 consistent with the guidance of SAB 118 and our initial determination of no tax due on the one-time mandatory deemed repatriation tax on accumulated foreign subsidiaries’ previously untaxed foreign earnings and profits was unchanged from our position at December 31, 2017. Comparison of the years ended December 31, 2017 and 2016 For the year ended December 31, 2017, income from continuing operations was $57.8 million, compared with income from continuing operations of $44.6 million in 2016. For the year ended December 31, 2017, net income was $57.8 million, compared with net loss of $19.9 million in 2016. For the year ended December 31, 2017, net income attributable to common shareholders was $57.1 million, or $0.68 earnings per share, compared with net loss attributable to common shareholders of $20.8 million, or $0.25 loss per share in 2016. Net Sales  Net sales increased by $251.5 million, or 22.0%, in the year ended December 31, 2017, compared with the prior year, with increased sales in Color Solutions, Performance Colors and Glass and Performance Coatings of $111.2 million, $73.2 million and $67.0 million, respectively. The increase in net sales was driven by both acquisitions and organic growth. Organic sales increased in Color Solutions by $39.6 million, Performance Coatings by $24.1 million and Performance Colors and Glass by $11.8 million. Gross Profit Gross profit increased $59.8 million, or 16.8%, in 2017 to $416.2 million, compared with $356.4 million in 2016 and, as a percentage of net sales, it decreased 130 basis points to 29.8%. The increase in gross profit was attributable to increases across all of our segments, with increases in Color Solutions, Performance Colors and Glass and Performance Coatings of $29.2 million, $23.6 million and $6.3 million, respectively. The increase in gross profit was primarily attributable to acquisitions of $46.9 million, lower manufacturing and product costs of $28.8 million, driven by higher volume and mix, as well as strategic purchasing actions, favorable product pricing of $12.9 million, higher sales volumes and mix of $9.5 million, favorable foreign currency impacts of $0.3 million, partially offset by higher raw material costs of $39.3 million. Geographic Revenues The following table presents our sales on the basis of where sales originated.   The increase in net sales of $251.5 million, compared with 2016, was driven by higher sales from all regions. The increase in sales from EMEA was attributable to higher sales in Color Solutions, Performance Coatings and Performance Colors and Glass of $69.3 million, $56.4 million and $42.8 million, respectively. The increase in sales from the United States was primarily attributable to higher sales in Color Solutions and Performance Colors and Glass of $33.0 million and $22.9 million, respectively. The increase in sales from Latin America and Asia Pacific was attributable to higher sales across all segments. The following table presents our sales on the basis of where sold products were shipped.    Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2017 and 2016.    SG&A expenses were $38.1 million higher in 2017 compared with the prior year. As a percentage of net sales, SG&A expenses decreased 80 basis points from 19.8% in 2016 to 19.0% in 2017. The higher SG&A expenses compared with the prior year are primarily driven by businesses acquired within the last year. The acquisitions were the primary driver of the increase in personnel expenses, business development expenses and accounted for the entire increase in intangible asset amortization. The increase in stock-based compensation expense of $4.5 million is the result of the Company’s performance relative to targets for certain awards compared with the prior year, as well as increases in the Company’s stock price. The following table presents SG&A expenses attributable to sales, research and development, and operations costs as strategic services and presents other SG&A costs as functional services.   Restructuring and Impairment Charges    Restructuring and impairment charges decreased by $4.5 million in 2017, compared with 2016. The decrease was primarily attributable to an impairment charge in 2016 within our Tile Coating Systems reporting unit, a component of the Performance Coatings operating segment of $13.2 million. The decrease was partially offset by an increase due to an “other than temporary impairment” charge on an equity method investment of $1.6 million and costs associated with a restructuring plan in Italy, which includes $1.2 million of asset impairment associated with assets that have been taken out of service, as well as actions taken in connection with recent acquisitions designed to achieve our targeted synergies. Interest Expense   Interest expense in 2017 increased $6.2 million compared with 2016. The increase in interest expense was due to an increase in the average long-term debt balance during 2017, compared with 2016 and an increase of the amortization of debt issuance costs associated with the Credit Facility, partially offset by a favorable average borrowing rate as a result of the refinancing completed in the first quarter of 2017. Income Tax Expense On December 22, 2017, U.S. federal tax legislation, commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”), was signed into law, significantly changing the U.S. corporate income tax system. These changes include a federal statutory rate reduction from 35% to 21% effective January 1, 2018. Changes in tax rates and tax law are accounted for in the period of enactment. Accordingly, the Company’s U.S. net deferred tax assets were re-measured to reflect the reduction in the federal statutory rate, resulting in a $21.5 million increase in income tax expense for the year ended December 31, 2017. The Tax Act also changed the U.S. taxation of worldwide income. Accordingly, we have assessed the one-time mandatory deemed repatriation tax on accumulated foreign subsidiaries’ previously untaxed foreign earnings and profits and have preliminarily determined no tax is due. Additional provisions of the Tax Act which may have an impact to the Company include, but are not limited to, the repeal of the domestic production deduction, limitations on interest expense, accelerated depreciation that will allow for full expensing of qualified property, provisions related to performance-based executive compensation and international provisions, which generally establish a territorial-style system for taxing foreign-source income of domestic multinational corporations. We have recognized the provisional tax impacts related to the Tax Act under the guidance of SEC Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”). The ultimate impact may differ from these provisional amounts due to additional analysis, changes in interpretations and assumptions, additional regulatory guidance that may be issued, and actions we may take as a result of the Tax Act. Pursuant to SAB 118, adjustments to the provisional amounts recorded by the Company as of December 31, 2017, that are identified within a subsequent measurement period of up to one year from the enactment date will be included as an adjustment to income tax expense in the period the amounts are determined. In 2017, we recorded an income tax expense of $52.8 million, or 47.7% of income before income taxes, compared to an income tax expense of $17.9 million, or 28.6% of income before income taxes in 2016. The 2017 effective tax rate is greater than the statutory income tax rate of 35% primarily as a result of a net effect of a $21.5 million expense related to re-measuring the U.S. deferred tax assets as a result of the Tax Act, $5.6 million net expense related to uncertain tax positions and $8.0 million benefit related to foreign tax rate differences. The 2016 effective tax rate is less than the statutory income tax rate of 35%, primarily as a result of a $5.5 million net benefit related to greater levels of income earned in lower tax jurisdictions, $4.8 million net benefit for the release of valuation allowances related to deferred tax assets that were utilized in the current year, $2.0 million in net benefit for the release of valuation allowance, which are deemed no longer necessary based upon changes in the current and expected future years operating profits, $1.8 million benefit related to notional interest deductions, $2.8 million benefit for the generation of tax credits offset by a $4.1 expense related to the impairment of book basis goodwill and a $2.1 million expense related to non-deductible expenses. Results of Operations - Segment Information Comparison of the years ended December 31, 2018 and 2017 Performance Coatings      Net sales increased in Performance Coatings by $139.9 million compared with the prior year, primarily from sales of Endeka of $89.0 million, SPC of $10.1 million, Quimicer of $7.4 million and Gardenia of $3.3 million, and increases in sales of frits and glazes, digital inks and porcelain enamel of $14.9 million, $8.0 million and, $5.2 million, respectively. The increase in net sales was driven by higher product pricing of $27.1 million, sales from acquisitions of $111.7 million and favorable volume and mix of $4.8 million, partially offset by unfavorable foreign currency impacts of $3.7 million. Gross profit increased $19.9 million from the prior-year, primarily driven by favorable product pricing impacts of $27.1 million, gross profit from acquisitions of $28.0 million, favorable foreign currency impacts of $1.7 million and lower manufacturing costs of $0.9 million, partially offset by higher raw material costs of $37.0 million and lower sales volume and mix of $0.8 million.     The net sales increase of $139.9 million was primarily driven by increases in sales from EMEA and Asia Pacific. The increase in sales from EMEA was primarily attributable to sales from acquisitions, which contributed $109.0 million, and higher sales across all product lines. The increase in sales from Asia Pacific was driven by sales from acquisitions, which contributed $2.7 million, and higher sales of frits and glazes, digital inks and porcelain enamel of $7.1 million, $2.2 million and $1.6 million, respectively. The increase in sales from the United States was fully attributable to higher sales of porcelain enamel. The decrease in sales from Latin America was driven by lower sales of frits and glazes and porcelain enamel, partially offset by higher sales of digital inks.  Performance Colors and Glass    Net sales increased $42.8 million compared with the prior year, primarily driven by $12.2 million in sales from Dip-Tech and $12.9 million in sales from electronics products. The increase in net sales was driven by sales from acquisitions of $20.2 million, favorable volume and mix of $11.7 million, favorable foreign currency impacts of $6.3 million and higher product pricing of $4.6 million. Gross profit increased from the prior year, primarily due to gross profit from acquisitions of $4.7 million, higher product pricing of $4.6 million, favorable manufacturing costs of $3.1 million and favorable foreign currency impacts of $2.3 million, partially offset by higher raw material costs of $4.4 million and lower sales volume and mix of $0.3 million.    The net sales increase of $42.8 million was driven by higher sales from all regions. The increase in sales from EMEA was primarily attributable to $10.5 million in sales from acquisitions and higher sales from all product groups. The increase from Asia Pacific was primarily due to an increase in sales of automotive products of $3.9 million and sales from acquisitions of $2.3 million. The increase in sales from the United States was primarily attributable an increase in sales from acquisitions of $7.2 million, partially offset by lower sales of automotive products and industrial products. The increase in sales from Latin America was primarily attributable to sales in automotive products and industrial products, partially offset by lower sales of decoration products. Color Solutions    Net sales increased $33.0 million compared with the prior year, primarily due to higher sales of surface technology products and pigments of $19.7 million and $8.7 million, respectively. The increase in net sales was driven by higher volume and mix of $11.9 million, higher product pricing of $11.5 million, sales from acquisitions of $4.9 million and favorable foreign currency impacts of $4.6 million. Gross profit increased from the prior year, primarily due to higher product pricing of $11.5 million, favorable sales volume and mix of $8.7 million, gross profit from acquisitions of $1.3 million and favorable foreign currency impacts of $1.3 million, partially offset by higher raw material costs of $10.4 million and higher manufacturing costs of $1.2 million.    The net sales increase of $33.0 million was driven by higher sales from all regions. The higher sales from EMEA, Asia Pacific and Latin America were driven by sales of pigment products. The increase in sales from the United States was primarily driven by sales of surface technology products. Comparison of the years ended December 31, 2017 and 2016 Performance Coatings    Net sales increased in Performance Coatings by $67.0 million compared with the prior year, primarily driven by sales from SPC of $22.6 million, sales from Endeka of $18.3 million, and by organic growth across all product lines. The increase in net sales included higher sales volume and mix of $24.4 million, sales from acquisitions of $42.9 million and higher product pricing of $4.3 million, partially offset by unfavorable foreign currency impacts of $4.7 million. Gross profit increased $6.3 million from the prior year, primarily driven by gross profit from acquisitions of $9.5 million, lower manufacturing and product costs of $13.0 million, higher sales volumes and mix of $6.6 million and favorable product pricing impacts of $4.3 million, partially offset by higher raw material costs of $26.5 million, and unfavorable foreign currency impacts of $0.6 million.    Net sales increased by $67.0 million with increases in sales from all regions. The increase in sales from EMEA was primarily driven by sales from SPC of $22.6 million, sales from Endeka of $16.8 million, and an increase in sales of porcelain enamel and colors of $5.7 million and $5.5 million, respectively. The sales increase from Latin America was primarily driven by higher sales of frits and glazes and porcelain enamel of $3.4 million and $1.4 million, respectively. The sales increase from Asia Pacific was primarily driven by higher sales of digital inks, sales from Endeka and higher sales of porcelain enamel of $4.4 million, $1.6 million and $1.2 million, respectively, partially offset by a decrease of frits and glazes sales of $1.8 million. The increase in sales from the United States was attributable to higher sales of porcelain enamel. Performance Colors and Glass    The net sales increase of $73.2 million was primarily attributable to sales from ESL of $38.2 million and Dip-Tech of $18.2 million and organic growth in decoration products of $12.5 million. The increase in net sales included sales from acquisitions of $61.4 million, favorable volume and mix of $6.8 million, higher product pricing of $2.6 million and favorable foreign currency impacts of $2.5 million. Gross profit increased from the prior year, primarily due to gross profit from acquisitions of $21.2 million, favorable manufacturing and product costs of $4.8 million, higher product pricing of $2.6 million and favorable foreign currency impacts of $0.7 million, partially offset by unfavorable raw material costs of $3.8 million and lower sales volumes and mix of $1.9 million.    The net sales increase of $73.2 million was driven by higher sales from all regions. The increase in sales from EMEA was primarily attributable to sales from acquisitions and higher sales of decoration products of $9.6 million. The increase in sales from the United States was driven by sales from ESL of $24.5 million and Dip-Tech of $3.3 million, partially offset by a decrease in sales of industrial products of $5.9 million. The increase from Asia Pacific was primarily due to higher sales of automotive and decoration products of $3.9 million and $1.1 million, respectively. The increase from Latin America was primarily driven by an increase in sales of decoration products of $2.1 million, partially offset by a decrease in sales of automotive and industrial products. Color Solutions    Net sales increased $111.2 million compared with the prior year, primarily due to sales from Cappelle of $69.5 million, and higher sales of pigments and surface technology products of $28.8 million and $12.7 million, respectively. The increase in net sales was driven by sales from acquisitions of $71.6 million, higher volumes and mix of $32.5 million, higher product pricing of $6.1 million and favorable foreign currency impacts of $1.0 million. Gross profit increased from the prior year, due to gross profit from acquisitions of $16.2 million, lower manufacturing and product costs of $10.9 million, higher product pricing of $6.1 million, higher sales volumes and mix of $4.8 million and favorable foreign currency impacts of $0.2 million, partially offset by unfavorable raw material costs of $9.0 million.    The net sales increase of $111.2 million was driven by higher sales from all regions. The increase in sales from EMEA was primarily driven by sales from Cappelle of $58.3 million and higher sales of pigments of $11.0 million. The increase in sales from the United States was primarily driven by sales from Cappelle of $11.2 million, surface technology products of $12.7 million and pigments of $9.0 million. The increases in sales from Asia Pacific and Latin America of $5.6 million and $3.3 million, respectively, were driven by an increase in pigments sales. Summary of Cash Flows for the years ended December 31, 2018, 2017, and 2016   Operating activities. Cash flows from operating activities increased $98.0 million in 2018 compared to 2017. The increase was primarily due to higher cash inflows for net working capital of $68.5 million and other current assets and liabilities of $28.2 million. Cash flows from operating activities increased $22.2 million in 2017 compared to 2016. The increase was primarily due to higher earnings after consideration of non-cash items, partially offset by higher cash outflows for net working capital of $15.7 million and other current assets and liabilities of $38.1 million. Investing activities. Cash flows used in investing activities decreased $30.4 million in 2018. The decrease was primarily due to lower cash outflows for business acquisitions, net of cash acquired of $56.2 million, partially offset by higher cash outflows for capital expenditures of $30.1 million. Cash flows from investing activities decreased approximately $28.1 million in 2017. The decrease was primarily due to higher cash outflows for capital expenditures of $25.6 million. Financing activities. Cash flows from financing activities decreased $99.0 million in 2018 compared with 2017. As further discussed in Note 9, during 2018, we paid off our Credit Facility and entered into our Amended Credit Facility, consisting of a $500 million secured revolving line of credit and $820 million secured term loan facilities. Further, compared to the prior year, purchase of treasury stock increased by $28.8 million. Cash flows from financing activities increased $26.4 million in 2017 compared with 2016. As further discussed in Note 9, we paid off our 2014 Credit Facility and entered into our new Credit Facility, consisting of a $400 million secured revolving line of credit, a $357.5 million secured term loan facility and a €250 million secured euro term loan facility. This transaction resulted in additional borrowings in 2017 of $53.6 million compared to 2016. Further, compared to 2016, net repayments under loans payable was $24.2 million higher. Additionally, during 2017, we paid debt issuance costs related to the Credit Facility entered into during the period, partially offset by no repurchases of common stock being made during 2017. We have paid no dividends on our common stock since 2009. Capital Resources and Liquidity Major debt instruments that were outstanding during 2018 are described below. Amended Credit Facility On April 25, 2018, the Company entered into an amendment (the “Amended Credit Facility”) to its existing credit facility (the “Credit Facility”) which Amended Credit Facility (a) provided a new revolving facility (the “2018 Revolving Facility”), which replaced the Company’s existing revolving facility, (b) repriced the (“Tranche B-1 Loans”), (c) provided new tranches of term loans (“Tranche B-2 Loans” and “Tranche B-3 Loans”) denominated in U.S. dollars and will be used for ongoing working capital requirements and general corporate purposes. The Tranche B-2 Loans are borrowed by the Company and the Tranche B-3 Loans are borrowed on a joint and several basis by Ferro GmbH and Ferro Europe Holdings LLC. The Amended Credit Facility consists of a $500 million secured revolving line of credit with a maturity of February 2023, a $355 million secured term loan facility with a maturity of February 2024, a $235 million secured term loan facility with a maturity of February 2024 and a $230 million secured term loan facility with a maturity of February 2024. The term loans are payable in equal quarterly installments in an amount equal to 0.25% of the original principal amount of the term loans, with the remaining balance due on the maturity date thereof. In addition, the Company is required, on an annual basis, to make a prepayment in an amount equal to a portion of the Company’s excess cash flow, as calculated pursuant to the Amended Credit Facility, which prepayment will be applied first to the term loans until they are paid in full, and then to the revolving loans. Subject to the satisfaction of certain conditions, the Company can request additional commitments under the revolving line of credit or term loans in the aggregate principal amount of up to $250 million to the extent that existing or new lenders agree to provide such additional commitments and/or term loans. The Company can also raise certain additional debt or credit facilities subject to satisfaction of certain covenant levels. Certain of the Company’s U.S. subsidiaries have guaranteed the Company’s obligations under the Amended Credit Facility and such obligations are secured by (a) substantially all of the personal property of the Company and the U.S. subsidiary guarantors and (b) a pledge of 100% of the stock of certain of the Company’s U.S. subsidiaries and 65% of the stock of certain of the Company’s direct foreign subsidiaries. The Tranche B-3 Loans are guaranteed by the Company, the U.S. subsidiary guarantors and a cross-guaranty by the borrowers of the Tranche B-3 Loans, and are secured by the collateral securing the revolving loans and the other term loans, in addition to a pledge of the equity interests of Ferro GmbH. Interest Rate - Term Loans: The interest rates applicable to the term loans will be, at the Company’s option, equal to either a base rate or a LIBOR rate plus, in both cases, an applicable margin. · The base rate for term loans will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate, (iii) the daily LIBOR rate plus 1.00% or (iv) 0.00%. The applicable margin for base rate loans is 1.25%. · The LIBOR rate for term loans shall not be less than 0.0% and the applicable margin for LIBOR rate term loans is 2.25%. · For LIBOR rate term loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2018, the Company had borrowed $352.3 million under the Tranche B-1 Loans at an interest rate of 5.05%, $233.2 million under the Tranche B-2 Loans at an interest rate of 5.05%, and $228.3 million under the Tranche B-3 Loans at an interest rate of 5.05%. At December 31, 2018, there were no additional borrowings available under the Tranche B-1 Loans, Tranche B-2 Loans and Tranche B-3 Loans. We entered into swap agreements in the second quarter of 2018. At December 31, 2018, the effective interest rate for the Tranche B-1 Loans, Tranche B-2 Loans, and Tranche B-3 Loans, after adjusting for the interest rate swap, was 5.19%, 3.43%, and 2.48%, respectively. Interest Rate - Revolving Credit Line: The interest rates applicable to loans under the 2018 Revolving Credit Facility will be, at the Company’s option, equal to either a base rate or a LIBOR rate plus, in both cases, an applicable variable margin. The variable margin will be based on the ratio of (a) the Company’s total consolidated net debt outstanding (as defined in the Amended Credit Agreement) at such time to (b) the Company’s consolidated EBITDA (as defined in the Amended Credit Agreement) computed for the period of four consecutive fiscal quarters most recently ended. · The base rate for revolving loans will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate, (iii) the daily LIBOR rate plus 1.00% or (iv) 0.00%. The applicable margin for base rate loans will vary between 0.50% to 1.50%. · The LIBOR rate for revolving loans shall not be less than 0% and the applicable margin for LIBOR rate revolving loans will vary between 1.50% and 2.50%. · For LIBOR rate revolving loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2018, there were no borrowings under the 2018 Revolving Credit Facility. After reductions for outstanding letters of credit secured by these facilities, we had $495.3 million of additional borrowings available under the revolving credit facilities at December 31, 2018. The Amended Credit Facility contains customary restrictive covenants including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. The Amended Credit Facility also contains standard provisions relating to conditions of borrowing and customary events of default, including the non-payment of obligations by the Company and the bankruptcy of the Company. Specific to the 2018 Revolving Facility, the Company is subject to a financial covenant regarding the Company’s maximum leverage ratio. If an event of default occurs, all amounts outstanding under the Amended Credit Facility agreement may be accelerated and become immediately due and payable. At December 31, 2018, we were in compliance with the covenants of the Amended Credit Facility. Credit Facility On February 14, 2017, the Company entered into a credit facility (the “Credit Facility”) with a group of lenders to refinance its then outstanding credit facility debt and to provide liquidity for ongoing working capital requirements and general corporate purposes. The Credit Facility consisted of a $400 million secured revolving line of credit with a term of five years, a $357.5 million secured term loan facility with a term of seven years and a €250 million secured Euro term loan facility with a term of seven years. The term loans were payable in equal quarterly installments in an amount equal to 0.25% of the original principal amount of the term loans, with the remaining balance due on the maturity date thereof. In addition, the Company was required, on an annual basis, to make a prepayment of term loans until they were fully paid and then to the revolving loans in an amount equal to a portion of the Company’s excess cash flow, as calculated pursuant to the Credit Facility. Subject to the satisfaction of certain conditions, the Company could request additional commitments under the revolving line of credit or term loans in the aggregate principal amount of up to $250 million, to the extent that existing or new lenders agree to provide such additional commitments and/or term loans. The Company could also raise certain additional debt or credit facilities subject to satisfaction of certain covenant levels. Certain of the Company’s U.S. subsidiaries guaranteed the Company’s obligations under the Credit Facility and such obligations were secured by (a) substantially all of the personal property of the Company and the U.S. subsidiary guarantors and (b) a pledge of 100% of the stock of certain of the Company’s U.S. subsidiaries and 65% of the stock of certain of the Company’s direct foreign subsidiaries. Interest Rate - Term Loans: The interest rates applicable to the U.S. term loans was, at the Company’s option, equal to either a base rate or a LIBOR rate plus, in both cases, an applicable margin. The interest rates applicable to the Euro term loans was a Euro Interbank Offered Rate (“EURIBOR”) rate plus an applicable margin. · The base rate for U.S. term loans will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate or (iii) the daily LIBOR rate plus 1.00%. The applicable margin for base rate loans is 1.50%. · The LIBOR rate for U.S. term loans shall not be less than 0.75% and the applicable margin for LIBOR rate U.S. term loans is 2.50%. · The EURIBOR rate for Euro term loans shall not be less than 0% and the applicable margin for EURIBOR rate loans is 2.75%. · For LIBOR rate term loans and EURIBOR rate term loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate or EURIBOR rate, as applicable, for the corresponding duration. At December 31, 2017, the Company had borrowed $354.8 million under the secured term loan facility at an interest rate of 4.07% and €248.1 million (approximately $297.9 million) under the secured Euro term loan facility at an interest rate of 2.75%. At December 31, 2017, there were no additional borrowings available under the term loan facilities. We entered into interest rate swap agreements in the second quarter of 2017. These swaps converted $150 million and €90 million of our term loans from variable interest rates to fixed interest rates. At December 31, 2017, the effective interest rate for the term loan facilities after adjusting for the interest rate swap was 4.27% for the secured term loan facility and 3.00% for the Euro term loan facility. Interest Rate - Revolving Credit Line: The interest rates applicable to loans under the revolving credit line was, at the Company’s option, equal to either a base rate or a LIBOR rate plus, in both cases, an applicable variable margin. The variable margin was based on the ratio of (a) the Company’s total consolidated net debt outstanding at such time to (b) the Company’s consolidated EBITDA computed for the period of four consecutive fiscal quarters most recently ended. · The base rate for revolving loans will be the highest of (i) the federal funds rate plus 0.50%, (ii) syndication agent’s prime rate or (iii) the daily LIBOR rate plus 1.00%. The applicable margin for base rate loans will vary between 0.75% and 1.75%. · The LIBOR rate for revolving loans shall not be less than 0% and the applicable margin for LIBOR rate revolving loans will vary between 1.75% and 2.75%. · For LIBOR rate revolving loans, the Company may choose to set the duration on individual borrowings for periods of one, two, three or six months, with the interest rate based on the applicable LIBOR rate for the corresponding duration. At December 31, 2017, there were $78.0 million borrowings under the revolving credit line at an interest rate of 3.63%. After reductions for outstanding letters of credit secured by these facilities, we had $317.3 million of additional borrowings available under the revolving credit facilities at December 31, 2017. In conjunction with the refinancing of the Credit Facility, we recorded a charge of $3.2 million in connection with the write-off of unamortized issuance costs, which is recorded within Loss on extinguishment of debt in our consolidated statement of operations for the year ended December 31, 2018. 2014 Credit Facility In 2014, the Company entered into a credit facility that was amended on January 25, 2016, and August 29, 2016, resulting in a $400 million secured revolving line of credit with a term of five years and a $300 million secured term loan facility with a term of seven years from the original issuance date (the “2014 Credit Facility”) with a group of lenders that was replaced on February 14, 2017, by the Credit Facility (as defined above). In conjunction with the refinancing of the 2014 Credit Facility, we recorded a charge of $3.9 million in connection with the write-off of unamortized issuance costs, which is recorded within Loss on extinguishment of debt in our consolidated statement of operations for the year ended December 31, 2017. Off Balance Sheet Arrangements Consignment and Customer Arrangements for Precious Metals. We use precious metals, primarily silver, in the production of some of our products. We obtain most precious metals from financial institutions under consignment agreements. The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign and the period of consignment. These fees were $2.1 million, $1.2 million and $0.8 million for 2018, 2017, and 2016, respectively. We had on hand precious metals owned by participants in our precious metals consignment program of $55.2 million at December 31, 2018 and $37.7 million at December 31, 2017, measured at fair value based on market prices for identical assets and net of credits. The consignment agreements under our precious metals program involve short-term commitments that typically mature within 30 to 90 days of each transaction and are typically renewed on an ongoing basis. As a result, the Company relies on the continued willingness of financial institutions to participate in these arrangements to maintain this source of liquidity. On occasion, we have been required to deliver cash collateral. While no deposits were outstanding at December 31, 2018, or December 31, 2017, we may be required to furnish cash collateral in the future based on the quantity and market value of the precious metals under consignment and the amount of collateral-free lines provided by the financial institutions. The amount of cash collateral required is subject to review by the financial institutions and can be changed at any time at their discretion, based in part on their assessment of our creditworthiness. International Receivable Sales Programs We have several international programs to sell without recourse trade accounts receivable to financial institutions. These transactions are treated as a sale and are accounted for as a reduction in accounts receivable because the agreements transfer effective control over and risk related to the receivables to the buyers. The Company continues to service the receivables sold in exchange for a fee. The program, whose maximum capacity is 100 million Euro, is scheduled to expire in December 2023. At December 31, 2018 the outstanding principal amount of receivables sold under this program was $71.3 million. The carrying amount of deferred purchase price was $23.0 million and is recorded in Other Receivables. Bank Guarantees and Standby Letters of Credit. At December 31, 2018, the Company and its subsidiaries had bank guarantees and standby letters of credit issued by financial institutions that totaled $6.7 million. These agreements primarily relate to Ferro’s insurance programs, foreign energy purchase contracts and foreign tax payments. Other Financing Arrangements We maintain other lines of credit to provide global flexibility for Ferro’s short-term liquidity requirements. These facilities are uncommitted lines for our international operations and totaled $41.4 million at December 31, 2018. We had $30.3 million of additional borrowings available under these lines at December 31, 2018. Liquidity Requirements Our primary sources of liquidity are available cash and cash equivalents, available lines of credit under the Amended Credit Facility, and cash flows from operating activities. As of December 31, 2018, we had $104.3 million of cash and cash equivalents. Cash generated in the U.S. is generally used to pay down amounts outstanding under our 2018 Revolving Facility and for general corporate purposes, including acquisitions. If needed, we could repatriate the majority of cash held by foreign subsidiaries without the need to accrue and pay U.S. income taxes. We do not anticipate a liquidity need requiring such repatriation of these funds to the U.S. Our liquidity requirements primarily include debt service, purchase commitments, labor costs, working capital requirements, restructuring expenditures, acquisition costs, capital investments, precious metals cash collateral requirements, and postretirement benefit obligations. We expect to meet these requirements in the long term through cash provided by operating activities and availability under existing credit facilities or other financing arrangements. Cash flows from operating activities are primarily driven by earnings before noncash charges and changes in working capital needs. In 2018, cash flows from operating activities were used to fund our investing activities. Additionally, we used the borrowings available under the Amended Credit Facility to fund acquisitions and for other general business purposes. We had additional borrowing capacity of $525.6 million at December 31, 2018, available under various credit facilities, primarily our revolving credit facility. Our Amended Credit Facility contains customary restrictive covenants, including those described in more detail in Note 9 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. These covenants include customary restrictions, including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. Specific to the 2018 Revolving Facility, we are subject to a financial covenant regarding the Company’s maximum leverage ratio. This covenant under our Amended Credit Facility restricts the amount of our borrowings, reducing our flexibility to fund ongoing operations and strategic initiatives. This facility is described in more detail in “Capital Resources and Liquidity” under Item 7 and in Note 9 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K.  As of December 31, 2018, we were in compliance with our maximum leverage ratio covenant of 4.25x as our actual ratio was 2.60, providing $116.9 million of EBITDA cushion on the leverage ratio, as defined within the Amended Credit Facility. To the extent that economic conditions in key markets deteriorate or we are unable to meet our business projections and EBITDA falls below approximately $184 million for a rolling four quarters, based on reasonably consistent net debt levels with those as of December 31, 2018, we could become unable to maintain compliance with our leverage ratio covenant. In such case, our lenders could demand immediate payment of outstanding amounts and we would need to seek alternate financing sources to pay off such debts and to fund our ongoing operations. Such financing may not be available on favorable terms, if at all. Difficulties experienced in global capital markets could affect the ability or willingness of counterparties to perform under our various lines of credit, forward contracts, and precious metals program. These counterparties are major, reputable, multinational institutions, all having investment-grade credit ratings. Accordingly, we do not anticipate counterparty default. However, an interruption in access to external financing could adversely affect our business prospects and financial condition. We assess on an ongoing basis our portfolio of businesses, as well as our financial and capital structure, to ensure that we have sufficient capital and liquidity to meet our strategic objectives. As part of this process, from time to time we evaluate the possible divestiture of businesses that are not critical to our core strategic objectives and, where appropriate, pursue the sale of such businesses and assets. We also evaluate and pursue acquisition opportunities that we believe will enhance our strategic position such as the acquisitions we completed in 2018, 2017 and 2016. Generally, we publicly announce material divestiture and acquisition transactions only when we have entered into a material definitive agreement or closed on those transactions. The Company’s aggregate amount of contractual obligations for the next five years and thereafter is set forth below:   _____________________ (1) Loans Payable includes our loans payable to banks. (2) Long-term debt excludes imputed interest and executory costs on capitalized lease obligations and unamortized issuance costs on the term loan facility. (3) Interest represents only contractual payments for fixed-rate debt. (4) Purchase commitments are noncancelable contractual obligations for raw materials and energy, and exclude capital expenditures for property, plant and equipment. (5) We have not projected payments past 2019 due to uncertainties in estimating the amount and period of any payments. The amount above relates to our current income tax liability as of December 31, 2018. We have $22.2 million in gross liabilities related to unrecognized tax benefits, including $1.8 million of accrued interest and penalties that are not included in the above table since we cannot reasonably predict the timing of cash settlements with various taxing authorities. (6) The funding amounts are based on the minimum contributions required under our various plans and applicable regulations in each respective country. We have not projected contributions past 2020 due to uncertainties regarding the assumptions involved in estimating future required contributions. Critical Accounting Policies When we prepare our consolidated financial statements we are required to make estimates and assumptions that affect the amounts we report in the consolidated financial statements and footnotes. We consider the policies discussed below to be more critical than other policies because their application requires our most subjective or complex judgments. These estimates and judgments arise because of the inherent uncertainty in predicting future events. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors. Revenue Recognition Under ASC 606, revenues are recognized when control of the promised goods is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods. In order to achieve that core principle, the Company applies the following five-step approach: 1) identify the contract with a customer, 2) identify the performance obligations, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract, and 5) recognize revenue when a performance obligation is satisfied. In order to ensure the revenue recognition in the proper period, we review material sales contracts for proper cut-off based upon the business practices and legal requirements of each country. For sales of products containing precious metals, we report revenues on a gross basis along with their corresponding cost of sales to arrive at gross profit. We record revenues this way because we act as the principal in the transactions into which we enter. Restructuring and Cost Reduction Programs In recent years, we have developed and initiated global cost reduction programs with the objectives of leveraging our global scale, realigning and lowering our cost structure, and optimizing capacity utilization. Management continues to evaluate our businesses, and therefore, there may be additional provisions for new optimization and cost-savings initiatives, as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Restructuring charges include both termination benefits and asset writedowns. We estimate accruals for termination benefits based on various factors including length of service, contract provisions, local legal requirements, projected final service dates, and salary levels. We also analyze the carrying value of long-lived assets and record estimated accelerated depreciation through the anticipated end of the useful life of the assets affected by the restructuring or record an asset impairment. In all likelihood, this accelerated depreciation will result in reducing the net book value of those assets to zero at the date operations cease. While we believe that changes to our estimates are unlikely, the accuracy of our estimates depends on the successful completion of numerous actions. Changes in our estimates could increase our restructuring costs to such an extent that it could have a material impact on the Company’s results of operations, financial position, or cash flows. Other events, such as negotiations with unions and works councils, may also delay the resulting cost savings. Accounts Receivable and the Allowance for Doubtful Accounts Ferro sells its products to customers in diversified industries throughout the world. No customer or related group of customers represents greater than 10% of net sales or accounts receivable. We perform ongoing credit evaluations of our customers and require collateral principally for export sales, when industry practices allow and as market conditions dictate, subject to our ability to negotiate secured terms relative to competitive offers. We regularly analyze significant customer accounts and provide for uncollectible accounts based on historical experience, customer payment history, the length of time the receivables are past due, the financial health of the customer, economic conditions, and specific circumstances, as appropriate. Changes in these factors could result in additional allowances. Customer accounts we conclude to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. Historically, write-offs of uncollectible accounts have been within our expectations. Goodwill We review goodwill for impairment each year using a measurement date of October 31st or more frequently in the event of an impairment indicator. We annually, or more frequently as warranted, evaluate the appropriateness of our reporting units utilizing operating segments as the starting point of our analysis. In the event of a change in our reporting units, we would allocate goodwill based on the relative fair value. We estimate the fair values of the reporting units associated with these assets using the average of both the income approach and the market approach, which we believe provides a reasonable estimate of the reporting units’ fair values, unless facts and circumstances exist that indicate more representative fair values. The income approach uses projected cash flows attributable to the reporting units over their useful lives and allocates certain corporate expenses to the reporting units. We use historical results, trends and our projections of market growth, internal sales efforts and anticipated cost structure assumptions to estimate future cash flows. Using a risk-adjusted, weighted-average cost of capital, we discount the cash flow projections to the measurement date. The market approach estimates a price reasonably expected to be paid by a market participant in the purchase of similar businesses. If the fair value of any reporting unit was determined to be less than its carrying value, we would proceed to the second step and obtain comparable market values or independent appraisals of its assets and liabilities to determine the amount of any impairment. The significant assumptions and ranges of assumptions we used in our impairment analyses of goodwill at October 31, 2018 and 2017, were as follows:    Our estimates of fair value can be adversely affected by a variety of factors. Reductions in actual or projected growth or profitability at our reporting units due to unfavorable market conditions or significant increases in cost structure could lead to the impairment of any related goodwill. Additionally, an increase in inflation, interest rates or the risk-adjusted, weighted-average cost of capital could also lead to a reduction in the fair value of one or more of our reporting units and therefore lead to the impairment of goodwill. Based on our 2018 annual impairment test performed as of October 31, 2018, the fair values of the reporting units tested for impairment exceeded the carrying values of the respective reporting units by amounts ranging from 21.3% to 206.7% at the 2018 measurement date. The lowest cushion relates to goodwill associated with the Performance Coatings reportable segment, which had a goodwill balance of $44.4 million at December 31, 2018. A future potential impairment is possible for any of these reporting units if actual results are materially less than forecasted results. Some of the factors that could negatively affect our cash flows and, as a result, not support the carrying values of our reporting units are: new environmental regulations or legal restrictions on the use of our products that would either reduce our product revenues or add substantial costs to the manufacturing process, thereby reducing operating margins; new technologies that could make our products less competitive or require substantial capital investment in new equipment or manufacturing processes; and substantial downturns in economic conditions. Long-Lived Asset Impairment The Company’s long-lived assets include property, plant and equipment, and intangible assets. We review property, plant and equipment and intangible assets for impairment whenever events or circumstances indicate that their carrying values may not be recoverable. The following are examples of such events or changes in circumstances: · An adverse change in the business climate of a long-lived asset or asset group; · An adverse change in the extent or manner in which a long-lived asset or asset group is used or in its physical condition; · Current operating losses for a long-lived asset or asset group combined with a history of such losses or projected or forecasted losses that demonstrate that the losses will continue; or · A current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise significantly disposed of before the end of its previously estimated useful life. The carrying amount of property, plant and equipment and intangible assets is not recoverable if the carrying value of the asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group. In the event of impairment, we recognize a loss for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of review. Income Taxes The breadth of our operations and complexity of income tax regulations require us to assess uncertainties and make judgments in estimating the ultimate amount of income taxes we will pay. Our income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. The final income taxes we pay are based upon many factors, including existing income tax laws and regulations, negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation, and resolution of disputes arising from federal, state and international income tax audits. The resolution of these uncertainties may result in adjustments to our income tax assets and liabilities in the future. Deferred income taxes result from differences between the financial and tax basis of our assets and liabilities. We adjust our deferred income tax assets and liabilities for changes in income tax rates and income tax laws when changes are enacted. We record valuation allowances to reduce deferred income tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and the magnitude of appropriate valuation allowances against deferred income tax assets. The realization of these assets is dependent on generating future taxable income, our ability to carry back or carry forward net operating losses and credits to offset tax liabilities, as well as successful implementation of various tax strategies to generate tax where net operating losses or credit carryforwards exist. In evaluating our ability to realize the deferred income tax assets, we rely principally on the reversal of existing temporary differences, the availability of tax planning strategies, and forecasted income. We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Our estimate of the potential outcome of any uncertain tax positions is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. We record a liability for the difference between the benefit recognized and measured based on a more-likely-than-not threshold and the tax position taken or expected to be taken on the tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. We report tax-related interest and penalties as a component of income tax expense. Derivative Financial Instruments We use derivative financial instruments in the normal course of business to manage our exposure to fluctuations in interest rates, foreign currency exchange rates, and precious metal prices. The accounting for derivative financial instruments can be complex and can require significant judgment. Generally, the derivative financial instruments that we use are not complex, and observable market-based inputs are available to measure their fair value. We do not engage in speculative transactions for trading purposes. The use of financial derivatives is managed under a policy that identifies the conditions necessary to identify the transaction as a financial derivative. Financial instruments, including derivative financial instruments, expose us to counterparty credit risk for nonperformance. We manage our exposure to counterparty credit risk through minimum credit standards and procedures to monitor concentrations of credit risk. We enter into these derivative financial instruments with major, reputable, multinational financial institutions. Accordingly, we do not anticipate counter-party default. We continuously evaluate the effectiveness of derivative financial instruments designated as hedges to ensure that they are highly effective. In the event the hedge becomes ineffective, we discontinue hedge treatment. Except as noted below, we do not expect any changes in our risk policies or in the nature of the transactions we enter into to mitigate those risks. Our exposure to interest rate changes arises from our debt agreements with variable interest rates. To reduce our exposure to interest rate changes on variable rate debt, we entered into interest rate swap agreements. These swaps are settled in cash, and the net interest paid or received is effectively recognized as interest expense. We mark these swaps to fair value and recognize the resulting gains or losses as other comprehensive income. We have executed cross currency interest rate swaps to minimize our exposure to floating rate debt agreements denominated in a currency other than functional currency. These swaps are settled in cash, and the net interest paid or received is effectively recognized as interest expense as the interest on the debt is accrued. These swaps are designated as cash flows hedges and we mark these swaps to fair value and recognize the resulting gains or losses as other comprehensive income. To help protect the value of the Company’s net investment in European operations against adverse changes in exchange rates, the Company uses non-derivative financial instruments, such as its foreign currency denominated debt, as economic hedges of its net investments in certain foreign subsidiaries. In addition, we have executed cross currency interest rate swaps to help protect the value of the Company’s net investment in European operations. These swaps are settled in cash, and the net interest paid or received is effectively recognized as interest expense. We mark these swaps to fair value and recognize the resulting gains or losses as cumulative translation adjustments (a component of other comprehensive income). We manage foreign currency risks in a wide variety of foreign currencies principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions arising from international trade. Our objective in entering into these forward contracts is to preserve the economic value of nonfunctional currency cash flows. Our principal foreign currency exposures relate to the Euro, the Egyptian Pound, the Turkish Lira, the Taiwan Dollar, the Colombian Peso, the Australian Dollar, the Indian Rupee, the Thailand Baht, the Indonesian Rupiah, the Japanese Yen, the Chinese Renminbi and the Romanian Leu. We mark these forward contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as other income or expense from foreign currency transactions. Precious metals (primarily silver, gold, platinum and palladium) represent a significant portion of raw material costs in our electronics products. When we enter into a fixed price sales contract at the customer’s request to establish the price for the precious metals content of the order, we also enter into a forward purchase arrangement with a precious metals supplier to completely cover the value of the precious metals content. Our current precious metal contracts are designated as normal purchase contracts, which are not marked to market. We also purchase portions of our energy requirements, including natural gas and electricity, under fixed price contracts to reduce the volatility of cost changes. Our current energy contracts are designated as normal purchase contracts, which are not marked to market. Transfer of Financial Assets The Company accounts for transfers of financial assets as sales when it has surrendered control over the related assets. Whether control has been relinquished requires, among other things, an evaluation of relevant legal considerations and an assessment of the nature and extent of the Company’s continuing involvement with the assets transferred. Pension and Other Postretirement Benefits We sponsor defined benefit plans in the U.S. and many countries outside the U.S., and we also sponsor retiree medical benefits for a segment of our salaried and hourly work force within the U.S. The U.S. pension plans and retiree medical plans represent approximately 86% of pension plan assets, 72% of benefit obligations and 56% of net periodic pension expense as of December 31, 2018. The assumptions we use in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. We meet with our actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. We determine the discount rate for the U.S. pension and retiree medical plans based on a bond model. Using the pension plans’ projected cash flows, the bond model considers all possible bond portfolios that produce matching cash flows and selects the portfolio with the highest possible yield. These portfolios are based on bonds with a quality rating of AA or better under either Moody’s Investor Services, Inc. or Standard & Poor’s Rating Group, but exclude certain bonds, such as callable bonds, bonds with small amounts outstanding, and bonds with unusually high or low yields. The discount rates for the non-U.S. plans are based on a yield curve method, using AA-rated bonds applicable in their respective capital markets. The duration of each plan’s liabilities is used to select the rate from the yield curve corresponding to the same duration. For the market-related value of plan assets, we use fair value, rather than a calculated value. The market-related value recognizes changes in fair value in a systematic and rational manner over several years. We calculate the expected return on assets at the beginning of the year for defined benefit plans as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. In determining the expected returns, we consider both historical performance and an estimate of future long-term rates of return. The Company consults with and considers the opinion of its actuaries in developing appropriate return assumptions. Our target asset allocation percentages are 35% fixed income, 60% equity, and 5% other investments for U.S. plans and 75% fixed income, 24% equity, and 1% other investments for non-U.S. plans. In 2018, our pension plan assets incurred losses of approximately 7% within the U.S. plans and 3% within non-U.S. plans. In 2017, investment returns on average plan assets were approximately 16% within the U.S. plans and 3% within non-U.S. plans. Future actual pension expense will depend on future investment allocation and performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans. All other assumptions are reviewed periodically by our actuaries and us and may be adjusted based on current trends and expectations as well as past experience in the plans. The following table provides the sensitivity of net annual periodic benefit costs for our pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25-basis-point decrease in both the discount rate and asset return assumption:    The following table provides the rates used in the assumptions and the changes between 2018 and 2017:   Our overall net periodic benefit cost for all defined benefit plans was $19.9 million in 2018 and a credit of $6.4 million in 2017. The change is mainly the result of mark to market actuarial net losses in 2018. For 2019, assuming expected returns on plan assets and no actuarial gains or losses, we expect our overall net periodic benefit expense to be approximately $3.8 million, compared with income of approximately $0.2 million in 2018 on a comparable basis. Inventories We value inventory at the lower of cost or net realizable value, with cost determined utilizing the first-in, first-out (FIFO) method. We periodically evaluate the net realizable value of inventories based primarily upon their age, but also upon assumptions of future usage in production, customer demand and market conditions. Inventories have been reduced to the lower of cost or realizable value by allowances for slow moving or obsolete goods. If actual circumstances are less favorable than those projected by management in its evaluation of the net realizable value of inventories, additional write-downs may be required. Slow moving, excess or obsolete materials are specifically identified and may be physically separated from other materials, and we rework or dispose of these materials as time and manpower permit. Environmental Liabilities Our manufacturing facilities are subject to a broad array of environmental laws and regulations in the countries in which they are located. The costs to comply with complex environmental laws and regulations are significant and will continue for the foreseeable future. We expense these recurring costs as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations. We also accrue for environmental remediation costs and other obligations when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events. Inherent uncertainties exist in such evaluations primarily due to unknown conditions and other circumstances, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress or as additional technical or legal information becomes available. Impact of Newly Issued Accounting Pronouncements Refer to Note 2 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K for a discussion of accounting standards we recently adopted or will be required to adopt.

<s>[INST] During the year ended December 31, 2018, net sales increased $215.7 million, or 15.4%, compared with 2017. The increase was driven by higher sales in Performance Coatings, Performance Colors and Glass and Color Solutions of $139.9 million, $42.8 million and $33.0 million, respectively. Gross profit increased $39.7 million compared with 2017. The increase in gross profit was attributable to increases across all of our segments, with increases in Performance Coatings, Color Solutions and Performance Colors and Glass and of $19.9 million, $11.2 million and $9.9 million, respectively. As a percentage of net sales, gross profit rate decreased approximately 150 basis points to 28.3%, from 29.8% in the prior year. For the year ended December 31, 2018, selling, general and administrative (“SG&A”) expenses increased $13.1 million, or 5.0%, compared with 2017. As a percentage of net sales, SG&A expenses decreased 170 basis points from 19.0% in 2017 to 17.3% in 2018. For the year ended December 31, 2018, net income was $80.9 million, compared with net income of $57.8 million in 2017, and net income attributable to common shareholders was $80.1 million, compared with net income attributable to common shareholders of $57.1 million in 2017. As previously disclosed on January 17, 2019, the Company is in the process of expanding its production facility in Villagran, Mexico, which will become the Company’s Manufacturing Center of Excellence for the Americas. The expansion of the Villagran facility is expected to significantly increase the revenue generated from products manufactured at that facility. With the expanded capacity in Villagran, the Company (i) will discontinue the production of glass enamels, other industrial specialty products, such as architectural glass coatings, and pigments at its Washington, Pennsylvania facility over the course of 2019 and into 2020, (ii) plans to discontinue production of porcelain enamel products at its Cleveland, Ohio facility and (iii) will close additional facilities in Latin America. As part of this optimization initiative, the Company is expanding its King of Prussia, Pennsylvania facility. Conductive glass coatings production will be discontinued at the Washington, Pennsylvania facility and will be produced at the King of Prussia, Pennsylvania facility, and the Company’s operations at its Vista, California facility will be transferred to the King of Prussia, Pennsylvania facility. In addition, the Company will be moving its Americas research and development center for glass products to its technology center in Independence, Ohio, where the Company is investing in expanded laboratory facilities. The Washington, Pennsylvania facility is expected to remain in operation until sometime in 2020. Production of specialty glasses for electronics applications will continue at the Cleveland, Ohio facility, and the Company will invest in the facility to equip it to serve as a logistics center. The Cleveland, Ohio facility also will serve as the Americas research and development center for the porcelain enamel business.  2018 Transactional Activity Transactions undertaken in 2018 included the following business acquisitions: Acquisition of Quimicer, S.A. (“Quimicer”): As discussed in Note 5, in the fourth quarter of 2018, the Company acquired 100% of the equity interests of Quimicer, for €27.0 million (approximately $31.3 million), including the assumption of debt of €5.2 million (approximately $6.1 million). Acquisition of UWiZ Technology Co., Ltd. (“UWiZ”): As discussed in Note 5, in the third quarter of 2018, the Company acquired 100% of the equity interest of UWiZ for TWD823.4 million (approximately $26.9 million). Acquisition of Ernst Diegel GmbH (“Diegel”): As discussed in Note 5, in [/INST] Positive. </s>

FERRO CORP

2020-03-02

2019-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview During the year ended December 31, 2019, net sales decreased $63.9 million, or 5.9%, compared with 2018. Net sales decreased by $42.5 million and $21.4 million in Performance Colors and Glass and Color Solutions, respectively. Gross profit decreased $30.9 million compared with 2018; as a percentage of net sales, it decreased approximately 110 basis points to 30.3%, from 31.4% in the prior year. The decrease in gross profit was primarily attributable to decreases across both our segments, with decreases in Performance Colors and Glass and Color Solutions of $18.9 million and $9.9 million, respectively. For the year ended December 31, 2019, selling, general and administrative (“SG&A”) expenses decreased $7.5 million, or 3.4%, compared with 2018. As a percentage of net sales, SG&A expenses increased 60 basis points from 20.3% in 2018 to 20.9% in 2019. For the year ended December 31, 2019, net income was $7.4 million, compared with net income of $80.9 million in 2018, and net income attributable to common shareholders was $6.0 million, compared with net income attributable to common shareholders of $80.1 million in 2018. Income from continuing operations was $35.4 million for the year ended December 31, 2019, compared with $56.9 million in 2018. As previously disclosed on January 17, 2019, the Company has been expanding its production facility in Villagran, Mexico, which will become the Company’s Manufacturing Center of Excellence for the Americas. The expansion of the Villagran facility is expected to significantly increase the revenue generated from products manufactured at that facility. With the expanded capacity in Villagran, the Company plans to (i) discontinue the production of glass enamels, other industrial specialty products, such as architectural glass coatings, and pigments at its Washington, Pennsylvania facility over the course of 2020 and (ii) discontinue production of porcelain enamel products at its Cleveland, Ohio facility. As part of this optimization initiative, the Company is expanding its King of Prussia, Pennsylvania facility. Conductive glass coatings production will be discontinued at the Washington, Pennsylvania facility and will be produced at the King of Prussia, Pennsylvania facility, and the Company’s operations at its Vista, California facility will be transferred to the King of Prussia, Pennsylvania facility. In addition, the Company plans to move its Americas research and development center for glass products to its technology center in Independence, Ohio, where the Company is investing in expanded laboratory facilities. The Washington, Pennsylvania facility is expected to remain in operation until sometime in 2020. Production of specialty glasses for electronics applications will continue at the Cleveland, Ohio facility, and the Company plans to invest in the facility to equip it to serve as a logistics center. The Cleveland, Ohio facility also will serve as the Americas research and development center for the porcelain enamel business. 2019 Transactional Activity During the fourth quarter of 2019, we entered into a definitive agreement to sell our Tile Coatings business which has historically been a part of our Performance Coatings reportable segment. As further discussed in Note 4 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K, substantially all of the assets and liabilities of our Tile Coatings business were classified as held-for-sale in the accompanying consolidated balance sheets and the associated operating results, net of income tax, have been classified as discontinued operations in the accompanying consolidated statements of operations for all periods presented. 2018 Transactional Activity Transactions undertaken in 2018 included the following business acquisitions: Acquisition of Quimicer, S.A. (“Quimicer”): As discussed in Note 5, in the fourth quarter of 2018, the Company acquired 100% of the equity interests of Quimicer, for €27.0 million (approximately $31.3 million), including the assumption of debt of €5.2 million (approximately $6.1 million). Acquisition of UWiZ Technology Co., Ltd. (“UWiZ”): As discussed in Note 5, in the third quarter of 2018, the Company acquired 100% of the equity interest of UWiZ for TWD823.4 million (approximately $26.9 million). Acquisition of Ernst Diegel GmbH (“Diegel”): As discussed in Note 5, in the third quarter of 2018, the Company acquired 100% of the equity interests of Diegel, including the real property of a related party, for €12.1 million (approximately $14.0 million). Acquisition of MRA Laboratories, Inc. (“MRA”): As discussed in Note 5, in the second quarter of 2018, the Company acquired 100% of the equity interests of MRA, for $16.0 million. Acquisition of PT Ferro Materials Utama. (“FMU”): As discussed in Note 5, in the second quarter of 2018, the Company acquired 66% of the equity interests of FMU, for $2.7 million in cash, in addition to the forgiveness of debt of $9.2 million, bringing our total ownership to 100%. Outlook Global economic conditions and slowing growth outside the U.S. presented challenges in 2019. Like many companies in our industry, Ferro experienced weaker demand in certain end markets and geographic regions. Order patterns and inventory destocking in some higher-end markets contributed to the weaker demand. Foreign exchange rates also caused headwinds throughout 2019. In the fourth quarter of 2019, the Company announced a definitive agreement to divest its Tile Coatings business, which when completed will improve the geographic balance and reduce manufacturing and end market exposure to more cyclical industries such as construction. The remaining business is more fully focused on higher-growth industries where the Company’s market-leading technology, innovation and customer-centric service generate higher gross margins. In 2020, we will transition the portfolio and organization while continuing to execute the dynamic innovation and optimization phase of our value creation strategy, which includes organic and inorganic growth and optimization. We expect organic growth through new products and positioning our portfolio to continue to transition to the higher end of our target markets. We intend to invest to advance the business through acquisitions, share repurchases or debt repayment depending on what we deem to be the best option at any given time. We are implementing optimization initiatives throughout the company to increase efficiency, productivity and profitability. Although we expect a level of macro-economic uncertainty in 2020, we expect demand will continue for our technology-driven functional coatings and color solutions in the niche markets we focus on, and that we will continue to develop innovative new products. We have identified a number of optimization opportunities in our manufacturing and logistics operations and will continue to implement strategic optimization initiatives. Foreign currency rates may continue to be volatile through 2020 and changes in interest rates could adversely impact reported results. We expect cash flow from operating activities to continue to be positive for 2020, providing additional liquidity. Factors that could adversely affect our future performance include those described under the heading “Risk Factors” in Item 1A of Part I of this Annual Report on Form 10-K for the year ended December 31, 2019. Results of Operations - Consolidated Comparison of the years ended December 31, 2019 and 2018 For the year ended December 31, 2019, net income from continuing operations was $35.4 million, compared with $56.9 million in 2018. For the year ended December 31, 2019, net income attributable to common shareholders was $6.0 million, or $0.07 earnings per share, compared with $80.1 million, or $0.95 earnings per share in 2018. Net Sales Net sales decreased by $63.9 million, or 5.9%, in the year ended December 31, 2019, compared with the prior year, with decreased sales in Performance Colors and Glass and Color Solutions of $42.5 million and $21.4 million, respectively. Gross Profit Gross profit decreased $30.9 million, or 9.1%, in 2019 to $308.8 million, compared with $339.7 million in 2018 and, as a percentage of net sales, it decreased 110 basis points to 30.3%. The decrease in gross profit was attributable to decreases in both of our segments, with decreases in Performance Colors and Glass and Color Solutions of $18.9 million and $9.9 million, respectively. The decrease in gross profit was primarily attributable to lower sales volumes and mix of $29.9 million, higher manufacturing and product costs of $15.7 million and unfavorable foreign currency impacts of $8.9 million, partially offset by lower raw material costs of $13.5 million, gross profit from acquisitions of $6.6 million and favorable product pricing of $5.5 million. Geographic Revenues The following table presents our sales on the basis of where sales originated. The decrease in net sales of $63.9 million, compared with 2018, was driven by lower sales across all regions. The decrease in sales from EMEA was attributable to lower sales in Performance Colors and Glass and Color Solutions of $30.1 million and $5.2 million, respectively. The decrease in sales from the United States was attributable to lower sales in Color Solutions and Performance Colors and Glass of $11.1 million and $9.5 million, respectively. The decrease in sales from Asia Pacific was attributable to lower sales in Color Solutions and Performance Colors and Glass of $4.2 million and $1.2 million, respectively. The decrease in sales from Latin America was attributable to lower sales in Performance Colors and Glass and Color Solutions of $1.7 million and $0.9 million, respectively. Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2019 and 2018: SG&A expenses were $7.5 million lower in 2019 compared with the prior year. As a percentage of net sales, SG&A expenses increased 60 basis points from 20.3% in 2018 to 20.9% in 2019. The lower SG&A expenses compared with the prior year were primarily driven by lower personnel expenses. The decrease in incentive compensation is the result of the Company’s performance relative to targets for certain awards compared to the prior year and the decrease in stock-based compensation expense of $1.0 million is the result of the Company’s performance relative to targets for certain awards compared with the prior year, as well as decreases in the Company’s stock price. The following table presents SG&A expenses attributable to sales, research and development, and operations costs as strategic services and presents other SG&A costs as functional services. Restructuring and Impairment Charges Restructuring and impairment charges increased $3.8 million in 2019, compared with 2018. The increase primarily relates to higher employee costs associated with our recent optimization programs in 2019. During the second and third quarters of 2019, the Company recorded $9.0 million of goodwill impairment charges related to our Tile Coatings business, which was historically recorded within our Performance Coatings reportable segment. The goodwill impairment charge recorded was a result of the finalization of purchase accounting of the recent Quimicer, FMU, and Gardenia acquisitions that changed the carrying amount of net assets attributable to the reporting unit that represented an impairment indicator. Based on our 2019 annual impairment test performed as of October 31, 2019, the Company recorded additional goodwill impairment charges of $33.5 million associated with the Tile Coatings business. The impairment charge and related assets are recorded within discontinued operations and as assets held-for-sale, respectively, in our consolidated financial statements as of December 31, 2019. Interest Expense Interest expense in 2019 increased $0.6 million compared with 2018. The increase in interest expense was primarily due to an increase in the average long-term debt balance during 2019, compared with 2018, partially offset by increased interest capitalization during 2019 and interest swap amortization. Income Tax Expense In 2019, we recorded an income tax expense of $8.1 million, or 18.7 % of income before income taxes, compared to an income tax expense of $14.1 million, or 19.9% of income before income taxes in 2018. The 2019 effective tax rate is less than the statutory income tax rate of 21% primarily as a result of a net effect of a $7.6 million net benefit related to the release of valuation allowances related to deferred tax assets that were utilized in the current year or are deemed no longer necessary based upon changes in the current and expected future years of operating profits and a $4.3 million net expense related to foreign tax rate differences. The 2018 effective tax rate is less than the statutory income tax rate of 21% primarily as a result of a net effect of a $4.3 million net benefit related to the release of valuation allowances related to deferred tax assets that were utilized in the current year or are deemed no longer necessary based upon changes in the current and expected future years of operating profits and a $5.3 million net expense related to foreign tax rate differences. Comparison of the years ended December 31, 2018 and 2017 For the year ended December 31, 2018, income from continuing operations was $56.9 million, compared with $36.9 million in 2017. For the year ended December 31, 2018, net income attributable to common shareholders was $80.1 million, or $0.95 earnings per share, compared with net income attributable to common shareholders of $57.1 million, or $0.68 earnings per share in 2017. Net Sales Net sales increased by $85.8 million, or 8.6%, in the year ended December 31, 2018, compared with the prior year, with increased sales in Performance Colors and Glass and Color Solutions of $52.8 million and $33.0 million, respectively. The increase in net sales was driven by both acquisitions and organic growth. Organic sales increased in Performance Colors and Glass by $32.7 million and Color Solutions by $28.1 million. Gross Profit Gross profit increased $13.0 million, or 4.0%, in 2018 to $339.7 million, compared with $326.7 million in 2017 and, as a percentage of net sales, it decreased 140 basis points to 31.4%. The increase in gross profit was attributable to increases in both of our segments, with increases in Color Solutions and Performance Colors and Glass of $11.2 million and $3.2 million, respectively. The increase in gross profit was primarily attributable to favorable product pricing of $25.9 million, gross profit from acquisitions of $6.0 million, higher sales volumes and mix of $6.0 million, favorable foreign currency impacts of $3.5 million and lower manufacturing and product costs of $3.5 million, partially offset by higher raw material costs of $30.5 million. Geographic Revenues The following table presents our sales on the basis of where sales originated. The increase in net sales of $85.8 million, compared with 2017, was driven by higher sales from EMEA, the United States and Asia Pacific, partially offset by a decrease in sales in Latin America. The increase in sales from EMEA was attributable to higher sales in Performance Colors and Glass and Color Solutions of $43.3 million and $8.0 million, respectively. The increase in sales from the United States was attributable to higher sales in Color Solutions and Performance Colors and Glass of $18.2 million and $5.2 million, respectively. The increase in sales from Asia Pacific was attributable to higher sales in Performance Colors and Glass and Color Solutions of $8.0 million and $5.3 million, respectively. The decrease in sales from Latin America was attributable to lower sales in Performance Colors and Glass of $3.7 million, partially mitigated by higher sales in Color Solutions of $1.5 million. Selling, General and Administrative Expense The following table includes SG&A components with significant changes between 2018 and 2017. SG&A expenses were $2.7 million higher in 2018 compared with the prior year. As a percentage of net sales, SG&A expenses decreased 150 basis points from 21.8% in 2017 to 20.3% in 2018. The higher SG&A expenses compared with the prior year were primarily driven by businesses acquired within the last year. The acquisitions were the primary driver of the increase in personnel expenses. The decrease in incentive compensation is the result of the Company’s performance relative to targets for certain awards compared to the prior year and the decrease in stock-based compensation expense of $3.3 million is the result of the Company’s performance relative to targets for certain awards compared with the prior year, as well as decreases in the Company’s stock price. The following table presents SG&A expenses attributable to sales, research and development, and operations costs as strategic services and presents other SG&A costs as functional services. Restructuring and Impairment Charges Restructuring and impairment charges decreased $1.4 million in 2018, compared with 2017. The decrease was primarily related to an “other than temporary impairment” charge of an equity method investment of $1.6 million in 2017, which did not occur in 2018. Interest Expense Interest expense in 2018 increased $3.0 million compared with 2017. The increase in interest expense was primarily due to an increase in the average long-term debt balance during 2018, compared with 2017, partially offset by increased interest capitalization during 2018. Income Tax Expense In 2018, we recorded an income tax expense of $14.1 million, or 19.9% of income before income taxes, compared to an income tax expense of $46.4 million, or 55.7% of income before income taxes in 2017. The 2018 effective tax rate is less than the statutory income tax rate of 21% primarily as a result of a net effect of a $4.3 million net benefit related to the release of valuation allowances related to deferred tax assets that were utilized in the current year or which are deemed no longer necessary based upon changes in the current and expected future years of operating profits and a $5.3 million net expense related to foreign tax rate differences. The 2017 effective tax rate is greater than the statutory income tax rate of 35% primarily as a result of a net effect of a $21.5 million expense related to re-measuring the U.S. deferred tax assets as a result of the Tax Act, $5.9 million net expense related to uncertain tax positions and $4.9 million benefit related to foreign tax rate differences. On December 22, 2017, U.S. federal tax legislation, commonly referred to as the Tax Cut and Jobs Act (the “Tax Act”), was signed into law, significantly changing the U.S. corporate income tax system. These changes include a federal statutory rate reduction from 35% to 21% effective January 1, 2018. Changes in tax rates and tax law are accounted for in the period of enactment. Accordingly, the Company’s U.S. net deferred tax assets were re-measured to reflect the reduction in the federal statutory rate, resulting in a $21.5 million increase in income tax expense for the year ended December 31, 2017. Results of Operations - Segment Information Comparison of the years ended December 31, 2019 and 2018 Performance Colors and Glass Net sales decreased $42.5 million compared with the prior year, primarily driven by lower sales in decoration, porcelain enamels and automotive products of $13.3 million, $12.9 million, and $9.5 million, respectively. The decrease in net sales was driven by unfavorable volume and mix of $33.9 million and unfavorable foreign currency impacts of $19.4 million, partially offset by sales from acquisitions of $5.7 million and higher product pricing of $5.1 million. Gross profit decreased from the prior year, primarily due to lower sales volume and mix of $20.1 million, unfavorable manufacturing costs of $8.9 million and unfavorable foreign currency impacts of $6.3 million, partially offset by lower raw material costs of $9.2 million, higher product pricing of $5.1 million and gross profit from acquisitions of $2.1 million. The net sales decrease of $42.5 million was driven by lower sales from all regions. The decrease in sales from EMEA was primarily attributable to lower sales of decoration, automotive, electronic, industrial and porcelain enamel products of $9.0 million, $4.2 million, $4.0 million, $3.7 million and $3.4 million, respectively. The decrease in sales from the United States was primarily attributable to lower sales of porcelain enamel, automotive and decoration products of $9.1 million, $4.4 million, and $3.5 million, respectively, partially offset by an increase in sales of electronic products of $9.1 million. The decrease in sales from Latin America was attributable to a decrease in sales of automotive products of $0.8 million. The decrease in sales from Asia Pacific was primarily attributable to lower sales of decoration products of $1.2 million. Color Solutions Net sales decreased $21.4 million compared with the prior year, primarily due to lower sales of pigment products of $22.1 million, inclusive of decreased sales from our Nubiola business of $12.5 million, and lower sales of surface technology products of $4.6 million, partially mitigated by higher sales of Dispersions and Colorants of $5.4 million. The decrease in net sales was driven by lower volume and mix of $22.4 million and unfavorable foreign currency impacts of $9.8 million partially offset by sales from acquisitions of $10.3 million. Gross profit decreased from the prior year, primarily due to unfavorable sales volume and mix of $9.8 million, higher manufacturing costs of $6.7 million and unfavorable foreign currency impacts of $2.7 million, partially offset by gross profit from acquisitions of $4.5 million and lower raw material costs of $4.3 million. The net sales decrease of $21.4 million was driven by lower sales from all regions. The decrease in sales from the United States was primarily driven by lower sales of surface technology products of $9.7 million and pigment products of $1.9 million. The decrease in sales from EMEA was primarily attributable to lower sales of pigment products of $10.0 million, inclusive of decreased sales from our Nubiola business of $5.5 million, partially mitigated by higher sales of Dispersions and Colorants of $4.8 million. The decrease in sales from Asia Pacific was primarily attributable to lower sales of pigment products of $9.2 million, inclusive of decreased sales from our Nubiola business of $6.5 million, partially mitigated by higher sales of surface technology products of $5.1 million. Comparison of the years ended December 31, 2018 and 2017 Performance Colors and Glass Net sales increased $52.9 million compared with the prior year, primarily driven by $12.9 million in sales from electronics products, $12.2 million in sales from Dip-Tech and $8.0 million in sales from porcelain enamel. The increase in net sales was driven by sales from acquisitions of $20.2 million, higher product pricing of $14.4 million, favorable volume and mix of $13.6 million and favorable foreign currency impacts of $4.7 million. Gross profit increased from the prior year, primarily due to gross profit from higher product pricing of $14.4 million, acquisitions of $4.7 million, favorable manufacturing costs of $4.6 million and favorable foreign currency impacts of $2.3 million, partially offset by higher raw material costs of $20.0 million and lower sales volume and mix of $2.7 million. The net sales increase of $52.9 million was driven by higher sales from EMEA, Asia Pacific and the United States, partially offset by lower sales from Latin America. The increase in sales from EMEA was primarily attributable to sales from acquisitions and higher sales from all product groups. The increase from Asia Pacific was driven by acquisitions and higher sales of automotive products of $3.9 million and porcelain enamel of $1.6 million, respectively. The increase in sales from the United States was primarily attributable an increase in sales from acquisitions of $7.2 million and higher sales of porcelain enamel, partially offset by lower sales of automotive products and industrial products. Color Solutions Net sales increased $33.0 million compared with the prior year, primarily due to higher sales of surface technology products and pigments of $19.7 million and $8.7 million, respectively. The increase in net sales was driven by higher volume and mix of $11.9 million, higher product pricing of $11.5 million, sales from acquisitions of $4.9 million and favorable foreign currency impacts of $4.6 million. Gross profit increased from the prior year, primarily due to higher product pricing of $11.5 million, favorable sales volume and mix of $8.7 million, gross profit from acquisitions of $1.3 million and favorable foreign currency impacts of $1.3 million, partially offset by higher raw material costs of $10.4 million and higher manufacturing costs of $1.2 million. The net sales increase of $33.0 million was driven by higher sales from all regions. The higher sales from EMEA, Asia Pacific and Latin America were driven by sales of pigment products. The increase in sales from the United States was primarily driven by sales of surface technology products. Summary of Cash Flows for the years ended December 31, 2019, 2018, and 2017 Operating activities. Cash flows from operating activities decreased $165.1 million in 2019 compared to 2018. The decrease was primarily due to higher cash outflows for net working capital of $116.9 million and a fourth quarter goodwill impairment charge of $33.5 million related to the Tile Coatings business. Cash flows from operating activities increased $98.0 million in 2018 compared to 2017. The increase was primarily due to higher cash inflows for net working capital of $68.5 million and other current assets and liabilities of $28.2 million. Investing activities. Cash flows from investing activities increased $169.8 million in 2019 compared to 2018. The increase was primarily due to higher collections of financing receivables of $77.5 million, lower cash outflows related to business acquisitions of $74.7 million and lower cash outflows for capital expenditures of $15.6 million. Cash flows used in investing activities decreased $30.4 million in 2018 compared to 2017. The decrease was primarily due to lower cash outflows for business acquisitions of $56.2 million, partially offset by higher cash outflows for capital expenditures of $30.1 million. Financing activities. Cash flows from financing activities decreased $48.6 million in 2019 compared with 2018. The decrease is primarily attributable to a decreased use of the Company’s financing instruments related to the prior year termination of the Credit Facility and acquisition of the Amended Credit Facility Cash flows from financing activities decreased $99.0 million in 2018 compared with 2017. As further discussed in Note 9, during 2018, we paid off our Credit Facility and entered into our Amended Credit Facility, consisting of a $500 million secured revolving line of credit and $820 million secured term loan facilities. Further, compared to the prior year, purchase of treasury stock increased by $28.8 million. We have paid no dividends on our common stock since 2009. Capital Resources and Liquidity Refer to Note 9 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K for a discussion of major debt instruments that were outstanding during 2019. Off Balance Sheet Arrangements Consignment and Customer Arrangements for Precious Metals. We use precious metals, primarily silver, in the production of some of our products. We obtain most precious metals from financial institutions under consignment agreements. The financial institutions retain ownership of the precious metals and charge us fees based on the amounts we consign and the period of consignment. These fees were $3.1 million, $2.1 million and $1.2 million for 2019, 2018, and 2017, respectively. We had on hand precious metals owned by participants in our precious metals consignment program of $66.2 million at December 31, 2019 and $55.2 million at December 31, 2018, measured at fair value based on market prices for identical assets and net of credits. The consignment agreements under our precious metals program involve short-term commitments that typically mature within 30 to 90 days of each transaction and are typically renewed on an ongoing basis. As a result, the Company relies on the continued willingness of financial institutions to participate in these arrangements to maintain this source of liquidity. On occasion, we have been required to deliver cash collateral. While no deposits were outstanding at December 31, 2019 or December 31, 2018, we may be required to furnish cash collateral in the future based on the quantity and market value of the precious metals under consignment and the amount of collateral-free lines provided by the financial institutions. The amount of cash collateral required is subject to review by the financial institutions and can be changed at any time at their discretion, based in part on their assessment of our creditworthiness. Bank Guarantees and Standby Letters of Credit. At December 31, 2019, the Company and its subsidiaries had bank guarantees and standby letters of credit issued by financial institutions that totaled $4.8 million. These agreements primarily relate to Ferro’s insurance programs, foreign energy purchase contracts and foreign tax payments. Liquidity Requirements Our primary sources of liquidity are available cash and cash equivalents, available lines of credit under the Amended Credit Facility, and cash flows from operating activities. As of December 31, 2019, we had $96.2 million of cash and cash equivalents. Cash generated in the U.S. is generally used to pay down amounts outstanding under our 2018 Revolving Facility and for general corporate purposes, including acquisitions. If needed, we could repatriate the majority of cash held by foreign subsidiaries without the need to accrue and pay U.S. income taxes. We do not anticipate a liquidity need requiring such repatriation of these funds to the U.S. During the fourth quarter of 2019, we entered into a definitive agreement to sell our Tile Coatings business which has historically been a part of our Performance Coatings reportable segment. We expect to use the proceeds of the sale to settle long-term obligations. Our liquidity requirements primarily include debt service, purchase commitments, labor costs, working capital requirements, restructuring expenditures, acquisition costs, capital investments, precious metals cash collateral requirements, and postretirement benefit obligations. We expect to meet these requirements in the long term through cash provided by operating activities and availability under existing credit facilities or other financing arrangements. Cash flows from operating activities are primarily driven by earnings before noncash charges and changes in working capital needs. In 2019, cash flows from operating activities were used to fund our investing activities. Additionally, we used the borrowings available under the Amended Credit Facility for other general business purposes. We had additional borrowing capacity of $524.0 million at December 31, 2019, available under various credit facilities, primarily our revolving credit facility. Our Amended Credit Facility contains customary restrictive covenants, including those described in more detail in Note 9 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. These covenants include customary restrictions, including, but not limited to, limitations on use of loan proceeds, limitations on the Company’s ability to pay dividends and repurchase stock, limitations on acquisitions and dispositions, and limitations on certain types of investments. Specific to the 2018 Revolving Facility, we are subject to a financial covenant regarding the Company’s maximum leverage ratio. This covenant under our Amended Credit Facility restricts the amount of our borrowings, reducing our flexibility to fund ongoing operations and strategic initiatives. This facility is described in more detail in Note 9 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K. As of December 31, 2019, we were in compliance with our maximum leverage ratio covenant of 4.00x as our actual ratio was 2.93, providing $61.6 million of EBITDA cushion on the leverage ratio, as defined within the Amended Credit Facility. To the extent that economic conditions in key markets deteriorate or we are unable to meet our business projections and EBITDA falls below approximately $196 million for a rolling four quarters, based on reasonably consistent net debt levels with those as of December 31, 2019, we could become unable to maintain compliance with our leverage ratio covenant. In such case, our lenders could demand immediate payment of outstanding amounts and we would need to seek alternate financing sources to pay off such debts and to fund our ongoing operations. Such financing may not be available on favorable terms, if at all. Difficulties experienced in global capital markets could affect the ability or willingness of counterparties to perform under our various lines of credit, forward contracts, and precious metals program. These counterparties are major, reputable, multinational institutions, all having investment-grade credit ratings. Accordingly, we do not anticipate counterparty default. However, an interruption in access to external financing could adversely affect our business prospects and financial condition. We assess on an ongoing basis our portfolio of businesses, as well as our financial and capital structure, to ensure that we have sufficient capital and liquidity to meet our strategic objectives. As part of this process, from time to time we evaluate the possible divestiture of businesses that are not critical to our core strategic objectives and, where appropriate, pursue the sale of such businesses and assets. We also evaluate and pursue acquisition opportunities that we believe will enhance our strategic position such as the acquisitions we completed in 2018 and 2017. Generally, we publicly announce material divestiture and acquisition transactions only when we have entered into a material definitive agreement or closed on those transactions. The Company’s aggregate amount of contractual obligations for the next five years and thereafter is set forth below: _____________________ (1)Long-term debt excludes imputed interest and executory costs on capitalized lease obligations and unamortized issuance costs on the term loan facility. (2)Interest represents only contractual payments for fixed-rate debt. (3)Purchase commitments are noncancelable contractual obligations for raw materials and energy, and exclude capital expenditures for property, plant and equipment. (4)We have not projected payments past 2020 due to uncertainties in estimating the amount and period of any payments. The amount above relates to our current income tax liability as of December 31, 2019. We have $24.3 million in gross liabilities related to unrecognized tax benefits, including $2.9 million of accrued interest and penalties that are not included in the above table since we cannot reasonably predict the timing of cash settlements with various taxing authorities. (5)The funding amounts are based on the minimum contributions required under our various plans and applicable regulations in each respective country. We have not projected contributions past 2020 due to uncertainties regarding the assumptions involved in estimating future required contributions. Critical Accounting Policies When we prepare our consolidated financial statements we are required to make estimates and assumptions that affect the amounts we report in the consolidated financial statements and footnotes. We consider the policies discussed below to be more critical than other policies because their application requires our most subjective or complex judgments. These estimates and judgments arise because of the inherent uncertainty in predicting future events. Management has discussed the development, selection and disclosure of these policies with the Audit Committee of the Board of Directors. Revenue Recognition Under ASC 606, revenues are recognized when control of the promised goods is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods. In order to achieve that core principle, the Company applies the following five-step approach: 1) identify the contract with a customer, 2) identify the performance obligations, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract, and 5) recognize revenue when a performance obligation is satisfied. In order to ensure the revenue recognition in the proper period, we review material sales contracts for proper cut-off based upon the business practices and legal requirements of each country. For sales of products containing precious metals, we report revenues on a gross basis along with their corresponding cost of sales to arrive at gross profit. We record revenues this way because we act as the principal in the transactions into which we enter. Restructuring and Cost Reduction Programs In recent years, we have developed and initiated global cost reduction programs with the objectives of leveraging our global scale, realigning and lowering our cost structure, and optimizing capacity utilization. Management continues to evaluate our businesses, and therefore, there may be additional provisions for new optimization and cost-savings initiatives, as well as changes in estimates to amounts previously recorded, as payments are made or actions are completed. Restructuring charges include both termination benefits and asset writedowns. We estimate accruals for termination benefits based on various factors including length of service, contract provisions, local legal requirements, projected final service dates, and salary levels. We also analyze the carrying value of long-lived assets and record estimated accelerated depreciation through the anticipated end of the useful life of the assets affected by the restructuring or record an asset impairment. In all likelihood, this accelerated depreciation will result in reducing the net book value of those assets to zero at the date operations cease. While we believe that changes to our estimates are unlikely, the accuracy of our estimates depends on the successful completion of numerous actions. Changes in our estimates could increase our restructuring costs to such an extent that it could have a material impact on the Company’s results of operations, financial position, or cash flows. Other events, such as negotiations with unions and works councils, may also delay the resulting cost savings. Accounts Receivable and the Allowance for Doubtful Accounts Ferro sells its products to customers in diversified industries throughout the world. No customer or related group of customers represents greater than 10% of net sales or accounts receivable. We perform ongoing credit evaluations of our customers and require collateral principally for export sales, when industry practices allow and as market conditions dictate, subject to our ability to negotiate secured terms relative to competitive offers. We regularly analyze significant customer accounts and provide for uncollectible accounts based on historical experience, customer payment history, the length of time the receivables are past due, the financial health of the customer, economic conditions, and specific circumstances, as appropriate. Changes in these factors could result in additional allowances. Customer accounts we conclude to be uncollectible or to require excessive collection costs are written off against the allowance for doubtful accounts. Historically, write-offs of uncollectible accounts have been within our expectations. Goodwill We review goodwill for impairment each year using a measurement date of October 31st or more frequently in the event of an impairment indicator. We annually, or more frequently as warranted, evaluate the appropriateness of our reporting units utilizing operating segments as the starting point of our analysis. In the event of a change in our reporting units, we would allocate goodwill based on the relative fair value. We estimate the fair values of the reporting units associated with these assets using the average of both the income approach and the market approach, which we believe provides a reasonable estimate of the reporting units’ fair values, unless facts and circumstances exist that indicate more representative fair values. The income approach uses projected cash flows attributable to the reporting units and allocates certain corporate expenses to the reporting units. We use historical results, trends and our projections of market growth, internal sales efforts and anticipated cost structure assumptions to estimate future cash flows. Using a risk-adjusted, weighted-average cost of capital, we discount the cash flow projections to the measurement date. The market approach estimates a price reasonably expected to be paid by a market participant in the purchase of similar businesses. If the fair value of any reporting unit was determined to be less than its carrying value, we would recognize an impairment for the difference between fair value and carrying value. The significant assumptions and ranges of assumptions we used in our impairment analyses of goodwill at October 31, 2019 and 2018, were as follows: Our estimates of fair value can be adversely affected by a variety of factors. Reductions in actual or projected growth or profitability at our reporting units due to unfavorable market conditions or significant increases in cost structure could lead to the impairment of any related goodwill. Additionally, an increase in inflation, interest rates or the risk-adjusted, weighted-average cost of capital could also lead to a reduction in the fair value of one or more of our reporting units and therefore lead to the impairment of goodwill. During the second and third quarters of 2019, the Company recorded $9.0 million of goodwill impairment charges related to our Tile Coatings business, which was historically recorded within our Performance Coatings reportable segment. The goodwill impairment charge recorded was a result of the finalization of purchase accounting of the recent Quimicer, FMU, and Gardenia acquisitions that changed the carrying amount of net assets attributable to the reporting unit that represented an impairment indicator. Based on our 2019 annual impairment test performed as of October 31, 2019, the Company recorded additional goodwill impairment charges of $33.5 million associated with a reporting unit within the Tile Coatings business. The impairment charge and related assets are recorded within discontinued operations and as assets held-for-sale, respectively, in our consolidated financial statements as of December 31, 2019. Future potential impairments are possible for any of the Company’s remaining reporting units if actual results are materially less than forecasted results. Some of the factors that could negatively affect our cash flows and, as a result, not support the carrying values of our reporting units are: new environmental regulations or legal restrictions on the use of our products that would either reduce our product revenues or add substantial costs to the manufacturing process, thereby reducing operating margins; new technologies that could make our products less competitive or require substantial capital investment in new equipment or manufacturing processes; and substantial downturns in economic conditions. Long-Lived Asset Impairment The Company’s long-lived assets include property, plant and equipment, and intangible assets. We review property, plant and equipment and intangible assets for impairment whenever events or circumstances indicate that their carrying values may not be recoverable. The following are examples of such events or changes in circumstances: An adverse change in the business climate of a long-lived asset or asset group; An adverse change in the extent or manner in which a long-lived asset or asset group is used or in its physical condition; Current operating losses for a long-lived asset or asset group combined with a history of such losses or projected or forecasted losses that demonstrate that the losses will continue; or A current expectation that, more likely than not, a long-lived asset or asset group will be sold or otherwise significantly disposed of before the end of its previously estimated useful life. The carrying amount of property, plant and equipment and intangible assets is not recoverable if the carrying value of the asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset group. In the event of impairment, we recognize a loss for the excess of the recorded value over fair value. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of review. Income Taxes The breadth of our operations and complexity of income tax regulations require us to assess uncertainties and make judgments in estimating the ultimate amount of income taxes we will pay. Our income tax expense, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. The final income taxes we pay are based upon many factors, including existing income tax laws and regulations, negotiations with taxing authorities in various jurisdictions, outcomes of tax litigation, and resolution of disputes arising from federal, state and international income tax audits. The resolution of these uncertainties may result in adjustments to our income tax assets and liabilities in the future. Deferred income taxes result from differences between the financial and tax basis of our assets and liabilities. We adjust our deferred income tax assets and liabilities for changes in income tax rates and income tax laws when changes are enacted. We record valuation allowances to reduce deferred income tax assets when it is more likely than not that a tax benefit will not be realized. Significant judgment is required in evaluating the need for and the magnitude of appropriate valuation allowances against deferred income tax assets. The realization of these assets is dependent on generating future taxable income, our ability to carry back or carry forward net operating losses and credits to offset tax liabilities, as well as successful implementation of various tax strategies to generate tax where net operating losses or credit carryforwards exist. In evaluating our ability to realize the deferred income tax assets, we rely principally on the reversal of existing temporary differences, the availability of tax planning strategies, and forecasted income. We recognize a tax benefit from an uncertain tax position when it is more likely than not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits. Our estimate of the potential outcome of any uncertain tax positions is subject to management’s assessment of relevant risks, facts, and circumstances existing at that time. We record a liability for the difference between the benefit recognized and measured based on a more-likely-than-not threshold and the tax position taken or expected to be taken on the tax return. To the extent that our assessment of such tax positions change, the change in estimate is recorded in the period in which the determination is made. We report tax-related interest and penalties as a component of income tax expense. Derivative Financial Instruments We use derivative financial instruments in the normal course of business to manage our exposure to fluctuations in interest rates, foreign currency exchange rates, and precious metal prices. The accounting for derivative financial instruments can be complex and can require significant judgment. Generally, the derivative financial instruments that we use are not complex, and observable market-based inputs are available to measure their fair value. We do not engage in speculative transactions for trading purposes. The use of financial derivatives is managed under a policy that identifies the conditions necessary to identify the transaction as a financial derivative. Financial instruments, including derivative financial instruments, expose us to counterparty credit risk for nonperformance. We manage our exposure to counterparty credit risk through minimum credit standards and procedures to monitor concentrations of credit risk. We enter into these derivative financial instruments with major, reputable, multinational financial institutions. Accordingly, we do not anticipate counter-party default. We continuously evaluate the effectiveness of derivative financial instruments designated as hedges to ensure that they are highly effective. In the event the hedge becomes ineffective, we discontinue hedge treatment. Except as noted below, we do not expect any changes in our risk policies or in the nature of the transactions we enter into to mitigate those risks. Our exposure to interest rate changes arises from our debt agreements with variable interest rates. To reduce our exposure to interest rate changes on variable rate debt, we entered into interest rate swap agreements. These swaps are settled in cash, and the net interest paid or received is effectively recognized as interest expense. We mark these swaps to fair value and recognize the resulting gains or losses as other comprehensive income. We have executed cross currency interest rate swaps to minimize our exposure to floating rate debt agreements denominated in a currency other than functional currency. These swaps are settled in cash, and the net interest paid or received is effectively recognized as interest expense as the interest on the debt is accrued. These swaps are designated as cash flows hedges and we mark these swaps to fair value and recognize the resulting gains or losses as other comprehensive income. To help protect the value of the Company’s net investment in European operations against adverse changes in exchange rates, the Company uses non-derivative financial instruments, such as its foreign currency denominated debt, as economic hedges of its net investments in certain foreign subsidiaries. In addition, we have executed cross currency interest rate swaps to help protect the value of the Company’s net investment in European operations. These swaps are settled in cash, and the net interest paid or received is effectively recognized as interest expense. We mark these swaps to fair value and recognize the resulting gains or losses as cumulative translation adjustments (a component of other comprehensive income). We manage foreign currency risks in a wide variety of foreign currencies principally by entering into forward contracts to mitigate the impact of currency fluctuations on transactions arising from international trade. Our objective in entering into these forward contracts is to preserve the economic value of nonfunctional currency cash flows. Our principal foreign currency exposures relate to the Euro, the Egyptian Pound, the Turkish Lira, the Taiwan Dollar, the Colombian Peso, the Australian Dollar, the Indian Rupee, the Thailand Baht, the Indonesian Rupiah, the Japanese Yen, the Chinese Renminbi and the Romanian Leu. We mark these forward contracts to fair value based on market prices for comparable contracts and recognize the resulting gains or losses as other income or expense from foreign currency transactions. Precious metals (primarily silver, gold, platinum and palladium) represent a significant portion of raw material costs in our electronics products. When we enter into a fixed price sales contract at the customer’s request to establish the price for the precious metals content of the order, we may enter into a forward purchase arrangement with a precious metals supplier to completely cover the value of the precious metals content. Our current precious metals contracts are designated as normal purchase contracts, which are not marked to market. We also purchase portions of our energy requirements, including natural gas and electricity, under fixed price contracts to reduce the volatility of cost changes. Our current energy contracts are designated as normal purchase contracts, which are not marked to market. Transfer of Financial Assets The Company accounts for transfers of financial assets as sales when it has surrendered control over the related assets. Whether control has been relinquished requires, among other things, an evaluation of relevant legal considerations and an assessment of the nature and extent of the Company’s continuing involvement with the assets transferred. Pension and Other Postretirement Benefits We sponsor defined benefit plans in the U.S. and many countries outside the U.S., and we also sponsor retiree medical benefits for a segment of our salaried and hourly work force within the U.S. The U.S. pension plans and retiree medical plans represent approximately 87% of pension plan assets, 73% of benefit obligations and 13% of net periodic pension expense as of December 31, 2019. The assumptions we use in actuarial calculations for these plans have a significant impact on benefit obligations and annual net periodic benefit costs. We meet with our actuaries annually to discuss key economic assumptions used to develop these benefit obligations and net periodic costs. We determine the discount rate for the U.S. pension and retiree medical plans based on a bond model. Using the pension plans’ projected cash flows, the bond model considers all possible bond portfolios that produce matching cash flows and selects the portfolio with the highest possible yield. These portfolios are based on bonds with a quality rating of AA or better under either Moody’s Investor Services, Inc. or Standard & Poor’s Rating Group, but exclude certain bonds, such as callable bonds, bonds with small amounts outstanding, and bonds with unusually high or low yields. The discount rates for the non-U.S. plans are based on a yield curve method, using AA-rated bonds applicable in their respective capital markets. The duration of each plan’s liabilities is used to select the rate from the yield curve corresponding to the same duration. For the market-related value of plan assets, we use fair value, rather than a calculated value. The market-related value recognizes changes in fair value in a systematic and rational manner over several years. We calculate the expected return on assets at the beginning of the year for defined benefit plans as the weighted-average of the expected return for the target allocation of the principal asset classes held by each of the plans. In determining the expected returns, we consider both historical performance and an estimate of future long-term rates of return. The Company consults with and considers the opinion of its actuaries in developing appropriate return assumptions. Our target asset allocation percentages are 35% fixed income, 60% equity, and 5% other investments for U.S. plans and 75% fixed income, 24% equity, and 1% other investments for non-U.S. plans. In 2019, our pension plan assets incurred gains of approximately 17% within the U.S. plans and 13% within non-U.S. plans. In 2018, our pension plan assets incurred losses of approximately 7% within the U.S. plans and 3% within non-U.S. plans. Future actual pension expense will depend on future investment allocation and performance, changes in future discount rates and various other factors related to the population of participants in the Company’s pension plans. All other assumptions are reviewed periodically by our actuaries and us and may be adjusted based on current trends and expectations as well as past experience in the plans. The following table provides the sensitivity of net annual periodic benefit costs for our pension plans, including a U.S. nonqualified retirement plan, and the retiree medical plan to a 25-basis-point decrease in both the discount rate and asset return assumption: The following table provides the rates used in the assumptions and the changes between 2019 and 2018: Our overall net periodic benefit cost for all defined benefit plans was $14.7 million in 2019 and $17.5 million in 2018. The change is mainly the result of mark to market actuarial net losses in 2019. For 2020, assuming expected returns on plan assets and no actuarial gains or losses, we expect our overall net periodic benefit income to be approximately $2.7 million, compared with expense of approximately $2.4 million in 2019 on a comparable basis. Inventories We value inventory at the lower of cost or net realizable value, with cost determined utilizing the first-in, first-out (FIFO) method. We periodically evaluate the net realizable value of inventories based primarily upon their age, but also upon assumptions of future usage in production, customer demand and market conditions. Inventories have been reduced to the lower of cost or realizable value by allowances for slow moving or obsolete goods. If actual circumstances are less favorable than those projected by management in its evaluation of the net realizable value of inventories, additional write-downs may be required. Slow moving, excess or obsolete materials are specifically identified and may be physically separated from other materials, and we rework or dispose of these materials as time and manpower permit. Environmental Liabilities Our manufacturing facilities are subject to a broad array of environmental laws and regulations in the countries in which they are located. The costs to comply with complex environmental laws and regulations are significant and will continue for the foreseeable future. We expense these recurring costs as they are incurred. While these costs may increase in the future, they are not expected to have a material impact on our financial position, liquidity or results of operations. We also accrue for environmental remediation costs and other obligations when it is probable that a liability has been incurred and we can reasonably estimate the amount. We determine the timing and amount of any liability based upon assumptions regarding future events. Inherent uncertainties exist in such evaluations primarily due to unknown conditions and other circumstances, changing governmental regulations and legal standards regarding liability, and evolving technologies. We adjust these liabilities periodically as remediation efforts progress or as additional technical or legal information becomes available. Impact of Newly Issued Accounting Pronouncements Refer to Note 2 to the consolidated financial statements under Item 8 of this Annual Report on Form 10-K for a discussion of accounting standards we recently adopted or will be required to adopt.

<s>[INST] During the year ended December 31, 2019, net sales decreased $63.9 million, or 5.9%, compared with 2018. Net sales decreased by $42.5 million and $21.4 million in Performance Colors and Glass and Color Solutions, respectively. Gross profit decreased $30.9 million compared with 2018; as a percentage of net sales, it decreased approximately 110 basis points to 30.3%, from 31.4% in the prior year. The decrease in gross profit was primarily attributable to decreases across both our segments, with decreases in Performance Colors and Glass and Color Solutions of $18.9 million and $9.9 million, respectively. For the year ended December 31, 2019, selling, general and administrative (“SG&A”) expenses decreased $7.5 million, or 3.4%, compared with 2018. As a percentage of net sales, SG&A expenses increased 60 basis points from 20.3% in 2018 to 20.9% in 2019. For the year ended December 31, 2019, net income was $7.4 million, compared with net income of $80.9 million in 2018, and net income attributable to common shareholders was $6.0 million, compared with net income attributable to common shareholders of $80.1 million in 2018. Income from continuing operations was $35.4 million for the year ended December 31, 2019, compared with $56.9 million in 2018. As previously disclosed on January 17, 2019, the Company has been expanding its production facility in Villagran, Mexico, which will become the Company’s Manufacturing Center of Excellence for the Americas. The expansion of the Villagran facility is expected to significantly increase the revenue generated from products manufactured at that facility. With the expanded capacity in Villagran, the Company plans to (i) discontinue the production of glass enamels, other industrial specialty products, such as architectural glass coatings, and pigments at its Washington, Pennsylvania facility over the course of 2020 and (ii) discontinue production of porcelain enamel products at its Cleveland, Ohio facility. As part of this optimization initiative, the Company is expanding its King of Prussia, Pennsylvania facility. Conductive glass coatings production will be discontinued at the Washington, Pennsylvania facility and will be produced at the King of Prussia, Pennsylvania facility, and the Company’s operations at its Vista, California facility will be transferred to the King of Prussia, Pennsylvania facility. In addition, the Company plans to move its Americas research and development center for glass products to its technology center in Independence, Ohio, where the Company is investing in expanded laboratory facilities. The Washington, Pennsylvania facility is expected to remain in operation until sometime in 2020. Production of specialty glasses for electronics applications will continue at the Cleveland, Ohio facility, and the Company plans to invest in the facility to equip it to serve as a logistics center. The Cleveland, Ohio facility also will serve as the Americas research and development center for the porcelain enamel business. 2019 Transactional Activity During the fourth quarter of 2019, we entered into a definitive agreement to sell our Tile Coatings business which has historically been a part of our Performance Coatings reportable segment. As further discussed in Note 4 to the consolidated financial statements under Item 8 of this Annual Report on Form 10K, substantially all of the assets and liabilities of our Tile Coatings business were classified as heldforsale in the accompanying consolidated balance sheets and the associated operating results, net of income tax, have been classified as discontinued operations in the accompanying consolidated statements of operations for all periods presented. 2018 Transactional Activity Transactions undertaken in 2018 included the following business acquisitions: Acquisition of Quimicer, S.A. (“Quimicer”): As discussed in Note 5, in the fourth quarter of 2018, the Company acquired 100% of the equity interests of [/INST] Negative. </s>

HOVNANIAN ENTERPRISES INC

2015-12-18

2015-10-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS During fiscal 2015, a number of our operating results were positive compared to the same period of the prior year. For the year ended October 31, 2015, sale of homes revenue increased 3.7% as compared to the prior year. The increase was primarily due to a higher average price per home, which was a result of geographic and community mix of our deliveries, as opposed to home price increases (which we increase or decrease in communities depending on the respective community’s performance). Net contracts per average active selling community increased to 30.0 for the year ended October 31, 2015 compared to 28.4 in the same period in the prior year. Active selling communities increased from 201 at October 31, 2014 to 219 at October 31, 2015. Net contracts increased 11.2% for the year ended October 31, 2015 as compared to the prior year. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased to 11.7% for the year ended October 31, 2015, which included a $15.2 million benefit from a reduction in reserves discussed further below, compared to 12.4% for the year ended October 31, 2014. Deliveries were relatively flat for the year ended October 31, 2015 compared to the same period of the prior year, partially resulting from extended cycle times due to labor shortages causing delays in deliveries. Despite the positive operating results, we also experienced some negative operating results. Gross margin percentage, before cost of sales interest expense and land charges, decreased from 19.9% for the year ended October 31, 2014 to 17.6% for the year ended October 31, 2015. In the first and second quarters of fiscal 2015, we significantly discounted some of our started unsold homes (commonly referred to as “specs”) to sell them. In addition, we have been experiencing pricing pressure since midway through fiscal 2014, leading us to increase incentives and concessions on to be built homes, although to a lesser extent than on specs in the first half of fiscal 2015. Combined, this resulted in a decrease in gross margin percentage for the year ended October 31, 2015 as compared to the prior year. The decrease in gross margin for fiscal 2015 resulted in a net loss before income taxes of $21.8 million for the year ended October 31, 2015, which compares to net income of $20.2 million for the year ended October 31, 2014. When comparing sequentially from the third quarter of fiscal 2015 to the fourth quarter of fiscal 2015, our gross margin percentage, before cost of sales interest expense and land charges, increased slightly to 18.0% compared to 17.8%. Selling, general and administrative costs decreased $15.9 million for the fourth quarter of fiscal 2015 compared to the third quarter of fiscal 2015, primarily due to an adjustment to our construction defect reserves, based on our annual actuarial estimates. Excluding this adjustment, selling, general and administrative costs remained flat. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased from 12.6% to 7.1% in the fourth quarter of fiscal 2015 compared to the third quarter of fiscal 2015 as a result of the decrease in selling, general and administrative costs, along with a 28.2% increase in homebuilding revenues in the fourth quarter. We had 2,905 homes in backlog with a dollar value of $1.2 billion at October 31, 2015 (an increase of 42.1% in dollar value compared to the year ended October 31, 2014). Based on this backlog and the anticipated gross margin associated with this backlog, along with the increase in net contracts per average active selling community as well as our increase in community count, we believe that we are well-positioned for stronger results in fiscal 2016 compared with fiscal 2015. However, several challenges, such as general U.S. economic weakness and uncertainty, historically low oil prices (which has affected our Texas markets), extreme weather conditions, increasing cycle times due to labor shortages, the restrictive mortgage lending environment and rising mortgage interest rates, could further impact the housing market and, consequently, our performance. Additionally, we could be negatively impacted by our inability to access capital as described below under “ - Capital Resources and Liquidity.” Both national new home sales and our home sales remain below historical levels. We continue to believe that we are still in the early stages of the housing recovery. However, given our recent uneven operating performance, we may continue to experience mixed results in some of our operating markets. Given the low levels of total U.S. housing starts, and our belief in the long-term recovery of the homebuilding market, we remain focused on identifying new land parcels, growing our community count and growing our revenues, which are critical to improving our financial performance. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales paces and plan to continue pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability. During the year ended October 31, 2015, we opened for sale 101 new communities and closed 83 communities, resulting in a net increase of 18 communities from 201 communities at October 31, 2014 to 219 communities at October 31, 2015. In addition, during the year ended October 31, 2015, we put under option or acquired approximately 10,000 lots in 172 wholly owned communities and walked away from 4,730 lots in 69 wholly owned communities. Homebuilding selling, general and administrative expenses decreased $3.1 million from $191.5 million for the year ended October 31, 2014 to $188.4 million for the year ended October 31, 2015. This decrease was primarily due to an adjustment to our construction defect reserves based on our annual actuarial estimates, partially offset by increases due to additional headcount related costs and increased architectural expense, related to recent and expected future community count growth, as well as a reduction of joint venture management fees, which offset general and administrative expenses, received as a result of fewer joint venture deliveries in the year ended October 31, 2015 as compared to the year ended October 31, 2014. Corporate general and administrative expenses as a percentage of total revenue remained relatively flat at 2.9% for the year ended October 31, 2015 compared to 3.1% for the year ended October 31, 2014. Improving the efficiency of our selling, general and administrative expenses will continue to be a significant area of focus, and as we generate revenue from our increased community count, we expect to be able to leverage these costs. Critical Accounting Policies Management believes that the following critical accounting policies require its most significant judgments and estimates used in the preparation of the consolidated financial statements: Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of MBS to hedge our mortgage-related interest rate exposure on agency and government loans. We elected the fair value option for our mortgage loans held for sale in accordance with Accounting Standards Codification (“ASC”) 825, “Financial Instruments,” which permits us to measure our loans held for sale at fair value. Management believes that the election of the fair value option for loans held for sale improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We believe there continues to be an industry-wide issue with the number of purchaser claims in which purchasers purport to have found inaccuracies related to the sellers’ representations and warranties in particular loan sale agreements. We have established reserves for probable losses. While we believe these reserves are adequate for known losses and projected repurchase requests, given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, if either actual repurchases or the losses incurred resolving those repurchases exceed our expectations, additional expense may be incurred. Inventories - Inventories consist of land, land development, home construction costs, capitalized interest, construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type. We record inventories in our consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all costs related to specific performance options, variable interest entities and other options, which consists primarily of model homes financed with an investor and inventory related to land banking arrangements accounted for as financings. We decide to mothball (or stop development on) certain communities when we determine that current market conditions do not justify further investment at that time. When we decide to mothball a community, the inventory is reclassified on our consolidated balance sheets from "Sold and unsold homes and lots under development" to "Land and land options held for future development or sale." As of October 31, 2015, the net book value associated with our 31 mothballed communities was $103.0 million, net of impairment charges recorded in prior periods of $334.5 million. We regularly review communities to determine if mothballing is appropriate. During fiscal 2015, we did not mothball any additional communities, or sell any mothballed communities, but re-activated 14 communities which were previously mothballed. From time to time we enter into option agreements that include specific performance requirements, whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with ASC 360-20-40-38, we are required to record this inventory on our Consolidated Balance Sheets. As of October 31, 2015, we had $1.2 million of specific performance options recorded on our Consolidated Balance Sheets to “Consolidated inventory not owned - specific performance options,” with a corresponding liability of $1.2 million recorded to “Liabilities from inventory not owned.” Consolidated inventory not owned also consists of other options that were included on our Consolidated Balance Sheets in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheet, at October 31, 2015, inventory of $95.9 million was recorded to “Consolidated inventory not owned - other options,” with a corresponding amount of $87.9 million recorded to “Liabilities from inventory not owned.” We have land banking arrangements, whereby we sell our land parcels to the land banker and they provide us an option to purchase back finished lots on a quarterly basis. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 360-20-40-38, these transactions are considered financings rather than sales. For purposes of our Consolidated Balance Sheet, at October 31, 2015, inventory of $25.1 million was recorded as “Consolidated inventory not owned - other options,” with a corresponding amount of $16.8 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. The recoverability of inventories and other long-lived assets is assessed in accordance with the provisions of ASC 360-10, “Property, Plant and Equipment - Overall” (“ASC 360-10”). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure. We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable. The projected operating profits, losses, or cash flows of each community can be significantly impacted by our estimates of the following: ● future base selling prices; ● future home sales incentives; ● future home construction and land development costs; and ● future sales absorption pace and cancellation rates. These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include: ● the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors; ● the current sales absorption pace for both our communities and competitor communities; ● community specific attributes, such as location, availability of lots in the market, desirability and uniqueness of our community, and the size and style of homes currently being offered; ● potential for alternative product offerings to respond to local market conditions; ● changes by management in the sales strategy of the community; ● current local market economic and demographic conditions and related trends of forecasts; and ● existing home inventory supplies, including foreclosures and short sales. These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair-value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful to an investor. If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written down to its fair value. We determine the estimated fair value of each community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from outside third parties. Our discount rates used for all impairments recorded from October 31, 2013 to October 31, 2015 ranged from 16.8% to 19.8%. The estimated future cash flow assumptions are virtually the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis. From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed not probable that the optioned property will be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant in comparison to the total costs written off. Inventories held for sale are land parcels ready for sale in their current condition, where we have decided not to build homes but are instead actively marketing for sale. These land parcels represented $1.3 million and $0.6 million of our total inventories at October 31, 2015 and 2014, respectively, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interests in the joint ventures vary but our voting interests are generally 50% or less. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, we assess whether the other partners have specific rights to overcome the presumption of control by us as the manager of the joint venture. In most cases, the presumption is overcome because the joint venture agreements require that both partners agree on establishing the significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, “Investments - Equity Method and Joint Ventures - Overall,” we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment below its carrying amount is other than temporary, we write down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture’s projected cash flows. This process requires significant management judgment and estimates. There were no write-downs in fiscal 2013, 2014 or 2015. Post-Development Completion, Warranty Costs and Insurance Deductible Reserves - In those instances where a development is substantially completed and sold and we have additional construction work to be incurred, an estimated liability is provided to cover the cost of such work. We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general, and administrative costs. For homes delivered in fiscal 2015 and 2014, our deductible under our general liability insurance is a $20 million aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2015 and 2014 is $0.25 million, up to a $5 million limit. Our aggregate retention in fiscal 2015 and 2014 is $21 million for construction defect, warranty and bodily injury claims. We do not have a deductible on our worker's compensation insurance. Reserves for estimated losses for construction defects, warranty and bodily injury claims have been established using the assistance of a third-party actuary. We engage a third-party actuary that uses our historical warranty and construction defect data to assist our management in estimating our unpaid claims, claim adjustment expenses and incurred but not reported claims reserves for the risks that we are assuming under the general liability and construction defect programs. The estimates include provisions for inflation, claims handling and legal fees. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. In addition, we establish a warranty accrual for lower cost-related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and title and possession have been transferred to the homebuyer. See Note 16 to the Consolidated Financial Statements for additional information on the amount of warranty costs recognized in cost of goods sold and administrative expenses. Deferred Income Taxes - Deferred income taxes are provided for temporary differences between amounts recorded for financial reporting and for income tax purposes. If the combination of future years’ income (or loss) combined with the reversal of the timing differences results in a loss, such losses can be carried back to prior years or carried forward to future years to recover the deferred tax assets. In accordance with ASC 740-10, “Income Taxes - Overall” (“ASC 740-10”), we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740-10 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more-likely-than-not” standard. See “Total Taxes” below under “Results of Operations” for further discussion of the valuation allowances. In evaluating the exposures associated with our various tax filing positions, we recognize tax liabilities in accordance with ASC 740-10, for more likely than not exposures. We re-evaluate the exposures associated with our tax positions on a quarterly basis. This evaluation is based on factors such as changes in facts or circumstances, changes in tax law, new audit activity by taxing authorities and effectively settled issues. Determining whether an uncertain tax position is effectively settled requires judgment. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision. A number of years may elapse before a particular matter for which we have established a liability is audited and fully resolved or clarified. We adjust our liability for unrecognized tax benefits and income tax provision in the period in which an uncertain tax position is effectively settled, or the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a liability that is materially different from our current estimate. Any such changes will be reflected as increases or decreases to income tax expense in the period in which they are determined. Recent Accounting Pronouncements See Note 3 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Capital Resources and Liquidity Our operations consist primarily of residential housing development and sales in the Northeast (New Jersey and Pennsylvania), the Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia), the Midwest (Illinois, Minnesota and Ohio), the Southeast (Florida, Georgia, North Carolina and South Carolina), the Southwest (Arizona and Texas) and the West (California). In addition, we provide certain financial services to our homebuilding customers. We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our bank credit facilities and the issuance of new debt and equity securities. Our homebuilding cash balance at October 31, 2015 decreased by $9.7 million from October 31, 2014 to $245.4 million at October 31, 2015. During the period, we spent $656.5 million on land and land development. After considering this land and land development and all other operating activities, including revenue received from deliveries, we used $320.5 million of cash in operations. During the year ended October 31, 2015, cash provided by investing activities was $2.5 million, primarily related to decreases in our restricted cash. Cash provided by financing activities was $309.9 million during the year ended October 31, 2015, which included proceeds from the issuance of $250.0 million of senior unsecured notes in the first quarter of fiscal 2015 and $47.0 million drawn under our revolving credit facility, along with net proceeds from nonrecourse mortgages and model sale leasebacks during the period. Cash used in financing activities in the year ended October 31, 2015 included the use of cash to pay off our 11.875% Senior Notes at maturity and to repay certain of our land banking arrangements. We intend to continue to use nonrecourse mortgage financings, model sale leaseback and land banking programs as our business needs dictate. Our cash uses during the year ended October 31, 2015 and 2014 were for operating expenses, land purchases, land deposits, land development, construction spending, financing transactions, debt payments, state income taxes, interest payments and investments in joint ventures. During these periods, we provided for our cash requirements from available cash on hand, housing and land sales, financing transactions, debt issuances, our revolving credit facility, model sale leasebacks, land banking deals, financial service revenues and other revenues. We believe that these sources of cash will be sufficient through fiscal 2016 to finance our working capital requirements and other needs, and enable us to add new communities to grow our homebuilding operations. We have $172.7 million of 6.25% Senior Notes due on January 15, 2016 and $86.5 million of 7.5% Senior Notes due on May 15, 2016. While our preference is to refinance these near term maturities as they come due, in light of the availability of debt financing in the capital and loan markets to companies with comparable credit ratings, we may not be able to refinance these obligations or do so at an attractive rate. In this situation, as an alternative to refinancing, we have a number of means to provide sufficient liquidity to enable us to pay these bonds at maturity while continuing to execute our strategic objectives, which include growing our company. Such means include: additional land banking transactions, an increase in joint venture activity and/or project specific financings and model sale leasebacks. For example, we recently announced one new land banking arrangement with Domain Real Estate Partners for up to $125.0 million and an increase to the existing GSO Capital Partners LP arrangement for up to $175.0 million. In these arrangements, we sell certain of our existing land parcels to the land bank partner with an option to buy back finished lots subject to a cost of carry. We will receive a majority of the $300.0 million funds available under our land banking programs at the time we sell our existing land parcels to our land banking partners. The remainder of the land banking programs’ funds will be paid to us by our land banking partners as reimbursement of our land development costs as incurred. Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, mortgage loans held for sale, interest and other accrued liabilities, deferred income taxes, accounts payable and other liabilities, and noncash charges relating to depreciation, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is partially offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease, which is what happened during the last half of fiscal 2007 through fiscal 2009, allowing us to generate positive cash flow from operations during this period. Since the latter part of fiscal 2009 cumulative through October 31, 2015, as a result of the new land purchases and land development, we have used cash in operations as we have added new communities. Looking forward, given the unstable housing market, we anticipate that it will continue to be difficult to generate positive cash flow from operations until we reach levels of sustained profitability higher than our recent fiscal years. However, we plan to continue to make adjustments to our structure and our business plans in order to maximize our liquidity while also taking steps to return to sustained profitability, including through land acquisitions. On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 4 million shares of Class A Common Stock. We did not repurchase any shares under this program during fiscal 2015 or 2014. As of October 31, 2015, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 0.5 million. (See Part II, Item 5 for information on equity purchases). On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol “HOVNP.” In fiscal 2015, 2014 and 2013, we did not make any dividend payments on the Series A Preferred Stock as a result of covenant restrictions in our debt instruments. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future. On August 8, 2005, K. Hovnanian issued $300.0 million 6.25% Senior Notes due 2016. The 6.25% Senior Notes were issued at a discount to yield 6.46% and have been reflected net of the unamortized discount in the accompanying Consolidated Balance Sheets. The notes are redeemable in whole or in part at our option at 100% of their principal amount plus the payment of a make-whole amount. The net proceeds of the issuance were used to repay the outstanding balance under our then existing revolving credit facility and for general corporate purposes, including acquisitions. These notes were the subject of a November 2011 exchange offer discussed below. On September 16, 2013, K. Hovnanian issued $41.6 million of additional 6.25% Senior Notes due 2016 at a price equal to 100% of their principal amount as discussed below. On February 27, 2006, K. Hovnanian issued $300.0 million of 7.5% Senior Notes due 2016. The notes are redeemable in whole or in part at our option at 100% of their principal amount plus the payment of a make-whole amount. The net proceeds of the issuance were used to repay a portion of the outstanding balance under our then existing revolving credit facility as of February 27, 2006. These notes were the subject of a November 2011 exchange offer discussed below. On June 12, 2006, K. Hovnanian issued $250.0 million of 8.625% Senior Notes due 2017. The notes are redeemable in whole or in part at our option at 100% of their principal amount plus the payment of a make-whole amount. The net proceeds of the issuance were used to repay a portion of the outstanding balance under our then existing revolving credit facility as of June 12, 2006. These notes were the subject of a November 2011 exchange offer discussed below. On February 14, 2011, K. Hovnanian issued $155.0 million aggregate principal amount of 11.875% Senior Notes due 2015. The notes are redeemable in whole or in part at our option at any time at 100% of their principal amount plus an applicable “Make-Whole Amount.” These notes were the subject of a November 2011 exchange offer discussed below. On October 15, 2015, the remaining $60.8 million of our 11.857% Senior Notes due 2015 matured and was paid. On November 1, 2011, K. Hovnanian issued $141.8 million aggregate principal amount of 5.0% Senior Secured Notes due 2021 (the “5.0% 2021 Notes”) and $53.2 million aggregate principal amount of 2.0% Senior Secured Notes due 2021 (the “2.0% 2021 Notes” and, together with the 5.0% 2021 Notes, the “2021 Notes”) in exchange for $195.0 million of certain of K Hovnanian’s unsecured senior notes with maturities ranging from 2014 through 2017. The 5.0% 2021 Notes and the 2.0% 2021 Notes were issued as separate series under an indenture, but have substantially the same terms other than with respect to interest rate and related redemption provisions, and vote together as a single class. The 2021 Notes are redeemable in whole or in part at our option at any time, at 100.0% of the principal amount plus the greater of 1% of the principal amount and an applicable “Make-Whole Amount.” The guarantees by K. Hovnanian JV Holdings, L.L.C. and its subsidiaries except for certain joint ventures and joint venture holding companies (collectively, the “Secured Group”) with respect to the 2021 Notes are secured, subject to permitted liens and other exceptions, by a first-priority lien on substantially all of the assets of the members of the Secured Group. As of October 31, 2015, the collateral securing the guarantees included (1) $50.9 million of cash and cash equivalents (subsequent to such date, cash uses include general business operations and real estate and other investments); (2) $140.1 million aggregate book value of real property of the Secured Group, which does not include the impact of inventory investments, home deliveries, or impairments thereafter and which may differ from the value if it were appraised, and (3) equity interests in guarantors that are members of the Secured Group. Members of the Secured Group also own equity in joint ventures, either directly or indirectly through ownership of joint venture holding companies, with a book value of $57.3 million as of October 31, 2015; this equity is not pledged to secure, and is not collateral for, the 2021 Notes. Members of the Secured Group are “unrestricted subsidiaries” under K. Hovnanian's other senior notes and senior secured notes, and thus have not guaranteed such indebtedness. On October 2, 2012, K. Hovnanian issued $577.0 million aggregate principal amount of 7.25% senior secured first lien notes due 2020 (the "First Lien Notes") and $220.0 million aggregate principal amount of 9.125% senior secured second lien notes due 2020 (the "Second Lien Notes" and, together with the First Lien Notes, the "2020 Secured Notes") in a private placement (the "2020 Secured Notes Offering"). The net proceeds from the 2020 Secured Notes Offering, together with the net proceeds of the Units offering discussed below, and cash on hand, were used to fund the tender offer and consent solicitation with respect to the Company’s then-outstanding 10.625% Senior Secured Notes due 2016 and the redemption of the remaining notes that were not purchased in the tender offer as described below. The First Lien Notes are secured by a first-priority lien and the Second Lien Notes are secured by a second-priority lien, in each case, subject to permitted liens and other exceptions, on substantially all the assets owned by us, K. Hovnanian and the guarantors of such notes. At October 31, 2015, the aggregate book value of the real property that constituted collateral securing the 2020 Secured Notes was $784.7 million, which does not include the impact of inventory investments, home deliveries, or impairments thereafter and which may differ from the value if it were appraised. In addition, cash collateral that secured the 2020 Secured Notes was $197.1 million as of October 31, 2015, which included $2.6 million of restricted cash collateralizing certain letters of credit. Subsequent to such date, cash uses include general business operations and real estate and other investments. We may redeem some or all of the First Lien Notes at 105.438% of principal commencing October 15, 2015, at 103.625% of principal commencing October 15, 2016, at 101.813% of principal commencing October 15, 2017 and 100% of principal commencing October 15, 2018. We may redeem some or all of the Second Lien Notes at 106.844% of principal commencing November 15, 2015, at 104.563% of principal commencing November 15, 2016, at 102.281% of principal commencing November 15, 2017 and 100% of principal commencing November 15, 2018. Also on October 2, 2012, the Company and K. Hovnanian issued $100,000,000 aggregate stated amount of 6.0% Exchangeable Note Units (the “Units”) (equivalent to 100,000 Units). Each $1,000 stated amount of Units initially consists of (1) a zero coupon senior exchangeable note due December 1, 2017 (a “Senior Exchangeable Note”) issued by K. Hovnanian, which bears no cash interest and has an initial principal amount of $768.51 per Senior Exchangeable Note, and that will accrete to $1,000 at maturity and (2) a senior amortizing note due December 1, 2017 (a “Senior Amortizing Note”) issued by K. Hovnanian, which has an initial principal amount of $231.49 per Senior Amortizing Note, bears interest at a rate of 11.0% per annum, and has a final installment payment date of December 1, 2017. Each Unit may be separated into its constituent Senior Exchangeable Note and Senior Amortizing Note after the initial issuance date of the Units, and the separate components may be combined to create a Unit. Each Senior Exchangeable Note had an initial principal amount of $768.51 (which will accrete to $1,000 over the term of the Senior Exchangeable Note at an annual rate of 5.17% from the date of issuance, calculated on a semi-annual bond equivalent yield basis). Holders may exchange their Senior Exchangeable Notes at their option at any time prior to 5:00 p.m., New York City time, on the business day immediately preceding December 1, 2017. Each Senior Exchangeable Note will be exchangeable for shares of Class A Common Stock at an initial exchange rate of 185.5288 shares of Class A Common Stock per Senior Exchangeable Note (equivalent to an initial exchange price, based on $1,000 principal amount at maturity, of approximately $5.39 per share of Class A Common Stock). The exchange rate will be subject to adjustment in certain events. If certain corporate events occur prior to the maturity date, the Company will increase the applicable exchange rate for any holder who elects to exchange its Senior Exchangeable Notes in connection with such corporate event. In addition, holders of Senior Exchangeable Notes will also have the right to require K. Hovnanian to repurchase such holders’ Senior Exchangeable Notes upon the occurrence of certain of these corporate events. As of October 31, 2015, 18,305 Senior Exchangeable Notes have been converted into 3.4 million shares of our Class A Common Stock, all of which were converted during the first quarter of fiscal 2013. On each June 1 and December 1 (each, an “installment payment date”), K. Hovnanian will pay holders of Senior Amortizing Notes equal semi-annual cash installments of $30.00 per Senior Amortizing Note (except for the June 1, 2013 installment payment, which was $39.83 per Senior Amortizing Note), which cash payment in the aggregate will be equivalent to 6.0% per year with respect to each $1,000 stated amount of Units. Each installment will constitute a payment of interest (at a rate of 11.0% per annum) and a partial repayment of principal on the Senior Amortizing Note. Following certain corporate events that occur prior to the maturity date, holders of the Senior Amortizing Notes will have the right to require K. Hovnanian to repurchase such holders’ Senior Amortizing Notes. The net proceeds of the Units offering, along with the net proceeds from the 2020 Secured Notes Offering previously discussed, and cash on hand, were used to fund the tender offer and consent solicitation with respect to the Company’s then outstanding 10.625% Senior Secured Notes due 2016 and redemption of the remaining notes that were not purchased in the tender offer. On September 16, 2013, K. Hovnanian issued an aggregate principal amount of $41.6 million of its 6.25% Senior Notes due 2016. The Notes were issued as additional 6.25% Senior Notes due 2016 under the indenture dated as of August 8, 2005. The net proceeds from this offering were used to fund the redemption on October 15, 2013 of all of K. Hovnanian’s outstanding 6.5% Senior Notes due 2014 and 6.375% Senior Notes due 2014 and to pay related fees and expenses. On January 10, 2014, K. Hovnanian issued $150.0 million aggregate principal amount of 7.0% Senior Notes due 2019, resulting in net proceeds of $147.8 million. The notes are redeemable in whole or in part at our option at any time prior to July 15, 2016 at 100% of their principal amount plus an applicable “Make-Whole Amount.” We may also redeem some or all of the notes at 103.5% of principal commencing July 15, 2016, at 101.75% of principal commencing January 15, 2017 and 100% of principal commencing January 15, 2018. In addition, we may redeem up to 35% of the aggregate principal amount of the notes prior to July 15, 2016, with the net cash proceeds from certain equity offerings at 107.0% of principal. We used a portion of the net proceeds to fund the redemption on February 9, 2014 (effected on February 10, 2014, which was the next business day after the redemption date) of the remaining outstanding principal amount ($21.4 million) of our 6.25% Senior Notes due 2015. The redemption resulted in a loss on extinguishment of debt of $1.2 million, net of the write-off of unamortized fees, and is included in the Consolidated Statement of Operations as “Loss on extinguishment of debt” for fiscal 2014. The remaining net proceeds from the offering were used to pay related fees and expenses and for general corporate purposes. In the fourth quarter of fiscal 2014, K. Hovnanian solicited and obtained the requisite consent of holders of its 2020 Secured Notes to certain amendments to the indentures under which such notes were issued. K. Hovnanian paid an aggregate of $3.3 million to holders who consented thereunder. On November 5, 2014, K. Hovnanian issued $250.0 million aggregate principal amount of 8.0% Senior Notes due 2019, resulting in net proceeds of $245.7 million. These proceeds were used for general corporate purposes. The notes are redeemable in whole or in part at K. Hovnanian’s option at any time prior to August 1, 2019 at a redemption price equal to 100% of their principal amount plus an applicable “Make-Whole Amount.” At any time and from time to time on or after August 1, 2019, K. Hovnanian may also redeem some or all of the notes at a redemption price equal to 100% of their principal amount. As of October 31, 2015, we had $992.0 million of outstanding senior secured notes ($981.3 million, net of discount), comprised of $577.0 million First Lien Notes, $220.0 million Second Lien Notes, $53.2 million 2.0% 2021 Notes and $141.8 million 5.0% 2021 Notes. As of October 31, 2015, we also had $780.3 million of outstanding senior notes, comprised of $172.8 million 6.25% Senior Notes due 2016, $86.5 million 7.5% Senior Notes due 2016, $121.0 million 8.625% Senior Notes due 2017, $150.0 million 7.0% Senior Notes due 2019 and $250.0 million 8.0% Senior Notes due 2019. In addition, as of October 31, 2015, we had outstanding $12.8 million 11.0% Senior Amortizing Notes due 2017 (issued as a component of our 6.0% Exchangeable Note Units) and $73.8 million Senior Exchangeable Notes due 2017 (issued as a component of our 6.0% Exchangeable Note Units). Except for K. Hovnanian, the issuer of the notes, our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures, certain of our title insurance subsidiaries and our foreign subsidiary, we and each of our subsidiaries are guarantors of the senior secured, senior, senior amortizing and senior exchangeable notes outstanding at October 31, 2015 (see Note 22 to the Consolidated Financial Statements). In addition, the 2021 Notes are guaranteed by the Secured Group. Members of the Secured Group do not guarantee K. Hovnanian's other indebtedness. The indentures governing the notes do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than certain permitted indebtedness, refinancing indebtedness and nonrecourse indebtedness), pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness (with respect to certain of the senior secured and senior notes), make other restricted payments, make investments, sell certain assets, incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets and enter into certain transactions with affiliates. The indentures also contain events of default which would permit the holders of the notes to declare the notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the notes or other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency and, with respect to the indentures governing the senior secured notes, the failure of the documents granting security for the senior secured notes to be in full force and effect and the failure of the liens on any material portion of the collateral securing the senior secured notes to be valid and perfected. As of October 31, 2015, we believe we were in compliance with the covenants of the indentures governing our outstanding notes. Under the terms of the indentures, we have the right to make certain redemptions and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to evaluate our capital structure and may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions. If our consolidated fixed charge coverage ratio, as defined in the indentures governing our senior secured and senior notes (other than the senior exchangeable notes) is less than 2.0 to 1.0, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness, and nonrecourse indebtedness. As a result of this restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. We anticipate that we will continue to be restricted from paying dividends for the foreseeable future. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our debt instruments or otherwise affect compliance with any of the covenants contained in the debt instruments. We have nonrecourse mortgage loans for certain communities totaling $143.9 million and $103.9 million at October 31, 2015 and 2014, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $388.1 million and $220.1 million, respectively. The weighted-average interest rate on these obligations was 5.1% and 5.0% at October 31, 2015 and 2014, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries. We also have nonrecourse mortgage loans on our corporate headquarters totaling $15.5 million and $16.6 million at October 31, 2015 and 2014, respectively. These loans had a weighted-average interest rate of 8.8% at October 31, 2015 and 7.0% at October 31, 2014. As of October 31, 2015, these loans had installment obligations with annual principal maturities in the years ending October 31 of: $1.2 million in 2016, $1.3 million in 2017, $1.4 million in 2018, $1.5 million in 2019, $1.7 million in 2020 and $8.4 million after 2020. In June 2013, K. Hovnanian Enterprises, Inc. (“K. Hovnanian”), as borrower, and we and certain of our subsidiaries, as guarantors, entered into a five-year, $75.0 million unsecured revolving credit facility (the “Credit Facility”) with Citicorp USA, Inc., as administrative agent and issuing bank, and Citibank, N.A., as a lender. The Credit Facility is available for both letters of credit and general corporate purposes. The Credit Facility does not contain any financial maintenance covenants, but does contain certain restrictive covenants that track those contained in our indenture governing the 8.0% Senior Notes due 2019, which are described in Note 9 to the Consolidated Financial Statements. The Credit Facility also contains certain customary events of default which would permit the administrative agent at the request of the required lenders to, among other things, declare all loans then outstanding to be immediately due and payable if such default is not cured within applicable grace periods, including the failure to make timely payments of amounts payable under the Credit Facility or other material indebtedness or the acceleration of other material indebtedness, the failure to comply with agreements and covenants or for representations or warranties to be correct in all material respects when made, specified events of bankruptcy and insolvency, and the entry of a material judgment against a loan party. Outstanding borrowings under the Credit Facility accrue interest at an annual rate equal to either, as selected by K. Hovnanian, (i) the alternate base rate plus the applicable spread determined on the date of such borrowing or (ii) an adjusted London Interbank Offered Rate (“LIBOR”) rate plus the applicable spread determined as of the date two business days prior to the first day of the interest period for such borrowing. As of October 31, 2015 there were $47.0 million of borrowings and $25.9 million of letters of credit outstanding under the Credit Facility. As of October 31, 2014, there were no borrowings and $26.5 million of letters of credit outstanding under the Credit Facility. As of October 31, 2015, we believe we were in compliance with the covenants under the Credit Facility. In addition to the Credit Facility, we have certain stand-alone cash collateralized letter of credit agreements and facilities under which there were a total of $2.6 million and $5.5 million letters of credit outstanding at October 31, 2015 and October 31, 2014, respectively. These agreements and facilities require us to maintain specified amounts of cash as collateral in segregated accounts to support the letters of credit issued thereunder, which will affect the amount of cash we have available for other uses. As of October 31, 2015 and 2014, the amount of cash collateral in these segregated accounts was $2.6 million and $5.6 million, respectively, which is reflected in “Restricted cash and cash equivalents” on the Consolidated Balance Sheets. Our wholly owned mortgage banking subsidiary, K. Hovnanian American Mortgage, LLC (“K. Hovnanian Mortgage”), originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are sold in the secondary mortgage market within a short period of time. In certain instances, we retain the servicing rights for a small amount of loans. Our secured Master Repurchase Agreement with JPMorgan Chase Bank, N.A. (“Chase Master Repurchase Agreement”), which was amended on July 31, 2015, is a short-term borrowing facility that provides up to $50.0 million through July 29, 2016. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly on outstanding advances at an adjusted LIBOR rate, which was 0.19% at October 31, 2015, plus the applicable margin of 2.5% or 2.63% based upon type of loan. As of October 31, 2015 and 2014, the aggregate principal amount of all borrowings outstanding under the Chase Master Repurchase Agreement was $30.5 million and $25.5 million, respectively. K. Hovnanian Mortgage has another secured Master Repurchase Agreement with Customers Bank (“Customers Master Repurchase Agreement”), which was amended on February 19, 2015 to extend the maturity date to February 18, 2016, that is a short-term borrowing facility that provides up to $37.5 million through maturity. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable daily or as loans are sold to permanent investors on outstanding advances at the current LIBOR, plus the applicable margin ranging from 2.75% to 5.25% based on the type of loan and the number of days outstanding on the warehouse line. As of October 31, 2015 and 2014, the aggregate principal amount of all borrowings outstanding under the Customers Master Repurchase Agreement was $29.7 million and $20.4 million, respectively. K. Hovnanian Mortgage has a third secured Master Repurchase Agreement with Credit Suisse First Boston Mortgage Capital LLC (“Credit Suisse Master Repurchase Agreement”), which was amended on July 31, 2015, that is a short-term borrowing facility that provides up to $50.0 million through July 29, 2016. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly on outstanding advances at the Credit Suisse Cost of Funds, which was 0.58% at October 31, 2015, plus the applicable margin of 2.5% until the loan documents have been provided to the lender, at which point the margin is lowered to 2.25%. As of October 31, 2015 and 2014, the aggregate principal amount of all borrowings outstanding under the Credit Suisse Master Repurchase Agreement was $30.1 million and $19.7 million, respectively. In February 2014, K. Hovnanian Mortgage executed a secured Master Repurchase Agreement with Comerica Bank (“Comerica Master Repurchase Agreement”), which was amended on June 29, 2015 to extend the maturity date to June 28, 2016. The Comerica Master Repurchase Agreement is a short-term borrowing facility that provides up to $35.0 million through maturity. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. Interest is payable monthly at LIBOR, subject to a floor of 0.25%, plus the applicable margin of 2.5%. As of October 31, 2015 and 2014, the aggregate principal amount of all borrowings outstanding under the Comerica Master Repurchase Agreement was $18.6 million and $11.3 million, respectively. The Chase Master Repurchase Agreement, Customers Master Repurchase Agreement, Credit Suisse Master Repurchase Agreement and Comerica Master Repurchase Agreement (together, the “Master Repurchase Agreements”) require K. Hovnanian Mortgage to satisfy and maintain specified financial ratios and other financial condition tests. Because of the extremely short period of time mortgages are held by K. Hovnanian Mortgage before the mortgages are sold to investors (generally a period of a few weeks), the immateriality to us on a consolidated basis of the size of the Master Repurchase Agreements, the levels required by these financial covenants, our ability based on our immediately available resources to contribute sufficient capital to cure any default, were such conditions to occur, and our right to cure any conditions of default based on the terms of the agreement, we do not consider any of these covenants to be substantive or material. As of October 31, 2015, we believe we were in compliance with the covenants under the Master Repurchase Agreements. On November 9, 2015, Moody’s Investor Services (“Moody’s”) took certain rating actions as follows: ● Corporate Family Rating, downgraded to Caa1; ● Probability of Default Rating, downgraded to Caa1; ● Preferred stock, downgraded to Caa3; ● First Lien Notes, downgraded to B1; ● Second Lien Notes, downgraded to Caa1; and ● Senior unsecured notes, downgraded to Caa2. On December 9, 2015, Fitch Ratings (“Fitch”) took certain rating actions as follows: ● Long-term Issuer Default Rating, downgraded to CCC; ● First Lien Notes, downgraded to B; ● Second Lien Notes, downgraded to CCC-; ● Senior unsecured notes, downgraded to CCC-; and ● Series A perpetual preferred stock, downgraded to C. Downgrades in our credit ratings do not accelerate the scheduled maturity dates of our debt or affect the interest rates charged on any of our debt issues or our debt covenant requirements or cause any other operating issue. A potential risk from negative changes in our credit ratings is that they may make it more difficult or costly for us to access capital. However, due to the alternative means of providing us with sufficient liquidity as discussed above, these downgrades to our credit ratings are not anticipated to materially impact management’s operating plans, or our financial condition, results of operations or liquidity. Total inventory, excluding consolidated inventory not owned, increased $287.0 million during the year ended October 31, 2015 from October 31, 2014. Total inventory, excluding consolidated inventory not owned, increased in the Northeast by $17.6 million, in the Mid-Atlantic by $38.8 million, in the Midwest by $27.4 million, in the Southeast by $57.2 million, in the Southwest by $52.5 million and in the West by $93.5 million. The increases were primarily attributable to new land purchases and land development during the period, partially offset by home deliveries. During the year ended October 31, 2015, we had impairments in the amount of $7.3 million resulting from lowering prices due to increased competition from new communities by other homebuilders as well as weak economic conditions in certain markets. We wrote off costs in the amount of $4.7 million during the year ended October 31, 2015 related to land options that expired or that we terminated, as the communities’ forecasted profitability was not projected to produce adequate returns on investment commensurate with the risk. In the last few years, we have been able to acquire new land parcels at prices that we believe will generate reasonable returns under current homebuilding market conditions. There can be no assurances that this trend will continue in the near term. Substantially all homes under construction or completed and included in inventory at October 31, 2015 are expected to be closed during the next six to nine months. The total inventory increase discussed above excluded the increase in consolidated inventory not owned of $13.3 million. Consolidated inventory not owned consists of specific performance options and other options that were included in our Consolidated Balance Sheet in accordance with US GAAP. The increase in consolidated inventory not owned from October 31, 2014 to October 31, 2015 was primarily due to an increase in the sale and leaseback of certain model homes, partially offset by a decrease in land banking transactions during the period. We have land banking arrangements, whereby we sell land parcels to the land bankers and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes in accordance with ASC 360-20-40-38, these transactions are considered a financing rather than a sale. For purposes of our Consolidated Balance Sheet, at October 31, 2015, inventory of $25.1 million was recorded to “Consolidated inventory not owned - other options,” with a corresponding amount of $16.8 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. In addition, we sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale for accounting purposes. Therefore, for purposes of our Consolidated Balance Sheet, at October 31, 2015, inventory of $95.9 million was recorded to “Consolidated inventory not owned - other options,” with a corresponding amount of $87.9 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. From time to time, we enter into option agreements that include specific performance requirements whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with ASC 360-20-40-38, we are required to record this inventory on our Consolidated Balance Sheets. As of October 31, 2015, we had $1.2 million of specific performance options recorded on our Consolidated Balance Sheets to “Consolidated inventory not owned-specific performance options,” with a corresponding liability of $1.2 million recorded to “Liabilities from inventory not owned.” When possible, we option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option (other than with respect to specific performance options discussed above). As a result, our commitment for major land acquisitions is reduced. The costs associated with optioned properties are included in “Land and land options held for future development or sale” on the Consolidated Balance Sheets. Also included in “Land and land options held for future development or sale” are amounts associated with inventory in mothballed communities. We mothball (or stop development on) certain communities when we determine the current performance does not justify further investment at the time. That is, we believe we will generate higher returns if we decide against spending money to improve land today and save the raw land until such time as the markets improve or we determine to sell the property. As of October 31, 2015, we had mothballed land in 31 communities. The book value associated with these communities at October 31, 2015 was $103.0 million, which was net of impairment charges recorded in prior periods of $334.5 million. We continually review communities to determine if mothballing is appropriate. During fiscal 2015, we did not mothball any additional communities, or sell any mothballed communities, but re-activated 14 communities which were previously mothballed. Inventories held for sale, which are land parcels where we have decided not to build homes, represented $1.3 million and $0.6 million of our total inventories at October 31, 2015 and October 31, 2014, respectively, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. The following tables summarize home sites included in our total residential real estate. The decrease in remaining home sites available at October 31, 2015 compared to October 31, 2014 is attributable to terminating certain option agreements and delivering homes, partially offset by signing new land option agreements and acquiring new land parcels. The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures, in active and substantially completed communities. The decrease from October 31, 2014 to October 31, 2015 is due to a concerted effort to reduce our started unsold homes inventory. (1) Active selling communities (which are communities that are open for sale with ten or more home sites available) were 219 and 201 at October 31, 2015 and 2014, respectively. Ratio does not include substantially completed communities, which are communities with less than ten home sites available. Homebuilding - Restricted cash and cash equivalents decreased $5.8 million from October 31, 2014 to $7.3 million at October 31, 2015. The decrease is primarily due to a decrease in the cash collateral required on certain of our letters of credit issued under our stand alone letter of credit facilities/agreements, corresponding to a decrease in the letters of credit outstanding at October 31, 2015 as compared to October 31, 2014. Investments in and advances to unconsolidated joint ventures decreased $2.7 million during the fiscal year ended October 31, 2015 compared to October 31, 2014. The decrease was primarily due to partnership distributions, partially offset by additional investments during the period, along with the timing of advances at October 31, 2015 as compared to October 31, 2014. At both October 31, 2015 and 2014, we had investments in nine homebuilding joint ventures. We also had an investment in one land development joint venture as of each of October 31, 2015 and October 31, 2014. We have no guarantees associated with our unconsolidated joint ventures, other than guarantees limited only to performance and completion of development, environmental indemnification and standard warranty and representation against fraud misrepresentation and similar actions, including a voluntary bankruptcy. Receivables, deposits and notes, net decreased $22.2 million from October 31, 2014 to $70.3 million at October 31, 2015. The decrease was primarily due to receivables from our insurance carriers for certain warranty claims collected during the period. When reserves for claims are recorded or paid by us, the portion that is probable for recovery from insurance carriers is recorded as a receivable. This decrease was partially offset by an increase in refundable deposits during the period. Prepaid expenses and other assets were as follows as of: Prepaid insurance decreased $1.0 million due to the timing of premium payments. These costs are amortized over the life of the associated insurance policy, which can be one to three years. Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered. The increase of $10.3 million from October 31, 2014 to October 31, 2015 was associated with the opening of 101 new communities during fiscal 2015. Other prepaids decreased $0.7 million during the period, primarily due to the amortization of prepaid bond fees. Financial Services - Restricted cash and cash equivalents increased $3.0 million to $19.2 million at October 31, 2015. The increase was primarily related to an increase in the volume and timing of home closings at the end of fiscal 2015 compared to the end of fiscal 2014. Financial Services - Mortgage loans held for sale consist primarily of residential mortgages receivable held for sale of which $124.1 million and $92.1 million at October 31, 2015 and 2014, respectively, were being temporarily warehoused and are awaiting sale in the secondary mortgage market. The increase in mortgage loans held for sale from October 31, 2014 was related to an increase in the volume of loans originated during the fourth quarter of 2015 compared to the fourth quarter of 2014, along with an increase in the average loan value. Income Taxes Receivable increased $5.8 million from $284.5 million at October 31, 2014 to $290.3 million at October 31, 2015 primarily due to an increase in deferred federal taxes, as a result of the loss before income taxes for the year ended October 31, 2015, as discussed under “- Results of Operations” and Note 11 to the Consolidated Financial Statements. Nonrecourse mortgages increased to $143.9 million at October 31, 2015, from $103.9 million at October 31, 2014. The increase was primarily due to new mortgages for communities across all homebuilding segments obtained during fiscal 2015, partially offset by reductions in nonrecourse mortgages that existed as of October 31, 2014. Accounts payable and other liabilities are as follows as of: The increase in accounts payable was primarily related to the timing of invoices and payments, due to an increase in construction spending during the period, which correlates to the increase in backlog from October 31, 2014 to October 31, 2015. Reserves decreased during fiscal 2015 primarily because of the conclusion of the D’Andrea litigation discussed in Note 18 to the Consolidated Financial Statements and our reserves related to construction defects were reduced as a result of the annual actuarial study as discussed in Note 16 to the Consolidated Financial Statements. The decrease in accrued expenses was primarily due to the amortization of accruals related to abandoned lease space along with the timing of other accruals. The decrease in accrued compensation is primarily due to accrued bonuses payable at the end of fiscal 2015 as compared to the end of fiscal 2014. Customers’ deposits increased $9.2 million to $44.2 million at October 31, 2015. The increase was primarily related to the increase in backlog during the period. Liabilities from inventory not owned increased $13.5 million to $105.9 million at October 31, 2015. The increase was due to an increase in the sale and leaseback of certain model homes accounted for as financing transactions, partially offset by a decrease in land banking and specific performance transactions during the period as described above. Financial Services - Accounts payable and other liabilities increased $5.6 million to $27.9 million at October 31, 2015. The increase was primarily related to the increase in Financial Services restricted cash during the period, due to an increase in the volume and timing of home closings during the fourth quarter of fiscal 2015 compared to the fourth quarter of fiscal 2014. Financial Services - Mortgage warehouse lines of credit increased $32.0 million from $76.9 million at October 31, 2014, to $108.9 million at October 31, 2015. The increase correlates to the increase in the volume of mortgage loans held for sale during the period as discussed above. Accrued interest increased $8.2 million to $40.4 million at October 31, 2015. This increase was primarily due to interest related to our 8.0% Senior Notes issued in November 2014. Results of Operations Total Revenues Compared to the prior period, revenues increased (decreased) as follows: Homebuilding Sale of homes revenues increased $75.1 million, or 3.7%, for the year ended October 31, 2015, increased $228.7 million, or 12.8%, for the year ended October 31, 2014 and increased $378.7 million, or 26.9%, for the year ended October 31, 2013 as compared to the same period of the prior year. The increased revenues in fiscal 2015 were primarily due to the average price per home increasing to $379,177 in fiscal 2015 from $366,202 in fiscal 2014. The increased revenues in fiscal 2014 were primarily due to the number of home deliveries increasing 4.4% and the average price per home increasing to $366,202 in fiscal 2014 from $338,839 in fiscal 2013. The increased revenues in fiscal 2013 were primarily due to the number of home deliveries increasing 12.6% and the average price per home increasing to $338,839 in fiscal 2013 from $300,595 in fiscal 2012. For fiscal 2015 and 2014, the fluctuations in average prices were a result of the geographic and community mix of our deliveries, as opposed to home price increases (which we increase or decrease in communities depending on the respective community’s performance). Our ability to raise prices in fiscal 2015 and 2014 was limited because in order to increase our sales pace per community, we lowered prices or increased incentives in certain communities, especially with respect to spec homes in the first half of fiscal 2015. During fiscal 2013, we were able to raise prices in a number of our communities. For information on land sales, see the section titled “Land Sales and Other Revenues” below. Information on homes delivered by segment is set forth below: The increase in housing revenues during year ended October 31, 2015, as compared to year ended October 31, 2014, was primarily attributed to an increase in average sales price. Housing revenues and average sales prices in fiscal 2015 increased in all of our homebuilding segments combined by 3.7% and 3.5%, respectively, excluding joint ventures. In our homebuilding segments, homes delivered increased in fiscal 2015 as compared to fiscal 2014 by 21.8%, 21.4% and 3.5% in the Mid-Atlantic, Midwest and Southeast, respectively, and decreased by 30.9%, 5.3% and 9.4% in the Northeast, Southwest and West, respectively. Overall in fiscal 2015 as compared to fiscal 2014 homes delivered only increased 0.2% across all our segments, excluding unconsolidated joint ventures. The increase in housing revenues during year ended October 31, 2014, as compared to year ended October 31, 2013, was primarily attributed to an increase in deliveries and average sales price. The increase in deliveries was primarily due to the increase in community count. Housing revenues and average sales prices in fiscal 2014 increased in all of our homebuilding segments combined by 12.8% and 8.1%, respectively, excluding joint ventures. In our homebuilding segments, homes delivered increased in fiscal 2014 as compared to fiscal 2013 by 12.5%, 20.1%, 21.9% and 2.5% in the Mid-Atlantic, Midwest, Southeast and Southwest, respectively, and decreased by 10.9% and 17.3% in the Northeast and West, respectively. Quarterly housing revenues and net sales contracts by segment, excluding unconsolidated joint ventures, for the years ending October 31, 2015, 2014 and 2013 are set forth below: Contracts per average active selling community in fiscal 2015 were 30.0 compared to fiscal 2014 of 28.4. Our reported level of sales contracts (net of cancellations) has been impacted by an increase in the pace of sales in most of the Company’s segments during fiscal 2015. Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures: Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of the beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures. Most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of a buyer's failure to qualify for a mortgage, which generally occurs during the first few weeks after signing. The contract cancellations over the past several years, as shown in the tables above, have been within what we believe to be a normal range. However, market conditions remain uncertain and it is difficult to predict what cancellation rates will be in the future. An important indicator of our future results is recently signed contracts and our home contract backlog for future deliveries. Our consolidated contract backlog, excluding unconsolidated joint ventures, by segment is set forth below: Contract backlog dollars increased 42.1% as of October 31, 2015 compared to October 31, 2014, while the number of homes in backlog increased 30.3% for the same period. The increase in backlog is driven by an 11.2% increase in net contracts, excluding unconsolidated joint ventures, for the year ended October 31, 2015 compared to the prior fiscal year. In the month of November 2015, excluding unconsolidated joint ventures, we signed an additional 477 net contracts amounting to $194.6 million in contract value. Total cost of sales on our Consolidated Statements of Operations includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as “land charges” in the tables below). A breakout of such expenses for housing sales and housing gross margin is set forth below: Cost of sales expenses as a percentage of consolidated home sales revenues are presented below: We sell a variety of home types in various communities, each yielding a different gross margin. As a result, depending on the mix of communities delivering homes, consolidated gross margin may fluctuate up or down. Total homebuilding gross margin percentage, before interest expense and land impairment and option write-off charges, decreased to 17.6% for the year ended October 31, 2015 compared to 19.9% for the same period last year. During the first half of fiscal 2015, we significantly discounted some of our spec homes to sell them. In addition, we have experienced pricing pressure since midway through fiscal 2014, leading us to increase incentives and concessions on to be built homes as well, although to a lesser extent than started unsold homes. Combined, this resulted in a decrease in gross margin percentage for fiscal 2015 compared to fiscal 2014. The slight decrease in gross margin percentage during the year ended October 31, 2014 was due to minor increases in price concessions and direct costs from some of our communities delivering homes that year. For the years ended October 31, 2015, 2014 and 2013, gross margin was favorably impacted by the reversal of prior period inventory impairments of $35.6 million, $48.0 million and $60.5 million, respectively, which represented 1.7%, 2.4% and 3.4%, respectively, of “Sale of homes” revenue. Reflected as inventory impairment loss and land option write offs in cost of sales (“land charges”), we have written off or written down certain inventories totaling $12.0 million, $5.2 million and $5.0 million during the years ended October 31, 2015, 2014 and 2013, respectively, to their estimated fair value. See Note 12 to the Consolidated Financial Statements for an additional discussion. During the years ended October 31, 2015, 2014 and 2013, we wrote off residential land options and approval and engineering costs totaling $4.7 million, $4.0 million and $2.6 million, respectively, which are included in the total land charges mentioned above. Option, approval and engineering costs are written off when a community’s pro forma profitability is not projected to produce adequate returns on the investment commensurate with the risk and when we believe it is probable we will cancel the option, or when a community is redesigned engineering costs related to the initial design are written off. Such write-offs were located in all segments in fiscal 2015, and all segments except the West in fiscal 2014 and 2013. The inventory impairments amounted to $7.3 million, $1.2 million and $2.4 million for the years ended October 31, 2015, 2014 and 2013, respectively. For the past three years, inventory impairments were lower than they had been in several previous years. It is difficult to predict if impairment levels will remain low, and should it become necessary to further lower prices, or should the estimates or expectations used in determining estimated cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. Below is a breakdown of our lot option walk-aways and impairments by segment for fiscal 2015. In fiscal 2015, we walked away from 22.9% of all the lots we controlled under option contracts. The remaining 77.1% of our option lots are in communities that we believe remain economically feasible. The following table represents lot option walk-aways by segment for the year ended October 31, 2015: (1) Includes lots optioned at October 31, 2015 and lots optioned that the Company walked away from in the year ended October 31, 2015. The following table represents impairments by segment for the year ended October 31, 2015: (1) Represents carrying value, net of prior period impairments, if any, at the time of recording the applicable period’s impairments. Land Sales and Other Revenues Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below: Land sales are ancillary to our residential homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. Although we budget land sales, they are often dependent upon receiving approvals and entitlements, the timing of which can be uncertain. As a result, projecting the amount and timing of land sales is difficult. There were three land sales in the year ended October 31, 2015, compared to 13 in the same period of the prior year, resulting in a $4.4 million decrease in land sales revenue. There were 13 land sales in the year ended October 31, 2014, compared to 14 in the same period of the prior year. Despite one less number of land sales in the period, revenue associated therewith can vary significantly due to the mix of land parcels sold. For example, there was one significant land sale in the Southwest during the year ended October 31, 2013, resulting in a decrease of $12.5 million in land sales revenue for the year ended October 31, 2014. Land sales and other revenues decreased $4.3 million and $11.2 million for the years ended October 31, 2015 and 2014 compared to the same period in the prior year. Other revenues include income from contract cancellations where the deposit has been forfeited due to contract terminations, interest income, cash discounts and miscellaneous one-time receipts. The decrease for the year ended October 31, 2014, compared to the year ended October 31, 2013, was mainly due to the decrease in land sales discussed above, offset by an increase among the various components of other revenue with $0.4 million coming from an increase in forfeited deposits. Homebuilding Selling, General and Administrative Homebuilding selling, general and administrative (“SGA”) expenses decreased $3.1 million to $188.4 million for the year ended October 31, 2015 as compared to the year ended October 31, 2014. This decrease was mainly due to the reduction of $15.2 million of our construction defect reserves based on our annual actuarial estimates, as discussed further in Note 16 to the Consolidated Financial Statements, partially offset by increases due to additional headcount related costs and increased architectural expense, related to recent and expected future community growth, as well as a reduction of joint venture management fees, which offset general and administrative expenses, received as a result of fewer joint venture deliveries in the year ended October 31, 2015 as compared to the year ended October 31, 2014. SGA increased $25.7 million to 191.5 million for the year ended October 31, 2014 compared to the year ended October 31, 2013. Approximately half of the increase was due to higher sales compensation, increased advertising costs and increased architectural expense, all related to recent and future community count growth, as well as a reduction of joint venture management fees, which offset general and administrative expenses, received as a result of fewer joint venture deliveries. The other half of the increase was due to increased staffing levels primarily associated with the new communities and increased compensation reflective of the competitive homebuilding market. Homebuilding Operations by Segment Financial information relating to the Company’s operations was as follows: Segment Analysis (Dollars in thousands, except average sales price) Homebuilding Results by Segment Northeast - Homebuilding revenues decreased 31.3% in fiscal 2015 compared to fiscal 2014 primarily due to a 30.9% decrease in homes delivered, a 0.4% decrease in average selling price and a $0.6 million decrease in land sales and other revenue. The decrease in average sales prices was the result of the mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Loss before income taxes increased $0.2 million to a loss of $7.7 million, which was mainly due to the decrease in homebuilding revenues discussed above. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2015 compared to fiscal 2014. Homebuilding revenues decreased 2.5% in fiscal 2014 compared to fiscal 2013 primarily due to a 10.9% decrease in homes delivered and a $2.1 million decrease in land sales and other revenue, partially offset by a 10.2% increase in average selling price. The increase in average sales prices was the result of the mix of communities delivering in fiscal 2014 compared to fiscal 2013. Income before income taxes decreased $9.0 million to a loss of $7.5 million, compared to income before income taxes in the prior year of $1.5 million, which was mainly due to a $7.9 million increase in selling, general and administrative costs, a decrease of $5.0 million in income from unconsolidated joint ventures and a slight decrease in gross margin percentage before interest expense for fiscal 2014 compared to fiscal 2013. Mid-Atlantic - Homebuilding revenues increased 20.1% in fiscal 2015 compared to fiscal 2014 primarily due to a 21.8% increase in homes delivered, partially offset by a 1.5% decrease in average selling price. The decrease in average sales price was due to the mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $2.5 million to $21.4 million, due mainly to a $1.9 million increase in selling, general and administrative costs, a $0.9 million increase in inventory impairment loss and land option write-offs, partially offset by the increase in homebuilding revenues discussed above. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2015 compared to fiscal 2014. Homebuilding revenues increased 15.0% in fiscal 2014 compared to fiscal 2013 primarily due to a 12.5% increase in homes delivered and a 2.3% increase in average selling price. The increase in average sales price was due to the mix of communities that delivered in fiscal 2014 compared to fiscal 2013. Income before income taxes decreased $0.5 million to $23.9 million, due mainly to a $9.5 million increase in selling, general and administrative costs, offset by the increase in homebuilding revenues discussed above. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2014 compared to fiscal 2013. Midwest - Homebuilding revenues increased 37.7% in fiscal 2015 compared to fiscal 2014. The increase was primarily due to a 21.4% increase in homes delivered and a 13.5% increase in average sales price. The increase in average sales price was due to the mix of communities delivering in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $3.9 million to $14.0 million. The decrease in income was primarily due to a $10.7 million increase in selling, general and administrative costs and a slight decrease in gross margin percentage before interest expense, partially offset by the increase in homebuilding revenues discussed above. Homebuilding revenues increased 38.3% in fiscal 2014 compared to fiscal 2013. The increase was primarily due to a 20.1% increase in homes delivered and a 15.6% increase in average sales price. Income before income taxes increased $5.6 million to $17.9 million. The increase in income was primarily due to the increase in homebuilding revenues discussed above and a slight increase in gross margin percentage before interest expense, offset by a $4.8 million increase in selling, general and administrative costs and a $1.7 million increase in inventory impairment and land option write-offs. Southeast - Homebuilding revenues increased 1.5% in fiscal 2015 compared to fiscal 2014. The increase was primarily due to a 3.5% increase in homes delivered, partially offset by a 1.1% decrease in average sales price. The decrease in average sales price was due to the mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $15.6 million to a loss of $6.3 million due to a $5.4 million increase in selling, general and administrative costs, a $3.1 million increase in inventory impairment loss and land option write-offs and a slight decrease in gross margin percentage before interest expense. Homebuilding revenues increased 38.7% in fiscal 2014 compared to fiscal 2013. The increase was primarily due to a 21.9% increase in homes delivered and a 13.7% increase in average sales price. Income before income taxes increased by $2.8 million to $9.2 million due to the increase in homebuilding revenues discussed above, a $0.7 million increase in land sales and other revenue and a $0.8 million increase in income from unconsolidated joint ventures. These increases are being offset by a $4.9 million increase in selling, general and administrative costs and a slight decrease in gross margin percentage before interest expense. Southwest - Homebuilding revenues increased 9.6% in fiscal 2015 compared to fiscal 2014 primarily due to a 16.1% increase in average sales price, partially offset by a 5.3% decrease in homes delivered and a $2.2 million decrease in land sales and other revenue. The increase in average sales price was due to the mix of communities delivering in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $7.1 million to $67.4 million in fiscal 2015 mainly due to a $2.3 million increase in selling, general and administrative costs, the decrease in land sales and other revenue discussed above and a slight decrease in gross margin percentage before interest expense, offset by the increase in homebuilding revenues discussed above. Homebuilding revenues increased 7.8% in fiscal 2014 compared to fiscal 2013 primarily due to a 2.5% increase in homes delivered and a 6.6% increase in average sales price, offset by a $9.4 million decrease in land sales and other revenue. The increase in average sales price was due to the mix of communities that delivered in fiscal 2014 compared to fiscal 2013. Income before income taxes decreased $1.9 million to $74.5 million in fiscal 2014 mainly due to a $5.7 million increase in selling, general and administrative costs, the decrease in land sales and other revenue discussed above and a slight decrease in gross margin percentage before interest expense, offset by the increase in homebuilding revenues discussed above. West - Homebuilding revenues decreased 30.5% in fiscal 2015 compared to fiscal 2014 primarily due to a 23.4% decrease in average sales price and a 9.4% decrease in homes delivered, which was due to the different mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $38.4 million to a loss of $17.1 million in fiscal 2015 due mainly to a $1.5 million increase in selling, general and administrative costs, a $2.1 million increase in inventory impairment loss and land option write-offs, a significant decrease in gross margin percentage before interest expense and the decrease in homebuilding revenues discussed above. Homebuilding revenues increased 3.2% in fiscal 2014 compared to fiscal 2013 primarily due to a 24.8% increase in average sales price, partially offset by a 17.3% decrease in homes delivered, which was due to the different mix of communities delivered in fiscal 2014 compared to fiscal 2013. Income before income taxes increased $6.9 million to $21.3 million in fiscal 2014 due mainly to the increase in homebuilding revenues discussed above and an increase in gross margin percentage before interest expense, offset by $1.5 million increase in selling, general and administrative costs. Financial Services Financial services consist primarily of originating mortgages from our home buyers, selling such mortgages in the secondary market, and title insurance activities. We use mandatory investor commitments and forward sales of MBS to hedge our mortgage-related interest rate exposure on agency and government loans. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments and loan sales transactions is managed by limiting our counterparties to investment banks, federally regulated bank affiliates and other investors meeting our credit standards. Our risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments. For the years ended October 31, 2015, 2014 and 2013, FHA/VA loans represented 27.1%, 28.4%, and 32.7%, respectively, of our total loans. While the origination of FHA/VA loans have decreased over the last three fiscal years, our conforming conventional loan originations as a percentage of our total loans increased from 62.7% for fiscal 2013 to 69.2% for fiscal 2014 and was flat at 69.2% for fiscal 2015. The remaining 3.7%, 2.4% and 4.6% of our loan originations represent USDA and jumbo loans. Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer of the mortgage and the sales price is collected. During the years ended October 31, 2015, 2014, and 2013, financial services provided a $24.7 million, $13.8 million and $18.7 million pretax profit, respectively. In fiscal 2015, financial services pretax profit increased $10.9 million due to the increase in mortgage capture rate and the average price of loans settled. In fiscal 2014, financial services pretax profit decreased $4.9 million compared to fiscal 2013 due to a decrease in the number of mortgage originations, as the percentage of our noncash home buyers that obtained mortgages from our subsidiary decreased by 600 basis points. In the market areas served by our wholly owned mortgage banking subsidiaries, approximately 75%, 65%, and 71% of our noncash home buyers obtained mortgages originated by these subsidiaries during the years ended October 31, 2015, 2014, and 2013, respectively. Servicing rights on new mortgages originated by us are sold with the loans. Corporate General and Administrative Corporate general and administrative expenses include the operations at our headquarters in Red Bank, New Jersey. These expenses include payroll, stock compensation, facility and other costs associated with our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services and administration of insurance, quality and safety. Corporate general and administrative expenses decreased $0.9 million for the year ended October 31, 2015 compared to the year ended October 31, 2014, and increased $9.0 million for the year ended October 31, 2014 compared to the year ended October 31, 2013. The decrease in expense for fiscal 2015 was due mainly to lower stock compensation expense largely due to the impact of lower stock prices on stock awards granted in fiscal 2015, including under the Company’s 2013 long term incentive plan, which reached the end of its measurement period on October 31, 2015. See the discussion of the stock awards granted under the Company’s 2013 long term incentive plan in Note 15 to the Consolidated Financial Statements. The increase in expenses for fiscal 2014 was attributed to increased total compensation as a result of an increase in headcount, additional expenses related to earned amounts under the company’s 2010 long-term incentive plan and increased professional services for various corporate operations. Other Interest Other interest increased $4.5 million to $91.8 million for the year ended October 31, 2015 compared to October 31, 2014, but had decreased $3.9 million to $87.4 million for the year ended October 31, 2014 compared to October 31, 2013. Our assets that qualify for interest capitalization (inventory under development) are less than our debt, and therefore a portion of interest not covered by qualifying assets must be directly expensed. For fiscal 2015, other interest increased despite a continued increase in inventory because interest incurred increased as a result of higher debt balances, attributed primarily to the $250.0 million senior unsecured notes issued in November 2014. In fiscal 2014, as our inventory balances for the qualifying assets increased compared to 2013, the amount of interest required to be directly expensed decreased. Other Operations Other operations consist primarily of the amortization of prepaid bond fees along with rent expense for commercial office space. Compared to the previous year, other operations increased $1.4 million to $6.0 million for the year ended October 31, 2015, and increased $3.8 million to $4.6 million for the year ended October 31, 2014. This increase in other operations for the year ended October 31, 2015 compared to the prior year was due to increased prepaid bond fees amortization as a result of additional debt issuances. The increase in expenses from October 31, 2014 compared to October 31, 2013 was mainly due to the gain recognized in fiscal 2013 from the sale of our last remaining senior rental residential property. Loss on Extinguishment of Debt We did not incur any loss on the extinguishment of debt for the year ended October 31, 2015. For the year ended October 31, 2014, our loss on extinguishment of debt was $1.2 million, due to the redemption of the remaining outstanding principal amount ($21.4 million) of our 6.25% Senior Notes due 2015. During the year ended October 31, 2013, our loss on extinguishment of debt was $0.8 million. In the fourth quarter of 2013, K. Hovnanian issued an aggregate principal amount of $41.6 million of its 6.25% Senior Notes due 2016. The Notes were issued as additional 6.25% Senior Notes due 2016 under the indenture dated as of August 8, 2005. The net proceeds from this offering were used to fund the redemption on October 15, 2013 of all of K. Hovnanian’s outstanding 6.5% Senior Notes due 2014 and 6.375% Senior Notes due 2014 and to pay related fees and expenses. These transactions resulted in a write-off of prepaid fees and a make whole true-up, totaling $0.8 million Income from Unconsolidated Joint Ventures Income from unconsolidated joint ventures consists of our share of the earnings or losses of our joint ventures. Income from unconsolidated joint ventures decreased $3.7 million for the year ended October 31, 2015 from $7.9 million for the year ended October 31, 2014 to $4.2 million for the year ended October 31, 2015. The decrease in income was due to fewer deliveries in certain of our joint ventures and recognition of our share of losses on our newly formed joint ventures that have not yet begun to deliver homes or just started delivering homes. Income from unconsolidated joint ventures decreased $4.1 million to $7.9 million for the year ended October 31, 2014 compared to $12.0 million for the year ended October 31, 2013. The decrease in income was due to fewer deliveries in certain of our joint ventures, and a decrease in the average sales price of the joint venture deliveries. The decrease in average sales price was primarily the result of the mix of communities during each of the respective periods. Total Taxes The total income tax benefit of $5.7 million recognized for the year ended October 31, 2015 was primarily due to deferred taxes resulting from the loss before income taxes plus the reversal of state tax reserves for uncertain state tax positions, partially offset by state tax expenses. The total income tax benefit of $287.0 million recognized for the year ended October 31, 2014 was primarily due to the reversal of a substantial portion of our valuation allowance previously recorded against our deferred tax assets, plus a refund received for a loss carryback to a previously profitable year and the impact of state tax reserves for uncertain state tax positions, partially offset by state tax expenses. The total income tax benefit of $9.4 million recognized for the year ended October 31, 2013 was primarily due to the release of reserves for a federal tax position that was settled with the Internal Revenue Service and a favorable state tax audit settlement, partially offset by state tax expenses and state tax reserves for uncertain state tax positions. Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. If the combination of future years’ income (or loss) and the reversal of the timing differences results in a loss, such losses can be carried forward to future years. In accordance with ASC 740, we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more likely than not” standard. As of October 31, 2014, and again at October 31, 2015, we concluded that it was more likely than not that a substantial amount of our deferred tax assets (“DTA”) would be utilized. This conclusion was based on a detailed evaluation of all relevant evidence, both positive and negative. The positive evidence included factors such as positive earnings for two of the last three fiscal years and the expectation of earnings going forward over the long term and evidence of a sustained recovery in the housing markets in which we operate. Such evidence is supported by significant increases in key financial indicators over the last few years, including new orders, backlog, and community count compared with the prior years. Economic data has also been affirming the housing market recovery. Housing starts, homebuilding volume and prices are increasing and forecasted to continue to increase. Historically low mortgage rates, affordable home prices, reduced foreclosures and a favorable home ownership to rental comparison are key factors in the recovery. Potentially offsetting this positive evidence is the fact that we had a loss before income taxes for the fiscal year ended October 31, 2015. However, as we expected last year when we reversed a substantial portion of our deferred tax asset valuation allowance, we are no longer in a three year cumulative loss position as of October 31, 2015. As per ASC 740, cumulative losses are one of the most objectively verifiable forms of negative evidence; we no longer have this negative evidence and we expect to be profitable going forward over the long term. Our recent three years cumulative performance and our expectations for the coming years based on our current backlog, community count and recent sales contracts provide evidence that reaffirms our conclusion last year that a full valuation allowance was not necessary and that the current valuation allowance for deferred taxes of $635.3 million as of October 31, 2015 is appropriate. Off-Balance Sheet Financing In the ordinary course of business, we enter into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Lot option contracts enable us to control significant lot positions with a minimal capital investment and substantially reduce the risks associated with land ownership and development. At October 31, 2015, we had $82.8 million in option deposits in cash to purchase land and lots with a total purchase price of $1.4 billion. Our financial exposure is generally limited to forfeiture of the nonrefundable deposits, letters of credit and other nonrefundable amounts incurred. We have no material third-party guarantees. Contractual Obligations The following summarizes our aggregate contractual commitments at October 31, 2015. (1) Total contractual obligations exclude our accrual for uncertain tax positions of $1.4 million recorded for financial reporting purposes as of October 31, 2015 because we were unable to make reasonable estimates as to the period of cash settlement with the respective taxing authorities. (2) Represents our revolving credit facility, senior secured, senior, senior amortizing and senior exchangeable notes, and other notes payable and $533.1 million of related interest payments for the life of such debt. (3) Does not include $143.9 million of nonrecourse mortgages secured by inventory. These mortgages have various maturities spread over the next two to three years and are paid off as homes are delivered. (4) Does not include the mortgage warehouse lines of credit made under our Master Repurchase Agreements. See“- Capital Resources and Liquidity.” Also does not include $25.9 million of letters of credit issued as of October 31, 2015 under our $75.0 million revolving Credit Facility. (5) Represents obligations under option contracts with specific performance provisions, net of cash deposits. We had outstanding letters of credit and performance bonds of $28.5 million and $235.8 million, respectively, at October 31, 2015, related principally to our obligations to local governments to construct roads and other improvements in various developments. We do not believe that any such letters of credit or bonds are likely to be drawn upon. Inflation Inflation has a long-term effect, because increasing costs of land, materials and labor result in increasing sale prices of our homes. In general, these price increases have been commensurate with the general rate of inflation in our housing markets and have not had a significant adverse effect on the sale of our homes. A significant risk faced by the housing industry generally is that rising house construction costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers. Inflation has a lesser short-term effect, because we generally negotiate fixed-price contracts with many, but not all, of our subcontractors and material suppliers for the construction of our homes. These prices usually are applicable for a specified number of residential buildings or for a time period of between three to twelve months. Construction costs for residential buildings represent approximately 56% of our homebuilding cost of sales. Safe Harbor Statement All statements in this Annual Report on Form 10-K that are not historical facts should be considered as “Forward-Looking Statements” within the meaning of the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward looking statements include but are not limited to statements related to the Company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements: (i) speak only as of the date they are made, (ii) are not guarantees of future performance or results and (iii) are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as result of a variety of factors. Such risks, uncertainties and other factors include, but are not limited to: ● Changes in general and local economic, industry and business conditions and impacts of the sustained homebuilding downturn; ● Adverse weather and other environmental conditions and natural disasters; ● Levels of indebtedness and restrictions on the Company’s operations and activities imposed by the agreements governing the Company’s outstanding indebtedness; ● The Company’s sources of liquidity; ● Changes in credit ratings; ● Changes in market conditions and seasonality of the Company’s business; ● The availability and cost of suitable land and improved lots; ● Shortages in, and price fluctuations of, raw materials and labor; ● Regional and local economic factors, including dependency on certain sectors of the economy, and employment levels affecting home prices and sales activity in the markets where the Company builds homes; ● Fluctuations in interest rates and the availability of mortgage financing; ● Changes in tax laws affecting the after-tax costs of owning a home; ● Operations through joint ventures with third parties; ● Government regulation, including regulations concerning development of land, the home building, sales and customer financing processes, tax laws and the environment; ● Product liability litigation, warranty claims and claims made by mortgage investors; ● Levels of competition; ● Availability and terms of financing to the Company; ● Successful identification and integration of acquisitions; ● Significant influence of the Company’s controlling stockholders; ● Availability of net operating loss carryforwards; ● Utility shortages and outages or rate fluctuations; ● Geopolitical risks, terrorist acts and other acts of war; ● Increases in cancellations of agreements of sale; ● Loss of key management personnel or failure to attract qualified personnel; ● Information technology failures and data security breaches; and ● Legal claims are brought against us and not resolved in our favor. Certain risks, uncertainties and other factors are described in detail in Part I, Item 1 “Business” and Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Annual Report on Form 10-K.

<s>[INST] During fiscal 2015, a number of our operating results were positive compared to the same period of the prior year. For the year ended October 31, 2015, sale of homes revenue increased 3.7% as compared to the prior year. The increase was primarily due to a higher average price per home, which was a result of geographic and community mix of our deliveries, as opposed to home price increases (which we increase or decrease in communities depending on the respective community’s performance). Net contracts per average active selling community increased to 30.0 for the year ended October 31, 2015 compared to 28.4 in the same period in the prior year. Active selling communities increased from 201 at October 31, 2014 to 219 at October 31, 2015. Net contracts increased 11.2% for the year ended October 31, 2015 as compared to the prior year. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased to 11.7% for the year ended October 31, 2015, which included a $15.2 million benefit from a reduction in reserves discussed further below, compared to 12.4% for the year ended October 31, 2014. Deliveries were relatively flat for the year ended October 31, 2015 compared to the same period of the prior year, partially resulting from extended cycle times due to labor shortages causing delays in deliveries. Despite the positive operating results, we also experienced some negative operating results. Gross margin percentage, before cost of sales interest expense and land charges, decreased from 19.9% for the year ended October 31, 2014 to 17.6% for the year ended October 31, 2015. In the first and second quarters of fiscal 2015, we significantly discounted some of our started unsold homes (commonly referred to as “specs”) to sell them. In addition, we have been experiencing pricing pressure since midway through fiscal 2014, leading us to increase incentives and concessions on to be built homes, although to a lesser extent than on specs in the first half of fiscal 2015. Combined, this resulted in a decrease in gross margin percentage for the year ended October 31, 2015 as compared to the prior year. The decrease in gross margin for fiscal 2015 resulted in a net loss before income taxes of $21.8 million for the year ended October 31, 2015, which compares to net income of $20.2 million for the year ended October 31, 2014. When comparing sequentially from the third quarter of fiscal 2015 to the fourth quarter of fiscal 2015, our gross margin percentage, before cost of sales interest expense and land charges, increased slightly to 18.0% compared to 17.8%. Selling, general and administrative costs decreased $15.9 million for the fourth quarter of fiscal 2015 compared to the third quarter of fiscal 2015, primarily due to an adjustment to our construction defect reserves, based on our annual actuarial estimates. Excluding this adjustment, selling, general and administrative costs remained flat. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased from 12.6% to 7.1% in the fourth quarter of fiscal 2015 compared to the third quarter of fiscal 2015 as a result of the decrease in selling, general and administrative costs, along with a 28.2% increase in homebuilding revenues in the fourth quarter. We had 2,905 homes in backlog with a dollar value of $1.2 billion at October 31, 2015 (an increase of 42.1% in dollar value compared to the year ended October 31, 2014). Based on this backlog and the anticipated gross margin associated with this backlog, along with the increase in net contracts per average active selling community as well as our increase in community count, we believe that we are wellpositioned for stronger results in [/INST] Positive. </s>

HOVNANIAN ENTERPRISES INC

2016-12-20

2016-10-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview During fiscal 2016, we continued to experience some positive operating trends compared to fiscal 2015. The Company had income before income taxes of $2.4 million for the year ended October 31, 2016, compared to a loss before income taxes of $21.8 million for the year ended October 31, 2015. For the year ended October 31, 2016, sale of homes revenue increased 24.6% as compared to the prior year. The increase in revenues was primarily due to a 17.4% increase in deliveries, along with an increase in average price per home, which was a result of changes in geographic and community mix of our deliveries. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased to 9.2% for the year ended October 31, 2016 compared to 11.7% for the year ended October 31, 2015. These positive operating improvements were largely offset by a decrease in gross margin percentage, before cost of sales interest expense and land charges, which decreased from 17.6% for the year ended October 31, 2015 to 16.9% for the year ended October 31, 2016. This decrease was a result of deliveries in certain of our new communities in the year ended October 31, 2016 having higher land costs as a percentage of revenue compared to deliveries in the same period of the prior year, as well as higher construction costs in many of our markets. Net contracts per average active selling community increased to 31.3 for the year ended October 31, 2016 compared to 30.0 in the same period in the prior year. However, net contracts decreased slightly by 1.2% for the year ended October 31, 2016 as compared to the prior year, as active selling communities decreased from 219 at October 31, 2015 to 167 at October 31, 2016, as discussed further below. When comparing sequentially from the third quarter of fiscal 2016 to the fourth quarter of fiscal 2016, our gross margin percentage, before cost of sales interest expense and land charges, increased to 17.6% compared to 16.9%. Selling, general and administrative costs decreased $14.3 million for the fourth quarter of fiscal 2016 compared to the third quarter of fiscal 2016, primarily due to a $9.2 million adjustment to our construction defect reserves, based on our annual actuarial analysis of estimated construction defect costs on previously delivered homes. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased from 9.3% to 6.7% in the fourth quarter of fiscal 2016 compared to the third quarter of fiscal 2016 as a result of the decrease in selling, general and administrative costs, along with a 12.0% increase in homebuilding revenues in the fourth quarter. We had 2,398 homes in backlog with a dollar value of $1.1 billion at October 31, 2016 (a decrease of 12.1% in dollar value compared to the year ended October 31, 2015). Despite this decrease in backlog, we believe the improvement in our selling, general and administrative costs and reduction in interest expense as a result of reducing our notes payable balance by $249.8 million during fiscal 2016 are positive factors for fiscal 2017 compared with fiscal 2016. However, several challenges, such as economic weakness and uncertainty, lower oil prices (which could affect our Texas markets), the restrictive mortgage lending environment and rising mortgage interest rates, continue to impact the housing market and, consequently, our performance. Additionally, we could be negatively impacted by our inability to access capital as described below under “ - Capital Resources and Liquidity.” Both national new home sales and our home sales remain below historical levels. We continue to believe that we are still in the early stages of the housing recovery. However, given our recent uneven operating performance, we may continue to experience mixed results. Given the low levels of total U.S. housing starts, and our belief in the long-term recovery of the homebuilding market, we remain focused on identifying new land parcels, growing our community count and growing our revenues, which are critical to improving our financial performance. As previously disclosed in the first quarter of fiscal 2016, as a result of our evaluation of our geographic operating footprint as it related to our strategic objectives we decided to exit the Minneapolis, MN and Raleigh, NC markets by selling our land portfolios in those markets and to wind down our operations in the San Francisco Bay area in Northern California and in Tampa, FL by building and delivering homes to sell through our existing land position. In the third quarter of fiscal 2016, we completed the sales of our Minneapolis, MN and Raleigh, NC markets land portfolios. In our remaining markets, we continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales paces and plan to continue pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability. During fiscal 2016, we had approximately $260 million of bonds mature, which we were unable to refinance because financing was unavailable in the capital and loan markets to companies with comparable credit ratings to ours. As a result, we shifted our focus from growth to gaining operating efficiencies and improving our bottom line, and we decided to temporarily reduce some of our future land acquisition and to exit from four underperforming markets during fiscal 2016. In addition, we increased our use of land bank financings and joint ventures in order to enhance our liquidity position. The net effect of these liquidity enhancing efforts was to temporarily adversely affect our ability to invest as aggressively in new land parcels as previously planned, which resulted in a reduction in our community count in fiscal 2016, along with a decrease in net contracts. However, in the fourth quarter of fiscal 2016, we were able to refinance certain of our upcoming debt maturities as discussed further below in “Capital Resources and Liquidity−Debt Transactions” and we ended the fiscal year with homebuilding cash of $339.8 million at October 31, 2016. This cash position will allow us to actively seek land investment opportunities in fiscal 2017, which should ultimately result in community count growth and, assuming favorable market conditions, higher levels of profitability in the future. During the year ended October 31, 2016, our active communities decreased by 52 communities from 219 communities at October 31, 2015 to 167 communities at October 31, 2016, partially due to the sale of 10 communities (related to the sale of our land portfolios in our Minneapolis, MN and Raleigh, NC divisions), along with the contribution of four of our communities to a new joint venture during the period. In addition, we opened for sale 70 new communities and closed 108 communities during the same period. Also during the year ended October 31, 2016, we put under option or acquired approximately 8,700 lots in 100 wholly owned communities (which includes 1,860 lots in 35 wholly owned communities which are no longer owned inventory but are optioned inventory under our land banking transactions closed during the first quarter of fiscal 2016) and walked away from 6,102 lots in 88 wholly owned communities. Most of the walk-aways occurred during the due diligence period, in which case we recovered our option deposits and only wrote-off predevelopment costs. Homebuilding selling, general and administrative expenses (“SGA”) increased $4.5 million from $188.4 million for the year ended October 31, 2015 to $192.9 million for the year ended October 31, 2016. As a percentage of total revenues, SGA decreased 1.8% to 7.0% for the year ended October 31, 2016 as compared to the prior year, as revenues increased year over year. Corporate general and administrative expenses as a percentage of total revenue decreased to 2.2% for the year ended October 31, 2016 compared to 2.9% for the year ended October 31, 2015. Improving the efficiency of our selling, general and administrative expenses will continue to be a significant area of focus. Critical Accounting Policies Management believes that the following critical accounting policies require its most significant judgments and estimates used in the preparation of the consolidated financial statements: Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of mortgage backed securities (“MBS”) to hedge our mortgage-related interest rate exposure on agency and government loans. We elected the fair value option for our mortgage loans held for sale in accordance with Accounting Standards Codification (“ASC”) 825, “Financial Instruments,” which permits us to measure our loans held for sale at fair value. Management believes that the election of the fair value option for loans held for sale improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We believe there continues to be an industry-wide issue with the number of purchaser claims in which purchasers purport to have found inaccuracies related to the sellers’ representations and warranties in particular loan sale agreements. We have established reserves for probable losses. While we believe these reserves are adequate for known losses and projected repurchase requests, given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, if either actual repurchases or the losses incurred resolving those repurchases exceed our expectations, additional expense may be incurred. Inventories - Inventories consist of land, land development, home construction costs, capitalized interest, construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type. We record inventories in our consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all costs related to specific performance options, variable interest entities and other options, which consists primarily of model homes financed with an investor and inventory related to land banking arrangements accounted for as financings. We decide to mothball (or stop development on) certain communities when we determine that the current performance does not justify further investment at the time. When we decide to mothball a community, the inventory is reclassified on our Consolidated Balance Sheets from "Sold and unsold homes and lots under development" to "Land and land options held for future development or sale." As of October 31, 2016, the net book value associated with our 29 mothballed communities was $74.4 million, net of impairment charges recorded in prior periods of $296.3 million. We regularly review communities to determine if mothballing is appropriate. During fiscal 2016, we mothballed one new community, sold one previously mothballed community, re-activated one previously mothballed community and contributed one previously mothballed community to a new joint venture which began construction in fiscal 2016. From time to time we enter into option agreements that include specific performance requirements, whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with ASC 360-20-40-38, we are required to record this inventory on our Consolidated Balance Sheets. As of October 31, 2016, we had no specific performance options recorded on our Consolidated Balance Sheets. Consolidated inventory not owned also consists of other options that were included on our Consolidated Balance Sheets in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheets, at October 31, 2016, inventory of $79.2 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $70.8 million recorded to “Liabilities from inventory not owned.” We have land banking arrangements, whereby we sell our land parcels to the land banker and they provide us an option to purchase back finished lots on a quarterly basis. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 360-20-40-38, these transactions are considered financings rather than sales. For purposes of our Consolidated Balance Sheets, at October 31, 2016, inventory of $129.5 million was recorded as “Consolidated inventory not owned,” with a corresponding amount of $82.4 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. The recoverability of inventories and other long-lived assets is assessed in accordance with the provisions of ASC 360-10, “Property, Plant and Equipment − Overall” (“ASC 360-10”). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure. We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable. The projected operating profits, losses, or cash flows of each community can be significantly impacted by our estimates of the following: ● future base selling prices; ● future home sales incentives; ● future home construction and land development costs; and ● future sales absorption pace and cancellation rates. These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include: ● the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors; ● the current sales absorption pace for both our communities and competitor communities; ● community specific attributes, such as location, availability of lots in the market, desirability and uniqueness of our community, and the size and style of homes currently being offered; ● potential for alternative product offerings to respond to local market conditions; ● changes by management in the sales strategy of the community; ● current local market economic and demographic conditions and related trends of forecasts; and ● existing home inventory supplies, including foreclosures and short sales. These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair-value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful to an investor. If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written down to its fair value. We determine the estimated fair value of each community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from outside third parties. Our discount rates used for all impairments recorded from October 31, 2014 to October 31, 2016 ranged from 16.8% to 19.8%. The estimated future cash flow assumptions are virtually the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis. From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed not probable that the optioned property will be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant in comparison to the total costs written off. Inventories held for sale are land parcels ready for sale in their current condition, where we have decided not to build homes but are instead actively marketing for sale. These land parcels represented $48.7 million and $1.3 million of our total inventories at October 31, 2016 and 2015, respectively, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. The increase in land held for sale during the period was related to a few parcels that are planned to be sold in various markets. Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interests in the joint ventures vary but our voting interests are generally 50% or less. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, we assess whether the other partners have specific rights to overcome the presumption of control by us as the manager of the joint venture. In most cases, the presumption is overcome because the joint venture agreements require that both partners agree on establishing the significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, “Investments - Equity Method and Joint Ventures - Overall,” we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment below its carrying amount is other than temporary, we write down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture’s projected cash flows. This process requires significant management judgment and estimates. There were no write-downs in fiscal 2014, 2015 or 2016. Post-Development Completion, Warranty Costs and Insurance Deductible Reserves - In those instances where a development is substantially completed and sold and we have additional construction work to be incurred, an estimated liability is provided to cover the cost of such work. We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general, and administrative costs. For homes delivered in fiscal 2016 and 2015, our deductible under our general liability insurance is a $20 million aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2016 and 2015 is $0.25 million, up to a $5 million limit. Our aggregate retention in fiscal 2016 and 2015 is $21 million for construction defect, warranty and bodily injury claims. We do not have a deductible on our worker's compensation insurance. Reserves for estimated losses for construction defects, warranty and bodily injury claims have been established using the assistance of a third-party actuary. We engage a third-party actuary that uses our historical warranty and construction defect data to assist our management in estimating our unpaid claims, claim adjustment expenses and incurred but not reported claims reserves for the risks that we are assuming under the general liability and construction defect programs. The estimates include provisions for inflation, claims handling and legal fees. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. In addition, we establish a warranty accrual for lower cost-related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and title and possession have been transferred to the homebuyer. See Note 16 to the Consolidated Financial Statements for additional information on the amount of warranty costs recognized in cost of goods sold and administrative expenses. Deferred Income Taxes - Deferred income taxes are provided for temporary differences between amounts recorded for financial reporting and for income tax purposes. If the combination of future years’ income (or loss) combined with the reversal of the timing differences results in a loss, such losses can be carried back to prior years or carried forward to future years to recover the deferred tax assets. In accordance with ASC 740-10, “Income Taxes - Overall” (“ASC 740-10”), we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740-10 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more-likely-than-not” standard. See “Total Taxes” below under “Results of Operations” for further discussion of the valuation allowances. In evaluating the exposures associated with our various tax filing positions, we recognize tax liabilities in accordance with ASC 740-10, for more likely than not exposures. We re-evaluate the exposures associated with our tax positions on a quarterly basis. This evaluation is based on factors such as changes in facts or circumstances, changes in tax law, new audit activity by taxing authorities and effectively settled issues. Determining whether an uncertain tax position is effectively settled requires judgment. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision. A number of years may elapse before a particular matter for which we have established a liability is audited and fully resolved or clarified. We adjust our liability for unrecognized tax benefits and income tax provision in the period in which an uncertain tax position is effectively settled, or the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a liability that is materially different from our current estimate. Any such changes will be reflected as increases or decreases to income tax expense in the period in which they are determined. Recent Accounting Pronouncements See Note 3 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Capital Resources and Liquidity Our operations consist primarily of residential housing development and sales in the Northeast (New Jersey and Pennsylvania), the Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia), the Midwest (Illinois and Ohio), the Southeast (Florida, Georgia and South Carolina), the Southwest (Arizona and Texas) and the West (California). In addition, we provide certain financial services to our homebuilding customers. We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our bank credit facilities, the issuance of new debt and equity securities and other financing activities. Due to covenant restrictions in our debt instruments, we are currently limited in the amount of debt we can incur that does not qualify as refinancing indebtedness with certain maturity requirements (a limitation that we expect to continue for the foreseeable future), even if market conditions would otherwise be favorable, which could also impact our ability to grow our business. As a result of our evaluation of our geographic operating footprint as it relates to our strategic objectives, we decided to exit the Minneapolis, MN and Raleigh, NC markets, and in the third quarter of fiscal 2016, we completed the sale of our land portfolios in those markets. In addition, we entered into a new joint venture by contributing eight communities to the joint venture and receiving cash in return. The combination of these activities resulted in $78.9 million of net cash proceeds to us, enhancing our liquidity. We have also decided to wind down our operations in the San Francisco Bay area in Northern California and in Tampa, FL by building and delivering homes to sell through our existing land position. Any other liquidity-enhancing transaction will depend on identifying counterparties, negotiation of documentation and applicable closing conditions and any required approvals. Operating, Investing and Financing Activities - Overview Our homebuilding cash balance at October 31, 2016 increased $94.4 million from October 31, 2015 to $339.8 million. In addition to paying debt during the period, we spent $567.0 million on land and land development. After considering this land and land development and all other operating activities, including revenue received from deliveries, we generated $387.7 million of cash from operations. During the year ended October 31, 2016, net cash used in investing activities was $49.0 million, primarily related to investments in two new joint ventures. Net cash used in financing activities was $245.7 million during the year ended October 31, 2016, which included payments of our debt securities, partially offset by $150.0 million of new debt issuances as discussed below along with net proceeds from land banking. We intend to continue to use nonrecourse mortgage financings, model sale leaseback and, subject to covenant restrictions in our debt instruments, land banking programs as our business needs dictate. Our cash uses during the year ended October 31, 2016 and 2015 were for operating expenses, land purchases, land deposits, land development, construction spending, financing transactions, debt payments, state income taxes, interest payments and investments in joint ventures. During these periods, we provided for our cash requirements from available cash on hand, housing and land sales, financing transactions, debt issuances, our revolving credit facility, model sale leasebacks, land banking transactions, joint ventures, financial service revenues and other revenues. We believe that these sources of cash along with our existing cash balance will be sufficient in fiscal 2017 to finance our working capital requirements. In addition, because we do not have any significant debt maturities (other than non-recourse loans) due during the next fiscal year, compared to $400.8 million of debt retirements in fiscal 2016, we believe we will have sufficient capital to invest in more new communities in fiscal 2017 than we did in fiscal 2016. Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, mortgage loans held for sale, interest and other accrued liabilities, deferred income taxes, accounts payable and other liabilities, and noncash charges relating to depreciation, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is partially offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease, which is what happened during the last half of fiscal 2007 through fiscal 2009, allowing us to generate positive cash flow from operations during this period. Since the latter part of fiscal 2009 cumulative through January 31, 2016, as a result of new land purchases and land development, we have used cash in operations as we have added new communities. Thereafter in fiscal 2016, we shifted our focus from growing our community count and revenues to increasing operating efficiency and profitability while generating positive cash flow from operations in fiscal 2016 to pay debt as it matured. While we plan to actively seek land investment opportunities in fiscal 2017, because we may not be able to refinance our future debt maturities, we will also remain focused on liquidity. See “Inventory Activity” below for a detailed discussion of our inventory position. Debt Transactions As of October 31, 2016, we had a $75.0 million outstanding senior secured Term Loan (defined below), and $1,067.0 million of outstanding senior secured notes ($1,054.3 million, net of discount), comprised of $577.0 million 7.25% Senior Secured First Lien Notes due 2020 (the “First Lien Notes”), $145 million 9.125% Senior Secured Second Lien Notes due 2020 (the “Existing Second Lien Notes”), $75.0 million New Second Lien Notes (defined below), $53.2 million 2.0% 2021 Notes (defined below), $141.8 million 5.0% 2021 Notes (defined below) and $75.0 million Exchange Notes (defined below). As of October 31, 2016, we also had $400.0 million of outstanding senior notes, comprised of $150.0 million 7.0% Senior Notes due 2019 and $250.0 million 8.0% Senior Notes due 2019. In addition, as of October 31, 2016, we had outstanding $6.3 million 11.0% Senior Amortizing Notes due 2017 (issued as a component of our 6.0% Exchangeable Note Units) and $57.8 million Senior Exchangeable Notes due 2017 (issued as a component of our 6.0% Exchangeable Note Units). Except for K. Hovnanian Enterprises, Inc. (“K. Hovnanian”), the issuer of the notes, our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures and certain of our title insurance subsidiaries, we and each of our subsidiaries are guarantors of the senior secured, senior, senior amortizing and senior exchangeable notes outstanding at October 31, 2016 (collectively, the “Notes Guarantors”). In addition to the Notes Guarantors, the 5.0% Senior Secured Notes due 2021 (the “5.0% 2021 Notes”), the 2.0% Senior Secured Notes due 2021 (the “2.0% 2021 Notes” and together with the 5.0% 2021 Notes, the “2021 Notes”) and the 9.5% Senior Secured Notes due 2020 (collectively with the 2021 Notes, the “JV Holdings Secured Group Notes”) are guaranteed by K. Hovnanian JV Holdings, L.L.C. and its subsidiaries except for certain joint ventures and joint venture holding companies (collectively, the “JV Holdings Secured Group”). Members of the JV Holdings Secured Group do not guarantee K. Hovnanian's other indebtedness. The Term Loan Credit Agreement (defined below) and the indentures governing the notes outstanding at October 31, 2016 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than certain permitted indebtedness and refinancing indebtedness, under the Term Loan and certain of the senior secured notes, any new or refinancing indebtedness may not be scheduled to mature earlier than January 15, 2021 (so long as no member of the JV Holdings Secured Group is an obligor thereon), or February 15, 2021 (if otherwise) and nonrecourse indebtedness), pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness (with respect to the Term Loan and certain of the senior secured and senior notes) and common and preferred stock, make other restricted payments, make investments, sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets and enter into certain transactions with affiliates. The Term Loan Credit Agreement and the indentures also contain events of default which would permit the lenders/holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Term Loan Facility (defined below) (the “Term Loans”)/notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Term Loans/notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Term Loans, material inaccuracy of representations and warranties and a change of control, and, with respect to the indentures governing the Term Loans and senior secured notes, the failure of the documents granting security for the Term Loans and senior secured notes to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the Term Loans and senior secured notes to be valid and perfected. As of October 31, 2016, we believe we were in compliance with the covenants of Term Loan Facility the indentures governing our outstanding notes. Under the terms of our debt agreements, we have the right to make certain redemptions and prepayments and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to evaluate our capital structure and may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions. If our consolidated fixed charge coverage ratio, as defined in the agreements governing our debt instruments (other than the 6.0% Exchangeable Note Units), is less than 2.0 to 1.0, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness and nonrecourse indebtedness. As a result of this ratio restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. We anticipate that we will continue to be restricted from paying dividends for the foreseeable future. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our debt instruments or otherwise affect compliance with any of the covenants contained in our debt instruments. On January 15, 2016, $172.7 million principal amount of our 6.25% Senior Notes due 2016 matured and was paid and on May 15, 2016, $86.5 million principal amount of our 7.5% Senior Notes due 2016 matured and was paid. On October 11, 2016 (the next business day following the redemption date of October 8, 2016), all $121.0 million principal amount of our 8.625% Senior Notes due 2017 were redeemed for a redemption price of approximately $126.1 million, which included accrued and unpaid interest. The redemption was funded with proceeds from the Term Loan and New Second Lien Notes discussed below. On September 8, 2016, the Company and K. Hovnanian completed certain financing transactions with certain investment funds managed by affiliates of H/2 Capital Partners LLC (collectively, the “Investor”) pursuant to which the Investor (1) funded a $75.0 million senior secured term loan facility (the “Term Loan Facility”), which was borrowed by K. Hovnanian and guaranteed by the Notes Guarantors, (2) purchased $75.0 million aggregate principal amount of 10.0% Senior Secured Second Lien Notes due October 15, 2018 (the “New Second Lien Notes”) issued by K. Hovnanian and guaranteed by the Notes Guarantors, and (3) exchanged $75.0 million aggregate principal amount of Existing Second Lien Notes held by such Investor for $75.0 million of newly issued 9.50% Senior Secured Notes due November 15, 2020 issued by K. Hovnanian and guaranteed by the Notes Guarantors and the members of the JV Holdings Secured Group (the “Exchange Notes” and together with the Term Loan Facility and the New Second Lien Notes, the “Financings”) for aggregate cash proceeds of approximately $146.3 million, before expenses. In accordance with the conditions of the Financings, K. Hovnanian used all of the proceeds from the Financings in excess of the aggregate amount of funds needed for the redemption of the 8.625% Senior Notes due 2017 discussed above together with cash on hand to repurchase a total of 20,823 Exchangeable Note Units for an aggregate purchase price of $20.6 million. The Term Loan Facility has a maturity of August 1, 2019 (provided that if any of K. Hovnanian’s 7.0% Senior Notes due 2019 (the “7.0% Notes”) remain outstanding on October 15, 2018, the maturity date of the Term Loan Facility will be October 15, 2018, or if any refinancing indebtedness with respect to the 7.0% Notes has a maturity date prior to January 15, 2021, the maturity date of the Term Loan Facility will be October 15, 2018) and bears interest at a rate equal to LIBOR plus an applicable margin of 7.0% or, at K. Hovnanian’s option, a base rate plus an applicable margin of 6.0%, payable monthly. At any time from and after September 8, 2018, K. Hovnanian may voluntarily repay outstanding Term Loans, provided that voluntary prepayments of Eurodollar loans made on a date other than the last day of an interest period applicable thereto are subject to customary breakage costs and voluntary prepayments made prior to February 1, 2019 are subject to a premium equal to 1.0% of the aggregate principal amount of the Term Loans so prepaid (any prepayment of the Term Loans made on or after February 1, 2019 are without any prepayment premium). The New Second Lien Notes have a maturity of October 15, 2018, and bear interest at a rate of 10.0% per annum, payable semi-annually on February 15 and August 15 of each year, commencing February 15, 2017, to holders of record at the close of business on February 1 and August 1, as the case may be, immediately preceding such interest payment dates. The New Second Lien Notes are redeemable in whole or in part at our option at any time prior to July 15, 2018 at 100% of their principal amount plus an applicable “Make-Whole Amount.” At any time and from time to time on or after July 15, 2018, K. Hovnanian may also redeem some or all of the New Second Lien Notes at a redemption price equal to 100% of their principal amount. In addition, we may also redeem up to 35% of the aggregate principal amount of the New Second Lien Notes prior to July 15, 2018 with the net cash proceeds from certain equity offerings at 110.00% of principal. The Exchange Notes have a maturity of November 15, 2020, and bear interest at a rate of 9.50% per annum, payable semi-annually on February 15 and August 15 of each year, commencing February 15, 2017, to holders of record at the close of business on February 1 and August 1, as the case may be, immediately preceding such interest payment dates. The Exchange Notes are redeemable in whole or in part at our option at any time prior to November 15, 2018 at 100% of their principal amount plus an applicable “Make-Whole Amount.” At any time and from time to time on or after November 15, 2018, K. Hovnanian may also redeem some or all of the Exchange Notes at a redemption price equal to 100% of their principal amount. In addition, we may also redeem up to 35% of the aggregate principal amount of the Exchange Notes prior to November 15, 2018 with the net cash proceeds from certain equity offerings at 109.50% of principal. All of K. Hovnanian’s obligations under the Term Loan Facility and the New Second Lien Notes are guaranteed by the Notes Guarantors. The Term Loan Facility and the guarantees thereof are secured on a first lien super priority basis relative to K. Hovnanian’s First Lien Notes, the Existing Second Lien Notes and the New Second Lien Notes, and the New Second Lien Notes and the guarantees thereof are secured on a pari passu second lien basis with K. Hovnanian’s Existing Second Lien Notes, by substantially all of the assets owned by K. Hovnanian and the Notes Guarantors, in each case subject to permitted liens and certain exceptions. The Exchange Notes are guaranteed by the Notes Guarantors and the members of the JV Holdings Secured Group. The Exchange Notes are secured on a pari passu first lien basis with K. Hovnanian’s 2021 Notes, by substantially all of the assets of the members of the JV Holdings Secured Group, subject to permitted liens and certain exceptions. In connection with borrowing the Term Loan Facility and the issuance of the New Second Lien Notes and the Exchange Notes, K. Hovnanian and the applicable guarantors entered into security and pledge agreements pursuant to which K. Hovnanian, the Company and the applicable guarantors pledged substantially all of their assets to secure their obligations under the Term Loan Facility, the New Second Lien Notes and the Exchange Notes, subject to permitted liens and certain exceptions as set forth in such agreements. K. Hovnanian, the Company and the applicable guarantors also entered into applicable intercreditor and collateral agency agreements which set forth agreements with respect to the relative priority of their various secured obligations. The Term Loan Facility was incurred pursuant to a Credit Agreement dated July 29, 2016 (the “Term Loan Credit Agreement”) entered into among K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent (the “Administrative Agent”) and the Investor. The Term Loan Credit Agreement contains representations and warranties, affirmative and restrictive covenants and customary events of default (discussed above). The Indenture governing the New Second Lien Notes (the “New Second Lien Notes Indenture”) was entered into on September 8, 2016 among K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as trustee and collateral agent. The Indenture governing the Exchange Notes (the “Exchange Notes Indenture”) was entered into on September 8, 2016 among K. Hovnanian, the Notes Guarantors, the members of the JV Holdings Secured Group and Wilmington Trust, National Association, as trustee and collateral agent. The covenants and events of default in the New Second Lien Notes Indenture and the Exchange Notes Indenture are described further above. See Note 9 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a further discussion of the Company’s Term Loan, senior secured notes, senior notes and 6% Exchangeable Note Units. Mortgages and Notes Payable We have nonrecourse mortgage loans for certain communities totaling $83.5 million and $143.9 million at October 31, 2016 and 2015, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $201.8 million and $388.1 million, respectively. The weighted-average interest rate on these obligations was 4.9% and 5.1% at October 31, 2016 and 2015, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries. We also have nonrecourse mortgage loans on our corporate headquarters totaling $14.3 million and $15.5 million at October 31, 2016 and 2015, respectively. These loans had a weighted-average interest rate of 8.8% at both October 31, 2016 and October 31, 2015. As of October 31, 2016, these loans had installment obligations with annual principal maturities in the years ending October 31 of: $1.3 million in 2017, $1.4 million in 2018, $1.5 million in 2019, $1.7 million in 2020, $1.8 million in 2021 and $6.6 million after 2021. In June 2013, K. Hovnanian, as borrower, and we and certain of our subsidiaries, as guarantors, entered into a five-year, $75.0 million unsecured revolving credit facility (the “Credit Facility”) with Citicorp USA, Inc., as administrative agent and issuing bank, and Citibank, N.A., as a lender. The Credit Facility is available for both letters of credit and general corporate purposes. The Credit Facility does not contain any financial maintenance covenants, but does contain certain restrictive covenants that track those contained in our indenture governing the 8.0% Senior Notes due 2019, which are described in Note 9 to the Consolidated Financial Statements. The Credit Facility also contains certain customary events of default which would permit the administrative agent at the request of the required lenders to, among other things, declare all loans then outstanding to be immediately due and payable if such default is not cured within applicable grace periods, including the failure to make timely payments of amounts payable under the Credit Facility or other material indebtedness or the acceleration of other material indebtedness, the failure to comply with agreements and covenants or for representations or warranties to be correct in all material respects when made, specified events of bankruptcy and insolvency, and the entry of a material judgment against a loan party. Outstanding borrowings under the Credit Facility accrue interest at an annual rate equal to either, as selected by K. Hovnanian, (i) the alternate base rate plus the applicable spread determined on the date of such borrowing or (ii) an adjusted London Interbank Offered Rate (“LIBOR”) rate plus the applicable spread determined as of the date two business days prior to the first day of the interest period for such borrowing. As of October 31, 2016 there were $52.0 million of borrowings and $17.9 million of letters of credit outstanding under the Credit Facility. As of October 31, 2015, there were $47.0 million of borrowings and $25.9 million of letters of credit outstanding under the Credit Facility. As of October 31, 2016, we believe we were in compliance with the covenants under the Credit Facility. In addition to the Credit Facility, we have certain stand-alone cash collateralized letter of credit agreements and facilities under which there were a total of $1.7 million and $2.6 million letters of credit outstanding at October 31, 2016 and 2015, respectively. These agreements and facilities require us to maintain specified amounts of cash as collateral in segregated accounts to support the letters of credit issued thereunder, which will affect the amount of cash we have available for other uses. As of October 31, 2016 and October 31, 2015, the amount of cash collateral in these segregated accounts was $1.7 million and $2.6 million, respectively, which is reflected in “Restricted cash and cash equivalents” on the Condensed Consolidated Balance Sheets. Our wholly owned mortgage banking subsidiary, K. Hovnanian American Mortgage, LLC (“K. Hovnanian Mortgage”), originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are sold in the secondary mortgage market within a short period of time. In certain instances, we retain the servicing rights for a small amount of loans. The loan is secured by the mortgages held for sale and is repaid when we sell the underlying mortgage loans to permanent investors. As of October 31, 2016 and 2015, we had an aggregate of $145.6 million and $108.9 million, respectively, outstanding under several of K. Hovnanian Mortgage’s short-term borrowing facilities. See Note 8 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a discussion of these agreements and facilities. Equity On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 4 million shares of Class A Common Stock. We did not repurchase any shares under this program during fiscal 2016 or 2015. As of October 31, 2016, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 0.5 million. (See Part II, Item 5 for information on equity purchases). On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol “HOVNP.” In fiscal 2016, 2015 and 2014, we did not make any dividend payments on the Series A Preferred Stock as a result of covenant restrictions in our debt instruments. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future. Ratings Actions On November 9, 2015, Moody’s Investors Services (“Moody’s”) took certain rating actions as follows: ● Corporate Family Rating, downgraded to Caa1; ● Probability of Default Rating, downgraded to Caa1; ● 7.625% Series A Preferred Stock, downgraded to Caa3; ● First Lien Notes, downgraded to B1; ● Existing Second Lien Notes, downgraded to Caa1; and ● Senior unsecured notes, downgraded to Caa2. On December 9, 2015, Fitch Ratings (“Fitch”) took certain rating actions as follows: ● Long-term Issuer Default Rating, downgraded to CCC; ● First Lien Notes, downgraded to B; ● Existing Second Lien Notes, downgraded to CCC-; ● Senior unsecured notes, downgraded to CCC-; and ● 7.625% Series A Preferred Stock, downgraded to C. On April 20, 2016, Moody’s took certain rating actions as follows: ● Corporate Family Rating, downgraded to Caa2; ● Probability of Default Rating, downgraded to Caa2; ● 7.625% Series A Preferred Stock, downgraded to Ca; ● First Lien Notes, downgraded to B2; ● Existing Second Lien Notes, downgraded to Caa2; and ● Senior unsecured notes, downgraded to Caa3. On May 3, 2016, S&P Global Ratings took certain rating actions as follows: ● Corporate Credit Rating, downgraded to CCC+; ● First Lien Notes, downgraded to CCC+; ● 2021 Notes, downgraded to CCC; ● Existing Second Lien Notes, downgraded to CCC-; and ● Senior unsecured notes, downgraded to CCC-. On August 1, 2016, Moody’s took certain rating actions as follows: ● First Lien Notes, downgraded to B3; ● Existing Second Lien Notes, downgraded to Caa3 Downgrades in our credit ratings do not accelerate the scheduled maturity dates of our debt or affect the interest rates charged on any of our debt issues or our debt covenant requirements or cause any other operating issue. A potential risk from negative changes in our credit ratings is that they may make it more difficult or costly for us to access capital. Inventory Activities Total inventory, excluding consolidated inventory not owned, decreased $448.0 million during the year ended October 31, 2016 from October 31, 2015. Total inventory, excluding consolidated inventory not owned, decreased in the Northeast by $125.6 million, in the Mid-Atlantic by $75.4 million, in the Midwest by $96.5 million, in the Southeast by $10.0 million and in the Southwest by $144.2 million and increased in the West by $3.7 million. The decreases were primarily attributable to land banking transactions during the period (discussed below), along with home deliveries, land sales, and the contribution of certain of our communities to a new joint venture, partially offset by new land purchases and land development during the period. During the year ended October 31, 2016, we had aggregate impairments in the amount of $24.5 million primarily related to land held for sale in the Midwest (in connection with the sale of our land portfolio in the Minneapolis, MN market discussed above) and the Northeast. We wrote off costs in the amount of $8.9 million during the year ended October 31, 2016 related to land options that expired or that we terminated, as the communities’ forecasted profitability was not projected to produce adequate returns on investment commensurate with the risk. In the last few years, we have been able to acquire new land parcels at prices that we believe will generate reasonable returns under current homebuilding market conditions. There can be no assurances that this trend will continue in the near term. Substantially all homes under construction or completed and included in inventory at October 31, 2016 are expected to be closed during the next six to nine months. The total inventory decrease discussed above excluded the increase in consolidated inventory not owned of $86.5 million. Consolidated inventory not owned consists of specific performance options and other options that were included in our Consolidated Balance Sheet in accordance with US GAAP. The increase in consolidated inventory not owned from October 31, 2015 to October 31, 2016 was primarily due to an increase in land banking transactions, partially offset by a decrease in the sale and leaseback of certain model homes and specific performance options during the period. We have land banking arrangements, whereby we sell land parcels to the land bankers and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes in accordance with ASC 360-20-40-38, these transactions are considered a financing rather than a sale. For purposes of our Consolidated Balance Sheet, at October 31, 2016, inventory of $129.5 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $82.4 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. In addition, we sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheet, at October 31, 2016, inventory of $79.2 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $70.8 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. From time to time, we enter into option agreements that include specific performance requirements whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with ASC 360-20-40-38, we are required to record this inventory on our Consolidated Balance Sheets. As of October 31, 2016, we had no specific performance options recorded on our Consolidated Balance Sheets. When possible, we option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option (other than with respect to specific performance options discussed above). As a result, our commitment for major land acquisitions is reduced. The costs associated with optioned properties are included in “Land and land options held for future development or sale” on the Consolidated Balance Sheets. Also included in “Land and land options held for future development or sale” are amounts associated with inventory in mothballed communities. We mothball (or stop development on) certain communities when we determine the current performance does not justify further investment at the time. That is, we believe we will generate higher returns if we decide against spending money to improve land today and save the raw land until such time as the markets improve or we determine to sell the property. As of October 31, 2016, we had mothballed land in 29 communities. The book value associated with these communities at October 31, 2016 was $74.4 million, which was net of impairment charges recorded in prior periods of $296.3 million. We continually review communities to determine if mothballing is appropriate. During fiscal 2016, we mothballed one new community, sold one previously mothballed community, re-activated one previously mothballed community and contributed one previously mothballed community to a new joint venture which began construction in fiscal 2016. Inventories held for sale, which are land parcels where we have decided not to build homes, represented $48.7 million and $1.3 million of our total inventories at October 31, 2016 and October 31, 2015, respectively, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. The increase in land held for sale during the period was related to a few land parcels that are planned to be sold in various markets. The following tables summarize home sites included in our total residential real estate. The decrease in remaining home sites available at October 31, 2016 compared to October 31, 2015 was primarily attributable to the reduction of 2,185 lots related to the sale of our land portfolios in our Minneapolis, MN and Raleigh, NC divisions and the contribution of lots to our two new joint ventures during the period. The remaining reduction was due to our focus on liquidity in fiscal 2016 and delivering homes without investing in new land at the same rate during the period. As previously discussed, based on our cash position at October 31, 2016, we expect to actively seek new land investment opportunities in fiscal 2017. The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures, in active and substantially completed communities. The decrease in the number of unsold homes and models from October 31, 2015 to October 31, 2016 is due to the decrease in community count during the period. (1) Active selling communities (which are communities that are open for sale with ten or more home sites available) were 167 and 219 at October 31, 2016 and 2015, respectively. Ratio does not include substantially completed communities, which are communities with less than ten home sites available. Other Balance Sheet Activities Homebuilding - Restricted cash and cash equivalents decreased $3.4 million from October 31, 2015 to $3.9 million at October 31, 2016. The decrease was primarily due to the release of escrow cash related to operations in our Minnesota division which was sold in the third quarter of fiscal 2016, along with the release of escrow cash being held for a community in the Northeast that delivered its remaining homes during the period, and the release of escrow cash being held as collateral against a letter of credit which was settled during the period. Investments in and advances to unconsolidated joint ventures increased $39.3 million during the fiscal year ended October 31, 2016 compared to October 31, 2015. The increase was primarily due to an investment in two new joint ventures in the first and third quarters of fiscal 2016, along with an additional contribution to an existing joint venture during the period, partially offset by joint venture partnership distributions received during the period. As of October 31, 2016 and October 31, 2015, we had investments in ten and nine homebuilding joint ventures, respectively, and one land development joint venture. We have no guarantees associated with our unconsolidated joint ventures, other than guarantees limited only to performance and completion of development, environmental indemnification and standard warranty and representation against fraud misrepresentation and similar actions, including a voluntary bankruptcy. Receivables, deposits and notes, net decreased $20.6 million from October 31, 2015 to $49.7 million at October 31, 2016. The decrease was primarily due to the timing of cash received related to home closings and a decrease in refundable deposits. Property, plant and equipment, net increased $4.8 million from October 31, 2015 to October 31, 2016 primarily due to additions for building and leasehold improvements during the period. Prepaid expenses and other assets were as follows as of: Prepaid insurance increased $0.8 million due to the timing of premium payments. These costs are amortized over the life of the associated insurance policy, which can be one to three years. Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered. The decrease of $4.4 million from October 31, 2015 to October 31, 2016 was the result of the number of closed communities outpacing the number of new communities during fiscal 2016. Other prepaids decreased $2.4 million during the period, primarily due to the timing of payments and amortization of various prepaid costs including commissions and annual software licenses. Financial Services - Mortgage loans held for sale consist primarily of residential mortgages receivable held for sale of which $155.0 million and $124.1 million at October 31, 2016 and 2015, respectively, were being temporarily warehoused and are awaiting sale in the secondary mortgage market. The increase in mortgage loans held for sale from October 31, 2015 was related to an increase in the volume of loans originated during the fourth quarter of 2016 compared to the fourth quarter of 2015, along with an increase in the average loan value and an increase in the fair value adjustment required at October 31, 2016 compared to October 31 2015. Financial Services - Other Assets increased $4.0 million from October 31, 2015 to October 31, 2016, as a result of the timing of closings of certain mortgages, which were funded at October 31, 2016, but did not close until November 2016. Income Taxes Receivable decreased $6.7 million from $290.3 million at October 31, 2015 to $283.6 million at October 31, 2016 primarily due to a decrease in deferred tax assets. Nonrecourse mortgages decreased to $83.5 million at October 31, 2016, from $143.9 million at October 31, 2015. The decrease was primarily due to the payment of existing mortgages, including mortgages on certain communities which were sold to a new joint venture in the third quarter of fiscal 2016, partially offset by new mortgages for communities primarily in the Northeast, Midwest, Southeast and West obtained during the period. Accounts payable and other liabilities are as follows as of: The increase in accounts payable was due to both the 8.3% increase in deliveries in the fourth quarter of fiscal 2016 compared to the fourth quarter of fiscal 2015, as well as adjusted payment schedules in fiscal 2016 so that payments are made in accordance with payment due dates. Reserves decreased during fiscal 2016 primarily as our reserves related to construction defects were reduced as a result of the annual actuarial study as discussed in Note 16 to the Consolidated Financial Statements. The decrease in accrued expenses was primarily due to the amortization of accruals related to abandoned lease space along with the timing of other accruals. The increase in accrued compensation was primarily due to accrued bonuses payable at the end of fiscal 2016 as compared to the end of fiscal 2015. Other liabilities increased primarily due to deferred income from municipality reimbursements for infrastructure costs and development fees related to work performed under a bond issuance in one of our communities in the West. Customers’ deposits decreased $6.8 million to $37.4 million at October 31, 2016. The decrease was primarily related to the decrease in backlog during the period. Liabilities from inventory not owned increased $47.3 million to $153.2 million at October 31, 2016. The increase was due to new land banking transactions during the period, partially offset by a decrease in the sale and leaseback of certain model homes and specific performance options, all accounted for as financing transactions as described above. Financial Services - Mortgage warehouse lines of credit increased $36.7 million from $108.9 million at October 31, 2015, to $145.6 million at October 31, 2016. The increase correlates to the increase in the volume of mortgage loans held for sale during the period as discussed above. Accrued interest decreased $8.0 million to $32.4 million at October 31, 2016. The decrease was primarily due to the decrease in our notes payable balances from October 31, 2015 to October 31, 2016, as we paid at maturity approximately $260 million and redeemed $121.0 million in senior notes during fiscal 2016, partially offset by the issuances in the Financings, as discussed above. Results of Operations Total Revenues Compared to the prior period, revenues increased (decreased) as follows: Homebuilding Sale of homes revenues increased $512.7 million, or 24.6%, for the year ended October 31, 2016, increased $75.1 million, or 3.7%, for the year ended October 31, 2015 and increased $228.7 million, or 12.8%, for the year ended October 31, 2014 as compared to the same period of the prior year. The increased revenues in fiscal 2016 were primarily due to the 17.4% increase in deliveries, as well as the average price per home increasing to $402,350 in fiscal 2016 from $379,177 in fiscal 2015. The increased revenues in fiscal 2015 were primarily due to the average price per home increasing to $379,177 in fiscal 2015 from $366,202 in fiscal 2014. The increased revenues in fiscal 2014 were primarily due to the number of home deliveries increasing 4.4% and the average price per home increasing to $366,202 in fiscal 2014 from $338,839 in fiscal 2013. For fiscal 2016, 2015 and 2014, the fluctuations in average prices were a result of the geographic and community mix of our deliveries, as opposed to home price increases (which we increase or decrease in communities depending on the respective community’s performance). Our ability to raise prices in fiscal 2016, 2015 and 2014 was limited because in order to increase our sales pace per community, we lowered prices or increased incentives in certain communities, especially with respect to certain started unsold homes in the first half of fiscal 2015. For information on land sales, see the section titled “Land Sales and Other Revenues” below. Information on homes delivered by segment is set forth below: The increase in housing revenues during year ended October 31, 2016, as compared to year ended October 31, 2015, was primarily attributed to our increased deliveries, along with an increase in average sales price. Housing revenues and average sales prices in fiscal 2016 increased in all of our homebuilding segments combined by 24.6% and 6.1%, respectively, excluding joint ventures. In our homebuilding segments, homes delivered increased in fiscal 2016 as compared to fiscal 2015 by 46.6%, 12.4%, 21.5% and 84.4% in the Northeast, Mid-Atlantic, Southwest and West, respectively, and decreased by 3.9% and 13.9% in the Midwest and Southeast, respectively. Overall in fiscal 2016 as compared to fiscal 2015 homes delivered increased 17.4% across all our segments, excluding unconsolidated joint ventures. The increase in housing revenues during year ended October 31, 2015, as compared to year ended October 31, 2014, was primarily attributed to an increase in average sales price. Housing revenues and average sales prices in fiscal 2015 increased in all of our homebuilding segments combined by 3.7% and 3.5%, respectively, excluding joint ventures. In our homebuilding segments, homes delivered increased in fiscal 2015 as compared to fiscal 2014 by 21.8%, 21.4% and 3.5% in the Mid-Atlantic, Midwest and Southeast, respectively, and decreased by 30.9%, 5.3% and 9.4% in the Northeast, Southwest and West, respectively. Overall in fiscal 2015 as compared to fiscal 2014 homes delivered only increased 0.2% across all our segments, excluding unconsolidated joint ventures. Quarterly housing revenues and net sales contracts by segment, excluding unconsolidated joint ventures, for the years ended October 31, 2016, 2015 and 2014 are set forth below: (1) The Midwest net contracts include $1.9 million, $7.1 million and $18.4 million, respectively, for the quarters ended July 31, 2016, April 30, 2016 and January 31, 2016, from Minneapolis, MN. (2) The Southeast net contracts include $9.9 million and $21.7 million, respectively, for the quarters ended April 30, 2016 and January 31, 2016, from Raleigh, NC. (1) The Midwest net contracts include $23.0 million, $21.8 million, $31.6 million and $21.8 million, respectively, for the quarters ended October 31, 2015, July 31, 2015, April 30, 2015 and January 31, 2015, from Minneapolis, MN. (2) The Southeast net contracts include $12.2 million, $7.8 million, $12.5 million and $9.9 million, respectively, for the quarters ended October 31, 2015, July 31, 2015, April 30, 2015 and January 31, 2015, from Raleigh, NC. Contracts per average active selling community in fiscal 2016 were 31.3 compared to fiscal 2015 of 30.0. Our reported level of sales contracts (net of cancellations) has been impacted by an increase in the pace of sales in most of the Company’s segments during fiscal 2016. Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures: Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of the beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures. Most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of a buyer's failure to qualify for a mortgage, which generally occurs during the first few weeks after signing. The contract cancellations over the past several years, as shown in the tables above, have been within what we believe to be a normal range. However, market conditions remain uncertain and it is difficult to predict what cancellation rates will be in the future. An important indicator of our future results is recently signed contracts and our home contract backlog for future deliveries. Our consolidated contract backlog, excluding unconsolidated joint ventures, by segment is set forth below: (1) The Midwest contract backlog as of October 31, 2016 reflects the reduction of 64 homes and $24.1 million related to the sale of our land portfolio in Minneapolis, MN. (2) The Southeast contract backlog as of October 31, 2016 reflects the reduction of 67 homes and $33.7 million related to the sale of our land portfolio in Raleigh, NC. Contract backlog dollars decreased 12.1% as of October 31, 2016 compared to October 31, 2015, and the number of homes in backlog decreased 17.5% for the same period. The decrease in backlog was driven by a 17.4% increase in deliveries and a 1.2% decrease in net contracts, excluding unconsolidated joint ventures, for the year ended October 31, 2016 compared to the prior fiscal year as community count shrunk during fiscal 2016. In the month of November 2016, excluding unconsolidated joint ventures, we signed an additional 351 net contracts amounting to $144.3 million in contract value. Total cost of sales on our Consolidated Statements of Operations includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as “land charges” in the tables below). A breakout of such expenses for housing sales and housing gross margin is set forth below: Cost of sales expenses as a percentage of consolidated home sales revenues are presented below: We sell a variety of home types in various communities, each yielding a different gross margin. As a result, depending on the mix of communities delivering homes, consolidated gross margin may fluctuate up or down. Total homebuilding gross margin percentage, before interest expense and land impairment and option write-off charges, decreased to 16.9% for the year ended October 31, 2016 compared to 17.6% for the same period last year. We have experienced higher land and development costs as a percentage of sale of homes revenue in certain of our new communities delivering in fiscal 2016 compared to the same period last year, as well as higher construction costs in many of our markets, which resulted in a decrease in gross margin percentage for fiscal 2016 compared to fiscal 2015. During the first half of fiscal 2015, we significantly discounted some of our started unsold homes to sell them. In addition, we have experienced pricing pressure since midway through fiscal 2014, leading us to increase incentives and concessions on to be built homes as well, although to a lesser extent than started unsold homes. Combined, this resulted in a decrease in gross margin percentage for fiscal 2015 compared to fiscal 2014. For the years ended October 31, 2016, 2015 and 2014, gross margin was favorably impacted by the reversal of prior period inventory impairments of $57.9 million, $35.6 million and $48.0 million, respectively, which represented 2.2%, 1.7% and 2.4%, respectively, of “Sale of homes” revenue. Reflected as inventory impairment loss and land option write-offs in cost of sales (“land charges”), we have written off or written down certain inventories totaling $33.4 million, $12.0 million and $5.2 million during the years ended October 31, 2016, 2015 and 2014, respectively, to their estimated fair value. See Note 12 to the Consolidated Financial Statements for an additional discussion. During the years ended October 31, 2016, 2015 and 2014, we wrote off residential land options and approval and engineering costs totaling $8.9 million, $4.7 million and $4.0 million, respectively, which are included in the total land charges mentioned above. Option, approval and engineering costs are written off when a community’s pro forma profitability is not projected to produce adequate returns on the investment commensurate with the risk and when we believe it is probable we will cancel the option, or when a community is redesigned engineering costs related to the initial design are written off. Such write-offs were located in all segments in fiscal 2016 and 2015, and all segments except the West in fiscal 2014. The inventory impairments amounted to $24.5 million, $7.3 million and $1.2 million for the years ended October 31, 2016, 2015 and 2014, respectively. The amount of inventory impairments recorded in fiscal 2016 was higher than the past several years, primarily due to the land sales in the Midwest in fiscal 2016 related to our exit of the Minneapolis, MN market, as previously discussed, along with certain land held for sale in the Northeast. It is difficult to predict impairment levels, and should it become necessary or desirable to have additional land sales, further lower prices, or should the estimates or expectations used in determining estimated cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. Below is a breakdown of our lot option walk-aways and impairments by segment for fiscal 2016. In fiscal 2016, we walked away from 31.8% of all the lots we controlled under option contracts. The remaining 68.2% of our option lots are in communities that we believe remain economically feasible. The following table represents lot option walk-aways by segment for the year ended October 31, 2016: (1) Includes lots optioned at October 31, 2016 and lots optioned that the Company walked away from in the year ended October 31, 2016. The following table represents impairments by segment for the year ended October 31, 2016: (1) Represents carrying value, net of prior period impairments, if any, at the time of recording the applicable period’s impairments. Land Sales and Other Revenues Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below: Land sales are ancillary to our residential homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. Although we budget land sales, they are often dependent upon receiving approvals and entitlements, the timing of which can be uncertain. As a result, projecting the amount and timing of land sales is difficult. There were 26 land sales in the year ended October 31, 2016, compared to three in the same period of the prior year, resulting in a $75.2 million increase in land sales revenue. This increase was primarily due to the sale of six land parcels in the Midwest and ten land parcels in the Southeast in the third quarter of fiscal 2016 in connection with our previously discussed strategy to exit the Minneapolis, MN and Raleigh, NC markets. There were three land sales in the year ended October 31, 2015, compared to 13 in the same period of the prior year. Land sales and other revenues increased $75.2 million for the year ended October 31, 2016, and decreased $4.3 million for the year ended October 31, 2015 compared to the same periods in the prior year. Other revenues include income from contract cancellations where the deposit has been forfeited due to contract terminations, interest income, cash discounts and miscellaneous one-time receipts. Homebuilding Selling, General and Administrative Homebuilding selling, general and administrative (“SGA”) expenses increased $4.5 million to $192.9 million for the year ended October 31, 2016 as compared to the year ended October 31, 2015; however, SGA as a percentage of total revenues decreased 1.8% for the same period. The dollar increase was mainly due to increases in sales and other compensation related to increased headcount and increased compensation reflective of the competitive homebuilding market, increased advertising costs related to community count growth that occurred at the end of fiscal 2015 and higher bonus expense due to higher profits in certain markets. These increases were partially offset by the decrease of $3.7 million from the impact of our exit from the Minneapolis, MN and Raleigh, NC markets during the third quarter of fiscal 2016 and a decrease in insurance reserves of $9.2 million, as a result of our annual actuarial analysis of estimated construction defect costs on previously delivered homes, as discussed further in Note 16 to the Consolidated Financial Statements. SGA decreased $3.1 million to $188.4 million for the year ended October 31, 2015 compared to the year ended October 31, 2014. This decrease was mainly due to the reduction of $15.2 million of our construction defect reserves based on our annual actuarial estimates, partially offset by increases due to additional headcount related costs and increased architectural expense, related to community growth, as well as a reduction of joint venture management fees, which offset general and administrative expenses, received as a result of fewer joint venture deliveries in the year ended October 31, 2015 as compared to the year ended October 31, 2014. Homebuilding Operations by Segment Financial information relating to the Company’s operations was as follows: Segment Analysis (Dollars in thousands, except average sales price) Homebuilding Results by Segment Northeast - Homebuilding revenues increased 46.7% in fiscal 2016 compared to fiscal 2015 primarily due to a 46.6% increase in homes delivered and a $3.5 million increase in land sales and other revenue, partially offset by a 1.1% decrease in average selling price. The decrease in average sales prices was the result of the mix of communities delivering, along with pricing pressure in certain communities in fiscal 2016 compared to fiscal 2015. Loss before income taxes decreased $3.9 million to a loss of $3.9 million, which was mainly due to the increase in homebuilding revenues discussed above and a $4.0 million decrease in selling, general and administrative costs. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2016 compared to fiscal 2015. Homebuilding revenues decreased 31.3% in fiscal 2015 compared to fiscal 2014 primarily due to a 30.9% decrease in homes delivered, a 0.4% decrease in average selling price and a $0.6 million decrease in land sales and other revenue. The decrease in average sales prices was the result of the mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Loss before income taxes increased $0.2 million to a loss of $7.7 million, which was mainly due to the decrease in homebuilding revenues discussed above. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2015 compared to fiscal 2014. Mid-Atlantic - Homebuilding revenues increased 14.8% in fiscal 2016 compared to fiscal 2015 primarily due to a 12.4% increase in homes delivered and a 2.3% increase in average sales price. The increase in average sales price was due to the mix of communities delivering in fiscal 2016 compared to fiscal 2015. Income before income taxes decreased $4.0 million to $17.4 million, due mainly to a $4.5 million decrease in income from unconsolidated joint ventures. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2016 compared to fiscal 2015. Homebuilding revenues increased 20.1% in fiscal 2015 compared to fiscal 2014 primarily due to a 21.8% increase in homes delivered, partially offset by a 1.5% decrease in average selling price. The decrease in average sales price was due to the mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $2.5 million to $21.4 million, due mainly to a $1.9 million increase in selling, general and administrative costs, a $0.9 million increase in inventory impairment loss and land option write-offs, partially offset by the increase in homebuilding revenues discussed above. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2015 compared to fiscal 2014. Midwest - Homebuilding revenues were essentially flat for fiscal 2016 compared to fiscal 2015. There was a 3.9% decrease in homes delivered and a 4.0% decrease in average sales price. The decrease in average sales price was due to the mix of communities delivering in fiscal 2016 compared to fiscal 2015. These decreases were partially offset by a $23.8 million increase in land sales and other revenue due primarily to the sale of our land portfolio in our Minneapolis, MN division. Income before income taxes decreased $25.4 million to a loss of $11.4 million. The decrease in income was primarily due to a $12.9 million increase in inventory impairment loss and land option write-offs relating to our land portfolio sold in our Minneapolis, MN division, a $1.2 million decrease in income from unconsolidated joint ventures and a decrease in gross margin percentage before interest expense. Homebuilding revenues increased 37.7% in fiscal 2015 compared to fiscal 2014. The increase was primarily due to a 21.4% increase in homes delivered and a 13.5% increase in average sales price. The increase in average sales price was due to the mix of communities delivering in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $3.9 million to $14.0 million. The decrease in income was primarily due to a $10.7 million increase in selling, general and administrative costs and a slight decrease in gross margin percentage before interest expense, partially offset by the increase in homebuilding revenues discussed above. Southeast - Homebuilding revenues increased 25.5% in fiscal 2016 compared to fiscal 2015. The increase was primarily due to a 20.2% increase in average sales price, partially offset by a 13.9% decrease in homes delivered. In addition, there was a $45.7 million increase in land sales and other revenue mainly due to the sale of our land portfolio in our Raleigh, NC division during the period. The increase in average sales price was due to the mix of communities delivering in fiscal 2016 compared to fiscal 2015. Loss before income taxes increased $11.5 million to a loss of $17.8 million due to a $3.2 million increase in selling, general and administrative costs, a $3.0 million decrease in income from unconsolidated joint ventures and a slight decrease in gross margin percentage before interest expense. Homebuilding revenues increased 1.5% in fiscal 2015 compared to fiscal 2014. The increase was primarily due to a 3.5% increase in homes delivered, partially offset by a 1.1% decrease in average sales price. The decrease in average sales price was due to the mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $15.6 million to a loss of $6.3 million due to a $5.4 million increase in selling, general and administrative costs, a $3.1 million increase in inventory impairment loss and land option write-offs and a slight decrease in gross margin percentage before interest expense. Southwest - Homebuilding revenues increased 24.8% in fiscal 2016 compared to fiscal 2015 primarily due to a 21.5% increase in homes delivered, a 2.5% increase in average sales price and a $2.6 million increase in land sales and other revenue. The increase in average sales price was due to the mix of communities delivering in fiscal 2016 compared to fiscal 2015. Income before income taxes increased $17.0 million to $84.4 million in fiscal 2016 mainly due to the increase in homebuilding revenues discussed above. Homebuilding revenues increased 9.6% in fiscal 2015 compared to fiscal 2014 primarily due to a 16.1% increase in average sales price, partially offset by a 5.3% decrease in homes delivered and a $2.2 million decrease in land sales and other revenue. The increase in average sales price was due to the mix of communities delivering in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $7.1 million to $67.4 million in fiscal 2015 mainly due to a $2.3 million increase in selling, general and administrative costs, the decrease in land sales and other revenue discussed above and a slight decrease in gross margin percentage before interest expense, offset by the increase in homebuilding revenues discussed above. West - Homebuilding revenues increased 114.1% in fiscal 2016 compared to fiscal 2015 primarily due to an 84.4% increase in homes delivered, mainly resulting from increased community count, as well as a 16.2% increase in average sales price, which was due to the different mix of communities delivering in fiscal 2016 compared to fiscal 2015. Loss before income taxes decreased $20.6 million to income of $3.4 million in fiscal 2016 due mainly to the increase in homebuilding revenues discussed above, a $1.9 million decrease in inventory impairment loss and land option write-offs and an increase in gross margin percentage before interest expense. This decrease in loss was partially offset by a $3.6 million increase in selling, general and administrative costs. Homebuilding revenues decreased 30.5% in fiscal 2015 compared to fiscal 2014 primarily due to a 23.4% decrease in average sales price and a 9.4% decrease in homes delivered, which was due to the different mix of communities delivering, along with pricing pressure in certain communities in fiscal 2015 compared to fiscal 2014. Income before income taxes decreased $38.4 million to a loss of $17.1 million in fiscal 2015 due mainly to a $1.5 million increase in selling, general and administrative costs, a $2.1 million increase in inventory impairment loss and land option write-offs, a significant decrease in gross margin percentage before interest expense and the decrease in homebuilding revenues discussed above. Financial Services Financial services consist primarily of originating mortgages from our home buyers, selling such mortgages in the secondary market, and title insurance activities. We use mandatory investor commitments and forward sales of MBS to hedge our mortgage-related interest rate exposure on agency and government loans. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments and loan sales transactions is managed by limiting our counterparties to investment banks, federally regulated bank affiliates and other investors meeting our credit standards. Our risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments. For the years ended October 31, 2016, 2015 and 2014, FHA/VA loans represented 25.5%, 27.1%, and 28.4%, respectively, of our total loans. While the origination of FHA/VA loans have decreased over the last three fiscal years, our conforming conventional loan originations as a percentage of our total loans increased from 69.2% for fiscal 2014 and 2015 to 69.6% for fiscal 2016. The remaining 4.9%, 3.7% and 2.4% of our loan originations represent USDA and jumbo loans. Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer of the mortgage and the sales price is collected. During the years ended October 31, 2016, 2015, and 2014, financial services provided a $35.5 million, $24.7 million and $13.8 million pretax profit, respectively. In fiscal 2016, financial services pretax profit increased $10.8 million due to the increase in the percentage of homebuyers that used our mortgage company and the average price of loans settled. In fiscal 2015, financial services pretax profit increased $10.9 million compared to fiscal 2014 due to the same reasons discussed above. In the market areas served by our wholly owned mortgage banking subsidiaries, approximately 77%, 75%, and 65% of our noncash home buyers obtained mortgages originated by these subsidiaries during the years ended October 31, 2016, 2015, and 2014, respectively. Servicing rights on new mortgages originated by us are sold with the loans. Corporate General and Administrative Corporate general and administrative expenses include the operations at our headquarters in Red Bank, New Jersey. These expenses include payroll, stock compensation, facility and other costs associated with our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services and administration of insurance, quality and safety. Corporate general and administrative expenses decreased $2.4 million for the year ended October 31, 2016 compared to the year ended October 31, 2015, and decreased $0.9 million for the year ended October 31, 2015 compared to the year ended October 31, 2014. The decrease in expense for fiscal 2016 was due mainly to the reversal of previously recognized expense for certain performance based stock grants for which the performance metrics are no longer expected to be satisfied, along with a decrease in stock compensation expense resulting from lower fair values on our more recent grants. The decrease in expense for fiscal 2015 was due mainly to lower stock compensation expense, largely due to the impact of lower fair values on stock awards granted in fiscal 2015, and a remeasurement of the Company’s 2013 long term incentive plan, which reached the end of its measurement period on October 31, 2015. See the discussion of the stock awards granted under the Company’s 2013 long term incentive plan in Note 15 to the Consolidated Financial Statements. Other Interest Other interest decreased $0.8 million to $91.0 million for the year ended October 31, 2016 compared to October 31, 2015, but increased $4.5 million to $91.8 million for the year ended October 31, 2015 compared to October 31, 2014. Our assets that qualify for interest capitalization (inventory under development) are less than our debt, and therefore a portion of interest not covered by qualifying assets must be directly expensed. In fiscal 2016, the slight decrease was attributed to the reduction in total notes payable as a result of debt maturities that occured over the course of the year, offset by the increase in land banking transactions during the year. For fiscal 2015, other interest increased despite a continued increase in inventory because interest incurred increased as a result of higher debt balances, attributed primarily to the $250.0 million 8.0% Senior Notes due 2019 issued in November 2014. Other Operations Other operations consist primarily of the amortization of prepaid bond fees along with rent expense for commercial office space. Compared to the previous year, other operations decreased $1.1 million to $4.9 million for the year ended October 31, 2016, and increased $1.4 million to $6.0 million for the year ended October 31, 2015. This decrease in other operations for the year ended October 31, 2016 compared to the prior year was due to decreased prepaid bond fees amortization as a result of the maturity of our 11.875% Senior Notes due October 2015, 6.25% Senior Notes due January 2016 and 7.5% Senior Notes due May 2016. The increase in expenses from October 31, 2015 compared to October 31, 2014 was due to increased prepaid bond fees amortization as a result of the $250.0 million 8.0% Senior Notes due 2019 issued in November 2014. Loss on Extinguishment of Debt We incurred a $3.2 million loss on extinguishment of debt for the year ended October 31, 2016, due to the redemption of the remaining outstanding principal amount of our 8.625% Senior Notes due 2017 and the exchange of a portion of our Existing Second Lien Notes for Exchange Notes. These losses were slightly offset by a gain from the purchase of 20,823 6.0% Exchangeable Note Units due December 2017. We did not incur any loss on the extinguishment of debt for the year ended October 31, 2015. For the year ended October 31, 2014, our loss on extinguishment of debt was $1.2 million, due to the redemption of the remaining outstanding principal amount of our 6.25% Senior Notes due 2015. Income from Unconsolidated Joint Ventures (Loss) income from unconsolidated joint ventures consists of our share of the earnings or losses of our joint ventures. Income from unconsolidated joint ventures decreased $8.5 million for the year ended October 31, 2016 from income of $4.2 million for the year ended October 31, 2015 to a loss of $4.3 million for the year ended October 31, 2016. The decrease in income to a loss was mainly due to fewer deliveries at certain of our joint ventures and recognition of our share of losses on our newly formed joint ventures that have not yet begun delivering homes. Income from unconsolidated joint ventures decreased $3.7 million to $4.2 million for the year ended October 31, 2015 compared to $7.9 million for the year ended October 31, 2014. The decrease in income was due to fewer deliveries in certain of our joint ventures and recognition of our share of losses on our newly formed joint ventures that have not yet begun to deliver homes or just started delivering homes. Total Taxes The total income tax expense of $5.3 million for the period ended October 31, 2016 was primarily due to current state taxes and permanent differences related to stock compensation, partially offset by a federal tax benefit related to receiving a specified liability loss refund of taxes paid in fiscal year 2002. The total income tax benefit of $5.7 million recognized for the year ended October 31, 2015 was primarily due to deferred taxes resulting from the loss before income taxes plus the reversal of state tax reserves for uncertain state tax positions, partially offset by state tax expenses. The total income tax benefit of $287.0 million recognized for the year ended October 31, 2014 was primarily due to the reversal of a substantial portion of our valuation allowance previously recorded against our deferred tax assets, plus a refund received for a loss carryback to a previously profitable year and the impact of state tax reserves for uncertain state tax positions, partially offset by state tax expenses. Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. If the combination of future years’ income (or loss) and the reversal of the timing differences results in a loss, such losses can be carried forward to future years. In accordance with ASC 740, we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more likely than not” standard. As of October 31, 2015, and again at October 31, 2016, we concluded that it was more likely than not that a substantial amount of our deferred tax assets (“DTA”) would be utilized. This conclusion was based on a detailed evaluation of all relevant evidence, both positive and negative. The positive evidence included factors such as positive earnings before income taxes for two of the last three fiscal years and the expectation of earnings going forward over the long term and evidence of a sustained recovery in the housing markets in which we operate. Economic data has also been affirming the housing market recovery. Housing starts, homebuilding volume and prices are increasing and forecasted to continue to increase. Historically low mortgage rates, affordable home prices, reduced foreclosures and a favorable home ownership to rental comparison are key factors in the recovery. Potentially offsetting this positive evidence is the fact that we had a loss before income taxes for the fiscal year ended October 31, 2015. However, we did have income before income taxes for the twelve months ended October 31, 2016 and October 31, 2014 and we are not in a three year cumulative loss position as of October 31, 2016. As per ASC 740, cumulative losses are one of the most objectively verifiable forms of negative evidence; we no longer have this negative evidence and we expect to be profitable going forward over the long term. Our recent three years cumulative performance and our expectations for the coming years based on our current backlog, community count and recent sales contracts provide evidence that reaffirms our conclusion that a full valuation allowance was not necessary and that the current valuation allowance for deferred taxes of $627.9 million as of October 31, 2016 is appropriate. Off-Balance Sheet Financing In the ordinary course of business, we enter into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Lot option contracts enable us to control significant lot positions with a minimal capital investment and substantially reduce the risks associated with land ownership and development. At October 31, 2016, we had $62.1 million in option deposits in cash and letters of credit to purchase land and lots with a total purchase price of $952.6 million. Our financial exposure is generally limited to forfeiture of the nonrefundable deposits, letters of credit and other nonrefundable amounts incurred. We have no material third-party guarantees. Contractual Obligations The following summarizes our aggregate contractual commitments at October 31, 2016. (1) Total contractual obligations exclude our accrual for uncertain tax positions of $1.4 million recorded for financial reporting purposes as of October 31, 2016 because we were unable to make reasonable estimates as to the period of cash settlement with the respective taxing authorities. (2) Represents our revolving credit facility, senior secured term loan, senior secured, senior, senior amortizing and senior exchangeable notes, and other notes payable and $409.8 million of related interest payments for the life of such debt. (3) Does not include $83.5 million of nonrecourse mortgages secured by inventory. These mortgages have various maturities spread over the next two to three years and are paid off as homes are delivered. (4) Does not include the mortgage warehouse lines of credit made under our Master Repurchase Agreements. See“- Capital Resources and Liquidity.” Also does not include $17.9 million of letters of credit issued as of October 31, 2016 under our $75.0 million revolving Credit Facility. (5) Represents obligations under option contracts with specific performance provisions, net of cash deposits. We had outstanding letters of credit and performance bonds of $19.6 million and $221.3 million, respectively, at October 31, 2016, related principally to our obligations to local governments to construct roads and other improvements in various developments. We do not believe that any such letters of credit or bonds are likely to be drawn upon. Inflation Inflation has a long-term effect, because increasing costs of land, materials and labor result in increasing sale prices of our homes. In general, these price increases have been commensurate with the general rate of inflation in our housing markets and have not had a significant adverse effect on the sale of our homes. A significant risk faced by the housing industry generally is that rising house construction costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers. Inflation has a lesser short-term effect, because we generally negotiate fixed-price contracts with many, but not all, of our subcontractors and material suppliers for the construction of our homes. These prices usually are applicable for a specified number of residential buildings or for a time period of between three to twelve months. Construction costs for residential buildings represent approximately 53% of our homebuilding cost of sales. Safe Harbor Statement All statements in this Annual Report on Form 10-K that are not historical facts should be considered as “Forward-Looking Statements” within the meaning of the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include but are not limited to statements related to the Company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements: (i) speak only as of the date they are made, (ii) are not guarantees of future performance or results and (iii) are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as result of a variety of factors. Such risks, uncertainties and other factors include, but are not limited to: ● Changes in general and local economic, industry and business conditions and impacts of the sustained homebuilding downturn; ● Adverse weather and other environmental conditions and natural disasters; ● Levels of indebtedness and restrictions on the Company’s operations and activities imposed by the agreements governing the Company’s outstanding indebtedness; ● The Company’s sources of liquidity; ● Changes in credit ratings; ● Changes in market conditions and seasonality of the Company’s business; ● The availability and cost of suitable land and improved lots; ● Shortages in, and price fluctuations of, raw materials and labor; ● Regional and local economic factors, including dependency on certain sectors of the economy, and employment levels affecting home prices and sales activity in the markets where the Company builds homes; ● Fluctuations in interest rates and the availability of mortgage financing; ● Changes in tax laws affecting the after-tax costs of owning a home; ● Operations through joint ventures with third parties; ● Government regulation, including regulations concerning development of land, the home building, sales and customer financing processes, tax laws and the environment; ● Product liability litigation, warranty claims and claims made by mortgage investors; ● Levels of competition; ● Availability and terms of financing to the Company; ● Successful identification and integration of acquisitions; ● Significant influence of the Company’s controlling stockholders; ● Availability of net operating loss carryforwards; ● Utility shortages and outages or rate fluctuations; ● Geopolitical risks, terrorist acts and other acts of war; ● Increases in cancellations of agreements of sale; ● Loss of key management personnel or failure to attract qualified personnel; ● Information technology failures and data security breaches; and ● Legal claims brought against us and not resolved in our favor. Certain risks, uncertainties and other factors are described in detail in Part I, Item 1 “Business” and Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K as updated by our subsequent filings with the SEC. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Annual Report on Form 10-K.

<s>[INST] Overview During fiscal 2016, we continued to experience some positive operating trends compared to fiscal 2015. The Company had income before income taxes of $2.4 million for the year ended October 31, 2016, compared to a loss before income taxes of $21.8 million for the year ended October 31, 2015. For the year ended October 31, 2016, sale of homes revenue increased 24.6% as compared to the prior year. The increase in revenues was primarily due to a 17.4% increase in deliveries, along with an increase in average price per home, which was a result of changes in geographic and community mix of our deliveries. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased to 9.2% for the year ended October 31, 2016 compared to 11.7% for the year ended October 31, 2015. These positive operating improvements were largely offset by a decrease in gross margin percentage, before cost of sales interest expense and land charges, which decreased from 17.6% for the year ended October 31, 2015 to 16.9% for the year ended October 31, 2016. This decrease was a result of deliveries in certain of our new communities in the year ended October 31, 2016 having higher land costs as a percentage of revenue compared to deliveries in the same period of the prior year, as well as higher construction costs in many of our markets. Net contracts per average active selling community increased to 31.3 for the year ended October 31, 2016 compared to 30.0 in the same period in the prior year. However, net contracts decreased slightly by 1.2% for the year ended October 31, 2016 as compared to the prior year, as active selling communities decreased from 219 at October 31, 2015 to 167 at October 31, 2016, as discussed further below. When comparing sequentially from the third quarter of fiscal 2016 to the fourth quarter of fiscal 2016, our gross margin percentage, before cost of sales interest expense and land charges, increased to 17.6% compared to 16.9%. Selling, general and administrative costs decreased $14.3 million for the fourth quarter of fiscal 2016 compared to the third quarter of fiscal 2016, primarily due to a $9.2 million adjustment to our construction defect reserves, based on our annual actuarial analysis of estimated construction defect costs on previously delivered homes. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue decreased from 9.3% to 6.7% in the fourth quarter of fiscal 2016 compared to the third quarter of fiscal 2016 as a result of the decrease in selling, general and administrative costs, along with a 12.0% increase in homebuilding revenues in the fourth quarter. We had 2,398 homes in backlog with a dollar value of $1.1 billion at October 31, 2016 (a decrease of 12.1% in dollar value compared to the year ended October 31, 2015). Despite this decrease in backlog, we believe the improvement in our selling, general and administrative costs and reduction in interest expense as a result of reducing our notes payable balance by $249.8 million during fiscal 2016 are positive factors for fiscal 2017 compared with fiscal 2016. However, several challenges, such as economic weakness and uncertainty, lower oil prices (which could affect our Texas markets), the restrictive mortgage lending environment and rising mortgage interest rates, continue to impact the housing market and, consequently, our performance. Additionally, we could be negatively impacted by our inability to access capital as described below under “ Capital Resources and Liquidity.” Both national new home sales and our home sales remain below historical levels. We continue to believe that we are still in the early stages of the housing recovery. However, given our recent uneven operating performance, we may continue [/INST] Negative. </s>

HOVNANIAN ENTERPRISES INC

2017-12-28

2017-10-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview During fiscal 2016, we had approximately $260 million of bonds mature, which we were unable to refinance because financing was unavailable in the capital markets to companies with comparable credit ratings to ours. As a result, we shifted our focus from growth to gaining operating efficiencies and improving our bottom line, and in order to preserve and increase cash to fund our maturing debt, we decided to temporarily reduce the amount of cash we were spending on future land acquisitions and to exit from four underperforming markets during fiscal 2016. In addition, we increased our use of land banking and joint ventures in order to enhance our liquidity position. The net effect of these liquidity enhancing efforts was to temporarily reduce our ability to invest as aggressively in new land parcels as previously planned. This resulted in a reduction in our community count in fiscal 2016 and 2017, along with a decrease in net contracts during these periods, as compared to the prior year periods. However, in the fourth quarter of fiscal 2016, we were able to refinance certain of our debt maturities and had homebuilding cash of $339.8 million as of October 31, 2016. In addition, in July 2017, we successfully refinanced and extended the maturities of certain of our senior secured notes which were scheduled to mature in October 2018 and October and November 2020, with $440.0 million of new senior secured notes maturing in July 2022 and $400.0 million of new senior secured notes maturing in July 2024. While these transactions extended the maturities of a significant amount of debt giving us the ability to more fully invest in new communities again, they also resulted in a $42.3 million loss on early extinguishment of debt. When added to prior period results, this created a three-year cumulative loss, which led us to reconsider the realizability of our deferred tax assets in accordance with GAAP and record a $294.1 million non-cash increase in the valuation allowance for our deferred tax assets. See Note 11 to our Consolidated Financial Statements. Our cash position in fiscal 2017 has allowed us to spend $555.0 million on land purchases and land development during fiscal 2017 and still have $463.7 million of homebuilding cash and cash equivalents as of October 31, 2017. This cash and the July 2017 refinancing transaction, by extending our debt maturities, will enable us to allocate additional cash to further grow our business. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales pace and plan to continue actively pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability. The above factors during fiscal 2016 led to a reduction in our land position and a 22.2% decline in our community count for fiscal 2017 as compared to fiscal 2016 and as a result, during fiscal 2017, we experienced mixed operating results compared to the prior year. Net contracts per average active selling community increased 12.1% to 35.1 for the year ended October 31, 2017 compared to 31.3 in the same period in the prior year. This improvement in net contracts per average active selling community demonstrates an increase in sales absorption, which allows us to be more efficient by permitting us to deliver more homes per community without any increase in fixed overheads in those communities. Active selling communities decreased from 167 at October 31, 2016 to 130 at October 31, 2017, and net contracts decreased 14.9% for the year ended October 31, 2017, compared to the same period of the prior year. For the year ended October 31, 2017, sale of homes revenues decreased 10.0% as compared to the same period of the prior year, as a result of the decreased community count. Gross margin percentage increased from 12.2% for the year ended October 31, 2016 to 13.2% for the year ended October 31, 2017. Gross margin percentage, before cost of sales interest expense and land charges, increased slightly from 16.9% for the year ended October 31, 2016 to 17.2% for the year ended October 31, 2017. The improvements in both gross margin percentage and gross margin percentage, before cost of sales interest expense and land charges, are primarily the result of the mix of communities delivering homes and the reduction of our warranty reserves, rather than significant changes in prices or costs. Additionally, gross margin percentage improved due to a decrease in land charges for the year ended October 31, 2017 compared to the prior year because of the impairments recorded in fiscal 2016, which related to the sale of our land portfolio in Minneapolis, Minnesota. Selling, general and administrative costs (including corporate general and administrative expenses) increased $2.6 million for the year ended October 31, 2017 as compared to the prior year. As a percentage of total revenue such costs increased from 9.2% for the year ended October 31, 2016, to 10.4% for the year ended October 31, 2017 due to the decrease in sale of homes revenues resulting from our decreased community count, as discussed above. The increase in selling, general and administrative costs (including corporate general and administrative expenses) is primarily due to a $12.5 million adjustment recorded during the fourth quarter of fiscal 2017 to our construction defect reserves related to litigation. Excluding this adjustment, selling, general and administrative costs (including corporate general and administrative expenses) decreased $9.9 million for the year ended October 31, 2017 as compared to the prior year. When comparing sequentially from the third quarter of fiscal 2017 to the fourth quarter of fiscal 2017, our gross margin percentage increased from 12.8% to 13.7% and our gross margin percentage, before cost of sales interest expense and land charges, increased from 16.8% to 18.2%. Gross margin percentage increased primarily as a result of product mix and the reduction of our warranty reserves, along with price increases in certain communities primarily in the West. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenues decreased slightly from 10.3% to 10.1%, as compared to the third quarter of fiscal 2017, and decreased to 8.4% excluding the adjustment to our construction defect reserves discussed above. Selling, general and administrative costs include some fixed costs that are not impacted by delivery volume. Therefore, as revenues increased from the third quarter of fiscal 2017 to the fourth quarter of fiscal 2017, consistent with our normal seasonality trends, selling, general and administrative costs as a percentage of total revenues decreased. Improving the efficiency of our selling, general and administrative expenses will continue to be a significant area of focus. We had 1,983 homes in backlog with a dollar value of $808.0 million at October 31, 2017 (a decrease of 24.4% in dollar value compared to the prior year). As discussed above, we have invested $555.0 million in land purchases and land development during fiscal 2017, which along with continued land acquisitions is expected to eventually result in community count growth. However, there is typically a significant time lag from when we first control lots until the time that we open a community for sale. This timeline can vary significantly from a few months (in a market such as Houston) to three to five years (in a market such as New Jersey). Given the mix of land that we currently control and the land investment we currently anticipate, we are not expecting community count growth until the second half of fiscal 2018. Once our community count grows, absent adverse market factors, we expect delivery and revenue growth will follow. Our fourth quarter results in fiscal 2017 were impacted by Hurricane Harvey. Fortunately, less than ten homes within two of our 45 Houston communities experienced flood damage. The storm damage and construction delays caused by Hurricane Harvey reduced our fourth quarter deliveries and may impact fiscal 2018 results. In spite of this temporary impact, the long-term prospect for the Houston market remains strong. The fourth quarter of fiscal 2017 results were also negatively impacted by an issue related to I-joist’s coated with a certain type of fire resistance product that were manufactured by Weyerhaeuser Company. The Company identified a total of 63 homes located in our Delaware and New Jersey markets that were affected. Of these 63 impacted homes, 30 were scheduled to close in fiscal 2017 and did not as a result of this issue. Weyerhaeuser has accepted responsibility and is presently remediating all affected homes and we will not incur any material costs, expenses or charges as a result. We experienced a combination of delayed closings and cancellations with respect to these units which had a negative impact on net orders, closings and revenue in the fourth quarter of fiscal 2017. Subsequent to our fiscal year-end, there have been significant wildfires throughout Southern California. While none of our communities have been directly affected, we could experience labor shortages, construction delays or utility company delays, which in turn could impact our fiscal 2018 results. Critical Accounting Policies Management believes that the following critical accounting policies require its most significant judgments and estimates used in the preparation of the consolidated financial statements: Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of mortgage backed securities (“MBS”) to hedge our mortgage-related interest rate exposure on agency and government loans. We elected the fair value option for our mortgage loans held for sale in accordance with Accounting Standards Codification (“ASC”) 825, “Financial Instruments,” which permits us to measure our loans held for sale at fair value. Management believes that the election of the fair value option for loans held for sale improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We believe there continues to be an industry-wide issue with the number of purchaser claims in which purchasers purport to have found inaccuracies related to the sellers’ representations and warranties in particular loan sale agreements. We have established reserves for probable losses. While we believe these reserves are adequate for known losses and projected repurchase requests, given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, if either actual repurchases or the losses incurred resolving those repurchases exceed our expectations, additional expense may be incurred. Inventories - Inventories consist of land, land development, home construction costs, capitalized interest, construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type. We record inventories in our consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all costs related to specific performance options, variable interest entities and other options, which consists primarily of model homes financed with an investor and inventory related to land banking arrangements accounted for as financings. We decide to mothball (or stop development on) certain communities when we determine that the current performance does not justify further investment at the time. When we decide to mothball a community, the inventory is reclassified on our Consolidated Balance Sheets from “Sold and unsold homes and lots under development” to “Land and land options held for future development or sale.” As of October 31, 2017, the net book value associated with our 22 mothballed communities was $36.7 million, net of impairment charges recorded in prior periods of $214.1 million. We regularly review communities to determine if mothballing is appropriate. During fiscal 2017, we did not mothball any communities, but we sold five previously mothballed communities and re-activated two previously mothballed communities. From time to time we enter into option agreements that include specific performance requirements, whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with ASC 360-20-40-38, we are required to record this inventory on our Consolidated Balance Sheets. As of October 31, 2017, we had no specific performance options recorded on our Consolidated Balance Sheets. Consolidated inventory not owned also consists of other options that were included on our Consolidated Balance Sheets in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheets, at October 31, 2017, inventory of $58.5 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $51.8 million recorded to “Liabilities from inventory not owned.” We have land banking arrangements, whereby we sell our land parcels to the land banker and they provide us an option to purchase back finished lots on a quarterly basis. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 360-20-40-38, these transactions are considered financings rather than sales. For purposes of our Consolidated Balance Sheets, at October 31, 2017, inventory of $66.3 million was recorded as “Consolidated inventory not owned,” with a corresponding amount of $39.3 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. The recoverability of inventories and other long-lived assets is assessed in accordance with the provisions of ASC 360-10, “Property, Plant and Equipment − Overall” (“ASC 360-10”). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure. We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable. The projected operating profits, losses, or cash flows of each community can be significantly impacted by our estimates of the following: ● future base selling prices; ● future home sales incentives; ● future home construction and land development costs; and ● future sales absorption pace and cancellation rates. These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include: ● the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors; ● the current sales absorption pace for both our communities and competitor communities; ● community specific attributes, such as location, availability of lots in the market, desirability and uniqueness of our community, and the size and style of homes currently being offered; ● potential for alternative product offerings to respond to local market conditions; ● changes by management in the sales strategy of the community; ● current local market economic and demographic conditions and related trends of forecasts; and ● existing home inventory supplies, including foreclosures and short sales. These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair-value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful to an investor. If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written down to its fair value. We determine the estimated fair value of each community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from outside third parties. Our discount rates used for all impairments recorded from October 31, 2015 to October 31, 2017 ranged from 16.8% to 19.8%. The estimated future cash flow assumptions are virtually the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis. From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed not probable that the optioned property will be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant in comparison to the total costs written off. Inventories held for sale are land parcels ready for sale in their current condition, where we have decided not to build homes but are instead actively marketing for sale. These land parcels represented $23.6 million and $48.7 million of our total inventories at October 31, 2017 and 2016, respectively, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interests in the joint ventures vary but our voting interests are generally 50% or less. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, we assess whether the other partners have specific rights to overcome the presumption of control by us as the manager of the joint venture. In most cases, the presumption is overcome because the joint venture agreements require that both partners agree on establishing the significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, “Investments - Equity Method and Joint Ventures - Overall,” we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment below its carrying amount is other than temporary, we write down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture’s projected cash flows. This process requires significant management judgment and estimates. During fiscal 2017, we wrote down certain joint venture investments by $2.8 million. There were no write-downs in fiscal 2016 or 2015. Post-Development Completion, Warranty Costs and Insurance Deductible Reserves - In those instances where a development is substantially completed and sold and we have additional construction work to be incurred, an estimated liability is provided to cover the cost of such work. We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general, and administrative costs. For homes delivered in fiscal 2017 and 2016, our deductible under our general liability insurance is a $20 million aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2017 and 2016 is $0.25 million, up to a $5 million limit. Our aggregate retention in fiscal 2017 and 2016 is $21 million for construction defect, warranty and bodily injury claims. We do not have a deductible on our worker's compensation insurance. Reserves for estimated losses for construction defects, warranty and bodily injury claims have been established using the assistance of a third-party actuary. We engage a third-party actuary that uses our historical warranty and construction defect data to assist our management in estimating our unpaid claims, claim adjustment expenses and incurred but not reported claims reserves for the risks that we are assuming under the general liability and construction defect programs. The estimates include provisions for inflation, claims handling and legal fees. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. In addition, we establish a warranty accrual for lower cost-related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and title and possession have been transferred to the homebuyer. See Note 16 to the Consolidated Financial Statements for additional information on the amount of warranty costs recognized in cost of goods sold and administrative expenses. Deferred Income Taxes - Deferred income taxes are provided for temporary differences between amounts recorded for financial reporting and for income tax purposes. If the combination of future years’ income (or loss) combined with the reversal of the timing differences results in a loss, such losses can be carried back to prior years or carried forward to future years to recover the deferred tax assets. In accordance with ASC 740-10, “Income Taxes - Overall” (“ASC 740-10”), we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740-10 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more-likely-than-not” standard. See “Total Taxes” below under “Results of Operations” for further discussion of the valuation allowances. In evaluating the exposures associated with our various tax filing positions, we recognize tax liabilities in accordance with ASC 740-10, for more likely than not exposures. We re-evaluate the exposures associated with our tax positions on a quarterly basis. This evaluation is based on factors such as changes in facts or circumstances, changes in tax law, new audit activity by taxing authorities and effectively settled issues. Determining whether an uncertain tax position is effectively settled requires judgment. Such a change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision. A number of years may elapse before a particular matter for which we have established a liability is audited and fully resolved or clarified. We adjust our liability for unrecognized tax benefits and income tax provision in the period in which an uncertain tax position is effectively settled, or the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. Due to the complexity of some of these uncertainties, the ultimate resolution may result in a liability that is materially different from our current estimate. Any such changes will be reflected as increases or decreases to income tax expense in the period in which they are determined. Recent Accounting Pronouncements See Note 3 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Capital Resources and Liquidity Our operations consist primarily of residential housing development and sales in the Northeast (New Jersey and Pennsylvania), the Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia), the Midwest (Illinois and Ohio), the Southeast (Florida, Georgia and South Carolina), the Southwest (Arizona and Texas) and the West (California). In addition, we provide certain financial services to our homebuilding customers. We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our credit facilities, the issuance of new debt and equity securities and other financing activities. Due to covenant restrictions in our debt instruments, we are currently limited in the amount of debt we can incur that does not qualify as refinancing indebtedness with certain maturity requirements (a limitation that we expect to continue for the foreseeable future), even if market conditions would otherwise be favorable, which could also impact our ability to grow our business. In fiscal 2016, as a result of our evaluation of our geographic operating footprint as it relates to our strategic objectives, we exited the Minneapolis, Minnesota and Raleigh, North Carolina markets, and completed the sale of our land portfolios in those markets. In addition, we entered into a new joint venture by transferring eight communities to the joint venture and receiving cash in return. In fiscal 2017, we transferred an additional four communities to the joint venture, which resulted in $11.2 million of net cash proceeds to us during the period. We are in the process of completing a wind down of our operations in the San Francisco Bay area in Northern California and in Tampa, Florida by building and delivering homes to sell through our existing land position. Any other liquidity-enhancing transaction will depend on identifying counterparties, negotiation of documentation and applicable closing conditions and any required approvals. Operating, Investing and Financing Activities - Overview Our homebuilding cash balance at October 31, 2017 increased $123.9 million from October 31, 2016 to $463.7 million, which is above our target liquidity range of $170 million to $245 million. We would prefer to have our cash fully invested, but we are being disciplined in our underwriting of new land deals and the methods in which we control land (through more options and fewer direct purchases). In addition to using cash to pay down debt during fiscal 2017, we spent $555.0 million on land and land development. After considering this land and land development and all other operating activities, including revenue received from deliveries, we generated $297.6 million of cash from operations. During fiscal 2017, cash used in investing activities was $27.2 million, primarily related to investments in existing joint ventures, along with an investment in a new joint venture. Cash used in financing activities was $147.8 million during fiscal 2017, which included $862.0 million for repurchases of debt, $840.0 million of proceeds for debt issuances, $61.1 million used for model finance and land banking programs and a $31.0 million reduction in mortgage warehouse lines of credit. We intend to continue to use nonrecourse mortgage financings, model sale leaseback, joint ventures, and, subject to covenant restrictions in our debt instruments, land banking programs as our business needs dictate. Our cash uses during the year ended October 31, 2017 and 2016 were for operating expenses, land purchases, land deposits, land development, construction spending, debt payments, state income taxes, interest payments and investments in joint ventures. During these periods, we provided for our cash requirements from available cash on hand, housing and land sales, financing transactions, model sale leasebacks, land banking transactions, joint ventures, financial service revenues and other revenues. We believe that these sources of cash will be sufficient through fiscal 2018 to finance our working capital requirements. Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, mortgage loans held for sale, interest and other accrued liabilities, deferred income taxes, accounts payable and other liabilities, and noncash charges relating to depreciation, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is partially offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease, causing us to generate positive cash flow from operations. In fiscal 2017, with spending on land purchases and land development relatively flat as compared to fiscal 2016, we continued to generate cash from operations. As we continue to increase spending on land purchases and land development, cash flow from operations will decrease. As we continue to actively seek land investment opportunities, we will also remain focused on liquidity. See “Inventory Activities” below for a detailed discussion of our inventory position. Debt Transactions As of October 31, 2017, we had a $75.0 million outstanding senior secured term loan facility (the “Term Loan Facility”) ($73.0 million net of debt issuance costs), and $1,110.0 million of outstanding senior secured notes ($1,090.6 million, net of discount and debt issuance costs), comprised of $53.2 million 2.0% 2021 Notes (defined below), $141.8 million 5.0% 2021 Notes (defined below), $75.0 million 9.50% 2020 Notes (defined below), $440.0 million 10.0% Senior Secured Notes due 2022 and $400.0 million 10.5% Senior Secured Notes due 2024. As of October 31, 2017, we also had $368.5 million of outstanding senior notes ($366.3 million net of debt issuance costs), comprised of $132.5 million 7.0% Senior Notes due 2019 and $236.0 million 8.0% Senior Notes due 2019. In addition, as of October 31, 2017, we had outstanding $2.1 million 11.0% Senior Amortizing Notes due 2017 (issued as a component of our 6.0% Exchangeable Note Units) ($2.0 million net of debt issuance costs) and $53.9 million Senior Exchangeable Notes due 2017 (issued as a component of our 6.0% Exchangeable Note Units) ($53.9 million net of debt issuance costs). Except for K. Hovnanian, the issuer of the notes, our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures and certain of our title insurance subsidiaries, we and each of our subsidiaries are guarantors of the Term Loan Facility and senior secured, senior, senior amortizing and senior exchangeable notes outstanding at October 31, 2017 (collectively, the “Notes Guarantors”). In addition to the Notes Guarantors, the 5.0% Senior Secured Notes due 2021 (the “5.0% 2021 Notes”), the 2.0% Senior Secured Notes due 2021 (the “2.0% 2021 Notes” and together with the 5.0% 2021 Notes, the “2021 Notes”) and the 9.50% Senior Secured Notes due 2020 (the “9.50% 2020 Notes” and collectively with the 2021 Notes, the “JV Holdings Secured Group Notes”) are guaranteed by K. Hovnanian JV Holdings, L.L.C. and its subsidiaries, except for certain joint ventures and joint venture holding companies (collectively, the “JV Holdings Secured Group”). Members of the JV Holdings Secured Group do not guarantee K. Hovnanian's other indebtedness. The credit agreement governing the Term Loans (defined below) and the indentures governing the notes outstanding at October 31, 2017 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than nonrecourse indebtedness, certain permitted indebtedness and refinancing indebtedness (under the Term Loans and the 9.50% 2020 Notes, any new or refinancing indebtedness may not be scheduled to mature earlier than January 15, 2021 (so long as no member of the JV Holdings Secured Group is an obligor thereon), or February 15, 2021 (if otherwise), and under the 10.0% Senior Secured Notes due 2022 (the “10.0% 2022 Notes”) and the 10.5% Senior Secured Notes due 2024 (the “10.5% 2024 Notes”), any refinancing indebtedness of the 7.0% Senior Notes due 2019 (the “7.0% Notes”) and 8.0% Senior Notes due 2019 (the “8.0% Notes” and together with the 7.0% Notes, the “2019 Notes”) may not be scheduled to mature earlier than July 16, 2024)), pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness (with respect to the Term Loans and certain of the senior secured and senior notes) and common and preferred stock, make other restricted payments, including investments, sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets, enter into certain transactions with affiliates and make cash repayments of the 2019 Notes (with respect to the 10.0% 2022 Notes and 10.5% 2024 Notes). The credit agreement governing the Term Loans and the indentures also contain events of default which would permit the lenders/holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Term Loan facility (the “Term Loans”)/notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Term Loans/notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Term Loans, material inaccuracy of representations and warranties and a change of control, and, with respect to the Term Loans and senior secured notes, the failure of the documents granting security for the Term Loans and senior secured notes to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the Term Loans and senior secured notes to be valid and perfected. As of October 31, 2017, we believe we were in compliance with the covenants of the Term Loan Facility and the indentures governing our outstanding notes. If our consolidated fixed charge coverage ratio, as defined in the agreements governing our debt instruments (other than the senior exchangeable note units discussed below), is less than 2.0 to 1.0, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness and nonrecourse indebtedness. As a result of this ratio restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. We anticipate that we will continue to be restricted from paying dividends for the foreseeable future. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our debt instruments or otherwise affect compliance with any of the covenants contained in our debt instruments. Under the terms of our debt agreements, we have the right to make certain redemptions and prepayments and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to evaluate our capital structure and may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions. During the year ended October 31, 2017, we repurchased in open market transactions $17.5 million aggregate principal amount of 7.0% Notes, $14.0 million aggregate principal amount of 8.0% Notes and 6,925 senior exchangeable note units representing $6.9 million stated amount of senior exchangeable note units. The aggregate purchase price for these transactions was $30.8 million, plus accrued and unpaid interest. These transactions resulted in a gain on extinguishment of debt of $7.8 million, which is included as “Loss on Extinguishment of Debt” on the Consolidated Statement of Operations. This gain was offset by $0.4 million of costs associated with the 9.50% 2020 Notes issued during the fourth quarter of fiscal 2016 and the debt transactions during the third quarter of fiscal 2017 discussed below. On July 27, 2017, K. Hovnanian issued $440.0 million aggregate principal amount of 10.0% 2022 Notes and $400.0 million aggregate principal amount of 10.5% 2024 Notes. The net proceeds from these issuances together with available cash were used to (i) purchase $575,912,000 principal amount of 7.25% Senior Secured First Lien Notes due 2020 (the “7.25% First Lien Notes”), $87,321,000 principal amount of 9.125% Senior Secured Second Lien Notes due 2020 (the “9.125% Second Lien Notes” and, together with the 7.25% First Lien Notes, the “2020 Secured Notes”) and all $75,000,000 principal amount of 10.0% Senior Secured Second Lien Notes due 2018 (the “10.0% Second Lien Notes”) that were tendered and accepted for purchase pursuant to K. Hovnanian’s offers to purchase for cash (the “Tender Offers”) any and all of the 7.25% First Lien Notes, the 9.125% Second Lien Notes and the 10.0% Second Lien Notes and to pay related tender premiums and accrued and unpaid interest thereon to the date of purchase and (ii) satisfy and discharge all obligations (and cause the release of the liens on the collateral securing such indebtedness) under the indentures under which the 7.25% First Lien Notes, the 9.125% Second Lien Notes and the 10.0% Second Lien Notes were issued and in connection therewith to call for redemption on October 15, 2017 and on November 15, 2017 all remaining $1,088,000 principal amount of 7.25% First Lien Notes and all remaining $57,679,000 principal amount of 9.125% Second Lien Notes, respectively, that were not validly tendered and purchased in the applicable Tender Offer in accordance with the redemption provisions of the indentures governing the 2020 Secured Notes. These transactions resulted in a loss on extinguishment of debt of $42.3 million, which is included as “Loss on Extinguishment of Debt” on the Consolidated Statement of Operations. The 10.0% 2022 Notes have a maturity of July 15, 2022 and bear interest at a rate of 10.0% per annum payable semi-annually on January 15 and July 15 of each year, commencing January 15, 2018, to holders of record at the close of business on January 1 and July 1, as the case may be, immediately preceding such interest payment dates. The 10.0% 2022 Notes are redeemable in whole or in part at our option at any time prior to July 15, 2019 at 100.0% of their principal amount plus an applicable “Make-Whole Amount.” K. Hovnanian may also redeem some or all of the 10.0% 2022 Notes at 105.0% of principal commencing July 15, 2019, at 102.50% of principal commencing July 15, 2020 and at 100.0% of principal commencing July 15, 2021. In addition, K. Hovnanian may also redeem up to 35% of the aggregate principal amount of the 10.0% 2022 Notes prior to July 15, 2019 with the net cash proceeds from certain equity offerings at 110.0% of principal. The 10.5% 2024 Notes have a maturity of July 15, 2024 and bear interest at a rate of 10.5% per annum payable semi-annually on January 15 and July 15 of each year, commencing January 15, 2018, to holders of record at the close of business on January 1 and July 1, as the case may be, immediately preceding such interest payment dates. The 10.5% 2024 Notes are redeemable in whole or in part at our option at any time prior to July 15, 2020 at 100.0% of their principal amount plus an applicable “Make-Whole Amount.” K. Hovnanian may also redeem some or all of the 10.5% 2024 Notes at 105.25% of principal commencing July 15, 2020, at 102.625% of principal commencing July 15, 2021 and at 100.0% of principal commencing July 15, 2022. In addition, K. Hovnanian may also redeem up to 35.0% of the aggregate principal amount of the 10.5% 2024 Notes prior to July 15, 2020 with the net cash proceeds from certain equity offerings at 110.50% of principal. All of K. Hovnanian’s obligations under the 10.0% 2022 Notes and the 10.5% 2024 Notes are guaranteed by the Notes Guarantors. In addition to pledges of the equity interests in K. Hovnanian and the subsidiary Notes Guarantors which secure the 10.0% 2022 Notes and the 10.5% 2024 Notes, the 10.0% 2022 Notes and the 10.5% 2024 Notes and the guarantees thereof will also be secured in accordance with the terms of the indenture and security documents governing such Notes by pari passu liens on substantially all of the assets owned by K. Hovnanian and the Notes Guarantors, in each case subject to permitted liens and certain exceptions (the collateral securing the 10.0% 2022 Notes and the 10.5% 2024 Notes will be the same as that securing the Term Loans). The liens securing the 10.0% 2022 Notes and the 10.5% 2024 Notes rank junior to the liens securing the Term Loans and any other future secured obligations that are senior in priority with respect to the assets securing the 10.0% 2022 Notes and the 10.5% 2024 Notes. In connection with the issuance of the 10.0% 2022 Notes and the 10.5% 2024 Notes, K. Hovnanian and the Notes Guarantors entered into security and pledge agreements pursuant to which K. Hovnanian and the Notes Guarantors pledged substantially all of their assets to secure their obligations under the 10.0% 2022 Notes and the 10.5% 2024 Notes, subject to permitted liens and certain exceptions as set forth in such agreements. K. Hovnanian and the Notes Guarantors also entered into applicable intercreditor and collateral agency agreements which set forth agreements with respect to the relative priority of their various secured obligations. The indenture governing the 10.0% 2022 Notes and the 10.5% 2024 Notes was entered into on July 27, 2017 among K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as trustee and collateral agent. The covenants and events of default in the indenture are described above. See Note 9 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a further discussion of K. Hovnanian’s Term Loans, senior secured notes, senior notes and senior exchangeable note units. Mortgages and Notes Payable We have nonrecourse mortgage loans for certain communities totaling $64.5 million and $82.1 million (net of debt issuance costs) at October 31, 2017 and 2016, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $157.8 million and $201.8 million, respectively. The weighted-average interest rate on these obligations was 5.3% and 4.9% at October 31, 2017 and 2016, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries. We also had nonrecourse mortgage loans on our corporate headquarters totaling $13.0 million and $14.3 million at October 31, 2017 and 2016, respectively. These loans had a weighted-average interest rate of 8.9% at October 31, 2017 and 8.8% at October 31, 2016. As of October 31, 2017, these loans had installment obligations with annual principal maturities in the years ending October 31 of: $1.4 million in 2018, $1.5 million in 2019, $1.7 million in 2020, $1.8 million in 2021, $2.0 million in 2022 and $4.6 million after 2022. On November 1, 2017, the non-recourse loans on our corporate headquarters were paid in full, in connection with the sale of building. In June 2013, K. Hovnanian, as borrower, and we and certain of our subsidiaries, as guarantors, entered into a five-year, $75.0 million unsecured revolving credit facility (the “Credit Facility”) with Citicorp USA, Inc., as administrative agent and issuing bank, and Citibank, N.A., as a lender. The Credit Facility is available for both letters of credit and general corporate purposes. The Credit Facility does not contain any financial maintenance covenants, but does contain certain restrictive covenants that track those contained in our indenture governing the 8.0% Senior Notes due 2019, which are described in Note 9 to the Consolidated Financial Statements. The Credit Facility also contains certain customary events of default which would permit the administrative agent at the request of the required lenders to, among other things, declare all loans then outstanding to be immediately due and payable if such default is not cured within applicable grace periods, including the failure to make timely payments of amounts payable under the Credit Facility or other material indebtedness or the acceleration of other material indebtedness, the failure to comply with agreements and covenants or for representations or warranties to be correct in all material respects when made, specified events of bankruptcy and insolvency, and the entry of a material judgment against a loan party. Outstanding borrowings under the Credit Facility accrue interest at an annual rate equal to either, as selected by K. Hovnanian, (i) the alternate base rate plus the applicable spread determined on the date of such borrowing or (ii) an adjusted London Interbank Offered Rate (“LIBOR”) rate plus the applicable spread determined as of the date two business days prior to the first day of the interest period for such borrowing. As of October 31, 2017 there were $52.0 million of borrowings and $14.6 million of letters of credit outstanding under the Credit Facility. As of October 31, 2016, there were $52.0 million of borrowings and $17.9 million of letters of credit outstanding under the Credit Facility. As of October 31, 2017, we believe we were in compliance with the covenants under the Credit Facility. In addition to the Credit Facility which matures in 2018, we have certain stand-alone cash collateralized letter of credit agreements and facilities under which there were a total of $1.7 million letters of credit outstanding at both October 31, 2017 and 2016, respectively. These agreements and facilities require us to maintain specified amounts of cash as collateral in segregated accounts to support the letters of credit issued thereunder, which will affect the amount of cash we have available for other uses. At both October 31, 2017 and October 31, 2016, the amount of cash collateral in these segregated accounts was $1.7 million, respectively, which is reflected in “Restricted cash and cash equivalents” on the Consolidated Balance Sheets. Our wholly owned mortgage banking subsidiary, K. Hovnanian American Mortgage, LLC (“K. Hovnanian Mortgage”), originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are sold in the secondary mortgage market within a short period of time. In certain instances, we retain the servicing rights for a small amount of loans. The loans are secured by the mortgages held for sale and repaid when we sell the underlying mortgage loans to permanent investors. As of October 31, 2017 and 2016, we had an aggregate of $114.6 million and $145.6 million, respectively, outstanding under several of K. Hovnanian Mortgage’s short-term borrowing facilities. See Note 8 to the Consolidated Financial Statements for a discussion of these agreements and facilities. Equity On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 4 million shares of Class A Common Stock. We did not repurchase any shares under this program during fiscal 2017 or 2016. As of October 31, 2017, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 0.5 million. (See Part II, Item 5 for information on equity purchases). On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol “HOVNP.” In fiscal 2017, 2016 and 2015, we did not make any dividend payments on the Series A Preferred Stock as a result of covenant restrictions in our debt instruments. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future. Ratings Actions On November 9, 2015, Moody’s Investors Services (“Moody’s”) took certain rating actions as follows: ● Corporate Family Rating, downgraded to Caa1; ● Probability of Default Rating, downgraded to Caa1; ● 7.625% Series A Preferred Stock, downgraded to Caa3; ● First Lien Notes, downgraded to B1; ● Existing Second Lien Notes, downgraded to Caa1; and ● Senior unsecured notes, downgraded to Caa2. On December 9, 2015, Fitch Ratings (“Fitch”) took certain rating actions as follows: ● Long-term Issuer Default Rating, downgraded to CCC; ● First Lien Notes, downgraded to B; ● Existing Second Lien Notes, downgraded to CCC-; ● Senior unsecured notes, downgraded to CCC-; and ● 7.625% Series A Preferred Stock, downgraded to C. On April 20, 2016, Moody’s took certain rating actions as follows: ● Corporate Family Rating, downgraded to Caa2; ● Probability of Default Rating, downgraded to Caa2; ● 7.625% Series A Preferred Stock, downgraded to Ca; ● First Lien Notes, downgraded to B2; ● Existing Second Lien Notes, downgraded to Caa2; and ● Senior unsecured notes, downgraded to Caa3. On May 3, 2016, S&P Global Ratings took certain rating actions as follows: ● Corporate Credit Rating, downgraded to CCC+; ● First Lien Notes, downgraded to CCC+; ● 2021 Notes, downgraded to CCC; ● Existing Second Lien Notes, downgraded to CCC-; and ● Senior unsecured notes, downgraded to CCC-. On August 1, 2016, Moody’s took certain rating actions as follows: ● First Lien Notes, downgraded to B3; ● Existing Second Lien Notes, downgraded to Caa3 Downgrades in our credit ratings do not accelerate the scheduled maturity dates of our debt or affect the interest rates charged on any of our debt issues or our debt covenant requirements or cause any other operating issue. A potential risk from negative changes in our credit ratings is that they may make it more difficult or costly for us to access capital. Inventory Activities Total inventory, excluding consolidated inventory not owned, decreased $189.4 million during the year ended October 31, 2017 from October 31, 2016. Total inventory, excluding consolidated inventory not owned, decreased in the Northeast by $56.4 million, in the Mid-Atlantic by $26.1 million, in the Midwest by $19.1 million, in the Southwest by $49.8 million and in the West by $59.6 million. These decreases were partially offset by an increase in the Southeast of $21.6 million. These inventory fluctuations were primarily attributable to home deliveries and land sales during the period, partially offset by new land purchases and land development. During the year ended October 31, 2017, we had aggregate impairments in the amount of $15.1 million. We wrote-off costs in the amount of $2.7 million during the year ended October 31, 2017 related to land options that expired or that we terminated, as the communities’ forecasted profitability was not projected to produce adequate returns on investment commensurate with the risk. In the last few years, we have been able to acquire new land parcels at prices that we believe will generate reasonable returns under current homebuilding market conditions. There can be no assurances that this trend will continue in the near term. Substantially all homes under construction or completed and included in inventory at October 31, 2017 are expected to be closed during the next six to nine months. Consolidated inventory not owned decreased $83.9 million. Consolidated inventory not owned consists of options related to land banking and model financing transactions that were added to our Consolidated Balance Sheet in accordance with US GAAP. The decrease from October 31, 2016 to October 31, 2017 was primarily due to a decrease in land banking transactions along with a decrease in the sale and leaseback of certain model homes during the period. We have land banking arrangements, whereby we sell land parcels to the land bankers and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes in accordance with ASC 360-20-40-38, these transactions are considered a financing rather than a sale. For purposes of our Consolidated Balance Sheet, at October 31, 2017, inventory of $66.3 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $39.3 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. In addition, we sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheet, at October 31, 2017, inventory of $58.5 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $51.8 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. When possible, we option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option (other than with respect to specific performance options discussed above). As a result, our commitment for major land acquisitions is reduced. The costs associated with optioned properties are included in “Land and land options held for future development or sale” on the Consolidated Balance Sheets. Also included in “Land and land options held for future development or sale” are amounts associated with inventory in mothballed communities. We mothball (or stop development on) certain communities when we determine the current performance does not justify further investment at the time. That is, we believe we will generate higher returns if we decide against spending money to improve land today and save the raw land until such time as the markets improve or we determine to sell the property. As of October 31, 2017, we had mothballed land in 22 communities. The book value associated with these communities at October 31, 2017 was $36.7 million, which was net of impairment charges recorded in prior periods of $214.1 million. We continually review communities to determine if mothballing is appropriate. During fiscal 2017, we did not mothball any additional communities, but we sold five previously mothballed communities and re-activated two previously mothballed communities. Inventories held for sale, which are land parcels where we have decided not to build homes, represented $23.6 million and $48.7 million, respectively, of our total inventories at October 31, 2017 and October 31, 2016, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. The following tables summarize home sites included in our total residential real estate. The decrease in remaining home sites available at October 31, 2017 compared to October 31, 2016 was primarily attributable to our decreased community count and our delivering homes without investing in new land at the same rate during the period due to the reasons discussed above in “-Overview”. As previously discussed, based on our cash position at October 31, 2017, we expect to continue to actively seek new land investment opportunities in fiscal 2018. The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures, in active and substantially completed communities. The decrease in the total homes from October 31, 2016 to October 31, 2017 is due to the decrease in community count during the period. (1) Active selling communities (which are communities that are open for sale with ten or more home sites available) were 130 and 167 at October 31, 2017 and 2016, respectively. Ratio does not include substantially completed communities, which are communities with less than ten home sites available. Other Balance Sheet Activities Homebuilding - Restricted cash and cash equivalents decreased $1.8 million from October 31, 2016 to $2.1 million at October 31, 2017. The decrease was primarily due to the release of escrow cash related to our warranty obligations in certain communities which have been closed for more than a year. Investments in and advances to unconsolidated joint ventures increased $14.6 million during the fiscal year ended October 31, 2017 compared to October 31, 2016. The increase was primarily due to additional investments and advances to existing joint ventures during fiscal 2017, along with an investment in a new joint venture in the second quarter of fiscal 2017. These increases were partially offset by decreases primarily related to partner distributions during the period. As of both October 31, 2017 and October 31, 2016, we had investments in 10 homebuilding joint ventures and one land development joint venture. We have no guarantees associated with our unconsolidated joint ventures, other than guarantees limited only to performance and completion of development, environmental indemnification and standard warranty and representation against fraud misrepresentation and similar actions, including a voluntary bankruptcy. Receivables, deposits and notes, net increased $8.4 million from October 31, 2016 to $58.1 million at October 31, 2017. The increase was primarily due to a new receivable related to a land sale in the fourth quarter of fiscal 2017, partially offset by a decrease in refundable deposits resulting from reimbursements received during the period. Prepaid expenses and other assets were as follows as of: Prepaid insurance decreased due to the timing of premium payments. These costs are amortized over the life of the associated insurance policy, which can be one to three years. Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered and therefore have declined as our community count has declined. Financial services other assets consist primarily of residential mortgages receivable held for sale of which $131.5 million and $155.0 million at October 31, 2017 and 2016, respectively, were being temporarily warehoused and are awaiting sale in the secondary mortgage market. The decrease in mortgage loans held for sale from October 31, 2016 was related to a decrease in the volume of loans originated during the fourth quarter of 2017 compared to the fourth quarter of 2016, along with a decrease in the average loan value. Income Taxes Receivable decreased $285.8 million from $283.6 million at October 31, 2016 to a payable of $2.2 million at October 31, 2017. The decrease is due to the increase in the valuation allowance against our deferred tax assets during the period, as discussed in Note 11 to the Consolidated Financial Statements. Nonrecourse mortgages decreased to $64.5 million at October 31, 2017, from $82.1 million at October 31, 2016. The decrease was primarily due to the payment of existing mortgages, including a mortgage on a community which was transferred to a joint venture, partially offset by new mortgages for communities mainly in the Northeast, Mid-Atlantic and Southwest obtained during the year ended October 31, 2017. Accounts payable and other liabilities are as follows as of: The decrease in accounts payable was primarily due to the 14.2% decrease in deliveries in the fourth quarter of fiscal 2017 compared to the fourth quarter of fiscal 2016. Reserves increased during fiscal 2017 primarily due to an increase in our construction defect reserves due to an adjustment for litigation, partially offset by a reduction in our warranty reserves, which were reduced based on our annual assessment, as discussed in Note 16 to the Consolidated Financial Statements. The decrease in accrued expenses was primarily due to the amortization of accruals related to abandoned lease space along with the timing of other accruals. The increase in accrued compensation was primarily due to accrued bonuses payable at the end of fiscal 2017 as compared to the end of fiscal 2016. Other liabilities decreased primarily due to deferred income recorded in fiscal 2016 and recognized in fiscal 2017 from municipality reimbursements for infrastructure costs and development fees related to work performed under a bond issuance in one of our communities in the West. This decrease was partially offset by an increase in deferred income related to the delay of home closings associated with the Weyerhaeuser-manufacture I-joist issue, discussed previously in Management’s Discussion and Analysis of Financial Condition and Results of Operations. Customers’ deposits decreased $3.7 million to $33.8 million at October 31, 2017. The decrease was primarily related to the decrease in backlog during the period. Liabilities from inventory not owned decreased $59.1 million to $91.1 million at October 31, 2017. The decrease was due a decrease in land banking transactions during the period, along with a decrease in the sale and leaseback of certain model homes, both of which are accounted for as financing transactions as described above. Financial services (liabilities) decreased $30.5 million from $172.4 million at October 31, 2016, to $141.9 million at October 31, 2017. The decrease is primarily due to the decrease in our mortgage warehouse lines of credit, and correlates to the decrease in the volume of mortgage loans held for sale during the period as discussed above. Accrued interest increased $9.4 million to $41.8 million at October 31, 2017. The increase was primarily due to a combination of the timing of interest payments and higher interest rates on our 10.0% 2022 Notes and 10.5% 2024 Notes issued in July 2017. Results of Operations Total Revenues Compared to the prior period, revenues increased (decreased) as follows: Homebuilding Sale of homes revenues decreased $260.8 million, or 10.0%, for the year ended October 31, 2017, increased $512.7 million, or 24.6%, for the year ended October 31, 2016 and increased $75.1 million, or 3.7%, for the year ended October 31, 2015 as compared to the same period of the prior year. The decreased revenues in fiscal 2017 were primarily due to the number of home deliveries decreasing 13.3%, partially offset by the average price per home increasing to $417,714 in fiscal 2017 from $402,350 in fiscal 2016. The decrease in deliveries is primarily the result of a reduction in community count by 22.2%. The increased revenues in fiscal 2016 were primarily due to the 17.4% increase in deliveries, as well as the average price per home increasing to $402,350 in fiscal 2016 from $379,177 in fiscal 2015. The increased revenues in fiscal 2015 were primarily due to the average price per home increasing to $379,177 in fiscal 2015 from $366,202 in fiscal 2014. For fiscal 2017, the fluctuations in average prices were primarily the result of the geographic and community mix of our deliveries, along with our ability to raise home prices in certain communities. For fiscal 2016 and 2015, the fluctuations in average prices were primarily a result of the geographic and community mix of our deliveries, as opposed to home price increases (which we increase or decrease in communities depending on the respective community’s performance). For further detail on changes in segment revenues see “Homebuilding Operations by Segment” below. For further detail on land sales and other revenue, see the section titled “Land Sales and Other Revenues” below. Information on homes delivered by segment is set forth below: (1) Represents housing revenue and home deliveries for our unconsolidated homebuilding joint ventures for the period. We provide this data as a supplement to our consolidated results as an indicator of the volume managed in our unconsolidated joint ventures. See Note 20 to the Consolidated Financial Statements for a further discussion of our joint ventures. The decrease in housing revenues during year ended October 31, 2017, as compared to year ended October 31, 2016, was primarily attributed to our decreased deliveries, partially offset by an increase in average sales price. Housing revenues in fiscal 2017 decreased in all of our homebuilding segments combined by 10.0%, while average sales price increased by 3.8%, excluding joint ventures. In our homebuilding segments, homes delivered decreased in fiscal 2017 as compared to fiscal 2016 by 37.0%, 10.8%, 30.5% and 14.3% in the Northeast, Mid-Atlantic, Midwest and Southwest, respectively, and increased by 5.7% and 12.8% in the Southeast and West, respectively. Overall in fiscal 2017 as compared to fiscal 2016 homes delivered decreased 13.3% across all our segments, excluding unconsolidated joint ventures. The increase in housing revenues during year ended October 31, 2016, as compared to year ended October 31, 2015, was primarily attributed to our increased deliveries, along with an increase in average sales price. Housing revenues and average sales prices in fiscal 2016 increased in all of our homebuilding segments combined by 24.6% and 6.1%, respectively, excluding joint ventures. In our homebuilding segments, homes delivered increased in fiscal 2016 as compared to fiscal 2015 by 46.6%, 12.4%, 21.5% and 84.4% in the Northeast, Mid-Atlantic, Southwest and West, respectively, and decreased by 3.9% and 13.9% in the Midwest and Southeast, respectively. Overall in fiscal 2016 as compared to fiscal 2015 homes delivered increased 17.4% across all our segments, excluding unconsolidated joint ventures. Quarterly housing revenues and net sales contracts by segment, excluding unconsolidated joint ventures, for the years ended October 31, 2017, 2016 and 2015 are set forth below (Net contracts are defined as new contracts executed during the period for the purchase of homes, less cancellations of contracts in the same period): (1) The Midwest net contracts include $1.9 million, $7.1 million and $18.4 million, respectively, for the quarters ended July 31, 2016, April 30, 2016 and January 31, 2016, from Minneapolis, Minnesota. (2) The Southeast net contracts include $9.9 million and $21.7 million, respectively, for the quarters ended April 30, 2016 and January 31, 2016, from Raleigh, North Carolina. (1) The Midwest net contracts include $23.0 million, $21.8 million, $31.6 million and $21.8 million, respectively, for the quarters ended October 31, 2015, July 31, 2015, April 30, 2015 and January 31, 2015, from Minneapolis, Minnesota. (2) The Southeast net contracts include $12.2 million, $7.8 million, $12.5 million and $9.9 million, respectively, for the quarters ended October 31, 2015, July 31, 2015, April 30, 2015 and January 31, 2015, from Raleigh, North Carolina. Contracts per average active selling community in fiscal 2017 were 35.1 compared to fiscal 2016 of 31.3. Our reported level of sales contracts (net of cancellations) has been impacted by an increase in the pace of sales in most of the Company’s segments during fiscal 2017. Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures: Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of the beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures. Most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of a buyer's failure to qualify for a mortgage, which generally occurs during the first few weeks after signing. As shown in the tables above, the contract cancellations over the past several years have been within what we believe to be a normal range. However, market conditions remain uncertain and it is difficult to predict what cancellation rates will be in the future. An important indicator of our future results is recently signed contracts and our home contract backlog for future deliveries. Our consolidated contract backlog, excluding unconsolidated joint ventures, by segment is set forth below: (1) The Midwest contract backlog as of October 31, 2016 reflects the reduction of 64 homes and $24.1 million related to the sale of our land portfolio in Minneapolis, Minnesota. (2) The Southeast contract backlog as of October 31, 2016 reflects the reduction of 67 homes and $33.7 million related to the sale of our land portfolio in Raleigh, North Carolina. (3) Contract backlog as of October 31, 2016 excluded 9 homes that were sold to one of our joint ventures at the time of the joint venture formation. Contract backlog dollars decreased 24.4% as of October 31, 2017 compared to October 31, 2016, and the number of homes in backlog decreased 17.3% for the same period. The decrease in backlog was driven by a 14.9% decrease in net contracts and the decrease in community count for the year ended October 31, 2017 compared to the prior fiscal year. In the month of November 2017, excluding unconsolidated joint ventures, we signed an additional 350 net contracts amounting to $131.0 million in contract value. Total cost of sales on our Consolidated Statements of Operations includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as “land charges” in the tables below). A breakout of such expenses for housing sales and homebuilding gross margin is set forth below. Homebuilding gross margin before cost of sales interest expense and land charges is a non-GAAP financial measure. This measure should not be considered as an alternative to homebuilding gross margin determined in accordance with GAAP as an indicator of operating performance. Management believes this non-GAAP measure provides investors another way to understand our operating performance. This measure is also useful internally, helping management evaluate our operating results on a consolidated basis and relative to other companies in our industry. In particular, the magnitude and volatility of land charges for the Company, and for other homebuilders, have been significant and, as such, have made financial analysis of our industry more difficult. Homebuilding metrics excluding land charges, as well as interest amortized to cost of sales, and other similar presentations prepared by analysts and other companies are frequently used to assist investors in understanding and comparing the operating characteristics of homebuilding activities by eliminating many of the differences in companies’ respective level of impairments and levels of debt. Cost of sales expenses as a percentage of consolidated home sales revenues are presented below: We sell a variety of home types in various communities, each yielding a different gross margin. As a result, depending on the mix of communities delivering homes, consolidated gross margin may fluctuate up or down. Total homebuilding gross margin percentage increased to 13.2% for the year ended October 31, 2017 compared to 12.2% for the same period last year. This increase was primarily attributed to the mix of communities delivering homes and the reduction of our warranty reserves, as a result of our annual analysis performed in the fourth quarter of each year. Additionally, there was a decrease in land charges compared to the prior year because of the impairments recorded in the prior year, which related to the sale of our land portfolio in Minneapolis, Minnesota. Total homebuilding gross margin percentage decreased to 12.2% for the year ended October 31, 2016 compared to 14.1% for fiscal 2015. We have experienced higher land and development costs as a percentage of sale of homes revenue in certain of our new communities delivering in fiscal 2016 compared to the same period last year, as well as higher construction costs in many of our markets, which resulted in a decrease in gross margin percentage for fiscal 2016 compared to fiscal 2015. For the years ended October 31, 2017, 2016 and 2015, gross margin was favorably impacted by the reversal of prior period inventory impairments of $74.4 million, $57.9 million and $35.6 million, respectively, which represented 3.2%, 2.2% and 1.7%, respectively, of “Sale of homes” revenue. Reflected as inventory impairment loss and land option write-offs in cost of sales (“land charges”), we have written off or written down certain inventories totaling $17.8 million, $33.4 million and $12.0 million during the years ended October 31, 2017, 2016 and 2015, respectively, to their estimated fair value. See Note 12 to the Consolidated Financial Statements for an additional discussion. During the years ended October 31, 2017, 2016 and 2015, we wrote off residential land options and approval and engineering costs totaling $2.7 million, $8.9 million and $4.7 million, respectively, which are included in the total land charges mentioned above. Option, approval and engineering costs are written off when a community’s pro forma profitability is not projected to produce adequate returns on the investment commensurate with the risk and when we believe it is probable we will cancel the option, or when a community is redesigned engineering costs related to the initial design are written off. Such write-offs were located in all segments in fiscal 2017, 2016 and 2015. The inventory impairments amounted to $15.1 million, $24.5 million and $7.3 million for the years ended October 31, 2017, 2016 and 2015, respectively. The impairments recorded in fiscal 2017 were related to two communities in the Northeast, one community in the Mid-Atlantic, two communities in the Midwest, three communities in the Southeast and two communities in the West. The amount of inventory impairments recorded in fiscal 2016 was higher than the previous several years, primarily due to the land sales in the Midwest in fiscal 2016 related to our exit of the Minneapolis, Minnesota market, as previously discussed, along with certain land held for sale in the Northeast. It is difficult to predict impairment levels, and should it become necessary or desirable to have additional land sales, further lower prices, or should the estimates or expectations used in determining estimated cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. Below is a breakdown of our lot option walk-aways and impairments by segment for fiscal 2017. In fiscal 2017, we walked away from 22.0% of all the lots we controlled under option contracts. The remaining 78.0% of our option lots are in communities that we believe remain economically feasible. The following table represents lot option walk-aways by segment for the year ended October 31, 2017: (1) Includes lots optioned at October 31, 2017 and lots optioned that the Company walked away from in the year ended October 31, 2017. The following table represents impairments by segment for the year ended October 31, 2017: (1) Represents carrying value, net of prior period impairments, if any, at the time of recording the applicable period’s impairments. Land Sales and Other Revenues Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below: Land sales are ancillary to our residential homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. Although we budget land sales, they are often dependent upon receiving approvals and entitlements, the timing of which can be uncertain. As a result, projecting the amount and timing of land sales is difficult. There were ten land sales in the year ended October 31, 2017, compared to 26 in the same period of the prior year, resulting in a $27.4 million decrease in land sales revenue. This decrease was primarily due to the sale of six land parcels in the Midwest and ten land parcels in the Southeast in the third quarter of fiscal 2016 in connection with our previously discussed strategy to exit the Minneapolis, Minnesota and Raleigh, North Carolina markets. As discussed, there were 26 land sales in the year ended October 31, 2016, compared to only three in the year ended October 31, 2015. Land sales and other revenues decreased $26.0 million for the year ended October 31, 2017, and increased $75.2 million for the year ended October 31, 2016 compared to the same periods in the prior year. Other revenues include income from contract cancellations where the deposit has been forfeited due to contract terminations, interest income, cash discounts and miscellaneous one-time receipts. The decrease from fiscal 2016 to fiscal 2017 and the increase from fiscal 2015 to fiscal 2016 was mainly due to the fluctuations in land sales revenue noted above. Homebuilding Selling, General and Administrative Homebuilding selling, general and administrative (“SGA”) expenses increased $3.4 million to $196.3 million for the year ended October 31, 2017 as compared to the year ended October 31, 2016. The increase was primarily due to a $12.5 million adjustment in the fourth quarter of fiscal 2017 in our construction defect reserves related to litigation. Excluding this adjustment, SGA expenses decreased $9.1 million to $183.8 million for the year ended October 31, 2017 as compared to the year ended October 31, 2016. The decrease was mainly due to our decision to exit four markets during 2016, the reduction of our community count and the increase of joint venture management fees received, which offset general and administrative expenses, as a result of more joint venture deliveries. SGA increased $4.5 million to $192.9 million for the year ended October 31, 2016 compared to the year ended October 31, 2015. This increase was mainly due to increases in sales and other compensation related to increased headcount and increased compensation reflective of the competitive homebuilding market, increased advertising costs related to community count growth that occurred at the end of fiscal 2015 and higher bonus expense due to higher profits in certain markets. These increases were partially offset by the decrease of $3.7 million from the impact of our exit from the Minneapolis, Minnesota and Raleigh, North Carolina markets during the third quarter of fiscal 2016 and a decrease in insurance reserves of $9.2 million, as a result of our annual actuarial analysis of estimated construction defect costs on previously delivered homes, as discussed further in Note 16 to the Consolidated Financial Statements. Homebuilding Operations by Segment Financial information relating to the Company’s operations was as follows: Segment Analysis (Dollars in thousands, except average sales price) Homebuilding Results by Segment Northeast - Homebuilding revenues decreased 24.6% in fiscal 2017 compared to fiscal 2016 primarily due to a 37.0% decrease in homes delivered and a 3.5% decrease in average selling price. The decrease in average sales price was the result of new communities delivering lower priced townhomes and single family homes in lower-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had higher priced townhomes and single family homes in higher-end submarkets of the segment in fiscal 2016. Loss before income taxes decreased $6.2 million to income of $2.3 million, which was mainly due a $38.9 million increase in land sales and other revenue, a $7.3 million decrease in inventory impairment loss and land option write-offs and a $4.5 million decrease in selling, general and administrative costs, partially offset by the decrease in homebuilding revenues discussed above. Additionally, the gross margin percentage before interest expense was flat for fiscal 2017 compared to fiscal 2016. Homebuilding revenues increased 46.7% in fiscal 2016 compared to fiscal 2015 primarily due to a 46.6% increase in homes delivered and a $3.5 million increase in land sales and other revenue, partially offset by a 1.1% decrease in average selling price. The decrease in average sales price was the result of new communities delivering lower priced townhomes and single family homes in lower-end submarkets of the segment in fiscal 2016 compared to some communities that are no longer delivering that had higher priced single family homes in higher-end submarkets of the segment in fiscal 2015. Loss before income taxes decreased $3.9 million to a loss of $3.9 million, which was mainly due to the increase in homebuilding revenues discussed above and a $4.0 million decrease in selling, general and administrative costs. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2016 compared to fiscal 2015. Mid-Atlantic - Homebuilding revenues increased 1.2% in fiscal 2017 compared to fiscal 2016 primarily due to a 13.5% increase in average sales price, partially offset by a 10.8% decrease in homes delivered. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had lower priced, entry-level single family homes in lower-end submarkets of the segment in fiscal 2016. The increase in average sales price was also impacted by our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. This increase had a minimal impact on our gross margin percentage as it was partially offset by higher construction costs we experienced during the same period. Income before income taxes decreased $0.3 million to $17.2 million, due mainly to a $0.8 million increase in selling, general and administrative costs and a $1.3 million increase in inventory impairment loss and land option write-offs, partially offset by the increase in homebuilding revenues discussed above and a $1.2 million increase in income from unconsolidated joint ventures. Additionally, the gross margin percentage before interest expense was flat for fiscal 2017 compared to fiscal 2016. Homebuilding revenues increased 14.8% in fiscal 2016 compared to fiscal 2015 primarily due to a 12.4% increase in homes delivered and a 2.3% increase in average sales price. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2016 compared to some communities that are no longer delivering that had lower priced townhomes and single family homes in lower-end submarkets of the segment in fiscal 2015. Income before income taxes decreased $4.0 million to $17.4 million, due mainly to a $4.5 million decrease in income from unconsolidated joint ventures. Additionally, the gross margin percentage before interest expense was relatively flat for fiscal 2016 compared to fiscal 2015. Midwest - Homebuilding revenues decreased 35.8% in fiscal 2017 compared to fiscal 2016. There was a 30.5% decrease in homes delivered and a 0.4% decrease in average sales price. The decrease in average sales price was the result of less deliveries and home sales revenue for the segment due to our decision to exit the Minneapolis, Minnesota market in fiscal 2016, which had higher priced, single family homes delivering compared to the lower priced, single family homes delivering for the remaining markets in the segment. Also impacting the decrease was a $23.1 million decrease in land sales and other revenue due to the sale of our land portfolio in our Minneapolis, Minnesota division in fiscal 2016. Loss before income taxes decreased $10.3 million to a loss of $1.2 million. The decrease in loss was primarily due to a $14.3 million decrease in inventory impairment loss and land option write-offs relating to our land portfolio sold in our Minneapolis, Minnesota division, a $5.7 million decrease in selling, general and administrative costs and a slight increase in gross margin percentage before interest expense. Homebuilding revenues were essentially flat for fiscal 2016 compared to fiscal 2015. There was a 3.9% decrease in homes delivered and a 4.0% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced single family homes in lower-end submarkets of the segment in fiscal 2016 compared to some communities that are no longer delivering that had higher priced single family homes in higher-end submarkets of the segment in fiscal 2015. These decreases were partially offset by a $23.8 million increase in land sales and other revenue due primarily to the sale of our land portfolio in our Minneapolis, Minnesota division. Income before income taxes decreased $25.4 million to a loss of $11.4 million. The decrease in income was primarily due to a $12.9 million increase in inventory impairment loss and land option write-offs relating to our land portfolio sold in our Minneapolis, Minnesota division, a $1.2 million decrease in income from unconsolidated joint ventures and a decrease in gross margin percentage before interest expense. Southeast - Homebuilding revenues decreased 0.1% in fiscal 2017 compared to fiscal 2016. The decrease was primarily due to a $42.7 million decrease in land sales and other revenue due to the sale of our land portfolio in our Raleigh, North Carolina division during fiscal 2016, partially offset by 13.4% increase in average sales price and a 5.7% increase in homes delivered. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had lower priced, townhomes and single family homes in lower-end and submarkets of the segment in fiscal 2016. The increase in average sales price was also impacted by our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. This increase had a minimal impact on our gross margin percentage as it was partially offset by higher construction costs we experienced during the same period. Loss before income taxes decreased $11.6 million to a loss of $6.2 million due to a $6.8 million decrease in selling, general and administrative costs and a $2.6 million increase in income from unconsolidated joint ventures, while gross margin percentage before interest expense remained flat. This decrease in loss was partially offset by the decrease in land sales and other revenue noted above and a $5.6 million increase in inventory impairment loss and land option write-offs. Homebuilding revenues increased 25.5% in fiscal 2016 compared to fiscal 2015. The increase was primarily due to a 20.2% increase in average sales price, partially offset by a 13.9% decrease in homes delivered. In addition, there was a $45.7 million increase in land sales and other revenue mainly due to the sale of our land portfolio in our Raleigh, North Carolina division during the period. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2016 compared to some communities that are no longer delivering that had lower priced single family homes in lower-end and submarkets of the segment in fiscal 2015. Loss before income taxes increased $11.5 million to a loss of $17.8 million due to a $3.2 million increase in selling, general and administrative costs, a $3.0 million decrease in income from unconsolidated joint ventures and a slight decrease in gross margin percentage before interest expense. Southwest - Homebuilding revenues decreased 19.5% in fiscal 2017 compared to fiscal 2016 primarily due to a 14.3% decrease in homes delivered, a 5.9% decrease in average sales price and a $3.0 million decrease in land sales and other revenue. The decrease in average sales price was the result of new communities delivering lower priced, single family homes in lower-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had higher priced, single family homes in higher-end submarkets of the segment in fiscal 2016. The decrease in average sales price was partially offset our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. This increase had a minimal impact on our gross margin percentage as it was partially offset by higher construction costs we have been experienced during the same period. Income before income taxes decreased $12.9 million to $71.5 million in fiscal 2017 mainly due to the decrease in homebuilding revenues discussed above, partially offset by a $1.5 million decrease in selling, general and administrative costs and a $2.8 million decrease in inventory impairment loss and land option write-offs. Additionally, the gross margin percentage before interest expense was flat for fiscal 2017 compared to fiscal 2016. Homebuilding revenues increased 24.8% in fiscal 2016 compared to fiscal 2015 primarily due to a 21.5% increase in homes delivered, a 2.5% increase in average sales price and a $2.6 million increase in land sales and other revenue. The increase in average sales price was the result of new communities delivering higher priced, townhomes and larger single family homes in higher-end submarkets of the segment in fiscal 2016 compared to some communities that are no longer delivering that had lower priced, single family homes in lower-end and submarkets of the segment in fiscal 2015. Income before income taxes increased $17.0 million to $84.4 million in fiscal 2016 mainly due to the increase in homebuilding revenues discussed above. West - Homebuilding revenues increased 25.7% in fiscal 2017 compared to fiscal 2016 primarily due to a 12.8% increase in homes delivered and a 10.7% increase in average sales price. The increase in average sales price was the result of our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. In addition, there was a $2.9 million increase in land sales and other revenue for fiscal 2017 compares to fiscal 2016. Income before income taxes increased $16.2 million to $19.6 million in fiscal 2017 due mainly to the increase in homebuilding revenues discussed above, a $2.9 million decrease in selling, general and administrative costs and a slight increase in gross margin percentage before interest expense. This increase in income was partially offset by a $4.4 million decrease in income from unconsolidated joint ventures and a $1.9 million increase in inventory impairment loss and land option write-offs. Homebuilding revenues increased 114.1% in fiscal 2016 compared to fiscal 2015 primarily due to an 84.4% increase in homes delivered, mainly resulting from increased community count, as well as a 16.2% increase in average sales price. The increase in average sales price was the result of our ability to raise prices in certain communities that were delivering homes during both periods. Loss before income taxes decreased $20.6 million to income of $3.4 million in fiscal 2016 due mainly to the increase in homebuilding revenues discussed above, a $1.9 million decrease in inventory impairment loss and land option write-offs and an increase in gross margin percentage before interest expense. This decrease in loss was partially offset by a $3.6 million increase in selling, general and administrative costs. Financial Services Financial services consist primarily of originating mortgages from our home buyers, selling such mortgages in the secondary market, and title insurance activities. We use mandatory investor commitments and forward sales of MBS to hedge our mortgage-related interest rate exposure on agency and government loans. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments and loan sales transactions is managed by limiting our counterparties to investment banks, federally regulated bank affiliates and other investors meeting our credit standards. Our risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments. For the years ended October 31, 2017, 2016 and 2015, FHA/VA loans represented 25.1%, 25.5%, and 27.1%, respectively, of our total loans. While the origination of FHA/VA loans have decreased over the last three fiscal years, our conforming conventional loan originations as a percentage of our total loans increased from 69.2% for fiscal 2015 to 69.6% for fiscal 2016 and decreased slightly to 69.0% for fiscal 2017. The remaining 5.9%, 4.9% and 3.7% of our loan originations represent USDA and/or jumbo loans. Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer of the mortgage and the sales price is collected. During the years ended October 31, 2017, 2016, and 2015, financial services provided a $26.4 million, $35.5 million and $24.7 million pretax profit, respectively. In fiscal 2017, financial services pretax profit decreased $9.1 million due to the decrease in the homebuilding deliveries, along with a decrease in the average price of loans settled. In fiscal 2016, financial services pretax profit increased $10.8 million compared to fiscal 2015 due to the increase in homebuilding deliveries, along with an increase in the average price of loans settled. In the market areas served by our wholly owned mortgage banking subsidiaries, 67.8%, 67.3%, and 73.4% of our noncash home buyers obtained mortgages originated by these subsidiaries during the years ended October 31, 2017, 2016, and 2015, respectively. Additionally, approximately 77% and 75%, excluding cash homebuyers and mortgages which we do not originate, obtained mortgages originated by these subsidiaries in fiscal 2016 and 2015. Servicing rights on new mortgages originated by us are sold with the loans. Corporate General and Administrative Corporate general and administrative expenses include the operations at our headquarters in Red Bank, New Jersey. These expenses include payroll, stock compensation, facility and other costs associated with our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services and administration of insurance, quality and safety. Corporate general and administrative expenses decreased $0.8 million for the year ended October 31, 2017 compared to the year ended October 31, 2016, and decreased $2.4 million for the year ended October 31, 2016 compared to the year ended October 31, 2015. The minor decrease in expense for 2017 was due mainly to the reversal of previously recognized expense for certain performance based stock compensation plans for which certain requirements are not expected to be satisfied, partially offset by the increase from an adjustment to reserves for self-insured medical claims that were reduced based on claim estimates that occurred in the prior year and which did not recur in 2017. The decrease in expense for fiscal 2016 was due mainly to the reversal of previously recognized expense for certain performance based stock grants for which the performance metrics are no longer expected to be satisfied, along with a decrease in stock compensation expense resulting from lower fair values on our more recent grants. Other Interest Other interest increased $6.3 million to $97.3 million for the year ended October 31, 2017 compared to October 31, 2016, but decreased $0.8 million to $91.0 million for the year ended October 31, 2016 compared to October 31, 2015. Our assets that qualify for interest capitalization (inventory under development) are less than our debt, and therefore a portion of interest not covered by qualifying assets must be directly expensed. In fiscal 2017, the increase can be attributed to the full year of interest from our senior secured term loan compared to one month in the prior year, as well as the higher interest rate on our secured debt that was refinanced in July 2017. In fiscal 2016, the slight decrease was attributed to the reduction in total notes payable as a result of debt maturities that occurred over the course of the year, offset by the increase in land banking transactions during the year. Other Operations Other operations consist of rent expense for commercial office space and amortization of prepaid bond fees. Compared to the previous year, other operations decreased $3.4 million to $1.5 million for the year ended October 31, 2017, and decreased $1.1 million to $4.9 million for the year ended October 31, 2016. The decrease in other operations for the year ended October 31, 2017 compared to the prior year is due amortizing bond fees to interest expense instead of amortizing them to other expense as a result of implementing ASU 2015-03 during fiscal 2017. The decrease in other operations for the year ended October 31, 2016 compared to the prior year was due to decreased prepaid bond fees amortization as a result of the maturity of our 11.875% Senior Notes due October 2015, 6.25% Senior Notes due January 2016 and 7.5% Senior Notes due May 2016. Loss on Extinguishment of Debt We incurred a $34.9 million loss on extinguishment of debt during the year ended October 31, 2017. This was due to three items that occurred during fiscal 2017. First, we repurchased in open market transactions $17.5 million aggregate principal amount of 7.0% Notes, $14.0 million aggregate principal amount of 8.0% Notes and 6,925 senior exchangeable note units representing $6.9 million stated amount of senior exchangeable note units. The aggregate purchase price for these transactions was $30.8 million, plus accrued and unpaid interest. These transactions resulted in a gain on extinguishment of debt of $7.8 million. Second, we incurred $0.4 million of costs associated with the 9.50% 2020 Notes issued during the fourth quarter of fiscal 2016. Third, we issued $440.0 million aggregate principal amount of 10.0% 2022 Notes and $400.0 million aggregate principal amount of 10.5% 2024 Notes. The net proceeds from these issuances together with available cash were used to (i) purchase $575,912,000 principal amount of 7.25% First Lien Notes, $87,321,000 principal amount of 9.125% Second Lien Notes and all $75,000,000 principal amount of 10.0% Second Lien Notes that were tendered and accepted for purchase pursuant to the Tender Offers and to pay related tender premiums and accrued and unpaid interest thereon to the date of purchase and (ii) satisfy and discharge all obligations (and cause the release of the liens on the collateral securing such indebtedness) under the indentures under which the 7.25% First Lien Notes, the 9.125% Second Lien Notes and the 10.0% Second Lien Notes were issued and in connection therewith to call for redemption on October 15, 2017 and on November 15, 2017 all remaining $1,088,000 principal amount of 7.25% First Lien Notes and all remaining $57,679,000 principal amount of 9.125% Second Lien Notes, respectively, that were not validly tendered and purchased in the applicable Tender Offer in accordance with the redemption provisions of the indentures governing the 2020 Secured Notes. These transactions resulted in a loss on extinguishment of debt of $42.3 million. We incurred a $3.2 million loss on extinguishment of debt for the year ended October 31, 2016, due to the redemption of the remaining outstanding principal amount of our 8.625% Senior Notes due 2017 and the exchange of a portion of our Existing Second Lien Notes for Exchange Notes. These losses were slightly offset by a gain from the purchase of 20,823 6.0% Exchangeable Note Units due December 2017. We did not incur any loss on the extinguishment of debt for the year ended October 31, 2015. (Loss) Income from Unconsolidated Joint Ventures (Loss) income from unconsolidated joint ventures consists of our share of the earnings or losses of our joint ventures. Loss from unconsolidated joint ventures increased $2.7 million for the year ended October 31, 2017 from a loss of $4.3 million for the year ended October 31, 2016 to a loss of $7.0 million. The increase in loss is due to the recognition of our share of losses on our newly formed joint ventures, some of which have not delivered any homes, and the write-off of our investment on a joint venture that has delivered its last home during fiscal 2017 and we have determined that for which we will not receive any future distributions. Income from unconsolidated joint ventures decreased $8.5 million for the year ended October 31, 2016 from income of $4.2 million for the year ended October 31, 2015 to a loss of $4.3 million for the year ended October 31, 2016. The decrease in income to a loss was mainly due to fewer deliveries at certain of our joint ventures and recognition of our share of losses on our newly formed joint ventures that have not yet begun delivering homes. Total Taxes The total income tax expense of $286.9 million for the period ended October 31, 2017 was primarily due to increasing our valuation allowance to fully reserve against our deferred tax assets (“DTAs”). In addition, this period was also impacted by state tax expense from income generated in some states, which was not offset by tax benefits in other states that had losses for which we fully reserve the net operating losses. The total income tax expense of $5.3 million for the period ended October 31, 2016 was primarily due to current state taxes and permanent differences related to stock compensation, partially offset by a federal tax benefit related to receiving a specified liability loss refund of taxes paid in fiscal year 2002. The total income tax benefit of $5.7 million recognized for the year ended October 31, 2015 was primarily due to deferred taxes resulting from the loss before income taxes plus the reversal of state tax reserves for uncertain state tax positions, partially offset by state tax expenses. Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from net operating loss carryforwards and temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. If the combination of future years’ income (or loss) and the reversal of the timing differences results in a loss, such losses can be carried forward to future years. In accordance with ASC 740, we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more likely than not” standard. As of October 31, 2017, we considered all available positive and negative evidence to determine whether, based on the weight of that evidence, an adjustment to our valuation allowance for our DTAs was necessary in accordance with ASC 740. As listed in Note 11 to the Consolidated Financial Statements, in order of the weighting of each factor, is the available positive and negative evidence that we considered in determining that it is more likely than not that all of our DTAs will not be realized. In analyzing these factors, overall the negative evidence, both objective and subjective, outweighed the positive evidence. Based on this analysis, we increased the valuation allowance against our DTAs such that we have a full valuation allowance and determined that the current valuation allowance for deferred taxes of $918.2 million as of October 31, 2017 is appropriate. Off-Balance Sheet Financing In the ordinary course of business, we enter into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Lot option contracts enable us to control significant lot positions with a minimal capital investment and substantially reduce the risks associated with land ownership and development. At October 31, 2017, we had $57.1 million in option deposits in cash and letters of credit to purchase land and lots with a total purchase price of $1.0 billion. Our financial exposure is generally limited to forfeiture of the nonrefundable deposits, letters of credit and other nonrefundable amounts incurred. We have no material third-party guarantees. Contractual Obligations The following summarizes our aggregate contractual commitments at October 31, 2017. (1) Total contractual obligations exclude our accrual for uncertain tax positions of $1.4 million recorded for financial reporting purposes as of October 31, 2017 because we were unable to make reasonable estimates as to the period of cash settlement with the respective taxing authorities. (2) Represents our revolving credit facility, senior secured term loan, senior secured, senior, senior amortizing and senior exchangeable notes, and other notes payable and $604.8 million of related interest payments for the life of such debt. (3) Does not include $64.5 million of nonrecourse mortgages secured by inventory. These mortgages have various maturities spread over the next two to three years and are paid off as homes are delivered. (4) Does not include the mortgage warehouse lines of credit made under our Master Repurchase Agreements. See“- Capital Resources and Liquidity.” Also does not include $14.6 million of letters of credit issued as of October 31, 2017 under our $75.0 million revolving Credit Facility. (5) Represents obligations under option contracts with specific performance provisions, net of cash deposits. We had outstanding letters of credit and performance bonds of $16.3 million and $199.5 million, respectively, at October 31, 2017, related principally to our obligations to local governments to construct roads and other improvements in various developments. We do not believe that any such letters of credit or bonds are likely to be drawn upon. Inflation Inflation has a long-term effect, because increasing costs of land, materials and labor result in increasing sale prices of our homes. In general, these price increases have been commensurate with the general rate of inflation in our housing markets and have not had a significant adverse effect on the sale of our homes. A significant risk faced by the housing industry generally is that rising house construction costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers and therefore limit our ability to raise home sale prices, which may result in lower gross margins. Inflation has a lesser short-term effect, because we generally negotiate fixed-price contracts with many, but not all, of our subcontractors and material suppliers for the construction of our homes. These prices usually are applicable for a specified number of residential buildings or for a time period of between three to twelve months. Construction costs for residential buildings represent approximately 53% of our homebuilding cost of sales for fiscal 2017. Safe Harbor Statement All statements in this Annual Report on Form 10-K that are not historical facts should be considered as “Forward-Looking Statements” within the meaning of the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include but are not limited to statements related to the Company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements: (i) speak only as of the date they are made, (ii) are not guarantees of future performance or results and (iii) are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as result of a variety of factors. Such risks, uncertainties and other factors include, but are not limited to: ● Changes in general and local economic, industry and business conditions and impacts of a sustained homebuilding downturn; ● Adverse weather and other environmental conditions and natural disasters; ● Levels of indebtedness and restrictions on the Company’s operations and activities imposed by the agreements governing the Company’s outstanding indebtedness; ● The Company’s sources of liquidity; ● Changes in credit ratings; ● Changes in market conditions and seasonality of the Company’s business; ● The availability and cost of suitable land and improved lots; ● Shortages in, and price fluctuations of, raw materials and labor; ● Regional and local economic factors, including dependency on certain sectors of the economy, and employment levels affecting home prices and sales activity in the markets where the Company builds homes; ● Fluctuations in interest rates and the availability of mortgage financing; ● Changes in tax laws affecting the after-tax costs of owning a home; ● Operations through joint ventures with third parties; ● Government regulation, including regulations concerning development of land, the home building, sales and customer financing processes, tax laws and the environment; ● Product liability litigation, warranty claims and claims made by mortgage investors; ● Levels of competition; ● Availability and terms of financing to the Company; ● Successful identification and integration of acquisitions; ● Significant influence of the Company’s controlling stockholders; ● Availability of net operating loss carryforwards; ● Utility shortages and outages or rate fluctuations; ● Geopolitical risks, terrorist acts and other acts of war; ● Increases in cancellations of agreements of sale; ● Loss of key management personnel or failure to attract qualified personnel; ● Information technology failures and data security breaches; and ● Legal claims brought against us and not resolved in our favor. Certain risks, uncertainties and other factors are described in detail in Part I, Item 1 “Business” and Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K as updated by our subsequent filings with the SEC. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Annual Report on Form 10-K.

<s>[INST] Overview During fiscal 2016, we had approximately $260 million of bonds mature, which we were unable to refinance because financing was unavailable in the capital markets to companies with comparable credit ratings to ours. As a result, we shifted our focus from growth to gaining operating efficiencies and improving our bottom line, and in order to preserve and increase cash to fund our maturing debt, we decided to temporarily reduce the amount of cash we were spending on future land acquisitions and to exit from four underperforming markets during fiscal 2016. In addition, we increased our use of land banking and joint ventures in order to enhance our liquidity position. The net effect of these liquidity enhancing efforts was to temporarily reduce our ability to invest as aggressively in new land parcels as previously planned. This resulted in a reduction in our community count in fiscal 2016 and 2017, along with a decrease in net contracts during these periods, as compared to the prior year periods. However, in the fourth quarter of fiscal 2016, we were able to refinance certain of our debt maturities and had homebuilding cash of $339.8 million as of October 31, 2016. In addition, in July 2017, we successfully refinanced and extended the maturities of certain of our senior secured notes which were scheduled to mature in October 2018 and October and November 2020, with $440.0 million of new senior secured notes maturing in July 2022 and $400.0 million of new senior secured notes maturing in July 2024. While these transactions extended the maturities of a significant amount of debt giving us the ability to more fully invest in new communities again, they also resulted in a $42.3 million loss on early extinguishment of debt. When added to prior period results, this created a threeyear cumulative loss, which led us to reconsider the realizability of our deferred tax assets in accordance with GAAP and record a $294.1 million noncash increase in the valuation allowance for our deferred tax assets. See Note 11 to our Consolidated Financial Statements. Our cash position in fiscal 2017 has allowed us to spend $555.0 million on land purchases and land development during fiscal 2017 and still have $463.7 million of homebuilding cash and cash equivalents as of October 31, 2017. This cash and the July 2017 refinancing transaction, by extending our debt maturities, will enable us to allocate additional cash to further grow our business. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales pace and plan to continue actively pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability. The above factors during fiscal 2016 led to a reduction in our land position and a 22.2% decline in our community count for fiscal 2017 as compared to fiscal 2016 and as a result, during fiscal 2017, we experienced mixed operating results compared to the prior year. Net contracts per average active selling community increased 12.1% to 35.1 for the year ended October 31, 2017 compared to 31.3 in the same period in the prior year. This improvement in net contracts per average active selling community demonstrates an increase in sales absorption, which allows us to be more efficient by permitting us to deliver more homes per community without any increase in fixed overheads in those communities. Active selling communities decreased from 167 at October 31, 2016 to 130 at October 31, 2017, and net contracts decreased 14.9% for the year ended October 31, 2017, compared to the same period of the prior year. For the year ended October 31, 2017, sale of homes revenues decreased 10.0% as compared to the same period of the prior year, as a result of [/INST] Positive. </s>